<PAGE>
================================================================================
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER 0-25812
PSINET INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
NEW YORK 16-1353600
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
510 HUNTMAR PARK DRIVE, HERNDON, VA 20170
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICE) (ZIP CODE)
(703) 904-4100
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
NOT APPLICABLE
(FORMER NAME, FORMER ADDRESS AND FORMER FISCAL YEAR, IF CHANGED SINCE LAST
REPORT DATE)
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
--- ---
COMMON STOCK, $.01 PAR VALUE 51,069,663 SHARES AS OF MAY 1, 1998
(INDICATE THE NUMBER OF SHARES OUTSTANDING OF EACH OF THE ISSUER'S CLASSES OF
COMMON STOCK, AS OF THE LATEST PRACTICABLE DATE)
The Index of Exhibits appears on page 21.
================================================================================
<PAGE>
PSINET INC.
TABLE OF CONTENTS
<TABLE>
<CAPTION>
Page
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements:
<S> <C>
Consolidated Balance Sheets as of March 31, 1998 and December 31, 1997.......3
Consolidated Statements of Operations for the three months ended
March 31, 1998 and March 31, 1997.........................................4
Consolidated Statements of Cash Flows for the three months ended
March 31, 1998 and March 31, 1997.........................................5
Notes to Consolidated Financial Statements...................................6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations....................................................9
PART II. OTHER INFORMATION
Item 2. Changes in Securities and Use of Proceeds...................................17
Item 4. Submission of Matters to a Vote of Security Holders.........................17
Item 6. Exhibits and Reports on Form 8-K............................................18
Signatures............................................................................20
Exhibit Index.........................................................................21
</TABLE>
<PAGE>
PART I. FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS
PSINET INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
March 31, 1998 December 31, 1997
------------------ ------------------
(Unaudited) (Audited)
(In thousands of U.S. dollars)
ASSETS
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 27,143 $ 33,322
Restricted cash and short-term investments 6,435 20,690
Short-term investments 5,849 -
Accounts receivable, net 18,894 11,022
Notes receivable 7,209 7,224
Prepaid expenses 2,412 1,478
Other current assets 5,609 5,162
------------------ ------------------
Total current assets 73,551 78,898
Property and equipment, net 135,591 95,619
Goodwill and other intangibles, net 20,099 4,675
Other assets and deferred charges 4,063 6,989
------------------ ------------------
Total assets $ 233,304 $ 186,181
================== ==================
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Lines of credit $ 3,818 $ 5,648
Current portion of long-term debt 43,434 33,985
Trade accounts payable 41,321 25,031
Accrued payroll and related expenses 4,208 4,636
Other accounts payable and accrued liabilities 7,915 2,382
Deferred revenue 7,756 5,944
------------------ ------------------
Total current liabilities 108,452 77,626
Long-term debt 74,676 33,820
Other liabilities 1,750 1,306
------------------ ------------------
Total liabilities 184,878 112,752
------------------ ------------------
Shareholders' equity:
Preferred stock - -
Convertible preferred stock 28,315 28,135
Common stock 511 406
Capital in excess of par value 396,753 210,162
Accumulated deficit (192,503) (162,649)
Treasury stock (2,005) (2,005)
Accumulated other comprehensive income 3,330 (620)
Bandwidth asset to be delivered under IRU agreement (185,975) -
------------------ ------------------
Total shareholders' equity 48,426 73,429
------------------ ------------------
Total liabilities and shareholders' equity $ 233,304 $ 186,181
================== ==================
</TABLE>
The accompanying notes are an integral part of these financial statements.
3
<PAGE>
PSINET INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
Three Months Ended March 31,
-------------------------------------------
1998 1997
----------- ------------
(In thousands of U.S. dollars, except per share amounts)
(Unaudited)
<S> <C> <C>
Revenue $ 44,469 $ 25,639
Operating costs and expenses:
Data communications and operations 36,666 20,968
Sales and marketing 10,732 6,002
General and administrative 7,585 5,481
Depreciation and amortization 9,465 8,034
Charge for acquired in-process research and development 7,000 -
----------- ------------
Total operating costs and expenses 71,448 40,485
----------- ------------
Loss from operations (26,979) (14,846)
Interest expense (2,579) (1,350)
Interest income 585 775
Other income (expense) (99) (25)
Gain on sale of subsidiary - 5,701
----------- ------------
Loss before income taxes (29,072) (9,745)
Income tax benefit - 476
----------- ------------
Net loss (29,072) (9,269)
Return to preferred shareholders (782) -
----------- ------------
Net loss to common shareholders $ (29,854) $ (9,269)
=========== ============
Basic and diluted loss per share $ (0.67) $ (0.23)
=========== ============
Shares used in computing basic and diluted loss per share (thousands) 44,596 40,158
=========== ============
</TABLE>
The accompanying notes are an integral part of these financial statements.
4
<PAGE>
PSINET INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
Three Months Ended March 31,
-------------------------------
1998 1997
------------- -----------
(In thousands of U.S. dollars)
(Unaudited)
<S> <C> <C>
Net cash used in operating activities $ (9,970) $ (9,495)
------------- -----------
Cash flows from investing activities:
Purchases of property and equipment, net (6,196) (2,678)
Purchase of short-term investments
and marketable securities (2,205) -
Investments in certain businesses, net of cash acquired (15,971) -
Net proceeds from sale of subsidiary - 20,353
Restricted cash and short-term investments 14,255 -
Other, net 195 19
------------- -----------
Net cash (used in) provided by investing activities (9,922) 17,694
------------- -----------
Cash flows from financing activities:
Net payments on lines of credit (1,828) -
Proceeds from issuance of notes payable 25,000 -
Repayments of notes payable (1,712) (1,591)
Principal payments under capital lease obligations (7,623) (4,241)
Dividends paid to preferred shareholders (940) -
Other, net 720 92
------------- -----------
Net cash provided by (used in) financing activities 13,617 (5,740)
------------- -----------
Effect of exchange rate changes on cash 96 -
Net (decrease) increase in cash and cash equivalents (6,179) 2,459
Cash and cash equivalents, beginning of period 33,322 52,695
------------- -----------
Cash and cash equivalents, end of period $ 27,143 $ 55,154
============= ===========
</TABLE>
The accompanying notes are an integral part of these financial statements.
5
<PAGE>
PSINET INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Note l - Basis of Presentation
These consolidated financial statements for the three months ended March 31,
1998 and 1997 and the related footnote information are unaudited and have been
prepared on a basis substantially consistent with the audited consolidated
financial statements of PSINet Inc. and subsidiaries (collectively, "PSINet" or
the "Company") as of and for the year ended December 31, 1997 included in the
Company's Annual Report on Form 10-K as filed with the Securities and Exchange
Commission (the "Annual Report"). These financial statements should be read in
conjunction with the audited consolidated financial statements and the related
notes to consolidated financial statements of the Company as of and for the year
ended December 31, 1997 included in the Annual Report. In the opinion of
management, the accompanying unaudited financial statements contain all
adjustments (consisting of normal recurring adjustments) which management
considers necessary to present fairly the consolidated financial position of the
Company at March 31, 1998 and the results of its operations and cash flows for
the three month periods ended March 31, 1998 and 1997. The results of operations
for the three month period ended March 31, 1998 may not be indicative of the
results expected for any succeeding quarter or for the entire year ending
December 31, 1998.
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the amounts reported in the financial statements. Actual results may
differ from those estimates.
Note 2 Summary of Significant Accounting Policies
On January 1, 1998, the Company adopted Statement of Financial Accounting
Standards ("SFAS") No. 130, "Reporting Comprehensive Income", which establishes
standards for reporting and displaying comprehensive income, as defined, and its
components. Accumulated other comprehensive income is reported in the
consolidated balance sheets and includes unrealized gain on investments and
cumulative foreign currency translation adjustment. Total comprehensive income
was $(25.1) million and $(9.3) million for the three month periods ended March
31, 1998 and 1997, respectively.
The Company classifies certain of its investment holdings in equity securities
as available-for-sale and reports such investments at fair value, with
unrealized gains and losses included in shareholders' equity as a component of
accumulated other comprehensive income. During the three month period ended
March 31, 1998, the Company purchased equity securities by exercising a warrant.
At March 31, 1998 such investment had an unrealized gain of $3.6 million.
Note 3 - Long-Term Debt
During the three months ended March 31, 1998, the Company incurred capital
lease obligations of $30.9 million upon the execution of leases for new
equipment and other fixed assets.
At March 31, 1998, the aggregate unused portion under the Company's various
financing arrangements for purchases of equipment and other fixed assets was
$28.6 million. The aggregate unused portion of the Company's operating lines of
credit was $0.1 million.
On April 13, 1998, the Company completed its offering of $600.0 million
aggregate principal amount of 10% Senior Notes due 2005. The notes were issued
and sold in accordance with Rule 144A and Regulation S under the Securities Act
of 1933, as amended (the "Securities Act"). The notes are senior unsecured
obligations of the Company ranking equivalent in right of payment to all
existing and future unsecured and unsubordinated indebtedness of the Company and
senior in right of payment to all existing and future subordinated indebtedness
of the Company. The net proceeds of the offering, after deducting discounts and
commissions and expenses payable by the Company, were approximately $580.8
million.
6
<PAGE>
PSINET INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Note 3 - Long-Term Debt (continued)
The Company was required to deposit $138.7 million of such proceeds net proceeds
into an escrow account to be invested in restricted short-term investments to
fund when due the first five semi-annual interest payments. The Company expects
to use the net proceeds to repay certain indebtedness, for capital expenditures,
acquisitions and other working capital needs.
Note 4 Strategic Alliances and Acquisitions
Strategic Alliance with IXC Internet Services, Inc.
- ---------------------------------------------------
On February 25, 1998, the Company acquired from IXC Internet Services, Inc.
("IXC"), an indirect subsidiary of IXC Communications, Inc., 20-year
noncancellable indefeasible rights of use ("IRUs") in up to 10,000 equivalent
route miles of fiber-based OC-48 network bandwidth (the "PSINet IRUs") in
selected portions across the IXC fiber optic telecommunications network within
the United States. The PSINet IRUs were acquired in exchange for 10,229,789
shares of common stock of the Company (the "IXC Initial Shares") pursuant to an
IRU and Stock Purchase Agreement dated as of July 22, 1997 between the Company
and IXC, as amended (the "IRU Purchase Agreement"). The issuance of the IXC
Initial Shares was recorded at $7.6875 per share (the last reported quoted
market price of the Company's common stock on the date of the closing). Such
amount equaled $78,642,000. If the fair market value of the IXC Initial Shares
(based on a 20 trading day volume-weighted average share price) is less than
$240,000,000 at the earlier of one year following delivery and acceptance of the
total amount of bandwidth corresponding to the PSINet IRUs or February 25, 2002
(the "Determination Date"), the Company will be obligated to provide IXC with
additional shares of its common stock, or at the sole option of the Company,
cash or a combination thereof equal to the shortfall (the "Contingent Payment
Obligation"). The Company has the right to accelerate the Contingent Payment
Obligation to any date (the "Acceleration Date") prior to the Determination
Date. In addition, the right of IXC to receive additional shares of common
stock and/or cash pursuant to the Contingent Payment Obligation will terminate
on such date as the fair market value of the IXC Initial Shares (based on a 20
trading day volume-weighted average share price) is equal to or greater than
$240,000,000. At May 1, 1998, the IXC Initial Shares had an aggregate market
value of $141,304,075 based on the closing market price per share of the
Company's common stock on such date of $13.813.
The Contingent Payment Obligation was recorded as capital in excess of par
value based on its fair value of $107,333,000. The fair value of the Contingent
Payment Obligation was determined utilizing a Black-Scholes valuation model
using an assumed term of four years, the closing market price per share of the
common stock on the date of the closing ($7.6875), an exercise price of $23.46
(which is the price per share required in order for the calculation of the IXC
Initial Shares to result in a value equal to $240,000,000), expected volatility
of 76% and an interest rate of 11%. The amount recorded for the fair value of
the Contingent Payment Obligation could be adjusted upward in a future period
under certain circumstances.
The amount representing the aggregate of the fair value of the IXC Initial
Shares and the Contingent Payment Obligation, $185,975,000, has been recorded as
an offset to shareholders' equity similar to a stock subscription receivable.
Such amount will be reduced, and a long-term asset relating to the PSINet IRUs
will be recorded, as each bandwidth unit corresponding to the PSINet IRUs is
accepted by the Company. The Company expects to amortize the capitalized amount
of the asset relating to the PSINet IRUs ratably over the 20-year period during
which the Company has the right to utilize the bandwidth corresponding to the
PSINet IRUs.
The bandwidth corresponding to the PSINet IRUs is contemplated to be delivered
to the Company (to the extent then available) in specified minimum increments
every six months during the two year period
7
<PAGE>
PSINET INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Note 4 Strategic Alliances and Acquisitions (continued)
following the closing. At March 31, 1998, the Company had not taken delivery on
any of the bandwidth. The Company expects to incur on an annual basis
approximately $1,150,000 in operations and maintenance fees with respect to the
PSINet IRUs for each 1,000 equivalent route miles of OC-48 bandwidth accepted
under the agreement. The IRU Purchase Agreement permits the Company to use the
bandwidth acquired from IXC for any purpose in connection with the provision of
Internet services and at a rate of DS-3 or less for non-Internet
telecommunications transport, but restricts the Company from using such
bandwidth to deliver any private line or long distance switched telephone
services (based on non-Internet telephone switching technologies) to any third
party. The Company also signed a long-term non-exclusive joint marketing and
services agreement with IXC pursuant to which each party is entitled to market
the products and services of the other.
iSTAR internet inc.
- -------------------
In February 1998, the Company acquired approximately 80% of the outstanding
common shares of iSTAR internet inc. ("iSTAR"), one of the leading Canadian
providers of Internet services and solutions for businesses, institutions and
individuals, pursuant to a January 6, 1998 offer to purchase all of the
outstanding common shares of iSTAR for cash consideration of Cdn. $0.75 (U.S.
$0.52) per share. The cost of the shares acquired, including transaction costs,
was $13,550,000. The acquisition was accounted for as a purchase business
combination. Accordingly, the purchase price was allocated to assets acquired
and liabilities assumed based on their respective fair values at the acquisition
date, and the results of operations of iSTAR are included in the Company's
financial statements from the date of acquisition. In connection with the
allocation of the purchase price, the Company recorded a charge for acquired in-
process research and development of $7,000,000. The excess of cost over fair
value of the net assets acquired was $8,265,000, which is being amortized over
ten years.
On January 29, 1998, the Company obtained a $20,000,000 acquisition credit
facility from a bank to finance this transaction. This acquisition credit
facility was repaid in April 1998 using a portion of the net proceeds of the
Company's offering of the 10% Senior Notes.
The following presents the Company's unaudited pro forma consolidated income
statement data for the three months ended March 31, 1998 and 1997, as if the
iSTAR acquisition had occurred at the beginning of the periods presented. The
pro forma data are not intended to reflect the results of operations that would
actually have been obtained if the acquisition had occurred at the beginning of
the periods presented.
Three Months Ended
------------------------------------
March 31, 1998 March 31, 1997
-------------- --------------
(in thousands of U.S. dollars, except per share data)
Revenue $ 46,500 $ 32,360
Net loss $(37,587) $(24,897)
Basic and diluted loss per share $ (0.84) $ (0.62)
Internet Prolink S.A.
- ---------------------
In January 1998, the Company acquired all of the issued and outstanding shares
of common stock of Internet Prolink S.A. ("Iprolink"), an Internet service
provider in Switzerland, for approximately $3,500,000 in cash. This transaction
was accounted for as a purchase business combination and, accordingly, the
results of operations are included in the Company's financial statements from
the date of acquisition. The excess of cost over the fair value of the net
assets acquired is being amortized over ten years.
8
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with the accompanying
unaudited Consolidated Financial Statements and associated Notes thereto and the
audited Consolidated Financial Statements, the Notes thereto and Management's
Discussion and Analysis of Financial Condition and Results of Operations of the
Company as of and for the year ended December 31, 1997 included in the
Company's Annual Report on Form 10-K, as filed with the Securities and Exchange
Commission. This discussion includes certain forward-looking statements.
Actual results could differ materially from the forward-looking statements as a
result of a number of factors. For a discussion of the risk factors that could
cause actual results to differ materially from the forward-looking statements,
see "Risk Factors" set forth in Exhibit 99.1 filed herewith and the Company's
other filings with the Securities and Exchange Commission.
GENERAL
PSINet is a leading global facilities-based provider of Internet access
services and related products to businesses. The Company provides dedicated and
dial-up Internet connectivity in 90 of the 100 largest metropolitan statistical
areas in the U.S. and in nine of the 20 largest international telecommunications
markets. The Company also offers Internet protocol ("IP")-based value-added
services and products to businesses, including corporate intranets, Web hosting
and collocation, remote user access, multi-currency electronic commerce and
security services, that enable businesses to maximize utilization of their
corporate networks and the Internet. Additionally, the Company provides network
backbone services to other telecommunications carriers and Internet service
providers ("ISPs") to further exploit its network capacity. To meet the growing
data communications needs of its customers, the Company seeks to continually
expand and enhance its network infrastructure. At March 31, 1998, the Company
served 33,300 business accounts, including 61 ISPs, and connected to more than
400 points of presence ("POPs") in ten countries throughout North America, Asia
and Europe.
The Company owns and operates a technologically advanced, high-speed data
communications network with over 230 POPs located in the U.S. and over 170 POPs
located internationally. Since the commencement of the Company's operations in
1989, the Company has undertaken an extensive program of developing and
expanding its data communications network. In connection with this program, the
Company has made significant investments in telecommunications circuits and
equipment to produce a multi-layered, geographically dispersed, Asynchronous
Transfer Mode ("ATM"), Integrated Services Digital Network ("ISDN"), and
Switched Multimegabit Data Service ("SMDS") compatible frame relay network
specially designed to optimize Internet traffic. The Company also continues to
expand its sales and marketing, customer support, network operations and field
services commitments in support of the expansion of its customer base. These
expansion efforts have caused the Company to experience fluctuations in expenses
from time to time, both in absolute terms and as a percentage of revenue. The
nature and amount of these expenses may continue to fluctuate over time as the
Company continues its growth.
ISSUANCE OF SENIOR NOTES
On April 13, 1998, the Company completed its offering of $600.0 million
aggregate principal amount of 10% Senior Notes due 2005, Series A (the "Initial
Notes"). The Initial Notes were issued and sold in accordance with Rule 144A
and Regulation S under the Securities Act. On May 8, 1998, the Company
commenced an offer to exchange up to an aggregate principal amount of $600.0
million of its new 10% Senior Notes due 2005, Series B (the "Exchange Notes"
and, together with the Initial Notes, the "Notes"), which have been registered
under the Securities Act, for the outstanding Initial Notes, which have not been
registered under the Securities Act. The Exchange Notes will evidence the same
debt as the Initial Notes (which they replace) and will be issued under, and be
entitled to the benefits of, the Indenture dated as of April 13, 1998 between
the Company and Wilmington Trust Company, as Trustee, which governs both the
Initial Notes and the Exchange Notes.
9
<PAGE>
The Notes are senior unsecured obligations of the Company ranking equivalent
in right of payment to all existing and future unsecured and unsubordinated
indebtedness of the Company and senior in right of payment to all existing and
future subordinated indebtedness of the Company.
The Notes will mature on February 15, 2005. Interest on the Notes will be
payable semi-annually on August 15 and February 15 of each year, commencing
August 15, 1998. The Notes will be redeemable at the option of the Company, in
whole or in part, at any time on or after February 15 of 2002, 2003 and 2004 at
105%, 102% and 100% of the principal amount thereof, respectively, in each case,
plus accrued and unpaid interest to the date of redemption. In addition, on or
prior to February 15, 2001, the Company may redeem up to 35% of the original
aggregate principal amount of the Notes at a redemption price of 110% of the
principal amount thereof, plus accrued and unpaid interest to the date of
redemption, with the net cash proceeds of certain public equity offerings or the
sale of stock to one or more strategic investors, provided that at least 65% of
the original aggregate principal amount of the Notes remains outstanding
immediately after such redemption. Upon the occurrence of certain change of
control events, the Company will be required to make an offer to purchase the
Notes at a purchase price equal to 101% of the principal amount thereof, plus
accrued and unpaid interest, if any, to the date of repurchase.
The net proceeds of the offering of the Initial Notes, after deducting
discounts and commissions and expenses payable by the Company, were
approximately $580.8 million. Concurrently with the closing of the offering,
the Company deposited $138.7 million of such net proceeds into an escrow
account, which, together with the proceeds of the investment thereof, will be
sufficient to pay when due the first five semi-annual interest payments on the
Notes. Of the remaining net proceeds of the offering, $20.0 million was used to
repay certain indebtedness incurred to finance the Company's acquisition of
iSTAR and the balance is expected to be used to finance capital expenditures
(including, without limitation, facilities and equipment in connection with the
development and expansion of the Company's domestic and international network)
and working capital requirements (including, without limitation, debt service
obligations) of the Company. In addition, a portion of the net proceeds is
expected to be used to make strategic investments in or acquisitions of
businesses or assets related or complementary to the Company's existing
business.
INTERNATIONAL OPERATIONS
The Company currently has operations in nine international telecommunications
markets including Canada, the United Kingdom, France, Switzerland, Germany, The
Netherlands, Belgium, Italy and Japan.
In February 1998, the Company acquired approximately 80% of the outstanding
common shares of iSTAR, one of the leading Canadian providers of Internet
services and solutions for businesses, institutions and individuals, pursuant to
a January 6, 1998 offer to purchase all of the outstanding common shares of
iSTAR for cash consideration of Cdn. $0.75 (U.S. $0.52) per share. The cost of
the shares acquired, including transaction costs, was $13.6 million. The
acquisition was accounted for as a purchase business combination. Accordingly,
the purchase price was allocated to assets acquired and liabilities assumed
based on their respective fair values at the acquisition date, and the results
of operations of iSTAR are included in the Company's financial statements from
the date of acquisition. In connection with the iSTAR acquisition, the Company
commissioned an independent valuation to allocate the Company's total basis in
iSTAR to the underlying tangible and intangible assets. Such valuation resulted
in the assignment of $7.0 million to acquired in-process research and
development, which was expensed in the first quarter of 1998. The Company
presently is seeking approval of iSTAR's shareholders to increase its ownership
interest in iSTAR to 100%. The Company has sufficient voting power in iSTAR
stock to obtain such approval, subject to certain rights of contestation of
iSTAR's shareholders and other interested parties. The Company estimates that
the cost of increasing its ownership interest in iSTAR will be approximately
$3.1 million plus transaction expenses.
In January 1998, the Company acquired Iprolink, an Internet service provider
in Switzerland, for approximately $3.5 million in cash.
As a result of the foregoing, the Company's revenue from international
operations was $12.6 million for the three months ended March 31, 1998 (28.4% of
consolidated revenue), an increase of 350% from the $2.8 million (10.8% of
consolidated revenue) generated in the three months ended March 31, 1997.
10
<PAGE>
The increase was due both to the effect of these acquisitions and to an increase
in the number of customer accounts.
THREE MONTHS ENDED MARCH 31, 1998 AS COMPARED TO THE THREE MONTHS ENDED MARCH
31, 1997
RESULTS OF OPERATIONS
Revenue. Revenue is derived primarily from the sale of Internet access and
related services to businesses. Revenue increased by 73.4% to $44.5 million for
the three months ended March 31, 1998, from $25.6 million for the three months
ended March 31, 1997. The increase was attributable to a number of factors,
including an increase in the number of business customer and ISP accounts, an
increase in the average annual revenue realized per new customer account and an
increase in sales by the Company's international subsidiaries. The growth was
driven by an expansion of the Company's sales force, by greater public awareness
and utilization of the Internet, and by the acquisition of ISP businesses.
The Company's customer account base increased by 59.3% to 33,300 business
customers at March 31, 1998, including 61 ISPs, from 20,900 business customers,
including 33 ISPs, at March 31, 1997.
Data Communications and Operations. Data communications and operations
expenses consist primarily of leased long distance and local circuit costs as
well as personnel and related operating expenses associated with network
operations, customer support and field service. Data communications and
operations expenses were $36.7 million (82.5% of revenue) for the three months
ended March 31, 1998, an increase of $15.7 million from $21.0 million (81.8% of
revenue) for the three months ended March 31, 1997. The increase in expenses
related principally to increases in (i) leased long distance, dedicated customer
and dial-up circuit costs, (ii) expenditures for additional primary rate
interfaces ("PRIs") to support the growth of the Company's Carrier and ISP
Services business, and (iii) personnel costs resulting from the expansion of the
Company's network operations, customer support and field service staff including
through acquisitions. Circuit costs relating to the Company's new and expanded
POPs and PRIs generally are incurred by the Company in advance of anticipated
growth in the Company's customer base. Although the Company expects that data
communications and operations expenses will continue to increase as the
Company's customer base grows, it anticipates that such expenses will decrease
over time as a percentage of revenue due to decreases in unit costs and
continued increases in network utilization. In particular, the Company
anticipates that costs for data communications and operations as a percentage of
revenue will decrease as the Company accepts delivery of bandwidth from IXC and,
in connection therewith, substitutes this bandwidth for leased circuit
arrangements with IXC as well as with other telecommunications carriers.
Sales and Marketing. Sales and marketing expenses consist primarily of sales
and marketing personnel costs, advertising costs, distribution costs and related
occupancy costs. Sales and marketing expenses were $10.7 million (24.1% of
revenue) for the three months ended March 31, 1998, an increase of $4.7 million
from $6.0 million (23.4% of revenue) for the three months ended March 31, 1997.
The increase resulted principally from costs related to a branding and
advertising campaign. All advertising and marketing costs are expensed in the
period incurred. The Company expects that as a result of continued emphasis on
expanding all of its lines of business and increasing its business customer
base, sales and marketing expenses will continue to grow, primarily with respect
to marketing personnel costs and advertising, but are expected to remain
constant or decrease as a percentage of revenue.
General and Administrative. General and administrative expenses consist
primarily of salaries and occupancy costs for executive, financial, legal and
administrative personnel and provision for uncollectible accounts receivable.
General and administrative expenses were $7.6 million (17.1% of revenue) for the
three months ended March 31, 1998, an increase of $2.1 million from $5.5 million
(21.4% of revenue) for the three months ended March 31, 1997. The increase
resulted from the addition of management staff and related operating expenses
across the organization, including in conjunction with the Company's expansion
outside of the United States, and increases in the provision for doubtful
accounts receivable associated with the growth in revenue.
Depreciation and Amortization. Depreciation and amortization costs were $9.5
million (21.3% of revenue) for the three months ended March 31, 1998, an
increase of $1.5 million from $8.0 million
11
<PAGE>
(31.3% of revenue) for the three months ended March 31, 1997. Depreciation costs
increased due to additional capital expenditures associated with network
infrastructure enhancements but decreased as a percentage of revenue. The
Company anticipates that as the Company accepts delivery of bandwidth from IXC,
and as the operations and assets of companies recently acquired are integrated
with existing operations, the Company's depreciation and amortization expenses
will increase significantly.
Acquired In-Process Research and Development. The results for the three
months ended March 31, 1998 include a $7.0 million charge (15.7% of revenue) for
acquired in-process research and development related to the iSTAR acquisition.
The charge is based upon an independent purchase price allocation that included
a valuation of the technology acquired, which is in the development stage but is
not yet technologically feasible.
Interest Expense. Interest expense was $2.6 million for the three months ended
March 31, 1998, an increase of $1.2 million from $1.4 million for the three
months ended March 31, 1997. The increase was principally due to increased
borrowings and capital lease obligations incurred by the Company to finance
network expansion and to fund working capital requirements. As a result of the
Company's recent issuance of $600.0 million aggregate principal amount of Notes,
the Company's interest expense will increase significantly in future quarters.
See "--Issuance of Senior Notes" and "Risk Factors--Substantial Indebtedness;
Ability to Service Debt."
Interest Income. Interest income was $0.6 million for the three months ended
March 31, 1998, a decrease of $0.2 million from $0.8 million for the three
months ended March 31, 1997. The decrease was principally due to a reduction in
the amount of cash and short-term, interest-bearing investments held by the
Company. The net proceeds of the Company's recently completed offering of Notes
will be invested in U.S. Government securities, A-1/P-1 rated certificates of
deposit or A-1/P-1 rated commercial paper until such time as the proceeds are
used for other purposes. Accordingly, the Company's interest income will
increase significantly in future quarters. See "--Issuance of Senior Notes."
Gain on Sale of Subsidiary. The gain on the sale of subsidiary of $5.7 million
in 1997 relates to the sale in the first quarter of 1997 of the Company's
software subsidiary.
Net Loss to Common Shareholders and Loss per Share. As a result of the factors
discussed above, the Company's net loss to common shareholders for the three
months ended March 31, 1998 was $29.9 million (67.1% of revenue), or $0.67 basic
and diluted loss per share, a $20.6 million increase from a net loss for the
three months ended March 31, 1997 of $9.3 million (36.2% of revenue), or $0.23
basic and diluted loss per share. The return to preferred shareholders, which
comprises the dividends with respect to the Company's Series B 8% Convertible
Preferred Stock ("Series B Preferred Stock") and accretion of the related
conversion premium on the Series B Preferred Stock, is subtracted from net loss
in determining the net loss to common shareholders. Because inclusion of common
stock equivalents is antidilutive, basic and diluted loss per share are the same
for each period presented.
LIQUIDITY AND CAPITAL RESOURCES
The Company historically has satisfied its cash requirements through cash from
operations, through borrowings and capital lease financings from vendors,
financial institutions and other third parties and through the issuance of
equity securities.
CASH FLOWS FOR THE THREE MONTHS ENDED MARCH 31, 1998 AND 1997
Cash flows used in operating activities were $10.0 million and $9.5 million
for the three months ended March 31, 1998 and 1997, respectively. Cash flows
used in operating activities can vary significantly from period to period
depending upon the timing of operating cash receipts and payments, especially
accounts receivable, prepaid expenses and other assets, and accounts payable and
accrued liabilities.
Cash flows used in investing activities for the three months ended March 31,
1998 were $9.9 million and cash flows provided by investing activities for the
three months ended March 31, 1997 were $17.7 million. The expansion of the
Company's network resulted in capital expenditures of $37.2 million and
12
<PAGE>
$10.8 million for the three months ended March 31, 1998 and 1997, respectively
(which included capital expenditures financed under equipment financing
agreements aggregating $30.9 million and $8.1 million, respectively). Cash flows
provided by investing activities for the three months ended March 31, 1997
benefited from the Company's sale in February 1997 of its software subsidiary
for cash consideration of $12.0 million and the receipt of $8.5 million as
repayment of intercompany debt owed by the subsidiary to the Company.
Cash flows provided by financing activities were $13.6 million and cash flows
used in financing activities were $5.7 million for the three months ended March
31, 1998 and 1997, respectively. During the three months ended March 31, 1998
and 1997, the Company made repayments aggregating $9.3 million and $5.8 million,
respectively, on its financing facilities.
As of March 31, 1998, the Company had $39.4 million of cash, cash equivalents,
restricted cash and short-term investments. As of May 1, 1998, after giving
effect to the proceeds received from the Company's recently completed offering
of Notes, the Company had $574.9 million of cash, cash equivalents, restricted
cash and short-term investments. See "--Issuance of Senior Notes."
CAPITAL STRUCTURE
The Company's capital structure consists of lines of credit, capital lease
obligations and notes payable (including the Notes), preferred stock and common
stock.
Total borrowings at March 31, 1998 were $121.9 million, which included $3.8
million under operating lines of credit and $118.1 million under capital lease
obligations and notes payable. The Company also had $1.1 million of letters of
credit outstanding as of March 31, 1998. As of that date, the aggregate unused
portion under the Company's various financing arrangements for purchases of
equipment and other fixed assets was $28.6 million. The aggregate unused portion
of the Company's operating lines of credit as of March 31, 1998, (some of which
are subject to a borrowing base formula) was $0.1 million. As of May 1, 1998,
after giving effect to the Company's recently completed offering of the Notes,
total borrowings were $697.2 million.
The Company's bank financing arrangements in the United States, which are
secured by substantially all of the Company's assets, require the Company to
satisfy certain financial covenants such as those relating to liquidity,
tangible net worth, EBITDA, leverage and debt and the repurchase of capital
stock of the Company without the lender's consent. The Company was in compliance
with all such covenants at March 31, 1998. The Company is required to maintain:
a ratio of consolidated cash and accounts receivable to debt of at least 0.9 to
1.0 for the quarters ending June 30, 1998 and September 30, 1998 and of at least
1.0 to 1.0 for each fiscal quarter thereafter; for the quarter June 30, 1998,
consolidated tangible net worth of at least $20.0 million plus 80% of all
positive net income earned after March 31, 1998 plus 50% of the cumulative net
tangible proceeds of the sale of capital stock after March 31, 1998, excluding
the proceeds of the sale of Series B Preferred Stock completed on November 10,
1997; EBITDA of not less than negative $5.0 million, and positive $4.0 million
for the fiscal quarters June 30, 1998, and September 30, 1998, respectively; a
ratio of consolidated total liabilities (other than deferred service contract
revenue and the Contingent Payment Obligation to IXC) to tangible net worth of
no more than 1.75 to 1.0 and 1.50 to 1.0 for the quarters ending June 30, 1998,
and September 30, 1998, respectively, and a ratio of EBITDA to consolidated debt
service payments (exclusive of any interest accreting in respect of the
Company's Contingent Payment Obligation to IXC) in respect of any fiscal quarter
commencing with the quarter ending December 31, 1998 of at least 1.25 to 1.0.
The Indenture governing the Notes contains certain financial covenants with
which the Company must comply relating to, among other things, the following
matters: (i) limitation on the Company's payment of cash dividends, repurchase
of capital stock, payment of principal on subordinated indebtedness and making
of certain investments, unless after giving effect to each such payment,
repurchase or investment, certain operating cash flow coverage tests are met,
excluding certain permitted payments and investments; (ii) limitation on the
Company's and its subsidiaries' incurrence of additional indebtedness, unless at
the time of such incurrence, the Company's ratio of debt to annualized operating
cash flow would be at least 6.0 to 1.0 prior to April 1, 2001 or at least 5.5 to
1.0 on or after April 1, 2001, excluding certain permitted incurrences of debt;
(iii) limitation on the Company's and its subsidiaries'
13
<PAGE>
incurrence of liens, unless the Notes are secured equally and ratably with the
obligation or liability secured by such lien, excluding certain permitted liens;
(iv) limitation on the ability of any subsidiary of the Company to create or
otherwise cause to exist any encumbrance or restriction on the payment of
dividends or other distributions on its capital stock, payment of indebtedness
owed to the Company or any other subsidiary, making of investments in the
Company or any other subsidiary, or transfer of any properties or assets to the
Company or any other subsidiary, excluding certain permitted encumbrances and
restrictions; (v) limitation on certain mergers, consolidations and sales of
assets by the Company or its subsidiaries; (vi) limitation on certain
transactions with affiliates of the Company; (vii) limitation on the ability of
any subsidiary of the Company to guarantee or otherwise become liable with
respect to any indebtedness of the Company unless such subsidiary provides for a
guarantee of the Notes on the same terms as the guarantee of such indebtedness;
(viii) limitation on certain sale and leaseback transactions by the Company or
its subsidiaries; (ix) limitation on certain issuances and sales of capital
stock of subsidiaries of the Company; and (x) limitation on the ability of the
Company or its subsidiaries to engage in any business not substantially related
to a telecommunications business.
In November 1997, the Company completed a private placement of 600,000 shares
of its Series B Preferred Stock for gross proceeds of $30.0 million. Each share
of Series B Preferred Stock has a stated value of $50.00 per share. The Series B
Preferred Stock accrues dividends at an annual rate of 8%, payable quarterly in
cash or, at the Company's option, the Company's Series B Preferred Stock. The
Series B Preferred Stock is convertible into a number of shares of the Company's
common stock equal to the stated value of the Series B Preferred Stock at a
conversion price of $10 per share of common stock during the first year. If the
stock price were to drop below $10 at the end of the first and second
anniversary dates, the conversion price would be reset to the stock's then
current market value. At the third anniversary date, the conversion price may be
reset, under certain circumstances, to 95% of the stock's then current market
value. To reflect the nature of the conversion rights, preferred stock has been
reduced by $1,500,000 with a corresponding increase to capital in excess of par
value. The Series B Preferred Stock may be redeemed, at the Company's option,
under certain circumstances commencing on the third anniversary of original
issuance. So long as any Series B Preferred Stock remains outstanding, except
for any payment which may be made pursuant to the IRU Purchase Agreement,
neither the Company nor any subsidiary will (i) redeem, purchase or otherwise
acquire directly or indirectly any common stock or other junior securities, (ii)
directly or indirectly pay or declare any dividend or make any distribution
(other than certain dividends or distributions or a distribution on securities
issuable pursuant to any rights under the Company's shareholder rights plan)
upon, nor will any distribution (other than certain dividends or distributions
or a distribution on securities issuable pursuant to any rights pursuant to the
rights plan) be made in respect of, any common stock or other junior securities,
or (iii) set aside any funds for or apply any funds to the purchase, redemption
or acquisition (through a sinking fund or otherwise) of any common stock or
other junior securities (other than pursuant to the rights plan); provided,
however, that the Company may redeem, purchase or otherwise acquire and set
aside funds for and apply funds to the purchase, redemption or acquisition of
common stock or other junior securities (a) for up to an aggregate amount not to
exceed, at any point in time the sum of: (i) $10 million plus (ii) an amount
equal to 100% of the aggregate net cash proceeds received by the Company after
November 10, 1997 from the issuance of common stock or other junior securities
or debt securities that have been converted into common stock or other junior
securities plus (iii) an amount equal to 50% of the Company's cumulative
consolidated positive earnings before interest, taxes, depreciation and
amortization as reported by the Company in respect of each fiscal quarter of the
Company commencing with the fiscal quarter that ended December 31, 1997 or (b)
pursuant to a right of first offer granted to the Company to purchase shares of
common stock held by IXC under certain circumstances pursuant to the IRU
Purchase Agreement, provided that immediately after giving effect thereto, the
Company's consolidated shareholders' equity will not be less than $20 million.
COMMITMENTS, CAPITAL EXPENDITURES AND FUTURE FINANCING REQUIREMENTS
As of March 31, 1998, the Company had commitments to certain
telecommunications vendors totaling $28.8 million. The commitments require
minimum monthly usage levels of data and voice communications over the next five
years. Additionally, the Company has various agreements to lease office space
and facilities and, as of March 31, 1998, the Company was obligated to make
future minimum lease payments of $37.6 million on non-cancellable operating
leases expiring in various years through 2005. The Company is obligated, under
the terms of one of its Carrier and ISP Services
14
<PAGE>
agreements, to provide the ISP customer with a rental facility of up to $5.0
million for telecommunications equipment owned or leased by the Company and
deployed in the customer's network. At March 31, 1998, the Company had provided
$1.4 million of equipment under this facility.
In February 1998, the Company completed the acquisition of approximately 80%
of the outstanding shares of iSTAR. The Company presently is seeking approval
of iSTAR's shareholders to increase its ownership interest in iSTAR to 100%. The
Company has sufficient voting power in iSTAR stock to obtain such approval,
subject to certain rights of contestation of iSTAR's shareholders and other
interested parties. The Company estimates that the cost of increasing its
ownership interest in iSTAR will be approximately $3.1 million plus transaction
costs.
In order to take full advantage of the bandwidth acquired from IXC, in
addition to other planned capital expenditures, the Company expects to incur
capital expenditures through the end of the year 2000 of up to $95 million. Such
capital expenditures are expected to be incurred in the deployment of high
activity POPs throughout the United States designed and located with the
objective of optimizing the efficient use of the bandwidth. These POPs are
expected to contain switching, routing and modem equipment, together with any
computing equipment as may be necessary to address the increase in customer
demand anticipated as a result of the enhanced capacity provided by the PSINet
IRUs. In addition, the Company expects to incur on an annual basis $1.15
million in operation and maintenance fees for each 1,000 equivalent route miles
of OC-48 bandwidth accepted from IXC. Other planned capital expenditures
expected to be incurred by the Company over the next four years include up to
$35 million in connection with the Company's anticipated buildout of its
international Internet network and a network operations center in Switzerland.
In connection with the buildout of its international network, the Company has
recently entered into agreements to acquire IRUs in certain transatlantic fiber
optic bandwidth between the United States, the United Kingdom and Europe, for
which it has secured financing.
The Company presently believes, based on the flexibility it expects to have in
the timing of its orders of bandwidth corresponding to the PSINet IRUs, in
outfitting its POPs with appropriate telecommunications and computer equipment,
and in controlling the pace and scope of its anticipated buildout of its
international Internet network, that it will have a reasonable degree of
flexibility to adjust the amount and timing of such capital expenditures in
response to the Company's then existing financing capabilities, market
conditions, competition and other factors. Accordingly, the Company believes
that working capital generated from the use of bandwidth corresponding to the
PSINet IRUs, together with other working capital from operations, from existing
credit facilities, from capital lease financings, the proceeds of the Notes
offering and from future equity or debt financings (which the Company presently
expects to be able to obtain when needed), will be sufficient to meet the
currently anticipated working capital and capital expenditure requirements of
its operations. There can be no assurance, however, that the Company will have
access to sufficient additional capital and/or financing on satisfactory terms
to enable it to meet its capital expenditure and working capital requirements.
See "Risk Factors Need--for Additional Capital to Finance Growth and Capital
Requirements."
As more fully described in "Notes to Consolidated Financial Statements (Note
Strategic Alliances and Acquisitions--Strategic Alliance with IXC Internet
Services, Inc.)," the Company could be obligated in accordance with the
Contingent Payment Obligation to provide IXC with additional shares of the
Company's common stock and/or cash, at the Company's sole option, as of the
Determination Date or the Acceleration Date, as applicable. In the event the
Contingent Payment Obligation to IXC becomes payable, the Company presently
believes that, because it may be satisfied by the Company, at its sole option,
by delivery of additional shares of common stock or cash or a combination
thereof, the Company will have sufficient flexibility to satisfy the Contingent
Payment Obligation. There can be no assurance, however, that satisfaction of the
Contingent Payment Obligation will not have a material adverse effect on the
Company. See "Risk Factors--Risks Associated with Strategic Alliance with IXC."
On May 11, 1998, the Company announced the acquisition of rights to use 18
dark fiber optic strands covering the New York City metropolitan area, the route
between New York and Washington, and the Washington, D.C. metropolitan area. The
dark fiber in the New York to Washington corridor includes multiple drop-off
locations in the major cities that are on the route. The acquisition agreement
provides for a commitment by the supplier to deliver the dark fiber during 1998.
PSINet's rights in these fibers are
15
<PAGE>
for 20 years. The fiber will be fully integrated with the OC-48 bandwidth
corresponding to the PSINet IRUs acquired from IXC in February 1998 and a 12,000
mile transatlantic STM-1 fiber IRU acquired in March 1998.
The recently acquired New York to Washington fiber route, together with the
optronics and other equipment required to light and utilize the fiber over the
next several years, is expected to cost a total of approximately $45.0 million.
The Company is in the process of selecting vendors to supply the necessary
equipment. A portion of the net proceeds from the Company's recently completed
Notes offering will be used to pay for the acquisition and related equipment.
OTHER POSSIBLE STRATEGIC RELATIONSHIPS AND ACQUISITIONS
The Company anticipates that it will continue to seek to develop relationships
with strategic partners both domestically and internationally and to acquire
assets (including, without limitation, additional telecommunications bandwidth)
and businesses principally relating to or complementary to PSINet's existing
business. Certain of these strategic relationships may involve other
telecommunications companies that desire to enter into joint marketing and
services arrangements with the Company pursuant to which the Company would
provide Internet and Internet-related services to such companies, which
transactions, if deemed appropriate by the Company, may also be effected in
conjunction with an equity and/or debt investment by such companies in the
Company. Such relationships and acquisitions may require additional financing
and may be subject to the consent of the Company's lenders and other third
parties.
YEAR 2000 DATA CONVERSION
The Company recognizes the need to ensure its operations will not be adversely
impacted by Year 2000 software failures. Software failures due to processing
errors potentially arising from calculations using the Year 2000 date are a
known risk. The Company is addressing this risk to the availability and
integrity of financial systems and the reliability of operational systems. Based
upon a review of its technology and software, the Company has concluded that
there are no material issues regarding its Year 2000 compliance that will not be
resolved through normal software upgrades and replacements that will be made
through 1999. While the Company believes its planning efforts are adequate to
address its Year 2000 concerns, there can be no guarantee that the systems of
other companies on which the Company's systems and operations rely will be
converted on a timely basis and will not have a material adverse effect on the
Company.
16
<PAGE>
PART II. OTHER INFORMATION
Item 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
Recent Sales of Unregistered Securities
On December 17, 1997 and March 26, 1998, the Company issued 722 and 721
shares, respectively, of its common stock to employees of the Company pursuant
to an exercise of options held by each such employee for aggregate consideration
of $100. The issuances of common stock in each of these transactions described
were exempt from registration under the Securities Act in reliance on Section
4(2) of the Securities Act as a transaction by an issuer not involving any
public offering. In each such transaction, the recipient of the securities had
adequate access to information regarding the Company and appropriate legends
regarding the restricted nature of such securities (within the meaning of Rule
144(a)(3) under the Securities Act) were affixed to the certificate representing
such securities.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
(a) A Special Meeting of Shareholders of the Company was held on January 23,
1998 (the "Special Meeting").
(c) The matters voted upon at the Special Meeting and the results of the voting
as to each such matter are set forth below:
(i) A proposal to approve the issuance to IXC Internet Services, Inc.
("IXC") of shares of common stock in excess of 20% of the number of
shares of common stock outstanding before such issuance (consisting of
a minimum of 10,165,779 shares at the closing and, if the fair market
value of such shares as of the earlier of (i) the first anniversary of
the date on which 100% of the PSINet IRUs is accepted by the Company
or (ii) the fourth anniversary of the closing is not equal or greater
than $240 million, such number of additional shares of common stock as
the Company may determine to issue to satisfy all or any portion of
the shortfall, to the extent it elects not to pay cash therefor), in
connection with the acquisition by the Company of certain
noncancellable indefeasible rights of use in up to 10,000 equivalent
route miles of OC-48 bandwidth in specified portions of IXC's fiber
optic telecommunications system pursuant to the IRU Purchase
Agreement.
Votes for 19,190,976
Votes against 1,625,890
Abstentions 141,140
Broker non-votes 14,637,046
(ii) A proposal to amend the Company's Certificate of Incorporation to
increase the number of the Company's authorized shares of capital
stock from 130,000,000 shares to 280,000,000 shares and to increase
the number of the Company's authorized shares of common stock from
100,000,000 shares to 250,000,000 shares.
Votes for 32,023,055
Votes against 3,327,131
Abstentions 244,866
17
<PAGE>
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
The following Exhibits are filed or incorporated by reference herewith:
Exhibit 4.1 Indenture, dated as of April 13, 1998, between PSINet Inc.
and Wilmington Trust Company, as trustee
Exhibit 4.2 Form of 10% Senior Note Due 2005, Series A
Exhibit 10.1 Registration Rights Agreement, dated April 13, 1998, among
PSINet Inc. and Donaldson Lufkin & Jenrette Securities
Corporation, Merrill Lynch, Pierce, Fenner & Smith
Incorporated and Chase Securities Inc.
Exhibit 10.2 Interest Escrow Agreement, dated as of April 13, 1998,
among PSINet Inc. and Wilmington Trust Company, as escrow
agent, and Wilmington Trust Company, as trustee
Exhibit 10.3 Sublease Agreement dated January 22, 1998, between the
Company and Unisys Corporation, as amended
Exhibit 11.1 Calculation of Basic and Diluted Loss per Share and
Weighted Average Shares Used in Calculation for the Three
Months Ended March 31, 1998
Exhibit 27 Financial Data Schedule
Exhibit 99.1 Risk Factors
(b) Reports on Form 8-K
On January 7, 1998, the Company filed a Current Report on Form 8-K, dated
December 23, 1997, relating to the execution of a Pre-Acquisition
Agreement for the acquisition of all of the outstanding common stock of
iSTAR internet inc. by the Company.
On January 22, 1998, the Company filed a Current Report on Form 8-K,
dated January 21, 1998, which included as an Exhibit a press release
issued by the Company relating to a proposal received by the Company's
Board of Directors from USinternetworking Inc.
On February 12, 1998, the Company filed a Current Report on Form 8-K,
dated January 30, 1998, relating to the acquisition of certain of the
common shares of iSTAR internet inc.
On March 10, 1998, the Company filed a Current Report on Form 8-K, dated
February 25, 1998, relating to the closing of its transaction pursuant to
the IRU and Stock Purchase Agreement dated as of July 22, 1997 with IXC
Internet Services, Inc.
On March 26, 1998, the Company filed a Current Report on Form 8-K, dated
March 20, 1998, which included as an Exhibit a press release issued by
the Company relating to the Company pursuing a placement of debt
securities.
18
<PAGE>
(b) Reports on Form 8-K (continued)
On April 8, 1998, the Company filed a Current Report on Form 8-K, dated
April 8, 1998, which included as an Exhibit a press release issued by the
Company relating to the Company's offering of $600 million aggregate
principal amount of 10% Senior Notes due 2005.
On April 23, 1998, the Company filed a Current Report on Form 8-K, dated
April 13, 1998, relating to the completion of its offering of $600
million aggregate principal amount of 10% Senior Notes due 2005.
19
<PAGE>
PSINET INC.
FORM 10-Q
MARCH 31, 1998
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
PSINET INC.
May 15, 1998 By: /s/ William L. Schrader
- ------------ ------------------------
Date William L. Schrader
Chairman, President, Chief
Executive Officer and Director
May 15, 1998 By: /s/ Edward D. Postal
- ------------ ---------------------
Date Edward D. Postal
Senior Vice President and
Chief Financial Officer
(Principal Financial Officer)
20
<PAGE>
EXHIBIT INDEX
<TABLE>
<CAPTION>
EXHIBIT
Number DESCRIPTION OF EXHIBIT LOCATION
------ ---------------------- --------
<C> <S> <C>
4.1 Indenture, dated as of April 13, 1998, between PSINet Inc. and Incorporated by reference from Exhibit
Wilmington Trust Company, as trustee 4.1 to the Company's Current Report on
Form 8K dated April 23, 1998 located
under Securities Exchange Commission
File No. 0-25812 ("April 23, 1998 Form 8-K")
4.2 Form of 10% Senior Note Due 2005, Series A Incorporated by reference from Exhibit
4.2 to the April 23, 1998 Form 8-K
10.1 Registration Rights Agreement, dated as of April 13, 1998, Incorporated by reference from Exhibit
among PSINet Inc. and Donaldson Lufkin & Jenrette Securities 10.1 to the April 23, 1998 Form 8-K
Corporation, Merrill Lynch, Pierce, Fenner & Smith
Incorporated and Chase Securities Inc.
10.2 Interest Escrow Agreement, dated as of April 13, 1998, among Incorporated by reference from Exhibit
PSINet Inc. and Wilmington Trust Company, as escrow agent, 10.2 to the April 23, 1998 Form 8-K
and Wilmington Trust Company, as trustee
10.3 Sublease Agreement dated January 22, 1998, between the Company Incorporated by reference from Exhibit
and Unisys Corporation, as amended 10.10 to the May 7, 1998 Form S4/A
11.1 Calculation of Basic and Diluted Loss Per Share and Weighted Sequentially numbered pages
Average Shares used in calculation for the Three Months Ended
March 31, 1998
*27 Financial Data Schedule Sequentially numbered pages
99.1 Risk Factors Sequentially numbered pages
</TABLE>
* Not deemed filed for purposes of Section 11 of the Securities
Act of 1933, Section 18 of the Securities Exchange Act of
1934 and Section 323 of the Trust Indenture Act of 1939 or
otherwise subject to the liabilities of such sections and not
deemed part of any registration statement to which such
exhibit relates.
21
<PAGE>
EXHIBIT 11.1
PSINET INC.
CALCULATION OF BASIC AND DILUTED LOSS PER SHARE AND WEIGHTED AVERAGE SHARES USED
IN CACULATION (UNAUDITED)
THREE MONTHS ENDED
March 31, 1998
--------------
Weighted average shares outstanding:
Common stock:
Shares outstanding at beginning of period.............. 40,477,786
Weighted average shares issued during the three
months ended March 31, 1998
(10,497,477 shares).................................... 4,118,638
-----------
44,596,424
===========
Net loss to common shareholders............................. $(29,854,000)
===========
Basic and diluted loss per share............................ $ (0.67)
===========
================================================================================
22
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
This schedule contains summary financial information extracted from THE
CONSOLIDATED STATEMENT OF OPERATIONS FOR THE THREE MONTHS ENDED MARCH 31, 1998
AND BY THE CONSOLIDATED BALANCE SHEET AS MARCH 31, 1998 and is qualified in its
entirety by reference to such financial statements.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> MAR-31-1998
<CASH> 27,143
<SECURITIES> 5,849
<RECEIVABLES> 22,688
<ALLOWANCES> 3,794
<INVENTORY> 0
<CURRENT-ASSETS> 73,551
<PP&E> 197,555
<DEPRECIATION> 61,964
<TOTAL-ASSETS> 233,304
<CURRENT-LIABILITIES> 108,452
<BONDS> 74,676
0
28,315
<COMMON> 511
<OTHER-SE> 19,600
<TOTAL-LIABILITY-AND-EQUITY> 233,304
<SALES> 44,469
<TOTAL-REVENUES> 44,469
<CGS> 36,666
<TOTAL-COSTS> 36,666
<OTHER-EXPENSES> 34,782
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 2,579
<INCOME-PRETAX> (29,072)
<INCOME-TAX> 0
<INCOME-CONTINUING> (29,072)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (29,072)
<EPS-PRIMARY> (0.67)
<EPS-DILUTED> (0.67)
</TABLE>
<PAGE>
EXHIBIT 99.1
RISK FACTORS
From time to time, in both written reports and in oral statements by PSINet
senior management, expectations and other statements are expressed regarding
future performance of the Company. These forward-looking statements are
inherently uncertain and investors must recognize that events could turn out to
be different than such expectations and statements. Key factors impacting
current and future performance are discussed in the Company's Annual Report on
Form 10-K and other filings with the Securities and Exchange Commission. In
addition, the following Risk Factors as well as the other information in this
Quarterly Report should be considered in evaluating the Company and its
business. Capitalized terms used in this Exhibit 99.1 but not otherwise defined
herein should have the respective meanings described thereto in the periodic
report with which this Exhibit 99.1 is filed.
SUBSTANTIAL INDEBTEDNESS; ABILITY TO SERVICE DEBT
Upon the consummation of the Notes offering, the Company became highly
leveraged. As of March 31, 1998, after giving pro forma effect to the Notes
offering (and the application of the net proceeds therefrom) and the
acquisitions of iSTAR and Iprolink, the Company's total indebtedness would have
been approximately $701.9 million, representing 93.5% of total capitalization,
and its interest expense would have been $17.9 million (in comparison to the
Company's actual interest expense of $2.6 million for the three months ended
March 31, 1998). The Company's high level of indebtedness could have several
important effects on its future operations, which could have important
consequences to the holders of the Company's securities, including, the
following: (i) a substantial portion of the Company's cash flow from operations
must be dedicated to the payment of interest on its indebtedness and, therefore,
will not be available for other purposes, (ii) covenants contained in the
Company's debt obligations will require the Company to meet certain financial
tests, and other restrictions will limit its ability to borrow additional funds
or to dispose of assets and may affect the Company's flexibility in planning
for, and reacting to, changes in its business, including possible acquisition
activities and capital expenditures, and (iii) the Company's ability to obtain
additional financing in the future for working capital, capital expenditures,
acquisitions, general corporate purposes or other purposes may be impaired. The
Company's ability to meet its debt service obligations and to reduce its total
indebtedness will be dependent upon the Company's future operating performance
and economic, financial, competitive, regulatory and other factors affecting the
operations of the Company, many of which are beyond its control. There can be no
assurance that the Company's future operating performance will not be adversely
affected by some or all of these factors. Based upon the Company's current level
of operations, management believes that working capital from operations, from
existing credit facilities, from capital lease financings, and from proceeds of
future equity or debt financings (including, without limitation, from the Notes
offering), will be adequate to meet the Company's presently anticipated future
requirements for working capital, capital expenditures and scheduled payments of
interest on its debt (including the Notes). There can be no assurance, however,
that the Company's business will generate sufficient cash flow from operations
or that future working capital borrowings will be available in an amount
sufficient to enable the Company to service its debt (including the Notes) or to
make necessary capital expenditures. Furthermore, there can be no assurance that
the Company will be able to raise additional capital for any such refinancing in
the future.
OPERATING DEFICIT; CONTINUING LOSSES; POTENTIAL FLUCTUATIONS IN OPERATING
RESULTS; ISTAR OPERATING LOSSES
The Company's prospects must be considered in light of the risks, expenses and
difficulties frequently encountered by companies in new and rapidly evolving
markets. To address these risks, the Company must, among other things, respond
to competitive developments, continue to attract and retain qualified persons,
and continue to upgrade its technologies and commercialize its network services
incorporating such technologies. There can be no assurance that the Company will
be successful in addressing such risks and the failure to do so could have a
material adverse effect on the Company's business, financial condition and
results of operations. Although the Company has experienced revenue growth on an
annual basis with revenue increasing from $38.7 million in 1995 to $84.4 million
in 1996 to
24
<PAGE>
$121.9 million in 1997 and $44.5 million for the first three months of 1998, it
has incurred losses and experienced negative earnings before interest, taxes,
depreciation and amortization ("EBITDA") during each of such periods. The
Company has incurred net losses of $45.6 million, $55.1 million and $53.2
million and has incurred negative EBITDA of $21.2 million, $28.0 million and
$27.9 million for each of the years ended December 31, 1997, 1996 and 1995,
respectively. Additionally, the Company incurred net losses of $29.1 million and
negative EBITDA of $10.5 million for the three months ended March 31, 1998. At
March 31, 1998, the Company had an accumulated deficit of $192.5 million.
Principal among factors that adversely affected the Company's operating
performance in 1997 and the first quarter of 1998 were delivery delays for
Primary Rate Interface ("PRI") telecommunications facilities required to meet
customer demand, accelerated investment by the Company in its overseas
operations in order to respond to rapidly developing markets, and lower than
expected growth during the third quarter of 1997 in the demand for its domestic
Internet services. The Company expects to focus in the near term on continuing
to increase its business customer base and expanding its Carrier and ISP
Services business unit strategy which will require it to continue to incur
expenses for marketing, network infrastructure, personnel and the development of
new products and services. Such continued expenses may adversely impact cash
flow and operating performance. The Company also plans to continue to enhance
its network and the administrative and operational infrastructure necessary to
support its Internet access service domestically and internationally.
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, including, among others, general economic
conditions, specific economic conditions in the Internet access industry, user
demand for Internet services, capital expenditures and other costs relating to
the expansion of operations and the Company network, the introduction of new
services by the Company or its competitors, the mix of services sold and the mix
of channels through which those services are sold, pricing changes and new
product introductions by the Company and its competitors and delays in obtaining
sufficient supplies of sole or limited source equipment and telecom facilities
(i.e., PRIs). As a strategic response to a changing competitive environment, the
Company may elect from time to time to make certain pricing, service or
marketing decisions that could have a material adverse effect on the Company's
business, results of operations and cash flow.
In February 1998, the Company acquired iSTAR, one of the leading Canadian
providers of Internet services and solutions. Prior to its acquisition by the
Company, iSTAR incurred a net loss of $39.1 million and had negative EBITDA of
$20.7 million for the twelve months ended November 30, 1997. While the Company
believes that after eliminating redundant network architecture and
administrative functions and taking other actions to integrate the operations of
iSTAR it will be able to realize significant cost savings on its Canadian
operations beginning in 1998, there can be no assurance that the Company's
integration of the operations of iSTAR will be accomplished successfully. The
inability of the Company to improve the operating performance of iSTAR's
business or to successfully integrate the operations of iSTAR could have a
material adverse effect on the Company's business, financial condition and
results of operations.
HOLDING COMPANY STRUCTURE; DEPENDENCE ON SUBSIDIARIES FOR REPAYMENT OF THE NOTES
The Company is an operating entity which also conducts a portion of its
business through its subsidiaries and may, in the future, conduct a greater
portion of its business through its subsidiaries. The Company's cash flow from
operations and consequent ability to service its debt, including the Notes, is,
therefore, in part, dependent (and may become more dependent) upon the earnings
of its subsidiaries and the distribution (through dividends or otherwise) of
those earnings to the Company, or upon loans, advances or other payments of
funds by those subsidiaries to the Company. The Company's subsidiaries will
have no obligation, contingent or otherwise to make any funds available to the
Company for payment of the principal of or interest on the Notes. The ability
of the Company's subsidiaries to make such payments will be subject to, among
other things, the availability of sufficient surplus funds, the terms of such
subsidiaries' indebtedness and applicable laws.
Claims of creditors of the Company's subsidiaries and holders of preferred
stock, if any, of such subsidiaries will have priority as to the assets of such
subsidiaries over the claims of the Company and the holders of the Company's
indebtedness, except to the extent that such subsidiaries have provided
25
<PAGE>
guarantees of the Company's indebtedness and to the extent that loans made by
the Company to its subsidiaries are recognized as indebtedness. Therefore, the
Notes are effectively subordinated in right of payment to all existing and
future indebtedness and other liabilities of the Company's subsidiaries,
including trade payables. As of March 31, 1998, after giving pro forma effect
to the Notes offering (and the application of the net proceeds therefrom), the
Company's subsidiaries would have had approximately $764.9 million of total
liabilities (including trade payables and accrued liabilities). Under the terms
of the Indenture governing the Notes, certain subsidiaries of the Company will
be restricted in their ability to incur debt in the future. The Notes also are
effectively subordinated to any secured indebtedness of the Company because
holders of such indebtedness will have claims that are prior to the claims of
the holders of the Notes with respect to the assets securing such indebtedness
except to the extent the Notes are equally and ratably secured by such assets.
COMPETITION
The market for Internet access and related services is highly competitive.
The industry has relatively insignificant barriers to entry and numerous
entities competing for the same customers. The Company expects that competition
will continue to intensify as the use of the Internet grows. The tremendous
growth and potential market size of the Internet access market has attracted
many new start-ups as well as existing businesses from different industries.
Current and prospective competitors include, in addition to other national,
regional and local ISPs, long distance and local exchange telecommunications
companies, cable television, direct broadcast satellite, wireless communications
providers, and on-line service providers. The Company believes that the primary
competitive factors for the provision of Internet services are quality of
service, reliability, price, technical expertise, ease of use, variety of value-
added services, quality and availability of customer support, experience of the
supplier, geographic coverage and name recognition. The Company's success in
this market will depend heavily upon its ability to provide high quality
Internet connectivity and related services at competitive prices.
As a result of industry competition, the Company has encountered and expects
to continue to encounter pricing pressure, which in turn could result in
reductions in the average selling price of the Company's services. For example,
certain of the Company's competitors which are telecommunications companies,
including AT&T Corporation and MCI Communications Corp., may be able to provide
customers with reduced or free communications costs in connection with their
Internet access services or offer Internet access as a standard component of
their overall service package, thereby increasing price pressure on the Company.
The Company has in the past reduced prices on certain of its Internet access
options and may continue to do so in the future. There can be no assurance that
the Company will be able to offset the effects of any such price reductions with
an increase in the number of its customers, higher revenue from enhanced
services, cost reductions or otherwise. The Company is not able presently to
predict the impact which future growth in the Internet access and on-line
services businesses will have upon competition in the industry. Increased price
or other competition could result in erosion of the Company's market share and
could have a material adverse effect on the Company's business, financial
condition and results of operations. There can be no assurance that the Company
will have the financial resources, technical expertise or marketing and support
capabilities to continue to compete successfully.
As the Company continues to expand its operations outside the United States,
it will encounter new competitors and competitive environments. In some cases,
the Company will be forced to compete with and buy services from government
owned or subsidized telecommunications providers, some of which may enjoy a
monopoly on telecommunications services essential to the Company's business.
There can be no assurance that the Company will be able to purchase such
services at a reasonable price or at all. In addition to the risks associated
with the Company's previously described competitors, foreign competitors may
possess a better understanding of their local markets and better working
relationships with local infrastructure providers and others. There can be no
assurance that the Company can obtain similar levels of local knowledge, and
failure to obtain that knowledge could place the Company at a significant
competitive disadvantage.
RISKS ASSOCIATED WITH STRATEGIC ALLIANCE WITH IXC
The Company is subject to a variety of risks relating to its transactions with
IXC and the acquisition, operation and maintenance of the bandwidth
corresponding to the PSINet IRUs. Such risks include,
26
<PAGE>
among other things, the following: (i) the risk that, if the difference between
$240 million and the fair market value of the IXC Initial Shares as of the
Determination Date or the Acceleration Date, as applicable, is significant,
satisfaction of the Contingent Payment Obligation by the Company through the
issuance of additional shares of common stock or, at the sole option of the
Company, by a payment of cash, or a combination of stock and cash, could result
in significant dilution to the Company's shareholders and in IXC's owning a
significant, or even a controlling, portion of the Company's outstanding common
stock, and/or could necessitate a significant cash outlay by the Company, which
in any such event could have a material adverse effect on the Company and its
shareholders; (ii) the risk that financial, legal, technical and/or other
matters may adversely affect IXC's ability to perform the operation, maintenance
and other services under the IRU Purchase Agreement with respect to the
bandwidth corresponding to the PSINet IRUs, which may adversely affect the
Company's use of such bandwidth; (iii) the risk that, in the event of a material
default by IXC under the IRU Purchase Agreement at such time as IXC is in
bankruptcy, the Company's use of the bandwidth corresponding to the PSINet IRUs
may be materially adversely affected or curtailed; (iv) the risk that the
Company will not have access to sufficient additional capital and/or financing
on satisfactory terms to enable it to make the necessary capital expenditures to
take full advantage of the PSINet IRUs; (v) the risk that IXC may not continue
to have the necessary financial resources to enable it to complete, or may
otherwise elect not to complete, its contemplated buildout of its fiber optic
telecommunications system or that such buildout may be delayed or otherwise
adversely affected by presently unforeseeable legal, technical and/or other
factors; (vi) the risk that, in the event of a change of control or change in
management of IXC, IXC's successor or new management, as the case may be, may
not share IXC's commitment to the buildout of its fiber optic telecommunications
system or may not otherwise allocate the necessary human, financial, technical
and other resources to satisfactorily meet its obligations to the Company under
the IRU Purchase Agreement that would adversely affect the Company's use of the
bandwidth corresponding to the PSINet IRUs; (vii) the risk that IXC, as the
Company's largest shareholder and through its chairman's seat on the Company's
Board of Directors, could subject the Company to certain conflicts of interest
or could influence the Company's management in a manner that could adversely
affect the Company's business or control of the Company; and (viii) the risk
that future sales by IXC of substantial numbers of shares of the Company's
common stock could adversely affect the market price of the Company's common
stock and make it more difficult for the Company to raise funds through equity
offerings and to effect acquisitions of businesses or assets in consideration
for issuances of its common stock. There can be no assurance that the Company
will be successful in overcoming these risks or any other problems encountered
in connection with its strategic alliance with IXC.
RISKS ASSOCIATED WITH MANAGEMENT OF GROWTH AND EXPANSION
The Company had over 400 POPs as of March 31, 1998 and plans to continue to
expand the capacity of existing POPs as customer-driven demand dictates. The
Company's rapid growth has placed, and in the future may continue to place, a
strain on the Company's administrative, operational and financial resources and
has increased demands on its systems and controls. The Company anticipates that
its Carrier and ISP Services business unit, as well as other business growth,
may require continued enhancements to and expansion of its network. Competition
for qualified personnel in the Internet services industry is intense and there
are a limited number of persons with the requisite knowledge of and experience
in such industry. The process of locating, training and successfully
integrating qualified personnel into the Company's operations is often lengthy
and expensive. There can be no assurance that the Company will be successful in
attracting, integrating and retaining such personnel. In addition, there can be
no assurance that the Company's existing operating and financial control systems
and infrastructure will be adequate to maintain and effectively monitor future
growth. The inability to continue to upgrade the networking systems or the
operating and financial control systems, the inability to recruit and hire
necessary personnel, the inability to successfully integrate new personnel into
the Company's operations, the inability to manage its growth effectively or the
emergence of unexpected expansion difficulties could adversely affect the
Company's business, results of operations and financial condition.
NEED FOR ADDITIONAL CAPITAL TO FINANCE GROWTH AND CAPITAL REQUIREMENTS
The Company expects to continue to enhance its network in order to maintain
its competitive position and continue to meet the increasing demands for service
quality, availability and competitive pricing. In
27
<PAGE>
order to take full advantage of the bandwidth acquired from IXC, in addition to
other planned capital expenditures, the Company expects to incur capital
expenditures through the end of the year 2000 of up to $95 million. In addition,
the Company expects to incur on an annual basis $1.15 million in operation and
maintenance fees with respect to the PSINet IRUs per each 1,000 equivalent route
miles of OC-48 bandwidth accepted under the IRU Purchase Agreement. Other
planned capital expenditures expected to be incurred by the Company over the
next three years include up to $35 million in connection with the Company's
anticipated buildout of its pan-European Internet network. The Company is also
obligated, under the terms of one of its Carrier and ISP Services agreements, to
provide the ISP customer with a rental facility of up to $5.0 million for
telecommunications equipment owned or leased by the Company and deployed in the
customer's network ($1.4 million was drawn at March 31, 1998). In addition, the
Company may be obligated pursuant to the Contingent Payment Obligation under the
IRU Purchase Agreement to provide IXC with additional shares of common stock
and/or cash, at the Company's sole option, in an amount equal to the difference
between $240 million and the then fair market value of the IXC Initial Shares on
the earlier of one year following delivery and acceptance of the total bandwidth
corresponding to the PSINet IRUs or February 25, 2002.
The Company believes it will have a reasonable degree of flexibility to adjust
the amount and timing of its capital expenditures in response to the Company's
then existing financing capabilities, market conditions, competition and other
factors. The Company believes that working capital generated from the use of
bandwidth corresponding to the PSINet IRUs, together with other working capital
from operations, from existing credit facilities, from capital lease financings,
proceeds of unsecured senior notes, and from proceeds of future equity or debt
financings (which the Company presently expects to be able to obtain when
needed), will be sufficient to meet the presently anticipated working capital
and capital expenditure requirements of its operations. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations--
Liquidity and Capital Resources."
The Company may seek to raise additional funds in order to take advantage of
unanticipated opportunities, more rapid international expansion or acquisitions
of complementary businesses, or to develop new products or otherwise respond to
changing business conditions or unanticipated competitive pressures. There can
be no assurance that the Company will be able to raise such funds on favorable
terms. In the event that the Company is unable to obtain such additional funds
on acceptable terms, the Company may determine not to enter into various
expansion opportunities.
RISKS ASSOCIATED WITH INTERNATIONAL EXPANSION
A component of the Company's strategy is its planned expansion into
international markets. There can be no assurance that the Company will be able
to obtain the permits and operating licenses required for it to operate, to hire
and train employees or to market, sell and deliver high quality services in
these markets. In addition to the uncertainty as to the Company's ability to
expand its international presence, there are certain risks inherent in doing
business on an international level, such as unexpected changes in regulatory
requirements, tariffs, customs, duties and other trade barriers, difficulties in
staffing and managing foreign operations, longer payment cycles, problems in
collecting accounts receivable, political instability, expropriation,
nationalization, war, insurrection and other political risks, fluctuations in
currency exchange rates, foreign exchange controls which restrict or prohibit
repatriation of funds, technology export and import restrictions or
prohibitions, delays from customs brokers or government agencies, seasonal
reductions in business activity during the summer months in Europe and certain
other parts of the world and potentially adverse tax consequences, which could
adversely impact the success of the Company's international operations. The
Company may need to enter into joint ventures or other strategic relationships
with one or more third parties in order to conduct its foreign operations
successfully. There can be no assurance that such factors will not have an
adverse effect on the Company's future international operations and,
consequently, on the Company's business, financial condition and results of
operations. In addition, there can be no assurance that laws or administrative
practice relating to taxation, foreign exchange or other matters of countries
within which the Company operates will not change. Any such change could have a
material adverse effect on the Company's business, financial condition and
results of operations.
28
<PAGE>
RISKS ASSOCIATED WITH ACQUISITIONS AND STRATEGIC ALLIANCES
As part of its business strategy, the Company expects to continue to seek to
develop strategic alliances both domestically and internationally and/or to
acquire assets and businesses principally relating to or complementary to its
current operations. Any such future strategic alliances or acquisitions would
be accompanied by the risks commonly encountered in strategic alliances with or
acquisitions of companies. Such risks include, among other things, the
difficulty of integrating the operations and personnel of the companies, the
potential disruption of the Company's ongoing business, the inability of
management to maximize the financial and strategic position of the Company by
the successful incorporation of licensed or acquired technology and rights into
the Company's service offerings, the maintenance of uniform standards, controls,
procedures and policies and the impairment of relationships with employees and
customers as a result of changes in management. There can be no assurance that
the Company would be successful in overcoming these risks or any other problems
encountered in connection with such strategic alliances or acquisitions.
In addition, if the Company were to proceed with one or more significant
acquisitions in which the consideration consists of cash, such as the Company's
recently completed transaction with iSTAR, a substantial portion of the
Company's available cash could be used to consummate such acquisitions. If the
Company were to consummate one or more significant acquisitions or strategic
alliances in which the consideration consists of stock, such as the Company's
recently completed transaction with IXC, existing shareholders of the Company
could suffer a significant dilution of their ownership interests in the Company.
Many of the businesses that might become attractive acquisition candidates for
the Company may have or generate significant goodwill and intangible assets, and
acquisition of these businesses, if accounted for as a purchase, would typically
result in increases in the Company's amortization expenses and the length of
time over which they are reported. In connection with acquisitions, the Company
could incur substantial expenses, including the expenses of integrating the
business of the acquired company or the strategic alliance with the Company's
business. Such expenses, in addition to the financial impact of such
acquisitions, could have a material adverse effect on the Company's business,
financial condition and results of operations and could cause substantial
fluctuations in the Company's quarterly and yearly operating results.
Additionally, while the Company believes that after eliminating redundant
network architecture and administrative functions and taking other actions to
integrate the operations of acquired companies it will be able to realize cost
savings, there can be no assurance that the Company's integration of acquired
companies' operations will be accomplished. The inability of the Company to
improve the operating performance of acquired companies' business or to
successfully integrate the operations of acquired companies could have a
material adverse effect on the Company's business, financial condition and
results of operations.
DEPENDENCE ON KEY PERSONNEL
The Company's success depends to a significant degree upon the continued
contributions of its senior management team and technical, marketing and sales
personnel. The Company's employees may voluntarily terminate their employment
with the Company at any time. Competition for qualified employees and personnel
in the Internet services industry is intense and there are a limited number of
persons with knowledge of and experience in the Internet service industry. The
Company's success also will depend on its ability to attract and retain
qualified management, marketing, technical and sales executives and personnel.
The process of locating such personnel with the combination of skills and
attributes required to carry out the Company's strategies is often lengthy. The
loss of the services of key personnel, or the inability to attract additional
qualified personnel, could have a material adverse effect on the Company's
results of operations, product development efforts and ability to expand its
network infrastructure. There can be no assurance that the Company will be
successful in attracting and retaining such executives and personnel. Any such
event could have a material adverse effect on the Company's business, financial
condition and results of operations.
RISKS OF TECHNOLOGY TRENDS AND EVOLVING INDUSTRY STANDARDS
The Company's products and services are targeted toward users of the Internet,
which has experienced rapid growth. The market for Internet access and related
services is relatively new and characterized by rapidly changing technology,
evolving industry standards, changes in customer needs
29
<PAGE>
and frequent new product and service introductions. The Company's future success
will depend, in part, on its ability to effectively use leading technologies, to
continue to develop its technical expertise, to enhance its current services, to
develop new products and services that meet changing customer needs, and to
influence and respond to emerging industry standards and other technological
changes on a timely and cost-effective basis. There can be no assurance that the
Company will be successful in effectively using new technologies, developing new
services or enhancing its existing services on a timely basis or that such new
technologies or enhancements will achieve market acceptance. The Company
believes that its ability to compete successfully is also dependent upon the
continued compatibility and interoperability of its services with products and
architectures offered by various vendors. There can be no assurance that the
Company will be able to effectively address the compatibility and
interoperability issues raised by technological changes or new industry
standards. In addition, there can be no assurance that services or technologies
developed by others will not render the Company's services or technology
uncompetitive or obsolete.
In addition, critical issues concerning the commercial use of the Internet
remain unresolved and may impact the growth of Internet use, especially in the
business market targeted by the Company. Despite growing interest in the many
commercial uses of the Internet, many businesses have been deterred from
purchasing Internet access services for a number of reasons, including, among
others, inconsistent quality of service, lack of availability of cost-effective,
high-speed options, a limited number of local access points for corporate users,
inability to integrate business applications on the Internet, the need to deal
with multiple and frequently incompatible vendors, inadequate protection of the
confidentiality of stored data and information moving across the Internet, and a
lack of tools to simplify Internet access and use. In particular, numerous
published reports have indicated that a perceived lack of security of commercial
data, such as credit card numbers, has significantly impeded commercial
exploitation of the Internet to date, and there can be no assurance that
encryption or other technologies will be developed that satisfactorily address
these security concerns. Published reports have also indicated that capacity
constraints caused by growth in the use of the Internet may, unless resolved,
impede further development of the Internet to the extent that users experience
delays, transmission errors and other difficulties. Further, the adoption of
the Internet for commerce and communications, particularly by those individuals
and enterprises that have historically relied upon alternative means of commerce
and communications, generally requires the understanding and acceptance of a new
way of conducting business and exchanging information. In particular,
enterprises that have already invested substantial resources in other means of
conducting commerce and exchanging information may be particularly reluctant or
slow to adopt a new strategy that may make their existing personnel and
infrastructure obsolete. The failure of the market for business-related
Internet solutions to continue to develop would adversely impact the Company's
business, financial condition and results of operations.
POTENTIAL LIABILITY FOR INFORMATION DISSEMINATED THROUGH NETWORK; REGULATORY
MATTERS
The law relating to liability of ISPs for information carried on or
disseminated through their networks is currently unsettled. A number of
lawsuits have sought to impose such liability for defamatory speech and
infringement of copyrighted materials. In one case, a federal district court
held that an online service provider could be found liable for defamatory matter
provided through its service, on the ground that the service provider exercised
active editorial control over postings to its service. Other courts have held
that online service providers and ISPs may, under certain circumstances, be
subject to damages for copying or distributing copyrighted materials. Certain
provisions of the Communications Decency Act, which imposed criminal penalties
for using an interactive computer service for transmitting obscene or indecent
communications, have been found unconstitutional by the U.S. Supreme Court. New
legislative attempts to curtail obscene or indecent communications are likely.
The imposition upon ISPs or web server hosts of potential liability for
materials carried on or disseminated through their systems could require the
Company to implement measures to reduce its exposure to such liability, which
may require the expenditure of substantial resources or the discontinuation of
certain product or service offerings, any of which could have a material adverse
effect on the Company's business, operating results and financial condition.
The Company carries errors and omissions insurance with a policy limit of $5.0
million, subject to deductibles and exclusions. Such coverage may not be
adequate or available to compensate the Company for all liability that may be
imposed. The imposition of liability in excess of, or the unavailability of,
30
<PAGE>
such coverage could have a material adverse effect on the Company's business,
financial condition and results of operations.
Although the Company's Internet operations are not currently subject to direct
regulation by the Federal Communications Commission (the "FCC") or any other
governmental agency (other than regulations applicable to businesses generally),
due to the increasingly widespread use of the Internet, it is possible that
additional laws and regulations may be adopted with respect to the Internet,
covering issues such as content, user pricing, privacy, libel, intellectual
property protection and infringement, and technology export and other controls.
The FCC is currently reviewing its regulatory position on the usage of the basic
network and communications facilities by ISPs. Changes in the regulatory
structure and environment affecting the Internet access market, including
regulatory changes that directly or indirectly affect telecommunications costs
or increase the likelihood of competition from Regional Bell Operating Companies
("RBOCs") or other telecommunications companies, could have an adverse effect on
the Company's business. Although the FCC has decided not to allow local
telephone companies to impose per-minute access charges on ISPs, the impact of
this decision on the availability of telephone service is the subject of a
congressionally-mandated report. In addition, some telephone companies are
seeking relief through state regulatory agencies. Such rules, if adopted, are
likely to have a greater impact on consumer-oriented Internet access providers
than on business-oriented ISPs such as the Company. Nonetheless, the imposition
of access charges would affect the Company's costs of serving dial-up customers
and could have a material adverse effect on the Company's business, financial
condition and results of operations.
The law relating to the regulation and liability of Internet access providers
in relation to information carried or disseminated also is undergoing a process
of development in other countries. Decisions, laws, regulations and other
activities regarding regulation and content liability may significantly affect
the development and profitability of companies offering on-line and Internet
access services, including the Company.
The Company's wholly-owned subsidiary, PSINet Telecom Limited, has received a
license from the FCC to provide global facilities-based telecommunications
services, subjecting it to regulation as a non-dominant international common
carrier. Further, the Company is also considering the financial, regulatory and
operational implications of becoming or acquiring a competitive local exchange
carrier ("CLEC") in certain selected cities. As a result, it is also possible
that the Company could become subject to further regulation by the FCC and/or
another regulatory agency, including state and local entities, as a provider of
domestic basic telecommunications services, particularly competitive local
exchange services.
The FCC exercises jurisdiction over all facilities of, and services offered
by, telecommunications common carriers to the extent that they involve the
provision, origination or termination of jurisdictionally interstate or
international communications. The state regulatory commissions retain
jurisdiction over the same facilities and services to the extent they involve
origination or termination of jurisdictionally intrastate communications. In
addition, many regulations may be subject to judicial review, the result of
which the Company is unable to predict.
Generally, the FCC has chosen not to exercise its statutory power to closely
regulate the charges or practices of non-dominant carriers. Nevertheless, the
FCC acts upon complaints against such carriers for failure to comply with
statutory obligations or with the FCC's rules, regulations and policies. The
FCC also has the power to impose more stringent regulatory requirements on the
Company and to change its regulatory classification. The Company believes that,
in the current regulatory environment, the FCC is unlikely to do so.
International non-dominant carriers must maintain tariffs on file with the FCC.
Regulation of CLECs occurs on both a state and federal level, to the extent
CLECs provide interstate exchange access service. Regulatory regimes vary from
state to state, however, competing local exchange carriers are non-dominant and
are likely to be subject to a relaxed form of regulation. Nevertheless, there
are numerous state and federal proceedings that may impose regulatory burdens on
CLECs. The Company cannot predict the impact, if any, that future regulation or
regulatory changes may have on the Company.
31
<PAGE>
RISKS ASSOCIATED WITH FINANCING ARRANGEMENTS
Certain of the Company's financing arrangements are secured by substantially
all of the Company's assets and stock of certain subsidiaries of the Company.
These financing arrangements require that the Company satisfy certain financial
covenants and currently prohibit the payment of dividends and the repurchase of
capital stock of the Company without, in each case, the lender's consent. The
Company's secured lenders would be entitled to foreclose upon those assets in
the event of a default under the financing arrangements and to be repaid from
the proceeds of the liquidation of those assets before the assets would be
available for distribution to the holders of the Company's securities in the
event that the Company is liquidated. In addition, the collateral security
arrangements under the Company's existing financing arrangements may adversely
affect the Company's ability to obtain additional borrowings.
RISK OF SYSTEM FAILURE OR SHUTDOWN
The success of the Company is dependent upon its ability to deliver reliable,
high-speed access to the Internet. The Company's network, as is the case with
other networks providing similar service, is vulnerable to damage or cessation
of operations from fire, earthquakes, severe storms, power loss,
telecommunications failures and similar events, particularly if such events
occur within a high traffic location of the network. The Company is also
dependent upon the ability and willingness of its telecommunications providers
to deliver reliable, high-speed telecommunications service through their
networks. While the Company's network has been designed with redundant circuits
among POPs to allow traffic rerouting, lab and field testing is performed before
integrating new and emerging technology into the network, and the Company
engages in capacity planning, there can be no assurance that the Company will
not experience failures or shutdowns relating to individual POPs or even
catastrophic failure of the entire network. The Company carries business
personal property insurance at scheduled locations (which are typically staffed
by Company personnel) and at unscheduled locations (which are typically
unstaffed) with a blanket property limit of $168 million and business
interruption insurance with a blanket limit of $10 million, in each case subject
to deductibles and exclusions. Such coverage may not be adequate or available
to compensate the Company for all losses that may occur. In addition, the
Company generally attempts to limit its liability to customers arising out of
network failures through contractual provisions disclaiming all such liability
and, in respect of certain services, limiting liability to a usage credit based
upon the amount of time that the system was not operational. There can be no
assurance that such limitations will be enforceable. In any event, significant
or prolonged system failures or shutdowns could damage the reputation of the
Company and result in the loss of customers.
NETWORK SECURITY RISKS; RISKS ASSOCIATED WITH PROVIDING SECURITY SERVICES
Despite the implementation of network security measures by the Company, such
as limiting physical and network access to its routers, its infrastructure is
potentially vulnerable to computer viruses, break-ins and similar disruptive
problems caused by its customers or other Internet users. Computer viruses,
break-ins or other problems caused by third parties could lead to interruptions,
delays or cessation in service to the Company's customers. Furthermore, such
inappropriate use of the Internet by third parties could also potentially
jeopardize the security of confidential information stored in the computer
systems of the Company's customers, which may deter potential customers and
adversely affect existing customer relationships. Security problems represent
an ongoing threat to public and private data networks. Attacks upon the
security of Internet sites and infrastructure continue to be reported to
organizations such as the CERT Coordination Center at Carnegie Mellon
University, which facilitates responses of the Internet community to computer
security events. Addressing problems caused by computer viruses, break-ins or
other problems caused by third parties could have a material adverse effect on
the Company.
The security services offered by the Company for use in connection with its
customers' networks also cannot assure complete protection from computer
viruses, break-ins and other disruptive problems. Although the Company attempts
to limit contractually its liability in such instances, the occurrence of such
problems may result in claims against or liability on the part of the Company.
Such claims, regardless of their ultimate outcome, could result in costly
litigation and could have a material adverse effect on the Company's business or
reputation or on its ability to attract and retain customers for its products.
Moreover, until more consumer reliance is placed on security technologies
available, the
32
<PAGE>
security and privacy concerns of existing and potential customers may inhibit
the growth of the Internet service industry and the Company's customer base and
revenues.
DEPENDENCE ON SUPPLIERS
The Company has few long-term contracts with its suppliers. The Company is
dependent on third party suppliers for its leased-line connections, or
bandwidth. Certain of these suppliers are or may become competitors of the
Company, and such suppliers are not subject to any contractual restrictions upon
their ability to compete with the Company. To the extent that these suppliers
change their pricing structures, the Company may be adversely affected.
Following the recent consummation of its transaction with IXC, the Company
anticipates that its dependence upon certain of these suppliers will be
decreased as it accepts delivery of OC-48 bandwidth under the IRU Purchase
Agreement. Nevertheless, until the IXC fiber optic telecommunications system is
completed (and IXC is not obligated under the IRU Purchase Agreement to extend
its buildout of the IXC system beyond 6,640 unique route miles of OC-48
bandwidth) and, in certain geographic areas, even after such completion, the
Company will continue to be dependent upon such suppliers. Moreover, any
failure or delay of IXC to deliver bandwidth under the IRU Purchase Agreement or
to provide operations, maintenance and other services with respect to such
bandwidth in a timely or adequate fashion could adversely affect the Company.
The Company is also dependent on certain third party suppliers of hardware
components. Although the Company attempts to maintain a minimum of two vendors
for each required product, certain components used by the Company in providing
its networking services are currently acquired or available from only one
source.
The Company has from time to time experienced delays in the receipt of certain
hardware components and telecommunications facilities, including, most recently,
delays in delivery of PRI telecommunications facilities (which connect dial-up
customers to the Company's network). A failure by a supplier to deliver quality
products on a timely basis, or the inability to develop alternative sources if
and as required, could result in delays which could materially adversely affect
the Company. The Company's remedies against suppliers who fail to deliver
products on a timely basis are limited by contractual liability limitations
contained in supply agreements and purchase orders and, in many cases, by
practical considerations relating to the Company's desire to maintain good
relationships with the suppliers. As the Company's suppliers revise and upgrade
their equipment technology, the Company may encounter difficulties in
integrating the new technology into the Company's network.
Certain of the vendors from whom the Company purchases telecommunications
bandwidth, including the RBOCs and other local exchange carriers ("LECs"),
currently are subject to tariff controls and other price constraints which in
the future may be changed. In addition, newly enacted legislation will produce
changes in the market for telecommunications services. These changes may affect
the prices charged by the RBOCs and other LECs to the Company, which could have
a material adverse effect on the Company's business, financial condition and
results of operations. Moreover, the Company is subject to the effects of other
potential regulatory actions which, if taken, could increase the cost of the
Company's telecommunications bandwidth through, for example, the imposition of
access charges.
DEPENDENCE ON TECHNOLOGY; PROPRIETARY RIGHTS
The Company's success and ability to compete is dependent in part upon its
technology and proprietary rights, although the Company believes that its
success is more dependent upon its technical expertise than its proprietary
rights. The Company relies on a combination of copyright, trademark and trade
secret laws and contractual restrictions to establish and protect its
technology. Nevertheless, it may be possible for a third party to copy or
otherwise obtain and use the Company's products or technology without
authorization or to develop similar technology independently, and there can be
no assurance that such measures are adequate to protect the Company's
proprietary technology. In addition, the Company's products may be licensed or
otherwise utilized in foreign countries where laws may not protect the Company's
proprietary rights to the same extent as do laws in the United States. It is
the Company's policy to require employees and consultants and, when obtainable,
suppliers to execute confidentiality agreements upon the commencement of their
relationships with the Company. There can be no assurance that the steps taken
by the Company will be adequate to prevent misappropriation of its technology or
that the Company's competitors will not independently develop technologies that
are substantially equivalent
33
<PAGE>
or superior to the Company's technology. The Company is also subject to the risk
of adverse claims and litigation alleging infringement of the intellectual
property rights of others. From time to time the Company has received claims of
infringement of other parties' proprietary rights. While the Company does not
believe that it has infringed the proprietary rights of other parties, there can
be no assurance that third parties will not assert infringement claims in the
future with respect to the Company's current or future products or that any such
claims will not require the Company to enter into license arrangements or result
in protracted and costly litigation, regardless of the merits of such claims. No
assurance can be given that any necessary licenses will be available or that, if
available, such licenses can be obtained on commercially reasonable terms.
YEAR 2000
The Company recognizes the need to ensure that its operations will not be
adversely impacted by Year 2000 software failures. Software failures due to
processing errors potentially arising from calculations using the year 2000 date
are a known risk. The Company has established procedures for evaluating and
managing the risks and costs associated with this problem and believes that its
computer systems are currently Year 2000 compliant. However, many of the
Company's customers maintain their Internet connections on UNIX-based servers,
which may be impacted by Year 2000 complications. The failure of the Company's
customers to ensure that their servers are Year 2000 compliant could have a
material adverse effect on the Company's customers, which in turn could have a
material adverse effect on the Company's business, results of operations and
financial condition. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Year 2000 Date Conversion.'"
POTENTIAL VOLATILITY OF STOCK PRICE
The market price and trading volume of the Company's common stock has been and
may continue to be highly volatile. Factors such as variations in the Company's
revenue, earnings and cash flow and announcements of new service offerings,
technological innovations, strategic alliances and/or acquisitions involving
competitors of the Company or price reductions by the Company, its competitors
or providers of alternative services could cause the market price of the common
stock to fluctuate substantially. In addition, the stock markets recently have
experienced significant price and volume fluctuations that particularly have
affected technology-based companies and resulted in changes in the market prices
of the stocks of many companies that have not been directly related to the
operating performance of those companies. Such broad market fluctuations have
adversely affected and may continue to adversely affect the market price of the
common stock.
FORWARD-LOOKING STATEMENTS
The statements contained in this Report that are not historical fact are
"forward-looking statements" (as such term is defined in the Private
Securities Litigation Reform Act of 1995), which can be identified by the use of
forward-looking terminology such as "believes," "expects," "may,"
"will," "should," or "anticipates" or the negative thereof or other
variations thereon or comparable terminology, or by discussions of strategy that
involve risks and uncertainties. These forward-looking statements, such as,
among others, those relating to the potential benefits to the Company resulting
from its acquisition of the OC-48 bandwidth from IXC, the revenue and
profitability levels of the Company's current operations and its operations
after integrating the operations of the companies it has recently acquired, and
other matters contained above and elsewhere in this Report regarding matters
that are not historical facts, are only predictions. No assurance can be given
that the future results indicated, whether expressed or implied, will be
achieved. While sometimes presented with numerical specificity, these forward-
looking statements are based upon a variety of assumptions relating to the
business of the Company, which, although presently considered reasonable by the
Company, may not be realized. Because of the number and range of the
assumptions underlying the Company's forward-looking statements, many of which
are subject to significant uncertainties and contingencies that are beyond the
reasonable control of the Company, some of the assumptions inevitably will not
materialize and unanticipated events and circumstances may occur subsequent to
the date of this Report. These forward-looking statements are based on current
expectations, and the Company assumes no obligation to update this information.
Therefore, the actual experience of the Company and results achieved during the
period covered by any particular forward-looking statements may differ
substantially from those projected. Consequently, the
34
<PAGE>
inclusion of forward-looking statements should not be regarded as a
representation by the Company or any other person that these estimates will be
realized, and actual results may vary materially. There can be no assurance that
any of these expectations will be realized or that any of the forward-looking
statements contained herein will prove to be accurate.
35
