<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 JUNE 30, 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 51,697,258 SHARES AS OF AUGUST 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 24
<PAGE>
PSINET INC.
TABLE OF CONTENTS
PAGE
----
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements:
<TABLE>
<CAPTION>
<S> <C>
Consolidated Balance Sheets as of June 30, 1998 and December 31, 1997..... 3
Consolidated Statements of Operations for the three and six months ended
June 30, 1998 and June 30, l997......................................... 4
Consolidated Statements of Cash Flows for the six months ended
June 30, 1998 and June 30, 1997......................................... 5
Notes to Consolidated Financial Statements................................ 6
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations................................................. 11
PART II. OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders.................... 21
Item 5. Other Information...................................................... 21
Item 6. Exhibits and Reports on Form 8-K....................................... 22
Signatures....................................................................... 23
Exhibit Index.................................................................... 24
</TABLE>
<PAGE>
Item 1. FINANCIAL STATEMENTS
PSINET INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
June 30, 1998 December 31, 1997
------------------ ----------
(In thousands of U.S. dollars)
(Unaudited) (Audited)
ASSETS
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 124,535 $ 33,322
Restricted cash and short-term investments 143,154 20,690
Short-term investments 246,018 --
Accounts receivable, net 20,839 11,022
Notes receivable 1,779 7,224
Prepaid expenses 4,127 1,478
Other current assets 7,602 5,162
--------- ---------
Total current assets 548,054 78,898
Property and equipment, net 171,526 95,619
Goodwill and other intangibles, net 50,297 4,675
Other assets and deferred charges 24,897 6,989
--------- ---------
Total assets $ 794,774 $ 186,181
========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Lines of credit $ 3,818 $ 5,648
Current portion of long-term debt 46,667 33,985
Trade accounts payable 43,579 25,031
Accrued payroll and related expenses 6,834 4,636
Other accounts payable and accrued liabilities 24,958 2,382
Deferred revenue 6,695 5,944
--------- ---------
Total current liabilities 132,551 77,626
Long-term debt 659,559 33,820
Other liabilities 3,772 1,306
--------- ---------
Total liabilities 795,882 112,752
--------- ---------
Shareholders' equity (deficit):
Preferred stock -- --
Convertible preferred stock 28,477 28,135
Common stock 513 406
Capital in excess of par value 398,083 210,162
Accumulated deficit (246,919) (162,649)
Treasury stock (2,005) (2,005)
Accumulated other comprehensive income 3,462 (620)
Bandwidth asset to be delivered under IRU agreement (182,719) --
--------- ---------
Total shareholders' equity (deficit) (1,108) 73,429
--------- ---------
Total liabilities and shareholders' equity (deficit) $ 794,774 $ 186,181
========= =========
</TABLE>
The accompanying notes are an integral part of
these consolidated financial statements.
3
<PAGE>
PSINET INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
Three Months Ended June 30, Six Months Ended June 30,
--------------------------------- ----------------------------
1998 1997 1998 1997
------------ ------------- -------------- -------------
(In thousands of U.S. dollars, except per share amounts)
(Unaudited) (Unaudited)
<S> <C> <C> <C> <C>
Revenue $ 53,713 $ 29,507 $ 98,182 $ 55,146
Operating costs and expenses:
Data communications and operations 41,943 22,114 78,609 43,082
Sales and marketing 12,486 5,858 23,219 11,860
General and administrative 10,287 6,141 17,872 11,622
Depreciation and amortization 12,889 6,058 22,354 14,092
Charge for acquired in-process
research and development 20,000 -- 27,000 --
--------- --------- --------- ---------
Total operating costs and expenses 97,605 40,171 169,054 80,656
--------- --------- --------- ---------
Loss from operations (43,892) (10,664) (70,872) (25,510)
Interest expense (16,892) (1,297) (19,471) (2,647)
Interest income 6,059 670 6,644 1,445
Other income (expense) 1,103 (32) 1,004 (57)
Gain on sale of subsidiary -- -- -- 5,701
--------- --------- --------- ---------
Loss before income taxes (53,622) (11,323) (82,695) (21,068)
Income tax benefit (expense) (29) 0 (29) 476
--------- --------- --------- ---------
Net loss (53,651) (11,323) (82,724) (20,592)
Return to preferred shareholders (763) -- (1,545) --
--------- --------- --------- ---------
Net loss to common shareholders $ (54,414) $ (11,323) $ (84,269) $ (20,592)
========= ========= ========= =========
Basic and diluted loss per share $ (1.06) $ (0.28) $ (1.76) $ (0.51)
========= ========= ========= =========
Shares used in computing basic and
diluted loss per share (thousands) 51,111 40,225 47,854 40,192
========= ========= ========= =========
</TABLE>
The accompanying notes are an integral part of these
consolidated financial statements.
4
<PAGE>
PSINET INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
Six Months Ended June 30,
-------------------------------------
1998 1997
-------------------------------------
(In thousands of U.S. dollars)
(Unaudited)
<S> <C> <C>
Net cash used in operating activities $ (20,730) $ (10,821)
--------- ---------
Cash flows from investing activities:
Purchases of property and equipment, net (25,214) (8,794)
Purchase of short-term investments (242,269) (3,000)
Proceeds from sale of investments 1,206 4,649
Investments in certain businesses, net of cash acquired (63,357) --
Net proceeds from sale of subsidiary -- 20,353
Change in restricted cash and short-term investments, net (122,478) --
Other, net 800 (61)
--------- ---------
Net cash (used in) provided by investing activities (451,312) 13,147
--------- ---------
Cash flows from financing activities:
Net payments on lines of credit (1,817) 1,000
Proceeds from issuance of notes payable, net 609,007 5,572
Repayments of notes payable (29,147) (3,668)
Principal payments under capital lease obligations (15,237) (9,199)
Dividends paid to preferred shareholders (1,540) --
Other, net 2,051 231
--------- ---------
Net cash provided by (used in) financing activities 563,317 (6,064)
--------- ---------
Effect of exchange rate changes on cash (62) --
--------- ---------
Net increase (decrease) in cash and cash equivalents 91,213 (3,738)
Cash and cash equivalents, beginning of period 33,322 52,695
--------- ---------
Cash and cash equivalents, end of period $ 124,535 $ 48,957
========= =========
</TABLE>
The accompanying notes are an integral part of these
consolidated financial statements.
5
<PAGE>
PSINET INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note l - Basis of Presentation
These consolidated financial statements for the three and six months ended June
30, 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 its 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 and the unaudited
quarterly consolidated financial statements and related notes to consolidated
financial statements of the company for the three months ended March 31, l998
included in the Company's Form 10-Q for the quarter then ended, as filed with
the Securities and Exchange Commission. 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 June 30, 1998 and
the results of its operations and cash flows for the three and six month periods
ended June 30, 1998 and 1997. The results of operations for the three and six
month periods ended June 30, 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.
Comprehensive income for the three and six months ended June 30, 1998 and 1997
was as follows (in thousands of U.S. dollars):
<TABLE>
<CAPTION>
Three Months Ended June 30, Six Months Ended June 30,
------------------------------- --------------------------------
1998 1997 1998 1997
----------------- ------------ ---------------- --------------
<S> <C> <C> <C> <C>
Net loss $(53,651) $(11,323) $(82,724) $(20,592)
Other comprehensive income:
Unrealized holding gain on investments 1,311 - 4 ,955 -
Foreign currency translation (1,179) 74 (873) 7
adjustment -------- -------- -------- --------
132 74 4,082 7
-------- -------- -------- --------
Comprehensive income $(53,519) $(11,249) $(78,642) $(20,585)
======== ======== ======== ========
</TABLE>
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 six month period ended June
30, 1998, the Company purchased equity securities by exercising a warrant. At
June 30, 1998, such investment had an unrealized gain of $5.0 million. On July
1,
6
<PAGE>
1998, the Company sold these securities, resulting in a gain of $5.6 million
that will be recognized in the third quarter.
Note 3 - Long-Term Debt
During the six months ended June 30, 1998, the Company incurred capital lease
obligations of $49.1 million upon the execution of leases for new equipment and
other fixed assets.
At June 30, 1998, the aggregate unused portion under the Company's various
financing arrangements for purchases of equipment and other fixed assets was
$18.2 million. The aggregate unused portion of the Company's operating lines of
credit was $0.1 million.
On April 13, 1998, the Company completed an 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 of 1933, as amended (the "Securities
Act"). On June 11, 1998, the Company completed an exchange offer of the Initial
Notes for equivalent 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. 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 $581.0 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, is expected to 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 primarily to finance the Company's acquisition of iSTAR internet inc.
("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, as of June 30, 1998, approximately
$72.0 million of the net proceeds has been used to make strategic investments in
or acquisitions of businesses or assets related or complementary to the
Company's existing business. See Note 5-Investments in and Acquisitions of
Certain Businesses.
Note 4 Strategic Alliances
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 $78.6 million. If the fair market value of the IXC Initial
Shares (based on a 20 trading day volume-weighted average share price) is less
than $240.0 million 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
7
<PAGE>
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 $240.0
million. At June 30, 1998, the IXC Initial Shares had an aggregate market value
of $133.0 million based on the closing market price per share of the Company's
common stock on such date of $13.00.
The Contingent Payment Obligation was recorded as capital in excess of par value
based on its fair value of $107.3 million. 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 $240.0 million), 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 initial aggregate of the fair value of the IXC
Initial Shares and the Contingent Payment Obligation, $186.0 million, was
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 following closing. As of June 30,
l998, the Company had accepted from IXC 175 equivalent route miles of OC-48
bandwidth and had recorded $3.3 million as an increase to fixed assets and a
decrease to "Bandwidth asset to be delivered under IRU agreement" in
shareholders' equity. As of August 14, 1998, the Company accepted from IXC and
put into use additional bandwidth which, together with the bandwidth previously
accepted by the Company, totals approximately 1,300 equivalent route miles of
OC-48 bandwidth.
The Company expects to incur on an annual basis approximately $1.15 million 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.
8
<PAGE>
Note 5 Investments in and Acquisitions of Certain Businesses
During the six months ended June 30, 1998, the Company acquired six companies
and an equity interest in a seventh company for total cash consideration of
$72.0 million, as follows:
<TABLE>
<CAPTION>
Acquisition Ownership
Business Name Location Date Interest
- ------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Internet Prolink S.A. Switzerland January 1998 100%
- ------------------------------------------------------------------------------------------------
iSTAR internet inc. Canada February and 100%
May 1998
- ------------------------------------------------------------------------------------------------
Interactive Telephony Limited Channel Islands, Jersey April 1998 100%
- ------------------------------------------------------------------------------------------------
WorldPay Ltd.* Channel Islands, Jersey April 1998 12.5%
- ------------------------------------------------------------------------------------------------
Interactive Networx GmbH Germany May 1998 100%
- ------------------------------------------------------------------------------------------------
LinkAge Online Limited Hong Kong June 1998 100%
- ------------------------------------------------------------------------------------------------
IoNET Internetworking Services United States June 1998 100%
- ------------------------------------------------------------------------------------------------
</TABLE>
* The investment in WorldPay is accounted for under the cost method.
Each of the acquisitions was accounted for using the purchase method of
accounting and, accordingly, the net assets and results of operations of the
acquired companies have been included in the Company's financial statements
since the acquisition dates. The purchase price of the acquisitions was
allocated to assets acquired, including intangible assets and liabilities
assumed, based on their respective fair values at the acquisition dates. The
excess of the purchase price over the fair value of the net tangible assets of
the acquisitions is being amortized over periods from two to ten years from the
dates of acquisition. In connection with these acquisitions and based on the
results of an independent valuation, the Company recorded charges in the results
of operations for acquired in-process research and development of $20.0 million
and $27.0 million for the three and six months ended June 30, 1998,
respectively. The charges reflect technology acquired for which technological
feasibility has not been reached and for which there is no alternative future
use.
All of the companies acquired are Internet service providers ("ISPs"), or data
transmission companies, offering a wide range of Internet-protocol based
solutions for businesses, institutions and small-office/home-office users.
Depending on the particular business activities of the company acquired, revenue
may also be derived from service to consumer users, network integration, web
hosting, managed co-location, as well as vertical market Internet services,
including comprehensive banking, medical and telecommunications Internet
solutions.
The purchase price relating to one transaction may be increased by up to $8
million pursuant to an earnout provision in the event the acquired company
achieves certain levels of operating results in the period following the
acquisition. Such amount will be recorded as additional cost of the acquired
company when it becomes probable that the amount will be paid.
In connection with the acquisition of these companies, liabilities assumed were
as follows (in thousands of U.S. dollars):
Fair value of assets acquired $ 111,430
Cash paid for the capital stock (72,011)
------------
Liabilities assumed $ 39,419
============
The following presents the unaudited pro forma results of operations of the
Company for the six month periods ended June 30, 1998 and 1997 as if all of the
companies acquired since the beginning of 1998 in business combinations
accounted for under the purchase method had been consummated at the beginning of
the periods presented. The pro forma results of operations include certain pro
forma adjustments, including the amortization of intangible assets and the
write-off of intangible assets consisting of in-process research and development
costs relating to the acquisitions. The pro forma results of operations are
prepared for comparative purposes only and do not necessarily reflect the
results that would have occurred had the acquisitions occurred at the beginning
of the periods presented or the results which may occur in the future.
9
<PAGE>
<TABLE>
<CAPTION>
Six Months Ended
--------------------------------------------------------------
June 30, 1998 June 30, 1997
----------------------------- -------------------------------
<S> <C> <C>
(in millions of U.S. dollars, except per share amounts)
Revenue $111.6 $ 77.8
Net loss $(94.1) $(77.8)
Basic and diluted loss per share $(2.00) $(1.93)
</TABLE>
Note 6 Subsequent Events
In August 1998, the Company entered into an agreement with a group of leading
global telecommunications companies to build an undersea cable system, called
the Japan-US Cable Network, that will connect the United States and Japan.
Under the agreement, PSINet will have the right to 22 STM-1s (each equivalent to
an OC-3, or 155 MBPS) along with additional rights as the system is upgraded.
The system is scheduled for completion by the second quarter of 2000. PSINet's
portion of the total investment in this facility, including equipment and local
interconnection, is expected to be in excess of $100 million over the 25 year
term of the agreement. It is currently anticipated that this expenditure will
be financed through a combination of capital leases and a portion of the net
proceeds from the Company's recently completed Notes offering along with other
sources of financing over the term of the agreement.
10
<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 for such period and the unaudited quarterly
consolidated financial statements and related notes to consolidated financial
statements of the Company for the period ended March 31, 1998 included in the
Company's Form 10-Q for such period, 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 primarily 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 11 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. The Company recently announced its product
line of Voice-Over-Internet Protocol ("VOIP") services, which will be rolled out
during the second half of 1998. Additionally, the Company provides network
backbone services to other telecommunications carriers and Internet service
providers ("ISPs") to further exploit its network capacity.
At June 30, 1998, the Company served 38,700 business accounts, including 109
ISPs, and connected to more than 400 points of presence ("POPs") in 12 countries
throughout North America, Asia and Europe. The 109 ISPs provide Internet
services to over 300,000 customers using PSINet Internet solutions.
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. To meet the growing data communications needs of its
customers, the Company seeks to continually expand and enhance its network
infrastructure and is committed to a strategy of being a facilities-based ISP,
rather than relying solely on leased bandwidth for its network backbone. This
strategy is intended to lower operating costs, improve capacity and ensure
sufficient availability of bandwidth when needed.
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.
11
<PAGE>
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 of 1933, as amended (the "Securities
Act"). On June 11, 1998, the Company completed an exchange offer of the Initial
Notes for equivalent 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. 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.
They are rated B3 by Moody's Investors Service and B- by Standard & Poor's.
The Notes will mature on February 15, 2005. Interest on the Notes is payable
semi-annually on August 15 and February 15 of each year, commencing August 15,
1998. The Notes are 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 $581.0
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, is expected to 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 primarily 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, as of June 30, 1998, approximately
$72.0 million of the net proceeds has been used to make strategic investments in
or acquisitions of businesses or assets related or complementary to the
Company's existing business. See "--Acquisitions and Investments."
ACQUISITIONS AND INVESTMENTS
In 1998, the Company has to date completed investments in or acquisitions of the
following businesses:
Internet Prolink S.A. - Switzerland
In January 1998, the Company acquired all of the outstanding capital shares of
Internet Prolink S.A. ("Iprolink"), the leading commercial ISP in Switzerland.
iSTAR internet inc. - Canada
Between February and May 1998, the Company acquired all of the outstanding
capital shares of iSTAR internet inc. ("iSTAR"), one of the leading Canadian
providers of Internet services and solutions for businesses, institutions and
individuals.
Interactive Telephony Limited Channel Islands, Jersey
12
<PAGE>
In April 1998, the Company acquired all of the outstanding capital shares of
Interactive Telephony Limited ("ITL"). ITL is the largest ISP based in Jersey
in the Channel Islands.
WorldPay Ltd Channel Islands, Jersey
In April 1998, the Company made a 12.5% investment in WorldPay Ltd., a leading
provider of electronic commerce payment solutions.
Interactive Networx GmbH - Germany
In May 1998, the Company acquired all of the outstanding capital shares of
Interactive Networx GmbH ("INX"). Headquartered in Germany's capital, INX is
the largest ISP in Berlin and is nationally recognized across Germany.
LinkAge Online Limited - Hong Kong
In May 1998, the Company acquired all of the outstanding capital shares of
LinkAge Online Limited ("LinkAge"), a supplier of Internet solutions to
businesses, professionals, government agencies and other ISPs in Hong Kong.
LinkAge also provides integrated business Internet solutions, including Web
hosting, managed co-location, intranet and extranet to companies throughout
Southeast Asia.
ioNET Internetworking Services - Oklahoma
In June 1998, the Company acquired all of the outstanding capital shares of
ioNET Internetworking Services ("ioNET"), a provider of Internet and network
systems integration services to businesses, universities and residential
customers in the south central region of the U.S. In addition to its Internet
offerings, ioNET has developed vertical market Internet services including
comprehensive banking, medical and telecommunications Internet solutions.
Interlog Internet Services Inc.- Canada
Subsequent to the end of the quarter, in July 1998, the Company acquired all of
the outstanding capital shares of Interlog Internet Services Inc., the largest
consumer ISP in Canada serving over 100,000 business and individual subscribers.
INTERNATIONAL OPERATIONS
In addition to its operations in the United States, the Company currently has
operations in eleven other international telecommunications markets, including
Africa, Belgium, Canada, France, Germany, Hong Kong, Italy, Japan, the
Netherlands, Switzerland and the United Kingdom.
Revenue from international operations continues to increase as a percentage of
consolidated results, comprising 31% of revenue in the second quarter of 1998.
By comparison, it was 18% of revenue in the fourth quarter of 1997 and 28% in
the first quarter of 1998.
THREE AND SIX MONTHS ENDED JUNE 30, 1998 AS COMPARED TO THE THREE AND SIX MONTHS
ENDED JUNE 30, 1997.
RESULTS OF OPERATIONS
Revenue. Revenue is derived primarily from the sale of Internet access and
related services to businesses. Revenue was $53.7 million for the three months
ended June 30, 1998, an increase of 82% from $29.5 million for the three months
ended June 30, 1997. Revenue was $98.2 million for the six months ended June
30, 1998, an increase of 78% from $55.1 million for the six months ended June
30, 1997. Due to their timing, acquisitions completed by the Company in the
13
<PAGE>
second quarter of 1998 added only a nominal amount of revenue to the quarter.
Revenue growth for the three and six month periods was derived primarily from
organic sources but also from sales of Internet services by companies acquired
by the Company in previous quarters. The Company's organic growth is
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, an increase in the business account retention
rate, and an increase in sales by the Company's international subsidiaries.
The Company's customer account base increased by 77% to 38,700 business accounts
at June 30, 1998, including 109 ISPs, from 21,900 business accounts, including
40 ISPs, at June 30, 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 $41.9 million (78.1% of revenue) for the three months ended June 30, 1998,
an increase of $19.8 million from $22.1 million (74.9% of revenue) for the three
months ended June 30, l997. Data communications and operations expenses were
$78.6 million (80.1% of revenue) for the six months ended June 30, 1998, an
increase of $35.5 million from $43.1 million (78.1% of revenue) for the six
months ended June 30, l997. 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 substitutes network bandwidth it purchases
or acquires under capital lease agreements for bandwidth currently taken under
operating lease agreements. This will, in turn, result in increases in
depreciation and amortization expense. As of June 30, l998, the Company had
accepted from IXC 175 equivalent route miles of OC-48 bandwidth out of the
10,000 equivalent route miles expected to be delivered over the next two years.
As of August 14, 1998, the Company had accepted from IXC and put into use
additional bandwidth which, together with the bandwidth previously accepted by
the Company, totals approximately 1,000 OC-48 equivalent route miles. The
Company expects to incur on an annual basis $1.15 million in operation and
maintenance fees for each 1,300 equivalent route miles of OC-48 bandwidth
accepted from IXC.
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 $12.5 million (23.2% of
revenue) for the three months ended June 30, 1998, an increase of $6.6 million
from $5.9 million (19.9% of revenue) for the three months ended June 30, l997.
Sales and marketing expenses were $23.2 million (23.6% of revenue) for the six
months ended June 30, 1998, an increase of $11.4 million from $11.9 million
(21.5% of revenue) for the six months ended June 30, l997. The increase
resulted principally from costs related to a branding and advertising campaign
and from costs associated with the growth of the Company's sales force in
conjunction with its growth and acquisition strategy. All advertising and
marketing costs are expensed in the period incurred.
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 $10.3 million (19.2% of revenue) for
the three months ended June 30, 1998, an increase of $4.1 million from $6.1
million (20.8% of revenue) for the three months ended June 30, 1997. General
and administrative expenses were $17.9 million (18.2% of revenue) for the six
months ended June 30,
14
<PAGE>
1998, an increase of $6.3 million from $11.6 million (21.1% of revenue) for the
six months ended June 30, 1997. The increase resulted from the addition of
management staff and related operating expenses across the organization,
including in conjunction with the Company's growth and acquisition strategy, and
increases in the provision for doubtful accounts receivable associated with the
Company's growth in revenue.
Depreciation and Amortization. Depreciation and amortization costs were $12.9
million (24.0% of revenue) for the three months ended June 30, 1998, an increase
of $6.8 million from $6.1 million (20.5% of revenue) for the three months ended
June 30, l997. Depreciation and amortization costs were $22.4 million (22.8% of
revenue) for the six months ended June 30, 1998, an increase of $8.3 million
from $14.1 million (25.6% of revenue) for the six months ended June 30, l997.
Depreciation and amortization costs have increased as a result of capital
expenditures associated with network infrastructure enhancements and
amortization of intangible assets related to acquisitions. The Company
anticipates that its depreciation and amortization expenses will continue to
increase significantly as a percentage of revenue as it substitutes network
bandwidth it purchases or acquires under capital lease agreements for bandwidth
currently taken under operating lease agreements, and as it records depreciation
and amortization on tangible and intangible assets related to business
combinations and expansion of its operations.
Acquired In-Process Research and Development. The results for the three months
ended June 30, 1998 include a $20.0 million charge (37.2% of revenue) for
acquired in-process research and development related to acquisitions completed
during the second quarter. The results for the six months ended June 30, 1998
include a $27.0 million charge (27.5% of revenue) for acquired in-process
research and development. The charges were based on independent valuations and
reflect technologies acquired prior to technological feasibility and for which
there is no alternative future use. There were no comparable charges in 1997.
Interest Expense. Interest expense was $16.9 million for the three months ended
June 30, 1998, an increase of $15.6 million from $1.3 million for the three
months ended June 30, l997. Interest expense was $19.5 million for the six
months ended June 30, 1998, an increase of $16.8 million from $2.6 million for
the six months ended June 30, l997. The increase was due to interest on the
Company's issuance of $600.0 million aggregate principal amount of Notes, as
well as to increased borrowings and capital lease obligations incurred by the
Company to finance network expansion and to fund working capital requirements.
Interest Income. Interest income was $6.1 million for the three months ended
June 30, 1998, an increase of $5.4 million from $0.7 million for the three
months ended June 30, l997. Interest income was $6.6 million for the six months
ended June 30, 1998, an increase of $5.2 million from $1.4 million for the six
months ended June 30, l997. The increase was due to interest received on the
net proceeds of the Company's recently completed offering of the Notes, which
proceeds are 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 they are used
for other purposes.
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 June 30, 1998 was $54.4 million (101.3% of revenue), or $1.06 basic
and diluted loss per share, a $43.1 million increase from a net loss for the
three months ended June 30, 1997 of $11.3 million (38.4% of revenue), or $0.28
basic and diluted loss per share. The Company's net loss to common shareholders
for the six months ended June 30, 1998 was $84.3 million (85.8% of revenue), or
$1.76 basic and diluted loss per share, a $63.7 million increase from a net loss
for the six months ended June 30, 1997 of $20.6 million (37.3% of revenue), or
$0.51 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
15
<PAGE>
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 debt
and equity securities.
CASH FLOWS FOR THE SIX MONTHS ENDED JUNE 30, 1998 AND 1997
Cash flows used in operating activities were $20.7 million and $10.8 million for
the six months ended June 30, 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 were $451.3 million and cash flows
provided by investing activities were $13.1 million for the six months ended
June 30, 1998 and 1997, respectively. Purchases of short-term investments
related to the Notes offering during the six months ended June 30, 1998 were
$242.3 million and restricted cash, including the escrow for interest on the
Notes, was $122.5 million. The expansion of the Company's network resulted in
capital expenditures of $74.3 million and $19.8 million for the six months ended
June 30, 1998 and 1997, respectively (which included capital expenditures
financed under equipment financing agreements aggregating $49.1 million and
$10.9 million, respectively). Acquisition activities resulted in the use of
$63.4 million of cash for the six months ended June 30, 1998, net of cash
acquired. Cash flows provided by investing activities for the six months ended
June 30, 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 $563.3 million and cash flows
used in financing activities were $6.1 million for the six months ended June 30,
1998 and 1997, respectively. The financing cash flow in 1998 primarily relates
to issuance of the Notes, offset by repayments on the Company's financing
facilities. During the six months ended June 30, 1998 and 1997, the Company
made repayments aggregating $44.3 million and $12.9 million, respectively, on
such financing facilities.
As of June 30, 1998, the Company had $513.7 million of cash, cash equivalents,
restricted cash and short-term investments, including $138.7 million escrowed
for the repayment of interest on the 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 June 30, 1998 were $710.0 million, which included $3.8
million under operating lines of credit and $706.2 million under capital lease
obligations and notes payable (including the Notes). The Company also had $1.1
million of letters of credit outstanding as of June 30, 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 $18.2 million. The
aggregate unused portion of the Company's operating lines of credit as of June
30, 1998 (some of which are subject to a borrowing base formula) was $0.1
million.
Certain of the Company's bank financing arrangements, which are secured by
substantially all of the Company's assets, require the Company to satisfy
certain financial
16
<PAGE>
covenants such as those relating to liquidity, 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 June 30, 1998. The Company
is required to maintain: a minimum ratio of quick assets (excluding any
restricted cash) to the sum of funded debt (excluding the Notes) and current
liabilities of 1.50 to 1.00 for the quarter ended June 30, 1998 and thereafter;
a maximum ratio of net debt to annualized revenues of 2.00 to 1.00 for quarters
ending September 30, 1998 and thereafter; a minimum ratio of consolidated EBITDA
to debt service (excluding any interest accreting in respect of the Company's
Contingent Payment Obligation to IXC) of 1.00 to 1.00 for each quarter
commencing with the quarter ending June 30, 1999; and, certain minimum levels of
EBITDA for the quarter ended June 30 1998 and quarters thereafter.
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 less than or equal to 6.0 to 1.0 prior to April 1, 2001 and
less than or equal to 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' 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. The Company was in compliance with all such
covenants at June 30, 1998.
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 $1.5 million with a corresponding increase to capital in excess of
par value. Such amount will be accreted as an additional return to preferred
shareholders over a period of three years. The Series B Preferred Stock may be
redeemed, at the Company's option, under certain circumstances commencing on the
third anniversary of original issuance. Subject to certain exceptions, the
terms of the Series B Preferred Stock provide that, 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
17
<PAGE>
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) $10.0 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 $20.0 million. The Company was in compliance with all
such covenants at June 30, 1998.
COMMITMENTS, CAPITAL EXPENDITURES AND FUTURE FINANCING REQUIREMENTS
As of June 30, 1998, the Company had commitments to certain telecommunications
vendors totaling $26.2 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 June 30, 1998, was obligated to make future minimum lease payments of $35.5
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 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 June 30, 1998, the Company had provided
$1.4 million of equipment under this facility. In certain cases the Company
also obtains local customer circuits under multi-year agreements that permit the
Company to redesignate the circuit to a different customer but which obligate
the Company for that circuit until expiration.
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 build-out of its
international Internet network and a network operations center in Switzerland.
In addition, the Company will continue to seek opportunities to acquire fiber
and bandwidth to enhance its international network capabilities.
During May 1998, the Company acquired the rights to use 18 dark fiber optic
strands covering the New York City metropolitan area, the route between New York
City and Washington, D.C., and the Washington, D.C. metropolitan area. The dark
fiber in the New York to Washington corridor includes 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.
18
<PAGE>
PSINet's rights in these fibers are for 20 years. The fiber is expected to be
integrated with the OC-48 bandwidth corresponding to the PSINet IRUs acquired
from IXC in February 1998 and the 12,000 miles of transatlantic STM-1 fiber IRU
acquired in March 1998. The New York City to Washington, D.C. 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. The acquisition of the dark fiber will be
financed under a capital lease with the supplier. It is currently anticipated
that the related equipment will be financed through a combination of capital
leases or the use of a portion of the net proceeds of the recently completed
Notes offering.
During June 1998, the Company entered into agreements to acquire IRUs in certain
transpacific fiber optic bandwidth between the United States and Japan that will
also serve as a gateway to the remainder of Asia. A portion of the bandwidth is
currently operational, with the remainder expected to come on line in the second
half of 1998 and in 1999. PSINet's total investment in these IRUs will be
approximately $32.0 million. It is currently anticipated that this expenditure
will be financed through a combination of capital leases and a portion of the
net proceeds from the Company's recently completed Notes offering.
In August 1998, the Company entered into an agreement with the group of leading
global telecommunications companies to build an undersea cable system, called
the Japan-US Cable Network, that will connect the United States and Japan. Under
the agreement, PSINet will have the right to 22 STM-1s (each equivalent to an
OC-3, or 155 MBPS) along with additional rights as the system is upgraded. The
system is scheduled for completion by the second quarter of 2000. PSINet's
portion of the total investment in this facility, including equipment and local
interconnection, is expected to be in excess of $100 million over the 25 year
term of the agreement. It is currently anticipated that this expenditure will be
financed through a combination of capital leases and a portion of the net
proceeds from the Company's recently completed Notes offering along with other
sources of financing over the term of the agreement.
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."
The purchase price relating to a recently completed acquisition may be increased
by up to $8 million pursuant to an earnout provision in the event the acquired
company achieves certain levels of operating results in the period following the
acquisition. Such amount will be recorded as additional cost of the acquired
company when it becomes probable that the amount will be paid.
As more fully described in "Notes to Consolidated Financial Statements (Note
4-Strategic Alliances-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."
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
19
<PAGE>
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
Currently, many computer systems and software products are coded to accept only
two digit entries in the date code field. These date code fields will need to
accept four digit entries to distinguish 21st century dates from 20th century
dates. As a result, many computer systems and software products will need to be
upgraded or replaced in order to comply with such Year 2000 requirements. The
Company recognizes the need to ensure that its operations will not be adversely
impacted by Year 2000 software failures. 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. In
addition to the Company's internal assessment of its computer systems' Year 2000
compliance, the Company is in the process of selecting an independent consultant
to conduct a Year 2000 audit of its systems' Year 2000 readiness and to submit a
plan for remediating any problem areas that are identified by such audit. Until
such audit is completed, which the Company expects to occur prior to the end of
1998, the Company is unable to estimate the cost of any such required
remediation. While the Company believes its planning efforts are adequate to
address its Year 2000 concerns, there can be no assurance that the systems of
other companies with which it has material relationships will be converted on a
timely basis and will not have a material adverse effect on the Company. For
example, 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 such customers, which in turn,
to the extent their demand for the Company's services and products are adversely
affected, could have a material adverse effect on the Company's business,
results of operations and financial condition. In addition, the Company faces
risks to the extent that suppliers of products, services and systems purchased
by the Company and others with whom the Company transacts business on a
worldwide basis do not have business systems or products that are Year 2000
compliant. The Company has requested Year 2000 compliance information from its
software vendors, but has not yet received all responses. The Company intends to
continue its efforts to monitor the Year 2000 compliance of key third parties,
although specific plans to assess third-party vendor network equipment have not
yet been formalized and the Company has not yet adopted a contingency plan to
address possible risks to its systems. In the event any third parties cannot
timely provide the Company with products, services or systems that meet the Year
2000 requirements, the Company's operations could be materially adversely
affected. There can be no assurance that these or other factors relating to the
Year 2000 compliance issues, including, without limitation, the possibility of
litigation, will not have a material adverse affect on the Company's business,
financial condition or results of operations. The Company expects to incur
significant internal staff costs as well as consulting and other expenses in
connection with addressing these issues, which costs will be expensed as
incurred.
20
<PAGE>
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
(a) The Annual Meeting of Shareholders of the Company was held on May 2, 1998.
(b) Proxies representing 45,214,132 shares were received (total shares
outstanding as of the Record Date were 50,981,175). The matters voted upon
at the Annual Meeting and the results of the voting as to each such matter
are set forth below:
(i) The election of Dr. William H. Baumer, Ralph T. Swett and Harold S. Wills
as directors of the Company for terms expiring in 2000.
Votes for Dr. Baumer 46,078,021
Votes withheld from Dr. Baumer 5,175
Votes for Mr. Swett 46,082,251
Votes withheld from Mr. Swett 945
Votes for Mr. Wills 46,080,283
Votes withheld from Mr. Wills 2,913
(ii) The ratification of the appointment by the Board of Directors of
PricewaterhouseCoopers LLP as independent accountants of the Company for
the year ending December 31, 1998.
Votes for 46,175,585
Votes against 45,027
There were no broker non-votes in respect of the foregoing matters.
Item 5. OTHER INFORMATION
The Securities and Exchange Commission (the "SEC") has amended recently its Rule
14a-4, which governs the use by the Company of discretionary voting authority
with respect to certain shareholder proposals. SEC Rule 14a-4(c)(1) provides
that, if the proponent of a shareholders proposal fails to notify the Company at
least 45 days prior to the month and day of mailing the prior year's proxy
statement, the proxies of the Company's management would be permitted to use
their discretionary authority at the Company's next annual meeting of
shareholders if the proposal were raised at the meeting without any discussion
of the matter in the proxy statement. In addition, the Company's Certificate of
Incorporation and By-laws require any shareholder who wishes to bring any
proposal before a meeting of shareholders or to nominate a person to serve as a
director to give written notice thereof and certain related information to the
Secretary of the Company at least 60 days prior to the date that is one year
from the date of the immediately preceding annual meeting, if such proposal or
nomination is to be submitted at an annual meeting, and within ten days of the
giving of notice to the shareholders, if such proposal or nomination is to be
submitted at a special meeting. The written notice must set forth with
particularity (i) the name and business address of the shareholder submitting
such proposal and all persons acting in concert with such shareholder; (ii) the
name and address of the persons identified in clause (i), as they appear on the
Company's books (if they so appear); (iii) the class and number of shares of the
Company's stock beneficially owned by the persons identified in clause (i); (iv)
a description of the proposal containing all material information relating
thereto, including, without limitation, the reasons for submitting such
proposal; and (v) such other information as the Board of Directors reasonably
determines is necessary or appropriate to enable the Board of Directors and
shareholders of the Company to consider such proposal. The Company hereby
notifies all shareholders of the Company that after March 21, 1999 any
shareholder proposal submitted outside the process of SEC Rule 14a-8 will be
considered untimely for purposes of SEC Rule 14a-4 and that after February 24,
1999 any shareholder proposal submitted outside the process of SEC Rule 14a-8
will be considered untimely for purposes of SEC Rule 14a-5(e).
21
<PAGE>
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
The following Exhibits are filed or incorporated by reference herewith:
Exhibit 10.1 Employment Agreement dated June 17, 1998 between the Company
and William A. Opet
Exhibit 10.2 Employment Agreement dated July 2, 1998 between the Company
and Robert D. Leahy
Exhibit 10.3 Fourth Amendment to the Amended and Restated Credit
Agreement dated as of July 20, 1998 between the Company and
Fleet Bank of Massachusetts, N.A.
Exhibit 11.1 Calculation of Basic and Diluted Loss per Share and Weighted
Average Shares Used in Calculation for the Three Months
Ended June 30, 1998
Exhibit 11.2 Calculation of Basic and Diluted Loss per Share and Weighted
Average Shares Used in Calculation for the Six Months Ended
June 30, 1998
Exhibit 27 Financial Data Schedule*
Exhibit 99.1 Risk Factors
* 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 of which such exhibit relates.
(b) Reports on Form 8-K
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
$600,000,000 aggregate principal amount of 10% Series Notes due 2005
in accordance with SEC Rule 144A.
On April 23, 1998, the Company filed a Current Report on Form 8-K,
dated April 13, 1998, relating to the completion of its previously
announced offering of $600,000,000 aggregate principal amount of 10%
Senior Notes due 2005.
On June 15, 1998, the Company filed a Current Report on Form 8-K,
dated June 11, 1998, which included as an Exhibit a press release
issued by the Company relating to an offer to exchange the Company's
10% Senior Notes due 2005, Series B, for its previously outstanding
10% Senior Notes due 2005, Series A.
22
<PAGE>
PSINET INC.
FORM 10-Q
JUNE 30, 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.
August 14, 1998 By: /s/ William L. Schrader
- --------------- -------------------------
Date William L. Schrader
Chairman, President, Chief
Executive Officer and Director
August 14, 1998 By: /s/ Edward D. Postal
- --------------- ---------------------
Date Edward D. Postal
Senior Vice President and
Chief Financial Officer
(Principal Financial Officer)
23
<PAGE>
EXHIBIT INDEX
<TABLE>
<CAPTION>
Exhibit
Number Description of Exhibit Location
- ------- ----------------------------------------------------- -------------------------------
<C> <S> <C>
10.1 Employment Agreement dated June 17, 1998 between the Sequentially numbered pages
Company and William A. Opet
10.2 Employment Agreement dated July 2, 1998 between the Sequentially numbered pages
Company and Robert D. Leahy
10.3 Fourth Amendment to the Amended and Restated Credit Sequentially numbered pages
Agreement dated as of July 20, 1998 between the
Company and Fleet Bank of Massachusetts, N.A.
11.1 Calculation of Basic and Diluted Loss per Share and Sequentially numbered pages
Weighted Average Shares Used in Calculation for the
Three Months Ended June 30, 1998
11.2 Calculation of Basic and Diluted Loss per Share and Sequentially numbered pages
Weighted Average Shares Used in Calculation for the
Six Months Ended June 30, 1998
27 Financial Data Schedule Sequentially numbered pages
99.1 Risk Factors Sequentially numbered pages
</TABLE>
24
<PAGE>
Exhibit 10.1
June 17, 1998
William A. Opet
806 Maple Glen Lane
Wayne, Pennsylvania 19087
Dear Bill:
This letter confirms our offer to you of employment by PSINet Inc. (the
"Company"), and sets forth the terms and conditions which shall govern such
employment as outlined below. This offer is subject to satisfactory completion
of reference checks and ratification by the Company's Board of Directors, but
otherwise shall remain open until noon on June 22, 1998.
1. EMPLOYMENT:
A) The Company agrees to employ you as President -- Corporate Network Services,
reporting to the Chief Operating Officer (COO) of the Company. This is a
corporate officer position and as an officer of the Company you must stand for
election by the Board of Directors each year. You accept the employment and
agree to begin work on or before July 15, 1998, and remain in the employ of the
Company, and, except during vacation periods and sickness, to provide during
standard business hours a minimum of forty hours per week of management services
to the Company, as determined by and under the direction of the COO.
B) During your employment you will, except during vacations, periods of
illness, and other absences beyond your reasonable control, devote your best
efforts, skill and attention to the performance of your duties on behalf of the
Company.
2. COMPENSATION:
A) BASE SALARY. The Company shall pay you a base salary at the rate of $185,000
per annum. Your base salary shall be subject to additional increases at the
discretion of the Company's Board of Directors. Your base salary shall be
payable in such installments as the Company regularly pays its other salaried
employees, subject to such deductions and withholdings as may be required by law
or by further agreement with you.
B) BONUS COMPENSATION. The Company will pay you a bonus upon the successful
completion of the objectives established for your performance, which will be
measured on or about January 25, 1999. The performance criteria will be issued
separately by the COO, and may be changed, with mutual fairness, from time to
time as situations develop. The target bonus for the period ending December 31,
1998 (start date through December 31, 1998) will be a total of up to $37,500.
Separate criteria will be established for your entitlement for the year starting
January 1, 1999.
C) INCENTIVE STOCK OPTIONS. Effective upon your start date, PSINet Inc. shall
grant you options, subject to Board approval, to purchase One Hundred Thousand
(100,000) shares of PSINet Inc.'s common stock (the "Options") pursuant to its
Executive Stock Incentive Plan (the "Plan"). Such Options shall be evidenced by
an option agreement in such form as required by the Plan. Among other terms and
provisions prescribed by the Plan, the option agreement shall provide that (a)
the exercise price of the Options shall be the price per share of the Company's
common stock as reported by the NASDAQ Stock Market at the close of business on
your start date, (b) the Options shall not be exercisable after the expiration
of ten years from the date such Options are granted, and (c) the stock shall
vest ratably, monthly, over forty-eight months, provided that for each month's
vesting purposes you continue to be employed
25
<PAGE>
full time by the Company or one of its subsidiaries during such month, and
provided that the Company's Board of Directors ratifies, no less often than
annually, that you have met the performance standards and criteria set for you
for the preceding period.
3. EMPLOYEE BENEFITS. You shall be provided employee benefits, including
(without limitation) 401(k), four weeks' paid vacation, and life, health,
accident and disability insurance under the Company's plans, policies and
programs available to employees in accordance with the provisions of such plans,
policies, and programs.
4. RELOCATION PACKAGE. Your "target" date for completing your relocation to the
Greater Washington, D.C. area shall be September 15, 1998. Prior to that time,
but ending when you complete your relocation, the Company shall pay for airfare
for your twice per month travel from Wayne, Pennsylvania to Washington, D.C.
(business class fare rate). The Company will provide you with a hotel
suite/apartment in the Herndon, VA area. The Company shall also reimburse you
for your reasonable household moving expenses here, up to $50,000.
5. TERMINATION:
A) Your employment with the Company may be terminated by the Company at any
time for "Cause" as defined in Section 5(c) hereof. Upon such termination, the
Company will provide written notice whether it has elected to use the non-
competition restrictions set forth in Section 6(a) hereof. Your employment may
also be terminated by the Company at any time without Cause provided the Company
shall have given you thirty (30) days' prior written notice of such termination.
That written notice must state whether the Company has elected to use the non-
Competition restriction (which decision may not be rescinded). If you are
terminated by the Company without case within the initial one-year term of your
employment, you will be paid ninety (90) days' severance pay. In addition, your
employment may be terminated by you at any time for any reason, provided you
shall have given the Company at least thirty (30) days' prior written notice of
such termination. By the 30th day the Company must notify you in writing whether
it has elected to use the non-Competition restriction. Such decision may not be
rescinded. Failure of the Company to so notify you shall result in the non-
Competition restriction not being in place.
B) Subject to your compliance with your obligations under Section 6 hereof, in
the event that your employment terminates or is terminated by you or the Company
for any reason other than for Cause, and the Company has elected to use the non-
Competition restriction, you shall be entitled, for a period of twelve (12)
months after termination of employment, to the following (collectively, the
"Termination Payments"): (i) your then current rate of base salary as provided
in Section 2; (ii) all life insurance and health benefits, disability insurance
and benefits and reimbursement theretofore being provided to you; and (iii)
Company contributions, to the extent permitted by applicable law, to a SEP-IRA,
Keogh or other retirement mechanism selected by you sufficient to provide the
same level of retirement benefits you would have received if you had remained
employed by the Company during such 12-month period. The Company shall make up
the difference in cash payments directly to you to the extent that applicable
law would not permit it to make such contributions.
C) The Company shall have "Cause" for your termination of your employment by
reason of any breach of your agreement not to compete pursuant to Section 6
hereof, your committing an act materially adversely affecting the Company which
constitutes wanton or willful misconduct, your conviction of a felony, or any
material breach by you of this Agreement.
6. AGREEMENT NOT TO COMPETE.
A) In consideration of your employment pursuant to this Agreement and for other
good and valuable consideration, the receipt and adequacy of which is hereby
acknowledged, you covenant to and agree with the Company that, so long as you
are employed by the Company under this Agreement and for a period of twelve (12)
months following the termination of such employment
26
<PAGE>
(but only if the Company has elected to enforce the restriction), you shall not,
without the prior written consent of the Company, either for yourself or for any
other person, firm or corporation, manage, operate, control, participate in the
management, operation or control of or be employed by any other person or entity
which is engaged in providing Internet-related network or communications
services competitive with the Internet-related network or communication services
offered to customers by the Company as of the date of termination or within six
(6) months thereafter. The foregoing shall in no event restrict you from: (i)
writing or teaching, whether on behalf of for-profit, or not-for-profit
institution(s); (ii) investing (without participating in management or
operation) in the securities of any private or publicly traded corporation or
entity; or (iii) after termination of employment, becoming employed by a
hardware, software or other vendor to the Company, provided that such vendor
does not offer network or communication services that are competitive with the
Internet-related network or communications services offered by the Company as of
the date of termination of employment or within six (6) months thereafter.
B) You may request permission from the Company's Board of Director's to engage
in activities which would otherwise be prohibited by Section 6(a). The Company
shall respond to such request within thirty (30) days after receipt. The Company
will notify you in writing if it becomes aware of any breach or threatened
breach of any of the provisions in Section 6(a), and you shall have thirty (30)
days after receipt of such notice in which to cure or prevent the breach, to the
extent that you are able to do so. You and the Company acknowledge that any
breach or threatened breach by you of any of the provisions in Section 6(a)
above cannot be remedied by the recovery of damages, and agree that in the event
of any such breach or threatened breach which is not cured with such 30-day
period, the Company may pursue injunctive relief for any such breach or
threatened breach. If a court of competent jurisdiction determines that you
breached any of such provisions, you shall not be entitled to any Termination
Payments from and after date of the breach. In such event, you shall promptly
repay any Termination Payments previously made plus interest thereon from the
date of such payment(s) at 12% per annum. If, however, the Company has suspended
making such Termination Payments and a court of competent jurisdiction finally
determines that you did not breach such provision or determines such provision
to be unenforceable as applied to your conduct, you shall be entitled to receive
any suspended Termination Payment, plus interest thereon from the date when due
at 12% per annum. The Company may elect (once) to continue paying the
Termination Payments before a final decision has been made by the court.
7. INTELLECTUAL PROPERTY. Ownership of Work Product. All copyrights, patents,
trade secrets, or other intellectual property rights associated with any ideas,
concepts, techniques, inventions, processes, or works of authorship developed or
created by you during the course of performing the Company's work (collectively
the "Work Product") shall belong exclusively to the Company and shall, to the
extent possible, be considered a work made for hire for the Company within the
meaning of Title 17 of the United States Code. You automatically assign, and
shall assign at the time of creation of the Work Product, without any
requirement of further consideration, any right, title, or interest you may have
in such Work Product, including any copyrights or other intellectual property
rights pertaining thereto. Upon request of the Company, you shall take such
further actions, including execution and delivery of instruments of conveyance,
as may be appropriate to give full and proper effect to such assignment.
8. TRANSFERABILITY.
A) As used in this Agreement, the term "Company" shall include any successor to
all or part of the business or assets of the Company who shall assume and agree
to perform this Agreement.
This Agreement shall inure to the benefit of and be enforceable by you and
your personal or legal representatives, executors, administrators, heirs,
distributees, devisees and legatees.
27
<PAGE>
B) Except as provided under paragraph (a) of this Section 8, neither this
Agreement nor any of the rights or obligations hereunder shall be assigned or
delegated by any party hereto without the prior written consent of the other
party.
9. SEVERABILITY. The invalidity or unenforceability of any particular provision
of this Agreement shall not affect the other provisions hereof, and this
Agreement shall be construed in all respects as if such invalid or unenforceable
provision were omitted. If a court of competent jurisdiction determines that any
particular provision of this Agreement is invalid or unenforceable, the court
shall restrict the provision so as to be enforceable. However, if the provisions
of Section 6 shall be restricted, a proportional reduction shall be made in the
payments under Section 5.
10. ENTIRE AGREEMENT; WAIVERS. This letter Agreement contains the entire
agreement of the parties concerning the subject matter hereof and supersedes and
cancels all prior agreements, negotiations, correspondence, undertakings and
communications of the parties, oral or written. No waiver or modification of any
provision of this Agreement shall be effective unless in writing and signed by
both parties.
11. NOTICES. Any notices, requests, instruction or other document to be given
hereunder shall be in writing and shall be sent certified mail, return receipt
requested, addressed to the party intended to be notified at the address of such
party as set for at the head of this agreement or such other address as such
party may designate in writing to the other.
12. GOVERNING LAW. THIS LETTER AGREEMENT SHALL BE SUBJECT TO, GOVERNED BY AND
CONSTRUED IN ACCORDANCE WITH THE LAWS OF THE STATE OF NEW YORK WITHOUT REFERENCE
TO ITS PRINCIPLES OF CONFLICTS OF LAW.
13. COUNTERPARTS. This letter Agreement may be executed in one or more
counterparts, each of which shall be deemed an original and all of which shall
be one and the same instrument.
Please confirm your agreement with the foregoing by signing and returning one
copy of this letter Agreement to the undersigned, whereupon this letter
agreement shall become a binding agreement between you and the Company.
Sincerely,
PSINet Inc.
By: /s/ Harold S. Wills
-------------------
HAROLD S. WILLS
Executive Vice President and Chief Operating Officer
Accepted and Agreed to as of June 19 , 1998:
-----------
By: /s/ William A. Opet
-------------------
WILLIAM A. OPET
28
<PAGE>
EXHIBIT 10.2
July 2, 1998
Mr. Robert D. Leahy
5121 52nd Street, N.W.
Washington, DC 20016
Dear Mr. Leahy:
This letter confirms our offer to you of employment by PSINet Inc. (the
"Company"), and sets forth the terms and conditions which shall govern such
employment as outlined below. This offer is subject to satisfactory completion
of reference checks and ratification by the Company's Board of Directors, but
otherwise shall remain open until midnight on Friday, July 10, 1998.
1. EMPLOYMENT:
A) The Company agrees to employ you as Senior Vice President of Corporate
Marketing and Communications, reporting to the Chief Operating Officer of the
Company. This is a corporate officer position and as an officer of the Company
you must stand for election by the Board of Directors each year. You accept the
employment and agree to begin work on or before July 27, 1998, and remain in the
employ of the Company, and, except during vacation periods and sickness, to
provide during standard business hours a minimum of forty hours per week of
management services to the Company, as determined by and under the direction of
the Chief Operating Officer. From the date hereof until you begin work, you
agree to act as a consultant to the Company.
B) During your employment you will, except during vacations, periods of
illness, and other absences beyond your reasonable control, devote your best
efforts, skill and attention to the performance of your duties on behalf of the
Company.
2. COMPENSATION:
A) BASE SALARY. The Company shall pay you a base salary at the rate of
$225,000 per annum. Your base salary shall be subject to additional annual
increases at the discretion of the Company's Board of Directors and predicted on
the results of an annual performance review. Your base salary shall be payable
in such installments as the Company regularly pays its other salaried employees,
subject to such deductions and withholdings as may be required by law or by
further agreement with you.
B) BONUS COMPENSATION. The Company will pay you a bonus upon the
successful completion of the objectives established for your performance, which
will be measured on or about February 1, 1999. The performance criteria will be
issued separately by the Chief Operating Officer, and may be changed, with
mutual fairness, from time to time as situations develop. The target bonus for
the period ending December 31, 1998 (start date through December 31, 1998) will
be a total of up to 32% of the base salary paid to you during such period.
Separate objective criteria will be established for your entitlement for the
year starting January 1, 1999.
C) STARTING BONUS. Upon your first day of employment, the Company will pay
you a cash bonus of $32,000, subject to such deductions and withholdings as may
be required by law or further agreement with you.
D) INCENTIVE STOCK OPTIONS. Effective upon your start date as a consultant
to the Company, PSINet Inc. shall grant you options, subject to Board approval,
to purchase One Hundred Thousand (100,000) shares of PSINet Inc.'s common stock
(the "Options") pursuant to its Executive Stock Incentive Plan (the "Plan").
Such Options shall be evidenced by an option agreement in such form as required
by the Plan. Among other terms and provisions prescribed by the Plan, the option
agreement shall provide that (a) the exercise price of the Options shall be the
price per share of the Company's
29
<PAGE>
common stock as reported by the NASDAQ Stock Market at the close of business on
the date of grant, (b) the Options shall not be exercisable after the expiration
of ten years from the date such Options are granted, and (c) the stock shall
vest ratably, monthly, over forty-eight months, provided that for each month's
vesting purposes you continue to be employed full time by the Company or one of
its subsidiaries during such month, and provided that the Company's Board of
Directors ratifies, no less often than annually, that you have met the
performance standards and criteria set for you for the preceding period. You
also may be eligible to receive additional options periodically during your
employment by the Company.
3. EMPLOYEE BENEFITS. You shall be provided employee benefits, including
(without limitation) 401(k), four weeks' paid vacation, and life, health,
accident and disability insurance under the Company's plans, policies and
programs available to employees in accordance with the provisions of such plans,
policies, and programs.
4. TERMINATION:
A) Your employment with the Company may be terminated by the Company at any
time for "Cause" as defined in Section 4(c) hereof. Upon such termination, the
Company will provide written notice whether it has elected to use the non-
competition restrictions set forth in Section 5(a) hereof. Your employment may
also be terminated by the Company at any time without Cause provided the Company
shall have given you twelve (12) months' prior written notice of such
termination. That written notice must state whether the Company has elected to
use the non-Competition restriction (which decision may not be rescinded). In
addition, your employment may be terminated by you at any time for any reason,
provided you shall have given the Company at least thirty (30) days' prior
written notice of such termination. By the 30th day the Company must notify you
in writing whether it has elected to use the non-Competition restriction. Such
decision may not be rescinded. Failure of the Company to so notify you shall
result in the non-Competition restriction not being in place.
B) Subject to your compliance with your obligations under Section 5
hereof, in the event that your employment terminates or is terminated by you or
the Company for any reason other than for Cause, and the Company has elected to
use the non-Competition restriction, you shall be entitled, for a period of
twelve (12) months after termination of employment, to the following
(collectively, the "Termination Payments"): (i) your then current rate of base
salary as provided in Section 2; (ii) all life insurance and health benefits,
disability insurance and benefits and reimbursement theretofore being provided
to you; and (iii) Company contributions, to the extent permitted by applicable
law, to a SEP-IRA, Keogh or other retirement mechanism selected by you
sufficient to provide the same level of retirement benefits you would have
received if you had remained employed by the Company during such 12-month
period. The Company shall make up the difference in cash payments directly to
you to the extent that applicable law would not permit it to make such
contributions.
C) The Company shall have "Cause" for your termination of your employment
by reason of any breach of your agreement not to compete pursuant to Section 5
hereof, your committing an act materially adversely affecting the Company which
constitutes wanton or willful misconduct, your conviction of a felony, or any
material breach by you of this Agreement.
5. AGREEMENT NOT TO COMPETE.
A) In consideration of your employment pursuant to this Agreement and for
other good and valuable consideration, the receipt and adequacy of which is
hereby acknowledged, you covenant to and agree with the Company that, so long as
you are employed by the Company under this Agreement and for a period of twelve
(12) months following the termination of such employment (but only if the
Company has elected to enforce the restriction), you shall not, without the
prior written consent of the Company, either for yourself or for any other
person, firm or corporation, manage, operate, control, participate in the
management, operation or control of or be employed by any other person or entity
which is engaged in providing Internet-related network or communications
services competitive with the Internet-related network or communication services
offered to customers by the Company as of the date of termination or within six
(6) months thereafter. The foregoing shall in no event restrict you from: (i)
writing or teaching, whether on behalf of for-profit, or not-for-profit
institution(s); (ii) investing (without
30
<PAGE>
participating in management or operation) in the securities of any private or
publicly traded corporation or entity; or (iii) after termination of employment,
becoming employed by a hardware, software or other vendor to the Company,
provided that such vendor does not offer network or communication services that
are competitive with the Internet-related network or communications services
offered by the Company as of the date of termination of employment or within six
(6) months thereafter.
B) You may request permission from the Company's Board of Director's to
engage in activities which would otherwise be prohibited by Section 5(a). The
Company shall respond to such request within thirty (30) days after receipt. The
Company will notify you in writing if it becomes aware of any breach or
threatened breach of any of the provisions in Section 5(a), and you shall have
thirty (30) days after receipt of such notice in which to cure or prevent the
breach, to the extent that you are able to do so. You and the Company
acknowledge that any breach or threatened breach by you of any of the provisions
in Section 5(a) above cannot be remedied by the recovery of damages, and agree
that in the event of any such breach or threatened breach which is not cured
with such 30-day period, the Company may pursue injunctive relief for any such
breach or threatened breach. If a court of competent jurisdiction determines
that you breached any of such provisions, you shall not be entitled to any
Termination Payments from and after date of the breach. In such event, you shall
promptly repay any Termination Payments previously made plus interest thereon
from the date of such payment(s) at 12% per annum. If, however, the Company has
suspended making such Termination Payments and a court of competent jurisdiction
finally determines that you did not breach such provision or determines such
provision to be unenforceable as applied to your conduct, you shall be entitled
to receive any suspended Termination Payment, plus interest thereon from the
date when due at 12% per annum. The Company may elect (once) to continue paying
the Termination Payments before a final decision has been made by the court.
6. INTELLECTUAL PROPERTY. Ownership of Work Product. All copyrights, patents,
trade secrets, or other intellectual property rights associated with any ideas,
concepts, techniques, inventions, processes, or works of authorship developed or
created by you during the course of performing the Company's work (collectively
the "Work Product") shall belong exclusively to the Company and shall, to the
extent possible, be considered a work made for hire for the Company within the
meaning of Title 17 of the United States Code. You automatically assign, and
shall assign at the time of creation of the Work Product, without any
requirement of further consideration, any right, title, or interest you may have
in such Work Product, including any copyrights or other intellectual property
rights pertaining thereto. Upon request of the Company, you shall take such
further actions, including execution and delivery of instruments of conveyance,
as may be appropriate to give full and proper effect to such assignment.
7. TRANSFERABILITY.
A) As used in this Agreement, the term "Company" shall include any
successor to all or part of the business or assets of the Company who shall
assume and agree to perform this Agreement.
This Agreement shall inure to the benefit of and be enforceable by you and your
personal or legal representatives, executors, administrators, heirs,
distributees, devisees and legatees.
B) Except as provided under paragraph (a) of this Section 7, neither this
Agreement nor any of the rights or obligations hereunder shall be assigned or
delegated by any party hereto without the prior written consent of the other
party.
8. SEVERABILITY. The invalidity or unenforceability of any particular provision
of this Agreement shall not affect the other provisions hereof, and this
Agreement shall be construed in all respects as if such invalid or unenforceable
provision were omitted. If a court of competent jurisdiction determines that any
particular provision of this Agreement is invalid or unenforceable, the court
shall restrict the provision so as to be enforceable. However, if the provisions
of Section 5 shall be restricted, a proportional reduction shall be made in the
payments under Section 4.
9. ENTIRE AGREEMENT; WAIVERS. This letter Agreement contains the entire
agreement of the parties concerning the subject matter hereof and supersedes and
cancels all prior agreements, negotiations, correspondence, undertakings and
communications of the parties, oral or written. No
31
<PAGE>
waiver or modification of any provision of this Agreement shall be effective
unless in writing and signed by both parties.
10. NOTICES. Any notices, requests, instruction or other document to be given
hereunder shall be in writing and shall be sent certified mail, return receipt
requested, addressed to the party intended to be notified at the address of such
party as set for at the head of this agreement or such other address as such
party may designate in writing to the other.
11. GOVERNING LAW. THIS LETTER AGREEMENT SHALL BE SUBJECT TO, GOVERNED BY AND
CONSTRUED IN ACCORDANCE WITH THE LAWS OF THE STATE OF NEW YORK WITHOUT REFERENCE
TO ITS PRINCIPLES OF CONFLICTS OF LAW.
12. COUNTERPARTS. This letter Agreement may be executed in one or more
counterparts, each of which shall be deemed an original and all of which shall
be one and the same instrument.
Please confirm your agreement with the foregoing by signing and returning one
copy of this letter Agreement to the undersigned, whereupon this letter
agreement shall become a binding agreement between you and the Company.
Sincerely,
PSINet Inc.
By: /s/ Harold S. Wills
-------------------
HAROLD S. WILLS
EXECUTIVE VICE PRESIDENT AND CHIEF OPERATING OFFICER
Accepted and Agreed to as of July 2, 1998:
-------
By: /s/ Robert D. Leahy
-------------------
ROBERT D. LEAHY
32
<PAGE>
EXHIBIT 10.3
FOURTH AMENDMENT TO
AMENDED AND RESTATED CREDIT AGREEMENT
-------------------------------------
This Fourth Amendment to Amended and Restated Credit Agreement ("Agreement")
is made as of this 20th day of July, 1998 by and between PSINet Inc. (f/k/a
Performance Systems International, Inc.), a New York corporation ("PSI"), (PSI
hereinafter sometimes referred to as "Borrower"), and Fleet National Bank,
formerly known as Fleet National Bank of Connecticut, successor by merger to
Fleet Bank of Massachusetts, N.A. (hereinafter referred to as the "Bank"), as
lender.
WHEREAS, as of November 30, 1994, PSI and the Bank entered into a Credit
Agreement (the "Original Credit Agreement");
WHEREAS, as of March 24, 1995, PSI and the Bank entered into an amendment to
the Original Credit Agreement (the "First Amendment to Credit Agreement") to (i)
increase the term credit from $2,000,000 to $8,500,000, (ii) add the then newly-
acquired PSINet Pipeline New York, Inc.("Pipeline") as a guarantor and (iii)
otherwise amend the Original Credit Agreement, all as set forth in the First
Amendment to Credit Agreement;
WHEREAS, as of November 10, 1995, PSI, InterCon Systems Corporation
("InterCon"), Software Ventures Corporation ("Software") and the Bank entered
into an Amended and Restated Credit Agreement (the "Amended and Restated Credit
Agreement") which amended and restated the terms of the Original Credit
Agreement as amended by the First Amendment to Credit Agreement to (i) increase
the revolving credit from $1,500,000 to $5,000,000, (ii) add Software and
InterCon as borrowers under the revolving credit (to the extent provided
therein), (iii) increase the term credit from $8,500,000 to $13,500,000 and (iv)
make certain other changes, all as set forth in the Amended and Restated Credit
Agreement;
WHEREAS, on April 6, 1996, Software merged with and into InterCon, with
InterCon as the surviving entity;
WHEREAS, as of August 13, 1996, PSI, InterCon and the Bank entered into a
First Amendment to Amended and Restated Credit Agreement (the "First Amendment
to Amended and Restated Credit Agreement") to (i) increase the term credit from
$13,500,000 to $18,500,000, (ii) extend the Term Credit Expiration Date to June
30, 1997, and (iii) make certain other changes, all as set forth in the First
Amendment to Amended and Restated Credit Agreement;
WHEREAS, as of February 1, 1997, PSI and the Bank entered into a Second
Amendment to Amended and Restated Credit Agreement (the "Second Amendment to
Amended and Restated Credit Agreement) to (i) consent to the sale of the stock
of InterCon and to release all obligations of InterCon and Software to the Bank,
including without limitation, all guarantees and security interests, and (ii)
make certain other changes, all as set forth in the Second Amendment to Amended
and Restated Credit Agreement;
WHEREAS, on or about June 1996, the assets of Pipeline were sold;
WHEREAS, as of January 29, 1998, PSI and the Bank entered into a Third
Amended and Restated Credit Agreement (the "Third Amendment to Amended and
Restated Credit Agreement") to (i) establish a new acquisition term credit in
the original principal amount of $20,000,000 to finance the purchase of stock of
iSTAR Internet Inc., a Canadian company, and for working capital, (ii) extend
the expiration date of the revolving credit to March 31, 1998, (iii) cause
delivery to the Bank of an outstanding letter of credit issued by the Bank on
December 31, 1997, as amended, and (iv) make certain other changes as set forth
in the Third Amendment to Amended and Restated Credit Agreement; and
33
<PAGE>
WHEREAS, the Borrower and the Bank now desire to further amend the Amended
and Restated Credit Agreement (as amended by the First Amendment to Amended and
Restated Credit Agreement, the Second Amendment to Amended and Restated Credit
Agreement, and the Third Amendment to Amended and Restated Credit Agreement
hereinafter referred to as the "Credit Agreement") to (i) extend the expiration
date of the revolving credit to September 30, 1998, and (ii) make certain other
changes, all as set forth in this Agreement. Unless otherwise defined herein,
capitalized terms used herein shall have the meanings ascribed to them in the
Credit Agreement.
NOW, THEREFORE, in consideration of the mutual promises contained in this
Agreement, the receipt and sufficiency of which are hereby acknowledged, the
parties hereto agree as follows:
1. Section 4.15 of the Credit Agreement is hereby amended by deleting the
amount "$50,000,000" appearing in line 3 of paragraph (d) thereof and
substituting therefore "$100,000,000".
2. Sections 4.22, 4.23, 4.25 and 4.26 of the Credit Agreement are hereby
amended by deleting said sections in their entirety and substituting therefore
the following:
Section 4.22. Quick Assets to Funded Debt Ratio and Current Liabilities.
------------ ---------------------------------------------------------
For the quarter ending June 30, 1998 and thereafter, the ratio of Quick
Assets to the sum of Funded Debt and Current Liabilities shall at all times
equal or exceed 1.50:1.00.
"Quick Assets" shall mean the sum of all cash, cash equivalents, accounts
receivable, short-term investments (as defined by generally accepted accounting
principles), and marketable securities (as defined by generally accepted
accounting principles) of the Borrower and its Subsidiaries on a consolidated
basis; provided that Restricted Cash shall not be included for purposes of
determining Quick Assets.
"Funded Debt" shall mean all indebtedness for borrowed money of the
Borrower and its Subsidiaries, including without limitation, the Revolving
Credit, the Term Credit and Capitalized Leases; provided that, for the purposes
of this Section 4.22 only, the 10% Senior Notes due 2005 of PSI in the aggregate
original principal amount of $600,000,000 (the "Senior Notes") shall not be
included for purposes of determining Funded Debt.
"Current Liabilities" shall mean all liabilities and obligations of the
Borrower and its subsidiaries on a consolidated basis that would be classified
as current liabilities determined in accordance with generally accepted
accounting principles consistently applied.
"Restricted Cash" shall mean the interest escrow for the Senior Notes or any
other cash that is encumbered, subject to a lien in favor of a third party other
than the Bank, subject to a sinking fund, or the use of which is otherwise
restricted (other than by the Bank).
Section 4.23. [Intentionally Deleted].
------------ -----------------------
Section 4.25. Net Debt to Annualized Revenues Ratio. The ratio of the Net
------------ -------------------------------------
Debt of the Borrower and its Subsidiaries on a consolidated basis to Annualized
Revenues on a consolidated basis shall as of the last day of each fiscal quarter
commencing with the fiscal quarter ended September 30, l998 not exceed
2.00:1.00.
"Net Debt" shall mean (a) Funded Debt less (b) all cash and short-term
investments (as defined by generally accepted accounting principles consistently
applied) of the Borrower and its Subsidiaries on a consolidated basis.
"Annualized Revenues" shall mean the revenues of the Borrower and its
Subsidiaries on a Consolidated basis determined in accordance with generally
accepted accounting principles consistently applied during the preceding twelve-
month period measured at the end of each fiscal quarter.
34
<PAGE>
Section 4.26. Debt Service Ratio. The ratio of Consolidated EBITDA to Debt
------------ ------------------
Service shall, as of the last day of each fiscal quarter commencing with the
fiscal quarter ended June 30, 1999 equal or exceed 1.00:1.00.
"Debt Service" shall mean, with respect to any period, all payments of
principal or interest by the Borrower and its Subsidiaries on a consolidated
basis on account of indebtedness for borrowed money including, without
limitation, payment of principal and interest on account of the Credit;
provided, that any interest accreting as a result of any obligations to deliver
additional securities, cash or a combination thereof (at the option of Borrower)
pursuant to the bandwidth transaction with IXC Communications, Inc. shall not be
included for purposes of determining Debt Service.
3. Section 1.03 of the Credit Agreement (as amended by letter agreement
dated September 30, 1997 and the Third Amendment to Amended and Restated Credit
Agreement) is hereby amended by deleting the date "March 31, 1998" (the
"Revolving Credit Maturity Date") appearing in line 4 of paragraph (a) thereof
and substituting therefore "September 30, 1998" (the "Revolving Credit Maturity
Date").
4. Section 4.24 of the Credit Agreement is hereby amended by deleting said
section in its entirety and substituting therefore Exhibit A hereof.
5. After giving effect to this Agreement, all representations and warranties
made by the Borrower and its Subsidiaries in the Credit Agreement and the
Security Documents are true and correct as of the date hereof, except for (i)
those representations which relate to a specific date which are true and correct
as of such date, and (ii) Schedule 2.02, Schedule 2.06 and Schedule I to the
extent that such Schedules, respectively, do not reflect additional
subsidiaries, litigation, and places of business or locations of collateral and
records. The Borrower acknowledges and agrees to deliver such updated Schedules
to the Bank promptly, and in any event within fifteen (15) days after the date
hereof, and any failure to so deliver shall be deemed to be an Event of Default
under Section 5.01(f) of the Credit Agreement. The Borrower represents and
warrants that the execution of this Agreement has been duly authorized by
Borrower by all necessary corporate and other action and that the execution will
not conflict with, violate the provisions of, or cause a default or cause an
event which, with the passage of time or giving of notice or both, could cause a
default on the part of Borrower under its charter documents or by-laws or under
any contract, agreement, law, rule, order, ordinance, franchise, instrument or
other document, or result in the imposition of any lien or encumbrance on any
property or asset of Borrower. The Borrower further represents that this
Agreement is the legal, valid and binding obligations of Borrower, enforceable
against Borrower in accordance with their respective terms.
6. The Borrower represents, on behalf of itself and its Subsidiaries, that
it has performed and complied with all covenants and agreements required to be
performed and complied with by them under the Credit Agreement as amended by
this Agreement and the Security Documents (as amended by the First Amendment to
Amended and Restated Credit Agreement, the Second Amendment to Amended and
Restated Credit Agreement, the Third Amendment to Amended and Restated Credit
Agreement, and this Agreement) except to the extent performance or compliance
has been waived or modified in writing by the Bank.
7. Except as amended by the First Amendment to Amended and Restated Credit
Agreement, the Second Amendment to Amended and Restated Credit Agreement, the
Third Amendment to Amended and Restated Credit Agreement and this Agreement and
any other written agreements of the Bank, all provisions of the Amended and
Restated Credit Agreement, the Security Documents and all other documents
referred to therein shall remain in full force and effect after giving effect to
this Agreement and are hereby ratified and confirmed as being in full force and
effect and are binding upon the parties thereto in accordance with their terms.
8. The amendments set forth in this Agreement shall be deemed effective as
of June 30, 1998. Immediately upon execution of this Agreement the Borrower
shall pay the Bank a fee of $5,000 in connection with this amendment. In
addition, upon presentation of an invoice therefor, the Borrower shall pay the
reasonable legal fees and disbursements of the Bank's legal counsel in
connection with this amendment.
35
<PAGE>
9. This Agreement represents the entire agreement among the parties thereto
relating to the amendment to the Amended and Restated Credit Agreement effected
hereby, and supersedes all prior understandings and agreements among the parties
relating to the subject matter of this amendment to the Amended and Restated
Credit Agreement.
[REMAINDER OF PAGE INTENTIONALLY LEFT BLANK]
36
<PAGE>
IN WITNESS WHEREOF, the parties hereto have executed this Agreement under seal
------------------------------------------------------------------------------
as of the date first above written.
-----------------------------------
PSINET INC.
-----------
By:
Name:
Title:
FLEET NATIONAL BANK
By:
Name:
Title:
DOCSC\652090.3
37
<PAGE>
Exhibit A to the Fourth Amendment to Amended and Restated Credit Agreement,
entitled "Consolidated EBITDA," has been omitted.
The Company agrees to furnish such omitted Exhibit supplementally to the
Securities and Exchange Commission upon request.
38
<PAGE>
EXHIBIT 11.1
PSINET INC.
CALCULATION OF BASIC AND DILUTED LOSS PER SHARE AND WEIGHTED AVERAGE SHARES USED
IN CALCULATION (UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
June 30, 1998
--------------
<S> <C>
Weighted average shares outstanding:
Common stock:
Shares outstanding at beginning of period 50,975,263
Weighted average shares issued during the three months ended June 30, 1998
(276,895 shares) 135,578
-------------
51,110,841
=============
Net loss to common shareholders $ (54,414,000)
==============
Basic and diluted loss per share $ (1.06)
==============
</TABLE>
39
<PAGE>
EXHIBIT 11.2
PSINET INC.
CALCULATION OF BASIC AND DILUTED LOSS PER SHARE AND WEIGHTED AVERAGE SHARES USED
IN CALCULATION (UNAUDITED)
<TABLE>
<CAPTION>
SIX MONTHS ENDED
June 30, 1998
--------------
Weighted average shares outstanding:
Common stock:
<S> <C>
Shares outstanding at beginning of period 40,477,786
Weighted average shares issued during the six months ended June 30, 1998
(10,774,372 shares) 7,375,944
--------------
47,853,730
==============
Net loss to common shareholders $ (84,269,000)
==============
Basic and diluted loss per share $ (1.76)
==============
</TABLE>
40
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
CONSOLIDATED STATEMENT OF OPERATIONS FOR THE SIX MONTHS ENDED JUNE 30, 1998 AND
THE CONSOLIDATED BALANCE SHEET AS OF JUNE 30, 1998 AND IS QUALIFIED IN ITS
ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> JUN-30-1998
<CASH> 124535
<SECURITIES> 246018
<RECEIVABLES> 24273
<ALLOWANCES> 3434
<INVENTORY> 0
<CURRENT-ASSETS> 548054
<PP&E> 243405
<DEPRECIATION> 71879
<TOTAL-ASSETS> 794774
<CURRENT-LIABILITIES> 132551
<BONDS> 659559
0
28477
<COMMON> 513
<OTHER-SE> (30098)
<TOTAL-LIABILITY-AND-EQUITY> 794774
<SALES> 98182
<TOTAL-REVENUES> 98182
<CGS> 78609
<TOTAL-COSTS> 78609
<OTHER-EXPENSES> 90445
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 19471
<INCOME-PRETAX> (82695)
<INCOME-TAX> 29
<INCOME-CONTINUING> (82724)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (82724)
<EPS-PRIMARY> (1.76)
<EPS-DILUTED> (1.76)
</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 in April l998, the Company became
highly leveraged, with significant debt service requirements. As of June 30,
1998, the Company's total indebtedness was $710.1 million, representing 100% of
total capitalization, and its interest expense was $16.9 million for the quarter
then ended. The Company's high level of indebtedness could have several
important effects on its future operations, which, in turn, 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, 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; OPERATING LOSSES OF CERTAIN ACQUIRED COMPANIES
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 $121.9
42
<PAGE>
million in 1997 and $98.2 million for the first six months of 1998, it has
incurred losses and experienced negative earnings before interest, taxes,
depreciation and amortization ("EBITDA") during each of such periods, and
management expects to continue to operate at a net loss and experience negative
EBITDA in the near term as the Company continues its acquisition program and the
expansion of its global network operations. The Company has incurred net losses
of $53.2 million, $55.1 million and $45.6 million and has incurred negative
EBITDA of $27.9 million, $28.0 million and $21.2 million for each of the years
ended December 31, 1995, 1996 and 1997, respectively. Additionally, the Company
incurred net losses of $84.3 million and negative EBITDA of $21.5 million,
respectively, for the six months ended June 30, 1998. At June 30, 1998, the
Company had an accumulated deficit of $246.9 million. There can be no assurance
that the Company will be able to achieve or sustain profitability or positive
EBITDA. Principal among factors that adversely affected the Company's operating
performance in 1997 and the first six months 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 geographic presence, and on 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. 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, which it does by ownership interest or capital lease wherever
possible. This includes the acquisition of bandwidth, which must often be
obtained in anticipation of future revenue. Such expenses may adversely impact
cash flow and operating performance.
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 ability to identify,
acquire and integrate successfully suitable acquisition candidates, charges
related to acquisitions, 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, delays in obtaining sufficient supplies of sole or
limited source equipment and telecom facilities (i.e., PRIs) and any potential
adverse regulatory developments. 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.
The Company has recently acquired a number of Internetrelated companies.
Certain of these companies incurred net losses and had negative EBITDA prior to
their acquisition by the Company. While the Company believes that after
eliminating redundant network architecture and administrative functions and
taking other actions to integrate the operations of these companies it will be
able to realize significant cost savings on its consolidated operations, there
can be no assurance that the Company's integration of the operations of these
companies will be accomplished successfully. The inability of the Company to
improve the operating performance of these businesses or to successfully
integrate their operations could have a material adverse effect on the Company's
business, financial condition and results of operations.
NEED FOR ADDITIONAL CAPITAL TO FINANCE GROWTH AND CAPITAL REQUIREMENTS
The Company expects to continue to enhance and build out its global network in
order to maintain its competitive position and continue to meet the increasing
demands for service quality, availability and competitive pricing. 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. 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. Additionally, the Company expects
to make capital expenditures of (i) approximately $45 million in
43
<PAGE>
connection with its acquisition in May 1998 of dark fiber optic capacity
covering the New York City and Washington, D.C. metropolitan areas and the route
between New York City and Washington, D.C., (ii) approximately $32 million in
connection with its agreements entered into in June 1998 to acquire IRUs in
certain transpacific fiber optic bandwidth between the United States and Japan
and (iii) in excess of $100 million over the 25 year term of the agreement in
connection with its agreement entered into in August 1998 with a group of
leading global telecommunication companies to build an undersea cable system
connecting the United States and Japan. 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 million for telecommunications
equipment owned or leased by the Company and deployed in the customer's network
($1.4 million was drawn at June 30, 1998). Furthermore, 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 also expects
that it will require substantial capital for acquisitions of Internet assets and
businesses.
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 the Notes offering, 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.
COMPETITION; PRICING FLUCTUATION
The market for Internet connectivity and related services is extremely
competitive. The Company anticipates 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. The Company believes
that a reliable international network, knowledgeable salespeople and the quality
of technical support currently are the primary competitive factors in the
Company's targeted market and that the price is usually secondary to these
factors.
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. While the Company believes that its
network, products and customer service distinguish it from these competitors,
some of these competitors have a significantly greater market presence, brand
recognition, and financial, technical and personnel resources than the Company.
All the major long distance companies (also known as interexchange carriers or
IXCs), including AT&T, WorldCom/MCI, Sprint and Cable & Wireless, offer Internet
access services and compete with the Company. The recent sweeping reforms in
the federal regulation of the telecommunications industry have created greater
opportunities for local exchange carriers ("LECs"), including the Regional Bell
Operating Companies ("RBOCs"), to enter the Internet connectivity market. In
order to address the Internet connectivity requirements of the current business
customers of long distance and local carriers, the Company believes that there
is a move toward horizontal integration through acquisitions of, joint ventures
with, and the wholesale purchase of connectivity from, ISPs. The
WorldCom/MFS/UUNet
44
<PAGE>
consolidation, the NETCOM/ICG merger, Cable & Wireless' purchase of the
internetMCI assets, the Intermedia/DIGEX merger and GTE's acquisition of BBN are
indicative of this trend. Accordingly, the Company expects that it will
experience increased competition from the traditional telecommunications
carriers. Many of these telecommunications carriers may have the ability to
bundle Internet access with basic local and long distance telecommunications
services. Such bundling of services may have an adverse effect on the Company's
ability to compete effectively with the telecommunications providers and may
result in pricing pressure on the Company that would have an adverse effect on
the Company's business, financial condition and results of operations.
Many of the major cable companies have announced that they are exploring the
possibility of offering Internet connectivity, relying on the viability of cable
modems and economical upgrades to their networks. Several announcements also
have recently been made by other alternative service companies approaching the
Internet connectivity market with various wireless terrestrial and satellite-
based service technologies.
The predominant on-line service providers, including America Online, CompuServe,
Microsoft Network and Prodigy, have all entered the Internet access business by
engineering their current proprietary networks to include Internet access
capabilities. The Company competes to a lesser extent with these on-line
service providers.
Recently, there have been several announcements regarding the planned deployment
of broadband services for high speed Internet access by cable and telephone
companies through new technologies such as cable modems and xDSL. While these
providers have initially targeted the residential consumer, it is likely that
their target markets will expand to encompass business customers, the Company's
target market, which may significantly affect the pricing of the Company's
service offerings.
As a result of the increase in the number of competitors and the vertical and
horizontal integration in the industry, the Company currently encounters and
expects to encounter significant pricing pressure and other competition in the
future. Advances in technology as well as changes in the marketplace and the
regulatory environment are constantly occurring, and the Company cannot predict
the effect that ongoing or future developments may have on the Company or the
pricing of its products and services. 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 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 ACQUISITIONS AND STRATEGIC ALLIANCES
As part of its business strategy, the Company expects to continue to acquire
assets and businesses principally relating to or complementary to its current
operations and/or to seek to develop strategic alliances both domestically and
internationally. Any such future acquisitions or strategic alliances 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
45
<PAGE>
with employees and customers as a result of changes in management. There can be
no assurance that the Company will be successful in overcoming these risks or
any other problems encountered in connection with such acquisitions or strategic
alliances.
In addition, as the Company proceeds with acquisitions in which the
consideration consists of cash, a substantial portion of the Company's available
cash will 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, 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. In this regard, an intangible asset that frequently arises in
connection with the acquisition of a technology company is "acquired in-process
research and development," which under U.S. accounting standards, as presently
in effect, must be expensed immediately upon acquisition. 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 integrate successfully the operations of acquired
companies could have a material adverse effect on the Company's business,
financial condition and results of operations.
The Company expects that competition for appropriate acquisition candidates may
be significant. The Company may compete with other telecommunications companies
with similar acquisition strategies, many of which may be larger and have
greater financial and other resources than the Company. Competition for
Internet companies is based on a number of factors including price, terms and
conditions, size and access to capital, ability to offer cash, stock or other
forms of consideration and other matters. There can be no assurance that the
Company will be able to successfully identify and acquire suitable companies on
terms and conditions acceptable to the Company.
RISKS ASSOCIATED WITH MANAGEMENT OF GROWTH AND EXPANSION
The Company had over 400 POPs as of June 30, 1998 and plans to continue to
expand the capacity of existing POPs as customer-driven demand dictates. In
addition, the Company completed a number of acquisitions of companies and
bandwidth during the six months ended June 30, 1998 and plans to continue to do
so. 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. 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 process of consolidating the businesses and implementing the
strategic integration of these acquired businesses with the Company may take a
significant amount of time, will place additional strain on the Company's
resources and could subject the Company to additional expenses. These can be no
assurance that the Company will be able to integrate these companies
successfully or in a timely manner. 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,
failure to integrate acquired companies, the inability to manage its growth
effectively or the emergence of unexpected expansion
46
<PAGE>
difficulties could have a material adverse effect on the Company's business,
results of operations and financial condition.
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, among other things, the
following: (i) the risk that, if the fair market value of the IXC Initial Shares
is less than $240 million on the applicable date, the payment by the Company of
the shortfall, whether in cash, stock or a combination thereof (at the Company's
option), 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 ex-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 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
47
<PAGE>
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.
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 characterized by rapidly changing technology, evolving industry
standards, changes in customer needs 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. There can be no assurance that services or technologies developed by
others will not render the Company's services or technology uncompetitive or
obsolete. Changes to the Company's services in response to market demand may
require the adoption of new technologies that could likewise render certain of
the Company's assets technologically uncompetitive or obsolete. As the Company
accepts bandwidth from IXC under the IRU Purchase Agreement or acquires
bandwidth or equipment from other suppliers that may better meet the Company's
needs than existing bandwidth or equipment, certain of the Company's assets
could be determined to be obsolete or excess. The cancellation of agreements or
disposition of obsolete or excess assets could have a material adverse effect on
the Company's business, financial condition and results of operations.
The Company also faces the risk of fundamental technological changes in the way
Internet access is delivered. Integrating technological advances may require
substantial time and expense, and there can be no assurance that the Company
will succeed in adapting its network infrastructure.
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 is 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.
COMPANY STRUCTURE; DEPENDENCE ON SUBSIDIARIES FOR REPAYMENT OF THE NOTES
The Company is an operating entity that 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,
partly 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 have no
obligation, contingent or otherwise, to make any funds available to the Company
for payment of the
48
<PAGE>
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
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 June 30, 1998, the Company's subsidiaries had
approximately $58.1 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.
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 not completely settled. A number of lawsuits have
sought to impose such liability for defamatory speech and infringement of
copyrighted materials. The U.S. Supreme Court has let stand a lower court
ruling which held that an online service provider was protected from liability
for material posted on its system by a provision of the Communications Decency
Act. However, the findings in that case may not be applicable in other
circumstances. 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 $10
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,
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 continues to review 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 was 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
49
<PAGE>
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 online and Internet
access services, including the Company.
The Company's wholly-owned subsidiary, PSINetworks Company (formerly known as
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. PSINetworks also has received
competitive local exchange carrier ("CLEC") certification in Colorado and is
considering the financial, regulatory and operational implications of becoming
or acquiring a CLEC in certain other states. 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.
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. Due to
the 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.
50<PAGE>
The Company has from time to time experienced delays in the receipt of certain
hardware components and telecommunications facilities, including 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 have a material adverse effect on
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.
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.
51
<PAGE>
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 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 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 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.
The Company has recently introduced new enterprise service offerings, including
the introduction of value-added, IP-based enterprise communication services and
DSL-based Internet access services in limited areas. The failure of these
services to gain market acceptance in a timely manner or at all, or the failure
of DSL-based services, in particular, to achieve significant market coverage
could have a material adverse effect on the business, financial condition and
results of operations of the Company. Introduction by the Company of new or
enhanced services with reliability, quality or compatibility problems could
significantly delay or hinder market acceptance of such services, which could
adversely affect the Company's ability to attract new customers and subscribers.
The Company's services may contain
52
<PAGE>
undetected errors or defects when first introduced or as enhancements are
introduced. There can be no assurance that, despite testing by the Company or
its customers, errors will not be found in new services after commencement of
commercial deployment, resulting in additional development costs, loss of, or
delays in, market acceptance, diversion of technical and other resources from
the Company's other development efforts and the loss of credibility with the
Company's customers and subscribers. Any such event could have a material
adverse effect on the Company's business, financial condition and results of
operations. Additionally, if the Company is unable to match its network capacity
to customer demand for its services, its network could become congested during
periods of peak customer demand, which could adversely affect the quality of
service provided by the Company. Conversely, owing to the high fixed cost nature
of PSINet's infrastructure, under-utilization of the PSINet network could
adversely affect the Company's ability to provide cost-efficient services. The
failure of the Company to match network capacity to demand could have a material
adverse effect on the Company's business, financial condition or results of
operations.
YEAR 2000
Currently, many computer systems and software products are coded to accept only
two digit entries in the date code field. These date code fields will need to
accept four digit entries to distinguish 21st century dates from 20th century
dates. As a result, many computer systems and software products will need to be
upgraded or replaced in order to comply with such Year 2000 requirements. The
Company recognizes the need to ensure that its operations will not be adversely
impacted by Year 2000 software failures. 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. In
addition to the Company's internal assessment of its computer systems' Year 2000
compliance, the Company is in the process of selecting an independent consultant
to conduct a Year 2000 audit of its systems' Year 2000 readiness and to submit a
plan for remediating any problem areas that are identified by such audit. Until
such audit is completed, which the Company expects to occur prior to the end of
1998, the Company is unable to estimate the cost of any such required
remediation.
While the Company believes its planning efforts are adequate to address its Year
2000 concerns, there can be no assurance that the systems of other companies
with which it has material relationships will be converted on a timely basis and
will not have a material adverse effect on the Company. For example, 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 such customers, which in turn, to the extent
their demand for the Company's services and products are adversely affected,
could have a material adverse effect on the Company's business, financial
condition and results of operations. In addition, the Company faces risks to
the extent that suppliers of products, services and systems purchased by the
Company and others with whom the Company transacts business on a worldwide basis
do not have business systems or products that are Year 2000 compliant. The
Company has requested Year 2000 compliance information from its software and
hardware vendors, but has not yet received all responses. The Company intends
to continue its efforts to monitor the Year 2000 compliance of key third
parties, although specific plans to assess third-party vendor network equipment
have not yet been formalized and the Company has not yet adopted a contingency
plan to address possible risks to these systems. In the event any third parties
cannot timely provide the Company with products, services or systems that meet
the Year 2000 requirements, the Company's operations could be materially
adversely affected. There can be no assurance that these or other factors
relating to the Year 2000 compliance issues, including, without limitation, the
possibility of litigation, will not have a material adverse affect on the
Company's business, financial condition or results of operations. The Company
expects to incur significant internal staff costs as well as consulting and
other expenses in connection with addressing these issues, which costs will be
expensed as incurred. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Year 2000.'"
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
53
<PAGE>
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 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.
54
