<PAGE>
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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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, 1999 OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
Commission File Number 0-25812
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PSINET INC.
(Exact Name of Registrant as Specified in its Charter)
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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)
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(703) 904-4100
(Registrant's Telephone Number, Including Area Code)
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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 - 64,832,205 SHARES AS OF AUGUST 3, 1999
(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 29
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<PAGE>
PSINET INC.
TABLE OF CONTENTS
<TABLE>
<CAPTION>
Page
----
<S> <C>
PART I. FINANCIAL INFORMATION
PAGE
Item 1. Financial Statements:
Consolidated Balance Sheets as of June 30, 1999 and December 31, 1998........................3
Consolidated Statements of Operations for the three and six months ended
June 30, 1999 and June 30, 1998...........................................................4
Condensed Consolidated Statements of Cash Flows for the six months
ended June 30, 1999 and June 30, 1998...................................................5
Notes to Consolidated Financial Statements...................................................6
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations...................................................................13
Item 3. Quantitative and Qualitative Disclosures About Market Risk..................................24
PART II. OTHER INFORMATION
Item 2. Changes in Securities and Use of Proceeds....................................................25
Item 4. Submission of Matters to a Vote of Security Holders..........................................25
Item 6. Exhibits and Reports on Form 8-K.............................................................26
Signatures................................................................................................28
Exhibit Index.............................................................................................29
</TABLE>
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<PAGE>
PART I. FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS
PSINET INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
JUNE 30, 1999 DECEMBER 31, 1998
------------- -----------------
(In thousands of U.S. dollars)
(Unaudited) (Audited)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 609,987 $ 56,842
Restricted cash and short-term investments 144,504 162,469
Short-term investments and marketable securities 106,369 265,666
Accounts receivable, net 58,596 50,211
Prepaid expenses 12,361 10,998
Other current assets 20,513 19,077
----------- -----------
Total current assets 952,330 565,263
Property, plant and equipment, net 620,687 389,476
Goodwill and other intangibles, net 373,583 282,781
Other assets and deferred charges 66,859 46,711
----------- -----------
Total assets $ 2,013,459 $ 1,284,231
----------- -----------
----------- -----------
LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Current portion of debt $ 78,455 $ 59,968
Trade accounts payable 82,504 89,973
Accrued payroll and related expenses 18,057 8,501
Other accounts payable and accrued liabilities 54,110 82,760
Accrued interest payable 29,397 28,988
Deferred revenue 21,306 19,427
----------- -----------
Total current liabilities 283,829 289,617
Long-term debt 1,141,730 1,064,633
Deferred income taxes 4,721 6,123
Other liabilities 53,252 44,032
----------- -----------
Total liabilities 1,483,532 1,404,405
----------- -----------
Commitments and contingencies
Shareholders' equity (deficit):
Preferred stock -- --
Convertible preferred stock, Series B -- 28,802
Convertible preferred stock, Series C 362,434 --
Common stock 648 522
Capital in excess of par value 823,636 401,990
Accumulated deficit (548,847) (427,597)
Treasury stock (2,005) (2,005)
Accumulated other comprehensive income 17,672 36,664
Bandwidth Asset/IRU Agreement (123,611) (158,550)
----------- -----------
Total shareholders' equity (deficit) 529,927 (120,174)
----------- -----------
Total liabilities and shareholders' equity (deficit) $ 2,013,459 $ 1,284,231
----------- -----------
----------- -----------
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
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<PAGE>
PSINET INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
-------------------------- ----------------------------
1999 1998 1999 1998
--------- -------- --------- ---------
(IN THOUSANDS OF U.S. DOLLARS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
<S> <C> <C> <C> <C>
Revenue $ 123,822 $ 53,713 $ 228,668 $ 98,182
Operating costs and expenses:
Data communications and operations 86,323 41,943 162,341 78,609
Sales and marketing 21,933 12,486 40,505 23,219
General and administrative 15,380 10,287 32,469 17,872
Depreciation and amortization 34,392 12,889 61,210 22,354
Charge for acquired in-process
research and development -- 20,000 -- 27,000
--------- -------- --------- ---------
Total operating costs and expenses 158,028 97,605 296,525 169,054
--------- -------- --------- ---------
Loss from operations (34,206) (43,892) (67,857) (70,872)
Interest expense (31,905) (16,892) (61,486) (19,471)
Interest income 8,078 6,059 12,798 6,644
Other income (expense), net (184) 1,103 (358) 1,004
--------- -------- --------- ---------
Loss before income taxes (58,217) (53,622) (116,903) (82,695)
Income tax benefit (expense) 450 (29) 450 (29)
--------- -------- --------- ---------
Net loss (57,767) (53,651) (116,453) (82,724)
Return to preferred shareholders (4,223) (763) (4,797) (1,545)
--------- -------- --------- ---------
Net loss available to common shareholders $ (61,990) $(54,414) $(121,250) $ (84,269)
--------- -------- --------- ---------
--------- -------- --------- ---------
Basic and diluted loss per share $ (1.00) $ (1.06) $ (2.10) $ (1.76)
--------- -------- --------- ---------
--------- -------- --------- ---------
Shares used in computing basic and diluted loss
per share (in thousands) 61,956 51,111 57,657 47,854
--------- -------- --------- ---------
--------- -------- --------- ---------
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
-4-
<PAGE>
PSINET INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
Six Months Ended June 30,
---------------------------
1999 1998
--------- ---------
(In thousands of U.S. dollars)
(Unaudited)
<S> <C> <C>
Net cash used in operating activities $(139,325) $ (20,730)
--------- ---------
Cash flows from investing activities:
Purchases of property and equipment (101,923) (25,214)
Purchases of investments (103,183) (242,269)
Proceeds from maturity or sale of investments 262,588 1,206
Investments in certain businesses, net of cash acquired (103,222) (63,357)
Restricted cash and short-term investments 17,965 (122,478)
Other, net 5 800
--------- ---------
Net cash used in investing activities (27,770) (451,312)
--------- ---------
Cash flows from financing activities:
Net payments on lines of credit -- (1,817)
Proceeds from issuance of notes payable, net 102,744 609,007
Repayments of debt (104,858) (29,147)
Principal payments under capital lease obligations (26,809) (15,237)
Proceeds from equity offerings, net 741,997 --
Proceeds from exercise of common stock options 9,061 2,053
Payments of dividends on preferred stock (452) (1,540)
Other, net -- (2)
--------- ---------
Net cash provided by financing activities 721,683 563,317
--------- ---------
Effect of exchange rate changes on cash (1,443) (62)
--------- ---------
Net increase in cash and cash equivalents 553,145 91,213
Cash and cash equivalents, beginning of period 56,842 33,322
--------- ---------
Cash and cash equivalents, end of period $ 609,987 $ 124,535
--------- ---------
--------- ---------
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
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<PAGE>
PSINET INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE 1 - BASIS OF PRESENTATION
These consolidated financial statements for the three and six month periods
ended June 30, 1999 and 1998 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, 1998 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, 1998 included in the Annual
Report and the unaudited quarterly consolidated financial statements and related
notes to unaudited consolidated financial statements of the Company for the
three month period ended March 31, 1999 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, 1999 and the results of its operations and
cash flows for the three and six month periods ended June 30, 1999 and 1998. The
results of operations for the three and six month periods ended June 30, 1999
may not be indicative of the results expected for any succeeding quarter or for
the entire year ending December 31, 1999.
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 - ACCOUNTING POLICIES
LOSS PER SHARE - Basic loss per share is computed using the weighted average
number of shares of common stock outstanding during the year. Diluted loss
per share is computed using the weighted-average number of shares of common
stock, adjusted for the dilutive effect of common stock equivalent shares
from common stock options and warrants and convertible preferred stock.
Common stock equivalent shares are calculated using the treasury stock
method. All common stock equivalents, totaling 16.3 million shares and 3.8
million shares at June 30, 1999 and 1998, respectively, have been excluded
from the computation of diluted loss per share as their effect would be
antidilutive and, accordingly, there is no reconciliation between basic and
diluted loss per share for each of the periods presented.
NOTE 3 - ACQUISITIONS OF CERTAIN BUSINESSES
During the six months ended June 30, 1999, the Company acquired the following
businesses:
<TABLE>
<CAPTION>
OWNERSHIP
BUSINESS NAME LOCATION ACQUISITION DATE INTEREST
------------- -------- ---------------- --------
<S> <C> <C> <C>
Planete.net France 2/99 100%
Satelnet France 2/99 100%
Tele Linx United Kingdom 2/99 100%
Horizontes Brazil 4/99 100%
Openlink Brazil 4/99 100%
STI Brazil 5/99 100%
Internet de Mexico Mexico 5/99 100%
DataNet Mexico 5/99 100%
TIC Switzerland 5/99 100%
Caribbean Internet U.S. (Puerto Rico) 6/99 100%
TIAC U.S. 6/99 100%
Argentina On-Line Argentina 6/99 100%
CSO.net Austria 6/99 100%
</TABLE>
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<PAGE>
Subsequently, during July 1999, the Company acquired the following businesses:
<TABLE>
<CAPTION>
OWNERSHIP
BUSINESS NAME LOCATION ACQUISITION DATE INTEREST
------------- -------- ---------------- --------
<S> <C> <C> <C>
Intercomputer Spain 7/99 100%
Abaforum Spain 7/99 100%
</TABLE>
All of the ISPs acquired generally serve both consumer and business customers
with dedicated and dial-up connectivity as well as Web hosting services. Tele
Linx operates a data center facility.
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 consolidated financial
statements since the acquisition dates. The purchase prices of the 1999
acquisitions have been preliminarily allocated to assets acquired, including
intangible assets, and liabilities assumed, based on their respective fair
values at the acquisition dates. As part of the allocation process, the Company
evaluates each acquisition for acquired in-process research and development
technologies. Based on the Company's preliminary allocation, no in-process
research and development technologies were identified for its 1999 acquisitions
to date.
In connection with the acquisitions made during the six months ended June 30,
1999, liabilities assumed were as follows (in thousands of U.S. dollars):
<TABLE>
<CAPTION>
CASH PAID
FAIR VALUE OF FOR THE LIABILITIES
ASSETS ACQUIRED CAPITAL STOCK ASSUMED
--------------- ------------- -------
<S> <C> <C> <C>
Tele Linx $ 88,219 $ (32,788) $ 55,431
TIAC 26,597 (16,045) 10,552
All Others 68,205 (48,551) 19,654
--------- --------- --------
$ 183,021 $ (97,384) $ 85,637
--------- --------- --------
--------- --------- --------
</TABLE>
For certain acquisitions made in 1999 and 1998, the Company has retained a
portion of the purchase price under holdback provisions of the purchase
agreements to secure performance by the sellers of indemnification or other
contractual obligations. These holdback amounts are generally payable up to 24
months after the date of closing of the related acquisitions.
The Company recorded a $6.0 million increase to goodwill during the three months
ended June 30, 1999, reflecting final settlement and payment of an earn-out
provision in connection with an acquisition made in 1998.
The following represents the unaudited pro forma results of operations of the
Company for the six months ended June 30, 1999 and 1998 as if the acquisitions
closed prior to June 30, 1999 were consummated on January 1, 1998. The unaudited
pro forma results of operations include certain pro forma adjustments, including
the amortization of intangible assets relating to the acquisitions. The
unaudited 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 actually been consummated on January 1, 1998 or the results which
may occur in the future.
<TABLE>
<CAPTION>
SIX MONTHS ENDED
----------------
JUNE 30, 1999 JUNE 30, 1998
------------- -------------
(IN THOUSANDS OF U.S. DOLLARS, EXCEPT PER SHARE AMOUNT)
<S> <C> <C>
Revenue....................................................... $ 244,012 $ 116,420
Net loss available to common shareholders..................... $ (125,569) $ (89,873)
Basic and diluted loss per share.............................. $ (2.18) $ (1.88)
</TABLE>
Total amortization expense of goodwill and other intangibles was $9.1 million
and $1.2 million for the three months ended June 30, 1999 and 1998,
respectively, and $17.5 million and $1.8 million for the six months ended June
30, 1999 and 1998, respectively.
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<PAGE>
NOTE 4 - SHORT-TERM INVESTMENTS AND MARKETABLE SECURITIES
Short-term investments and marketable securities, including restricted amounts,
consisted of the following:
<TABLE>
<CAPTION>
JUNE 30, 1999 DECEMBER 31, 1998
------------- -----------------
(IN THOUSANDS OF U.S. DOLLARS)
<S> <C> <C>
U.S. government obligations $137,913 $235,105
Commercial paper 60,354 112,290
Certificates of deposit 571 25,000
Other 2,318 --
-------- --------
$201,156 $372,395
-------- --------
-------- --------
</TABLE>
NOTE 5 - PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment consisted of the following:
<TABLE>
<CAPTION>
JUNE 30, 1999 DECEMBER 31, 1998
------------- -----------------
(IN THOUSANDS OF U.S. DOLLARS)
<S> <C> <C>
Telecommunications bandwidth $ 246,825 $ 148,429
Data communications equipment 396,547 275,402
Leasehold improvements 35,950 29,267
Software 23,924 17,724
Office and other equipment 29,124 18,799
Land and buildings 43,155 3,290
--------- ---------
775,525 492,911
Less accumulated depreciation and amortization (154,838) (103,435)
--------- ---------
Property, plant and equipment, net $ 620,687 $ 389,476
--------- ---------
--------- ---------
</TABLE>
Total depreciation and leasehold amortization expense was $25.3 million and
$11.7 million for the three months ended June 30, 1999 and 1998, respectively,
and $43.7 million and $20.6 million for the six months ended June 30, 1999 and
1998, respectively.
NOTE 6 - DEBT
Debt consisted of the following:
<TABLE>
<CAPTION>
JUNE 30, 1999 DECEMBER 31, 1998
------------- -----------------
(IN THOUSANDS OF U.S. DOLLARS)
<S> <C> <C>
Senior notes at interest rate of 10% $ 600,000 $ 600,000
Senior notes at interest rate of 11.5% 350,000 350,000
Capital lease obligations at interest rates ranging from 2.0% to 18.6% 231,306 120,670
Notes payable at interest rates ranging from 1.9% to 12.7% 36,079 50,981
----------- -----------
1,217,385 1,121,651
Plus unamortized premium 2,800 2,950
----------- -----------
1,220,185 1,124,601
Less current portion (78,455) (59,968)
----------- -----------
Long-term portion $ 1,141,730 $ 1,064,633
----------- -----------
----------- -----------
</TABLE>
The Company has deposited in an escrow account restricted cash and short-term
investments of $94.3 million at June 30, 1999 to fund, when due, the next three
semi-annual interest payments on the 10% senior notes. Each of the indentures
governing the Company's senior notes contain certain financial and other
covenants that, among other things, will restrict the Company's ability to incur
further indebtedness, make certain payments (including payments of dividends),
and sell assets.
The Company has various financing arrangements accounted for as capital leases
for the acquisition of equipment, telecommunications bandwidth, a building and
other fixed assets. During the six months ended June 30, 1999 and 1998, the
Company incurred capital lease obligations under these arrangements and from the
acquisitions of businesses of $78.6 million and $49.1 million, respectively. At
June 30, 1999, the aggregate unused portion under these arrangements totaled
$91.9 million after designating
-8-
<PAGE>
$20.4 million of payables for various equipment purchases, which will be
financed under capital lease facilities. These financing arrangements contain
provisions which, among other things, require the maintenance of certain
financial ratios and restrict the payment of dividends.
The Company has a senior secured credit facility ("Credit Facility") with a
maximum principal amount of $110.0 million; amounts drawn are payable in
September 2001. At June 30, 1999, no amounts were outstanding, $9.7 million was
being utilized for letters of credit, and $100.3 million was available to draw.
Interest on the Credit Facility is based on a spread over the London interbank
offered rate or the higher of the bank's prime rate or the Federal funds
effective rate, at the Company's option (9.0% at June 30, 1999). The Credit
Facility requires, among other things, the satisfaction of certain financial
covenants, including a minimum annual consolidated revenue test, a minimum
EBITDA test and requires the reduction in the maximum amount of availability and
prepayments equal to the net proceeds received from certain asset sales and
certain casualty events. The Company is required to pay a commitment fee ranging
from 0.50% to 0.875% of the unused amounts under the Credit Facility.
The Company was in compliance with the covenants under each of its financing
arrangements at June 30, 1999.
In July 1999, the Company issued $1.2 billion aggregate principal amount of 11%
senior notes due 2009, consisting of $1.05 billion aggregate principal amount of
11% senior notes due 2009 and Euro 150 million aggregate principal amount of 11%
senior notes due 2009, pursuant to Securities and Exchange Commission Rule 144A
and Regulation S. The aggregate net proceeds of the offering of the 11% senior
notes, after giving effect to discounts and commissions and other offering
expenses, was approximately $1.17 billion.
NOTE 7 - CAPITAL STOCK
ISSUANCE OF COMMON STOCK
During the six months ended June 30, 1999, options with respect to 1,593,858
shares of common stock were exercised for aggregate net proceeds of $9.1
million.
In May 1999, the Company completed a public offering of 8,000,000 shares of its
common stock at $50.50 per share for net proceeds of approximately $383.8
million after underwriting discounts and commissions and other offering
expenses.
TERMINATION OF CONTINGENT PAYMENT OBLIGATION TO IXC
In January 1999, the Company's contingent payment obligation to IXC Internet
Services, Inc. ("IXC") under an agreement relating to the purchase of OC-48
bandwidth from IXC was terminated without the payment of any additional amounts
or issuance of additional shares of common stock to IXC. This occurred when the
fair market value of the shares of common stock originally issued to IXC
exceeded the $240 million threshold in accordance with the terms of the
agreement.
CONVERSION OF CONVERTIBLE PREFERRED STOCK
During the first quarter of 1999, all 600,000 shares of the Company's Series B
8% convertible preferred stock were converted into an aggregate of 3,000,000
shares of the Company's common stock in accordance with the original terms of
the convertible preferred stock.
ISSUANCE OF CONVERTIBLE PREFERRED STOCK
In May 1999, the Company completed a public offering of 9,200,000 shares of its
6 3/4% Series C Cumulative Convertible Preferred Stock ("Series C Preferred
Stock") for net proceeds of approximately $358.2 million after underwriting
discounts and commissions and other offering expenses. The Series C Preferred
Stock has a liquidation preference of $50 per share. The Series C Preferred
Stock accrues dividends at an annual rate of 6 3/4%, payable quarterly in
arrears, commencing on August 15, 2002, in cash, or at the Company's option, in
shares of its common stock or a combination thereof.
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<PAGE>
At closing, the purchasers of the Series C Preferred Stock deposited
approximately $85.8 million into an account established with a deposit agent
("Deposit Account"). The Deposit Account is not an asset of the Company. Funds
in the Deposit Account will be paid to the holders of the Series C Preferred
Stock each quarter in the amount of $0.84375 per share in cash or may be used,
at the Company's option, to purchase shares of common stock from the Company at
95% of the market price of the common stock on that date for delivery to holders
of Series C Preferred Stock in lieu of cash payments. The funds placed in the
Deposit Account by the purchasers of the Series C Preferred Stock will, together
with the earnings on those funds, be sufficient to make payments, in cash or
stock, through May 15, 2002. Until the expiration of the Deposit Account, the
Company will accrete a return to preferred shareholders each quarter from the
date of issuance at an annual rate of approximately 6 3/4% of the liquidation
preference per share. Such amount will be recorded as a deduction from net
income to determine net income available to common shareholders. Upon the
expiration of the Deposit Account, which is expected to occur on May 15, 2002
unless earlier terminated, the Series C Preferred Stock will begin to accrue
dividends at an annual rate of 6 3/4% of the liquidation preference payable, at
the Company's option, in cash or in shares of its common stock at 95% of the
market price of the common stock on that date. Under certain circumstances, the
Company can elect to terminate the Deposit Account prior to May 15, 2002, at
which time the remaining funds in the Deposit Account would be distributed to
the Company and the Series C Preferred Stock would begin to accrue dividends.
Each share of Series C Preferred Stock is convertible at any time at the option
of the holders thereof into shares of the Company's common stock at an initial
conversion price of $62.3675 per share, subject to adjustment upon the
occurrence of specified events, equal to an initial conversion ratio of 0.8017
shares of the Company's common stock for each share of Series C Preferred Stock.
The Series C Preferred Stock is redeemable, at the Company's option, at a
redemption premium of 101.929% of the liquidation preference (plus accumulated
and unpaid dividends) on or after November 15, 2000 but prior to May 15, 2002 if
the trading price for the Series C Preferred Stock exceeds $124.74 per share for
a specified period. Except in the circumstances described in the preceding
sentence, the Company may not redeem the Series C Preferred Stock prior to May
15, 2002. Beginning on May 15, 2002, the Company may redeem shares of the Series
C Preferred Stock initially at a redemption premium of 103.857% and thereafter
at prices declining to 100% on May 15, 2006 (plus in each case, accumulated and
unpaid dividends).
In the event of a change in control of the Company and if the market price of
the Company's common stock at such time is less than the conversion price of the
Series C Preferred Stock, the holders of the Series C Preferred Stock will have
the right to convert their shares into the Company's common stock at the greater
of (i) the market price per share ending on the date on which a change of
control event occurs, or (ii) $38.73.
NOTE 8 - COMPREHENSIVE INCOME
Comprehensive income for the three and six months ended June 30, 1999 and 1998
was as follows (in thousands of U.S. dollars):
<TABLE>
<CAPTION>
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
--------------------------- -------------------------
1999 1998 1999 1998
-------- -------- --------- --------
<S> <C> <C> <C> <C>
Net loss $(57,767) $(53,651) $(116,453) $(82,724)
-------- -------- --------- --------
Other comprehensive income:
Unrealized holding gains 584 1,311 436 4,955
Foreign currency translation adjustment (5,438) (1,179) (19,428) (873)
-------- -------- --------- --------
(4,854) 132 (18,992) 4,082
-------- -------- --------- --------
Comprehensive income $(62,621) $(53,519) $(135,445) $(78,642)
-------- -------- --------- --------
-------- -------- --------- --------
</TABLE>
NOTE 9 - COMMITMENTS AND CONTINGENCIES
On March 23, 1999, an arbitrator awarded The Chatterjee Management Company
("Chatterjee") compensatory damages, including interest and legal expenses, from
PSINet. In conjunction with this arbitration decision, the Company recorded a
charge of $49.0 million during its fiscal year ended December 31, 1998, which
accrual was reflected in other accounts payable and accrued liabilities in its
consolidated balance sheets at December 31, 1998. During April 1999, the
Company's request that the International Chamber of Commerce reconsider the
amount of the damages awarded was denied. The
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<PAGE>
Company resolved this matter by payment of $48.0 million to Chatterjee in April
1999; after accounting for other expenses, the resolution of the previously
established accrual resulted in a non-recurring gain during the second quarter
of 1999 of $0.7 million.
The Company is subject to certain other claims and legal proceedings that arise
in the ordinary course of its business activities. Each of these matters is
subject to various uncertainties, and it is possible that some of these matters
may be decided unfavorably to the Company. Management believes that any
liability that may ultimately result from the resolution of these matters will
not have a material adverse effect on the financial condition or results of
operations or cash flows of the Company.
NOTE 10 - INDUSTRY SEGMENT AND GEOGRAPHIC REPORTING
During the second quarter of 1999, the Company redefined its reporting
segments to combine its U.S. and Canadian operations into one segment called
North America; and, due to acquisitions during the quarter, added a Latin
America segment. Its operations are now organized into four geographic
operating segments - North America, Latin America, Europe and Asia. The
Company evaluates the performance of its segments and allocates resources to
them based on revenue and EBITDA, which is defined as losses before interest
expense and interest income, taxes, depreciation and amortization, other
non-operating income and expense, and charge for acquired in-process research
and development.
Operations of the North America segment include shared network costs and
corporate functions which the Company does not allocate to its other geographic
segments for management reporting purposes. Capital expenditures include both
assets acquired for cash and financed through capital leases and seller-financed
arrangements.
Financial information for the Company's geographic segments is presented below
(in millions of U.S. dollars):
<TABLE>
<CAPTION>
NORTH AMERICA LATIN AMERICA EUROPE ASIA ELIMINATIONS TOTAL
<S> <C> <C> <C> <C> <C> <C>
THREE MONTHS ENDED
JUNE 30, 1999
Revenue $ 70.1 $ 3.2 $ 18.7 $ 31.8 $ --- $ 123.8
EBITDA (3.3) 0.8 (0.7) 3.4 --- 0.2
Assets 1,453.5 96.1 233.9 278.0 (48.0) 2,013.5
Capital expenditures 81.6 0.4 23.3 8.6 --- 113.9
THREE MONTHS ENDED
JUNE 30, 1998
Revenue $ 44.1 $ --- $ 8.0 $ 1.8 $ (0.2) $ 53.7
EBITDA (9.4) --- (1.7) 0.1 --- (11.0)
Assets 753.1 --- 45.5 (8.7) 4.9 794.8
Capital expenditures 40.6 --- 1.3 0.3 (0.2) 42.0
SIX MONTHS ENDED
JUNE 30, 1999
Revenue $ 129.2 $ 3.3 $ 34.6 $ 61.7 $ (0.1) $ 228.7
EBITDA (11.3) 0.8 (2.6) 6.5 --- (6.6)
Assets 1,453.5 96.1 233.9 278.0 (48.0) 2,013.5
Capital expenditures 162.9 0.4 37.7 14.4 --- 215.4
SIX MONTHS ENDED
JUNE 30, 1998
Revenue $ 81.0 $ --- $ 14.0 $ 3.4 $ (0.2) $ 98.2
EBITDA (18.7) --- (2.9) 0.1 --- (21.5)
Assets 753.1 --- 45.5 (8.7) 4.9 794.8
Capital expenditures 74.2 --- 4.9 0.3 (0.4) 79.0
</TABLE>
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<PAGE>
EBITDA for all reportable segments differs from consolidated loss before income
taxes reported in the consolidated statements of operations as follows (in
thousands of U.S. dollars):
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
1999 1998 1999 1998
-------- -------- --------- --------
<S> <C> <C> <C> <C>
EBITDA $ 186 $(11,003) $ (6,647) $(21,518)
Reconciling items:
Depreciation and amortization (34,392) (12,889) (61,210) (22,354)
Charge for acquired IPR&D -- (20,000) -- (27,000)
Interest expense (31,905) (16,892) (61,486) (19,471)
Interest income 8,078 6,059 12,798 6,644
Other income (expense), net (184) 1,103 (358) 1,004
-------- -------- --------- --------
Loss before income taxes $(58,217) $(53,622) $(116,903) $(82,695)
-------- -------- --------- --------
-------- -------- --------- --------
</TABLE>
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<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
YOU SHOULD READ THE FOLLOWING DISCUSSION IN CONJUNCTION WITH (1) OUR
ACCOMPANYING UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS AND NOTES THERETO, AND
(2) OUR AUDITED CONSOLIDATED FINANCIAL STATEMENTS, NOTES THERETO AND
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS AS OF AND FOR THE YEAR ENDED DECEMBER 31, 1998 INCLUDED IN OUR ANNUAL
REPORT ON FORM 10-K FOR SUCH PERIOD, AND (3) OUR UNAUDITED QUARTERLY
CONSOLIDATED FINANCIAL STATEMENTS AND RELATED NOTES TO UNAUDITED CONSOLIDATED
FINANCIAL STATEMENTS FOR THE THREE MONTH PERIOD ENDED MARCH 31, 1999 INCLUDED IN
OUR FORM 10-Q FOR THE QUARTER THEN ENDED, AS FILED WITH THE SECURITIES AND
EXCHANGE COMMISSION. THE RESULTS SHOWN HEREIN ARE NOT NECESSARILY INDICATIVE OF
THE RESULTS TO BE EXPECTED IN ANY FUTURE PERIODS. THIS DISCUSSION CONTAINS
FORWARD-LOOKING STATEMENTS BASED ON CURRENT EXPECTATIONS WHICH INVOLVE RISKS AND
UNCERTAINTIES. ACTUAL RESULTS AND THE TIMING OF EVENTS 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, YOU SHOULD READ "RISK FACTORS"
INCLUDED AS EXHIBIT 99.1 TO THIS FORM 10-Q AND OUR OTHER PERIODIC REPORTS AND
DOCUMENTS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION.
GENERAL
We derive a majority of our revenues from providing Internet access services to
business customers and other Internet service providers, or ISPs. Business
customers are typically signed to contracts for one year terms. Revenues
generated from business customers are typically comprised of recurring monthly
fees, installation and start-up charges and sales of related equipment and
services. Revenues from other ISPs are generated pursuant to network access
agreements which typically require a minimum number of subscribers and obligate
the ISP customers to pay specified monthly fees for each subscriber using the
PSINet network. In addition to Internet connectivity services, we also offer a
suite of value-added products and services, including, among others, Web hosting
services, intranets, virtual private networks or VPNs, e-commerce,
voice-over-Internet protocol, e-mail and managed security services that are
designed to enable our customers to maximize utilization of the Internet to more
efficiently communicate with their customers, suppliers, business partners and
remote office locations. Revenues from value-added services are typically in the
form of monthly charges and are often bundled with Internet access services. We
conduct our business through operations organized into four geographic operating
segments - North America, Latin America, Europe and Asia.
We currently have operations in 16 of the 20 largest international
telecommunications markets. We have operations in Argentina, Austria, Belgium,
Brazil, Canada, France, Germany, Hong Kong, Italy, Japan, the Republic of Korea,
Luxembourg, Mexico, the Netherlands, Spain, Switzerland, the United Kingdom and
the United States. We typically enter a new market through the acquisition of an
existing company within the particular market. Revenue from non-U.S. operations
remained consistent as a percentage of consolidated results, comprising 51% of
revenue in the second quarter of 1999. By comparison, non-U.S. operations
comprised 52% of revenue in the first quarter of 1999, 31% in the second quarter
of 1998 and 40% for all of 1998.
We operate one of the largest global commercial data communications networks.
Our Internet-optimized network has a footprint that extends around the globe and
is connected to approximately 600 sites, called points of presence or POPs,
situated throughout North America, Latin America, Europe and Asia that enable
our customers to connect to the Internet. Our network reach allows our
customers' employees to access their corporate network and systems resources
through local calls in over 150 countries.
Since the commencement of our operations, we have undertaken a program of
developing and expanding our data communications network. In connection with
this program, we have made significant investments in telecommunications
circuits and equipment to produce a geographically-dispersed, Asynchronous
Transfer Mode (ATM), Integrated Service Digital Network (ISDN) and Switched
Multimegabit Data Service (SMDS) compatible frame relay network specially
designed to optimize Internet traffic. ATM, ISDN and SMDS are among the most
widely used switching standards. These investments generally are made in advance
of obtaining customers and resulting revenue. As part of our ongoing efforts to
further expand and enhance our network, we have acquired or agreed to acquire
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significant amounts of global fiber-based telecommunications bandwidth,
including long-term rights, typically for 20 or more years, called indefeasible
rights of use, or IRUs, or other rights in:
- - 10,000 equivalent route miles of OC-48 capacity across the United States;
- - transatlantic capacity in two STM-1s connecting the United States, the
United Kingdom and continental Europe;
- - ten dark fiber optic strands connecting the New York City and Washington,
D.C. metropolitan areas and major metropolitan areas in between, and four
strands each within New York and Washington, D.C.;
- - six DS-3s of transpacific capacity connecting the United States and Japan;
- - four dark fiber optic strands connecting multiple locations in the San
Francisco Bay area;
- - STM-1 network bandwidth having the capability of connecting Japan, China,
Southeast Asia, India, the Middle East, Europe and the United Kingdom;
- - STM-1 network bandwidth inter-connecting 30 European cities; and
- - 20 dark fiber optic strands connecting the Vancouver, British Columbia and
Seattle, Washington metropolitan areas.
In addition, we have entered into an agreement with other leading global
telecommunications companies to build the Japan-U.S. Cable Network.
The acquisition of these telecommunications bandwidth assets is expected to
increase our network capacity by a substantial magnitude and to reduce
significantly our future data communications and operations costs per equivalent
mile. In addition, the increased network capacity is expected to enable us to
offer a wider variety of higher-speed Internet and Internet-related services to
a larger customer base. As a result, we anticipate that our data communications
and operations costs as a percentage of revenue will decrease as we substitute
the acquired bandwidth for existing leased circuit arrangements with various
telecommunications carriers.
In May 1999, we completed public offerings of our common stock and 6 3/4% Series
C cumulative convertible preferred stock for aggregate gross proceeds of $864
million and aggregate net proceeds of approximately $742.0 million (excluding,
in the calculation of net proceeds, amounts paid by the purchasers of the
convertible preferred stock into the deposit account therefor).
In July 1999, we completed a private placement of $1.2 billion aggregate
principal amount of our 11% senior notes due 2009, consisting of $1.05 billion
aggregate principal amount of 11% senior notes due 2009 and Euro 150 million
aggregate principal amount of 11% senior notes due 2009, for aggregate net
proceeds of approximately $1.17 billion after giving effect to discounts and
commissions and other offering expenses.
THREE AND SIX MONTHS ENDED JUNE 30, 1999 AS COMPARED TO THE THREE AND SIX MONTHS
ENDED JUNE 30, 1998
RESULTS OF OPERATIONS
REVENUE. We generate revenue primarily from the sale of Internet access and
related services to businesses. Revenue was $123.8 million for the three months
ended June 30, 1999, an increase of $70.1 million, or 131%, from $53.7 million
for the three months ended June 30, 1998 and an increase of $19.0 million, or
18%, over the three months ended March 31, 1999. Revenue was $228.7 million for
the six months ended June 30, 1999, an increase of $130.5 million, or 133%, from
$98.2 million for the six months ended June 30, 1998. Revenue growth from the
second quarter of 1998 was a result of both acquisitions and internally
generated growth, as further described below. Revenue growth of 18% from the
first quarter of 1999 consisted of organic growth of 14% and growth from
acquisitions of 4%. Our internally generated revenue growth is attributable to a
number of factors, including an increase in the
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<PAGE>
number of business customer and ISP accounts, an increase in the average annual
revenue realized per new business customer account, and an increase in hardware
sales to customers.
Our business customer account base increased by 90% to 73,400 business accounts
at June 30, 1999 from 38,700 business accounts at June 30, 1998. By comparison,
at March 31, 1999, we had 59,700 accounts. Of the total business account growth
from June 30, 1998, 21,400 accounts were attributable to the existing customer
base of the companies we acquired. The total number of our Carrier and ISP
customers grew to 364 at June 30, 1999, and, together with our small office/home
office ("SOHO") and consumer customers, provided service to 1,041,000 customers.
This compares with 109 Carrier and ISP customers and 412,000 customers at June
30, 1998. Average annual new contract value for business accounts increased to
$7,300 for the three months ended June 30, 1999 from $5,800 for the three months
ended June 30, 1998 and $6,000 for the full year 1998, which we believe reflects
an increasing demand for value-added services and higher levels of bandwidth.
Our business account retention rate remained strong at 80% for the three months
ended June 30, 1999, compared with 83% for the three months ended June 30, 1998
and a full-year retention rate in 1998 of 79%.
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 $86.3 million (69.7% of revenue) for the three months ended June 30, 1999,
an increase of $44.4 million, or 106%, from $41.9 million (78.1% of revenue) for
the three months ended June 30, 1998. Data communications and operations
expenses were $162.3 million (71.0% of revenue) for the six months ended June
30, 1999, an increase of $83.7 million, or 107%, from $78.6 million (80.1% of
revenue) for the six months ended June 30, 1998. The increase in expenses
related principally to increases in:
- - the number of leased backbone, dedicated customer and dial-up circuits,
- - expenditures for additional primary rate interface, or PRI, circuits to
support the growth of our Carrier and ISP Services business,
- - personnel costs resulting from the expansion of our network operations,
customer support and field service staff, including through acquisitions,
and
- - operating and maintenance charges on telecommunications bandwidth.
Our dedicated access customer account base grew to 19,300 at June 30, 1999 from
8,900 at June 30, 1998, an increase of 116%. Comparing the second quarter of
1999 to the second quarter of 1998, backbone circuit costs increased $15.1
million, or 158%, dedicated customer circuit costs increased $6.8 million, or
72%, PRI expense increased $4.9 million, or 65%, personnel and related operating
expenses associated with network operations, customer support and field service
increased $8.4 million, or 86% and operating and maintenance charges on our
bandwidth increased $2.3 million, or 2,500%. Circuit costs relating to our new
and expanded POPs and PRIs generally are incurred by us in advance of obtaining
customers and resulting revenue. Although we expect that data communications and
operations expenses will continue to increase as our customer base grows, we
anticipate that such expenses will continue to decrease over time as a
percentage of revenue due to decreases in unit costs and continued increases in
network utilization. In particular, we anticipate that costs for data
communications and operations as a percentage of revenue will decrease as we
substitute network bandwidth purchased or acquired under capital lease
agreements for existing bandwidth currently under operating lease agreements.
Network bandwidth purchased or acquired under capital lease agreements is
recorded as an asset and amortized over its useful life. This will, in turn,
result in an increase in the operating and maintenance expense component of data
communications costs as well as increases in depreciation and amortization
expense over the useful life of the bandwidth, typically 10 to 25 years.
SALES AND MARKETING. Sales and marketing expenses consist primarily of
personnel costs, advertising costs, distribution costs and related occupancy
costs. Sales and marketing expenses were $21.9 million (17.7% of revenue) for
the three months ended June 30, 1999, an increase of $9.4 million, or 76%,
from $12.5 million (23.2% of revenue) for the three months ended June 30,
1998. Sales and marketing expenses were $40.5 million (17.7% of revenue) for
the six months ended June 30, 1999, an increase of $17.3 million, or 74%,
from $23.2 million (23.6% of revenue) for the six months ended June 30, 1998.
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<PAGE>
The increase is principally attributable to costs associated with the growth
of our sales force in conjunction with our growth and acquisitions and to
advertising costs, including costs associated with our naming rights and
sponsorship agreements for PSINet Stadium with the Baltimore Ravens of the
National Football League.
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 $15.4 million (12.4% of revenue) for
the three months ended June 30, 1999, an increase of $5.1 million, or 50%, from
$10.3 million (19.2% of revenue) for the three months ended June 30, 1998.
General and administrative expenses were $32.5 million (14.2% of revenue) for
the six months ended June 30, 1999, an increase of $14.6 million, or 82%, from
$17.9 million (18.2% of revenue) for the six months ended June 30, 1998. The
increase resulted from the addition of management staff and related operating
expenses across our organization, including increases in conjunction with our
growth and acquisitions
DEPRECIATION AND AMORTIZATION. Depreciation and amortization costs were $34.4
million (27.8% of revenue) for the three months ended June 30, 1999, an increase
of $21.5 million, or 167%, from $12.9 million (24.0% of revenue) for the three
months ended June 30, 1998. Depreciation and amortization costs were $61.2
million (26.8% of revenue) for the six months ended June 30, 1999, an increase
of $38.8 million, or 174%, from $22.4 million (22.8% of revenue) for the six
months ended June 30, 1998.
Depreciation and amortization costs have increased as a result of capital
expenditures associated with network infrastructure enhancements, including
telecommunications bandwidth acquisitions, and depreciation and amortization of
tangible and intangible assets related to business acquisitions. We anticipate
that our depreciation and amortization expenses will continue to increase
significantly as we substitute network bandwidth purchased or acquired under
capital lease agreements for existing bandwidth under operating lease
agreements, and as we record depreciation and amortization on tangible and
intangible assets related to business combinations and expansion of our
operations.
ACQUIRED IN-PROCESS RESEARCH AND DEVELOPMENT. The results for the six months
ended June 30, 1999 include no charges for acquired in-process research and
development related to acquisitions completed during the period. 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 in 1998
were based on independent valuations and reflect technologies acquired prior to
technological feasibility and for which there was no alternative future use. We
are in the process of finalizing valuations for 1999 acquisitions and the
allocation of the purchase price for such acquisitions is preliminary. We do not
expect any change in the allocation, including any charge for acquired
in-process research and development, to have a material impact on our results of
operations.
INTEREST EXPENSE. Interest expense was $31.9 million (25.8% of revenue) for the
three months ended June 30, 1999, an increase of $15.0 million, or 89%, from
$16.9 million (31.4% of revenue) for the three months ended June 30, 1998.
Interest expense was $61.5 million (26.9% or revenue) for the six months ended
June 30, 1999, an increase of $42.0 million, or 216%, from $19.5 million (19.8%
of revenue) for the six months ended June 30, 1998. The increase was due to
interest on our $600.0 million aggregate principal amount of 10% senior notes
issued in April 1998 and our $350.0 million aggregate principal amount of 11
1/2% senior notes issued in November 1998, as well as to increased borrowings
and capital lease obligations incurred to finance our network expansion and to
fund our working capital requirements. As a result of the completion of our
offering of the 11% senior notes, our annual interest expense on the 10% senior
notes, 11 1/2% senior notes and 11% senior notes will be $232.6 million,
assuming an exchange rate of Euro 0.98 to U.S. $1.00, which was the exchange
rate on July 16, 1999, the date on which the offering of the 11% senior notes
was priced. We will have additional interest expense attributable to our
revolving credit facility and equipment lease arrangements.
INTEREST INCOME. Interest income was $8.1 million (6.5% of revenue) for the
three months ended June 30, 1999, an increase of $2.0 million, or 33%, from $6.1
million (11.3% of revenue) for the three months ended June 30, 1998. Interest
income was $12.8 million (5.6% of revenue) for the six months ended June 30,
1999, an increase of $6.2 million, or 93%, from $6.6 million (6.8% of revenue)
for the six months ended June 30, 1998. The increase was due to interest
received on the net proceeds of our offerings of
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<PAGE>
the 10% senior notes and 11 1/2% senior notes, which we invest in short-term
investment grade and government securities until such time as we use them for
other purposes.
NET LOSS AVAILABLE TO COMMON SHAREHOLDERS AND LOSS PER SHARE. Our net loss
available to common shareholders for the three months ended June 30, 1999 was
$62.0 million, or $1.00 basic and diluted loss per share, a $7.6 million, or
14%, increase from a net loss available to common shareholders for the three
months ended June 30, 1998 of $54.4 million, or $1.06 basic and diluted loss per
share. Our net loss available to common shareholders was $121.3 million, or
$2.10 basic and diluted loss per share, for the six months ended June 30, 1999,
an increase of $37.0 million, or 44%, from $84.3 million, or $1.76 basic and
diluted loss per share, for the six months ended June 30, 1998.
The primary reasons for the increase were:
- - the increase in interest expense due to the issuance of the 10% senior
notes and 11 1/2% senior notes,
- - our acquisitions of fiber-based telecommunications bandwidth, leading to an
increase in depreciation and personnel costs to manage the bandwidth, and
- - an increase in depreciation and amortization related to acquisitions,
offset by the absence of a charge for acquired in-process research and
development.
The return to preferred shareholders, which comprises the dividends with respect
to our convertible preferred stock, is subtracted from net loss in determining
the net loss available to common shareholders. Because inclusion of common stock
equivalents is antidilutive, basic and diluted loss per share are the same for
each period presented.
SEGMENT INFORMATION
During the second quarter of 1999, we redefined our reporting segments to
combine our U.S. and Canadian operations into one segment called North
America; and, due to acquisitions during the quarter, we added a Latin
America segment. Our operations are now organized into four geographic
operating segments - North America, Latin America, Europe and Asia.
All our reportable segments have experienced significant revenue increases from
the first six months of 1998 to the first six months of 1999. Starting in late
1997 and through June 30, 1999, we acquired 30 ISPs and one business that
operates a data center. Revenue growth by segment for the three and six months
ended June 30, 1999 compared to the three and six months ended June 30, 1998 was
as follows:
<TABLE>
<CAPTION>
REVENUE GROWTH
-----------------------------------------
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, 1999 JUNE 30, 1999
COMPARED TO COMPARED TO
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, 1998 JUNE 30, 1998
------------------ ------------------
<S> <C> <C>
North America 59% 60%
Latin America * *
Europe 134% 147%
Asia 1,667% 1,715%
All Segments 131% 133%
</TABLE>
(*) Segment new in second quarter of 1999
The Company evaluates the performance of its segments and allocates resources to
them based on revenue and EBITDA, which is defined as earnings (losses) before
interest expense and interest income, taxes, depreciation and amortization,
other non-operating income and expense, and charge for acquired in-process
research and development. EBITDA as a percentage of revenue improved in all
segments from the three months ended June 30, 1998 to the three months ended
June 30, 1999, reflecting the
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<PAGE>
overall development cycle of our businesses in these areas. Improvement in
EBITDA losses as a percentage of revenue for the North America segment was
(21.2%) to (4.7%), for the European segment was (21.1%) to (4.0%), and for the
Asian segment was 2.4% to 10.7%. The Latin America segment, new this quarter,
generated an EBITDA profit of 25.5% of revenue. These improvements have arisen
primarily as a result of two factors. First, improvements have been generated
based on internally generated growth factors, including high levels of revenue
growth and concentrated efforts to control operating costs, and second, almost
every company we acquired in 1998 and 1999 operated at EBITDA breakeven or
better, contributing to these improvements.
Our loss from operations differs from EBITDA for the quarters only by
depreciation and amortization and the charge for acquired in-process research
and development; therefore, loss from operations in each segment reflects the
same underlying trends as those impacting EBITDA as a percentage of revenue. Our
loss from operations as a percentage of revenue improved across all geographic
segments. In North America, our loss from operations as a percentage of revenue
was reduced from (68.1%) in the second quarter of 1998 to (35.0%) in the second
quarter of 1999. In Asia, it was reduced from (398.0%) to (16.2%), and in Europe
from (86.9%) to (24.1%) for those same quarters, respectively. Latin America
achieved an operating profit for the second quarter of 1999 of 8.3% of revenue.
LIQUIDITY AND CAPITAL RESOURCES
We historically have had losses from operations, which have been funded
primarily through borrowings and capital lease financings from vendors,
financial institutions and other third parties, and through the issuance of debt
and equity securities. In 1999, we have to date received net proceeds of
approximately $1.9 billion from debt and equity financings.
CASH FLOWS FOR THE SIX MONTHS ENDED JUNE 30, 1999 AND 1998
Cash flows used in operating activities were $139.3 million and $20.7 million
for the six months ended June 30, 1999 and 1998, respectively. Cash flows from
operating activities can vary significantly from period to period depending upon
the timing of operating cash receipts and payments and other working capital
changes, especially accounts receivable, prepaid expenses and other assets, and
accounts payable and accrued liabilities. In both of these six-month periods,
our net losses were the primary component of cash used in operating activities,
offset by significant non-cash depreciation and amortization expenses relating
to our network and intangible assets. Operating cash outflows in 1999 also
include the $48.0 million arbitration award payment.
Cash flows used in investing activities were $27.8 million and $451.3 million
for the six months ended June 30, 1999 and 1998, respectively. Acquisition
activities resulted in the use of $103.2 million of cash for the six months
ended June 30, 1999, net of cash acquired. Investments in our network and
facilities during the first six months of 1999 resulted in total additions to
fixed assets of $215.4 million. Of this amount, $78.6 million was financed under
vendor or other financing arrangements, $34.9 million of non-cash additions
related to the bandwidth acquired from IXC Internet Services, Inc., and $101.9
million was expended in cash. For the six months ended June 30, 1998, total
additions were $79.0 million, of which $49.1 million was financed under
equipment financing agreements, $4.7 million of non-cash additions related to
the bandwidth acquired from IXC and $25.2 million was expended in cash.
Purchases of short-term investments during the first six months of 1999 were an
aggregate of $103.2 million, offset by proceeds from the sale and maturity of
short-term investments of $262.6 million. Purchases of short-term investments
during the six months of 1998 were an aggregate of $242.3 million. Investing
cash flows in the first six months of 1999 and 1998 were increased by $18.0
million and decreased by $122.5 million, respectively, from changes in
restricted cash and short-term investments related to various financing and
acquisition activities.
Cash flows provided by financing activities were $721.7 million and $563.3
million for the six months ended June 30, 1999 and 1998, respectively. In the
first six months of 1999, we received $102.7 million from borrowings on our
credit facility and from the issuance of notes payable and $742.0 million from
equity offerings. In the first six months of 1998, we received net proceeds from
the issuance of notes payable of $609.0 million. We made repayments aggregating
$104.9 million and $29.1 million for the six months ended June 30, 1999 and
1998, respectively, on our lines of credit, capital lease obligations
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and notes payable. During the six months ended June 30, 1999 and 1998, we
received proceeds from the exercise of stock options of $9.1 million and $2.1
million, respectively.
As of June 30, 1999, we had $860.9 million of cash, cash equivalents, restricted
cash, short-term investments and marketable securities.
CAPITAL STRUCTURE
Our capital structure at June 30, 1999 consisted of a revolving credit facility,
other lines of credit, capital lease obligations, 10% senior notes, 11 1/2%
senior notes, convertible preferred stock, and common stock.
In July 1999, we issued $1.2 billion aggregate principal amount of our 11%
senior notes due 2009, consisting of $1.05 billion aggregate principal amount of
11% senior notes due 2009 and Euro 150 million aggregate principal amount of 11%
senior notes due 2009, pursuant to Securities and Exchange Commission Rule 144A
and Regulation S. The aggregate net proceeds of the offering of the 11% senior
notes, after giving effect to discounts and commissions and other offering
expenses, was approximately $1.17 billion.
Total borrowings at June 30, 1999 were $1.22 billion, which included $78.5
million in current obligations and $1.14 billion in long-term debt, capital
lease obligations and notes payable.
We have a senior secured revolving credit facility that expires on September 29,
2001 and has an aggregate principal amount of $110.0 million. At June 30, 1999,
no amounts were outstanding, $9.7 million was being utilized for letters of
credit, and $100.3 million was available to draw under the credit facility.
In addition, as of June 30, 1999, $91.9 million was available for purchases of
equipment and other fixed assets under various other financing arrangements,
after designating $20.4 million of payables for various equipment purchases.
Our bank financing arrangements, which are secured by substantially all of our
assets, require us to satisfy many financial covenants such as those relating to
consolidated revenue, leverage, liquidity and EBITDA (as defined therein), and
prohibit us from paying cash dividends and repurchasing our capital stock
without the lender's consent. In particular, we are prohibited from permitting:
- - consolidated revenue for the period of four consecutive fiscal quarters to
be less than $215.0 million during the six month period beginning December
31, 1998, $285.0 million during the six month period beginning June 30,
1999, $350.0 million during the six month period beginning December 31,
1999, $425.0 million during the six month period beginning June 30, 2000,
and $500.0 million on December 31, 2000 and thereafter;
- - the ratio of consolidated debt minus cash, excluding cash escrowed with
respect to the payment of obligations, to annualized consolidated revenue
for the most recent fiscal quarter for which financial statements have been
delivered, as adjusted to give pro forma effect to any acquisitions
completed during or after such fiscal quarter, to exceed 2.5 to 1 at any
time;
- - the sum of cash (excluding cash escrowed with respect to the payment of
obligations) and available borrowing capacity under our credit facility at
any time to be less than $100.0 million; and
- - EBITDA (as defined therein) to be less than ($31.0) million, ($15.0)
million, $0, $15.0 million, $25.0 million, $40.0 million and $50.0 million
for the period of four consecutive fiscal quarters ending on each of June
30, 1999, September 30, 1999, December 31, 1999, March 31, 2000, June 30,
2000, September 30, 2000 and December 31, 2000, respectively.
At June 30, 1999, we were in compliance with all such covenants.
At June 30, 1999, we had outstanding $600.0 million aggregate principal amount
of 10% senior notes due 2005 and $350.0 million aggregate principal amount of 11
1/2 % senior notes due 2008. At that date we had deposited in an escrow account
restricted cash and short-term investments of $94.3 million to fund, when due,
the next three semi-annual interest payments on the 10% senior notes.
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<PAGE>
In July 1999, we issued $1.2 billion aggregate principal amount of 11%
senior notes due 2009, consisting of $1.05 billion aggregate principal amount of
11% senior notes due 2009 and Euro 150 million aggregate principal amount of 11%
senior notes due 2009.
The indentures governing the 10% senior notes, the 11 1/2 % senior notes and the
11% senior notes contain many covenants with which we must comply relating to,
among other things, the following matters:
- - a limitation on our 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
permitted payments and investments;
- - a limitation on our incurrence and our subsidiaries' incurrence of
additional indebtedness, unless at the time of such incurrence, our 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 permitted incurrences of debt;
- - a limitation on our incurrence and our subsidiaries' incurrence of liens,
unless the 10% senior notes, the 11 1/2% senior notes and the 11% senior
notes are secured equally and ratably with the obligation or liability
secured by such lien, excluding permitted liens;
- - a limitation on the ability of any of our subsidiaries to create or
otherwise cause to exist any encumbrance or restriction on the payment of
dividends or other distributions on their capital stock, payment of
indebtedness owed to us or to any of our other subsidiaries, making of
investments in us or in any of our other subsidiaries, or transfer of any
of their properties or assets to us or any of our other subsidiaries,
excluding certain permitted encumbrances and restrictions;
- - a limitation on certain mergers, consolidations and sales of assets by us
or our subsidiaries;
- - a limitation on transactions with our affiliates;
- - a limitation on the ability of any of our subsidiaries to guarantee or
otherwise become liable with respect to any of our indebtedness unless such
subsidiary provides for a guarantee of the 10% senior notes, the 11 1/2%
senior notes and the 11% senior notes on the same terms as the guarantee of
such indebtedness;
- - a limitation on sale and leaseback transactions by us or our subsidiaries;
- - limitation on issuances and sales of capital stock of our subsidiaries; and
- - a limitation on the ability of us or our subsidiaries to engage in any
business not substantially related to a telecommunications business.
At June 30, 1999, we were in compliance with all such covenants.
In May 1999, we completed a public offering of 8,000,000 shares of our common
stock at $50.50 per share for net proceeds of approximately $383.8 million,
after underwriting discounts and commissions and other offering expenses.
In May 1999, we completed a public offering of 9,200,000 shares of our 6 3/4%
Series C Cumulative Convertible Preferred Stock ("Series C Preferred Stock") for
net proceeds of approximately $358.2 million after underwriting discounts and
commissions and other offering expenses. The Series C Preferred Stock has a
liquidation preference of $50 per share. The Series C Preferred Stock accrues
dividends at an annual rate of 6 3/4%, payable quarterly in arrears, commencing
on August 15, 2002, in cash, or at our option, in shares of our common stock or
a combination thereof.
At closing, the purchasers of the Series C Preferred Stock deposited
approximately $85.8 million into an account established with a deposit agent
("Deposit Account"). The Deposit Account is not an asset of ours. Funds in the
Deposit Account will be paid to the holders of the Series C Preferred Stock each
quarter in the amount of $0.84375 per share in cash or may be used, at our
option, to purchase shares of common stock at 95% of the market price of the
common stock on that date for delivery to holders of
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<PAGE>
Series C Preferred Stock in lieu of cash payments. The funds placed in the
Deposit Account by the purchasers of the Series C Preferred Stock will, together
with the earnings on those funds, be sufficient to make payments, in cash or
stock, through May 15, 2002. Until the expiration of the Deposit Account, we
will accrete a return to preferred shareholders each quarter from the date of
issuance at an annual rate of approximately 6 3/4% of the liquidation preference
per share. Such amount will be recorded as a deduction from net income to
determine net income available to common shareholders. Upon the expiration of
the Deposit Account, which is expected to occur on May 15, 2002 unless earlier
terminated, the Series C Preferred Stock will begin to accrue dividends at an
annual rate of 6 3/4% of the liquidation preference payable in cash or, at our
option, in shares of our common stock at 95% of the market price of the common
stock on that date. Under certain circumstances, we can elect to terminate the
Deposit Account prior to May 15, 2002, at which time the remaining funds in the
Deposit Account would be distributed to us and the Series C Preferred Stock
would begin to accrue dividends.
Each share of Series C Preferred Stock is convertible at any time at the option
of the holders thereof into shares of our common stock at an initial conversion
price of $62.3675 per share, subject to adjustment upon the occurrence of
specified events, equal to an initial conversion ratio of 0.8017 shares of our
common stock for each share of Series C Preferred Stock. The Series C Preferred
Stock is redeemable, at our option, at a redemption premium of 101.929% of the
liquidation preference (plus accumulated and unpaid dividends) on or after
November 15, 2000 but prior to May 15, 2002 if the trading price for the Series
C Preferred Stock exceeds $124.74 per share for a specified period. Except in
the circumstances described in the preceding sentence, we may not redeem the
Series C Preferred Stock prior to May 15, 2002. Beginning on May 15, 2002, we
may redeem shares of the Series C Preferred Stock initially at a redemption
premium of 103.857% and thereafter at prices declining to 100% on May 15, 2006
(plus in each case, accumulated and unpaid dividends).
In the event of a change in control of PSINet and if the market price of our
common stock at such time is less than the conversion price of the Series C
Preferred Stock, the holders of the Series C Preferred Stock will have the right
to convert their shares into shares of our common stock at the greater of (i)
the market price per share ending on the date on which a change of control event
occurs, or (ii) $38.73.
COMMITMENTS, CAPITAL EXPENDITURES AND FUTURE FINANCING REQUIREMENTS
As of June 30, 1999, we had commitments to certain telecommunications vendors
totaling $162.1 million payable in various years through 2011. Additionally, we
have various agreements to lease office space and facilities and, as of June 30,
1999, were obligated to make future minimum lease payments of $43.7 million on
non-cancelable operating leases expiring in various years through 2009.
For some of the acquisitions, we have retained a portion of the purchase price
under holdback provisions of the purchase agreements to secure performance by
certain sellers of indemnification or other contractual obligations of the
sellers. These holdback amounts are generally payable up to 24 months after the
date of closing of the related acquisitions. Acquisition holdback amounts
totaled $50.2 million at June 30, 1999.
In connection with our naming rights and sponsorship agreements with the
Baltimore Ravens of the National Football League, we will make payments over the
next 19 years totaling approximately $81.7 million.
We acquire fiber-based telecommunications bandwidth through purchases and
capital leases. Some of the purchase agreements have obligations for future cash
payments that coincide with the delivery of bandwidth. At June 30, 1999, we were
obligated to make future payments under these purchase agreements that total
$73.9 million.
We expect to continue to seek opportunities to acquire fiber-based
telecommunications bandwidth to enhance our global network capabilities. In
addition to North America, we anticipate that such bandwidth acquisitions will
be in Latin America, Europe and Asia and would be accompanied by capital
expenditures in the deployment of high activity POPs designed and located with
the objective of optimizing the efficient use of the bandwidth. We currently
believe that our capital expenditures in 1999 will be greater than those in 1998
and that as a result of our completion of the offering of the 11% senior
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<PAGE>
notes and recent equity offerings, we will accelerate our capital expenditures.
This will occur as we continue to execute our expansion strategy in the 20
largest global telecommunications markets and beyond.
We presently believe, based on the flexibility we expect to have in the timing
of orders of bandwidth, in outfitting our POPs with appropriate
telecommunications and computer equipment, and in controlling the pace and scope
of our anticipated buildout of our international Internet network, that we will
have a reasonable degree of flexibility to adjust the amount and timing of such
capital expenditures in response to our then existing financing capabilities,
market conditions, competition and other factors. Accordingly, we believe that
working capital generated from the use of acquired bandwidth, together with
other working capital, working capital from existing credit facilities, from
capital lease financings, from the proceeds of our recent debt and equity
offerings and from future equity or debt financings, which we presently expect
to be able to obtain when needed, will be sufficient to meet the currently
anticipated working capital and capital expenditure requirements of our
operations. We cannot assure you, however, that we will have access to
sufficient additional capital and/or financing on satisfactory terms to enable
us to meet our capital expenditure and working capital requirements.
OTHER POSSIBLE STRATEGIC RELATIONSHIPS AND ACQUISITIONS
We anticipate that we 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 our existing
business. Certain of these strategic relationships may involve other
telecommunications companies that desire to enter into joint marketing and
services arrangements with us pursuant to which we would provide Internet and
Internet-related services to such companies. Such transactions, if deemed
appropriate by us, may also be effected in conjunction with an equity or debt
investment by such companies in us. Such relationships and acquisitions may
require additional financing and may be subject to the consent of our lenders
and other third parties.
We have not entered into any material financial instruments to serve as
hedges against certain financial and currency risks or for trading. However,
as a result of the recent increase in our foreign operations and the issuance
of Euro-denominated 11% senior notes, we may begin to use various financial
instruments, including derivative financial instruments, in the ordinary
course of business, for purposes other than trading. These instruments could
include letters of credit, guarantees of debt, interest rate swap agreements
and foreign currency exchange contracts relating to intercompany payables of
foreign subsidiaries. We do not intend to use derivative financial
instruments for speculative purposes Foreign currency exchange contracts
would be used to mitigate foreign currency exposure and with the intent of
protecting the U.S. dollar value of certain currency positions and future
foreign currency transactions. Interest rate swap agreements would be used to
reduce our exposure to risks associated with interest rate fluctuations. By
their nature, all such instruments would involve risk, including the risk of
nonperformance by counterparties. We would attempt to control our exposure to
counterparty credit risk through monitoring procedures and by entering into
multiple contracts.
RISKS ASSOCIATED WITH YEAR 2000
The commonly referred to Year 2000 or Y2K problem results from the fact that
many existing computer programs and systems use only two digits to identify the
year in the date field. These programs were designed and developed without
considering the impact of a change in the century designation. If not corrected,
computer applications that use a two-digit format could fail or create erroneous
results in any computer calculation or other processing involving the Year 2000
or a later date. We have identified two main areas of Y2K risk:
- - Internal computer systems or embedded chips could be disrupted or fail,
causing an interruption or decrease in productivity in our operations; and
- - Computer systems or embedded chips of third parties, including, without
limitation, financial institutions, suppliers, vendors, landlords,
customers, international suppliers of telecommunications services and
others could be disrupted or fail, causing an interruption or decrease in
our ability to continue our operations.
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<PAGE>
We have developed detailed plans for implementing, testing and completing any
necessary modifications to our key computer systems and equipment with embedded
chips to ensure that they are Y2K compliant. We have engaged a third party
consultant to perform an assessment of our U.S. internal systems (e.g.,
accounting, billing, customer support and network operations) to determine the
status of their Y2K compliance. The assessment of these systems has been
completed and, while some minor changes are necessary, we believe that no
material changes or modifications to our internal systems are required to
achieve Y2K compliance. Our U.S. chief information officer has developed a test
bed of our U.S. internal systems to implement and complete testing of the
requisite minor changes. We anticipate that our U.S. internal systems will be
Y2K ready by September 30, 1999. We are in the process of completing an
inventory of our internal systems that we use outside of the United States to
determine the status of their Y2K compliance. Each international office has
plans in place to test, upgrade or, if necessary, replace components of its
internal systems to ensure they are Y2K compliant. We anticipate that our
international operations will be Y2K compliant during the fourth quarter of
1999. To help ensure that our network operations and services to our customers
are not interrupted due to the Y2K problem, we have established a network
operations team that meets weekly to examine our network on a worldwide basis.
This team of operational staff have conducted inventories of our network
equipment (software and hardware) and have found no material Y2K compliance
issues. We believe that all equipment currently being purchased for use in the
PSINet network is Y2K compliant. Any existing equipment that is not Y2K
compliant is planned to be made Y2K compliant through minor changes to the
software or hardware or, in limited instances, replacement of the equipment. We
anticipate that our network will be Y2K compliant by September 30, 1999. In
addition to administering the implementation of necessary upgrades for Y2K
compliance, our network team is developing a contingency plan to address any
potential problems that may occur with our network as we enter the year 2000. We
believe that, as a result of our detailed assessment and completed
modifications, the Y2K issue will not pose significant operational problems for
us. However, if the requisite modifications and conversions are not made, or not
completed in a timely fashion, it is possible that the Y2K problem could have a
material impact on our operations.
Our cost of addressing Y2K issues has been minor to date, less than 5% of our
information technology and network operations budgets, but this amount may
increase if additional outside consultants or personnel resources are required
or if important operational equipment must be remediated or replaced. Our
estimated total costs related to Y2K issues for 1999 is not expected to exceed
$2.0 million. These costs include equipment, consulting fees, software and
hardware upgrades, testing, remediation and, in limited instances, replacement
of equipment. The risk that Y2K issues could present to us include, without
limitation, disruption, delay or cessation of operations, including operations
that are subject to regulatory compliance. In each case, the correction of the
problem could result in substantial expense and disruption or delay of our
operations. The total cost of Y2K assessments and remediation is funded through
cash on hand and available from other sources and we are expensing these costs,
as appropriate. The financial impact of making all required systems changes or
other remediation efforts cannot be known precisely, but it is not expected to
be material to our financial position, results of operations, or cash flows. We
have not canceled any principal information technology projects as a result of
our Y2K effort, although we have rescheduled some internal tasks to accommodate
this effort.
In addition, we have identified, prioritized and are communicating with our
suppliers, vendors, customers, lenders and other material third parties to
determine their Y2K status and any probable impact on us. To date, our inquiries
have not revealed any significant Y2K noncompliance issue affecting our material
third parties. We will continue to monitor and evaluate our long- term
relationships with our material third parties based on their responses to our
inquiries and on information learned from other sources. If any of our material
third parties are not Y2K ready and their non-compliance causes a material
disruption to any of their respective businesses, our business could be
materially adversely affected. Disruptions could include, among other things:
- - the failure of a material third party's business;
- - a financial institution's inability to take and transfer funds;
- - an interruption in delivery of supplies from vendors;
- - a loss of voice and data connections;
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<PAGE>
- - a loss of power to our facilities; and
- - other interruptions in the normal course of our operations, the nature and
extent of which we cannot foresee.
We will continue to evaluate the nature of these risks, but at this time we are
unable to determine the probability that any such risk will occur, or if it does
occur, what the nature, length or other effects, if any,of such a risk may have
on us. If any of our material third parties experience significant failures in
their computer systems or operations due to Y2K non-compliance, it could affect
our ability to process transactions or otherwise engage in similar normal
business activities. For example, while we expect our internal systems, U.S. and
non-U.S., to be Y2K ready in stages during 1999, we and our customers who
communicate internationally will be dependent upon the Y2K-readiness of many
non-U.S. providers of telecommunication services and their vendors and
suppliers. If these providers and others are not Y2K ready, we and our customers
will not be able to send and receive data and other electronic transmissions,
which would have a material adverse effect on our revenues and business and that
of our customers. While many of these risks are outside our control, we have
identified and contacted our critical third party vendors and suppliers and are
establishing contingency plans to remedy any potential interruption to our
operations.
While we believe that we are adequately addressing the Y2K issue, we can not
assure you that our Y2K compliance effort will prevent every potential
interruption or that the cost and liabilities associated with the Y2K issue
will not materially adversely impact our business, prospects, revenues or
financial position. We are uncertain as to our most reasonably likely worst
case Y2K scenario and have not yet completed a contingency plan to handle a
worst case scenario. We expect to have such contingency plan in place by
September 30, 1999.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
At June 30, 1999, we had other financial instruments consisting of fixed and
variable rate debt and short-term investments. The substantial majority of
our debt obligations have fixed interest rates and are denominated in U.S.
dollars, which is our reporting currency. We had no amounts outstanding under
our credit facility at June 30, 1999. Any borrowings under our credit
facility would have a variable interest rate. Annual maturities of our debt
obligations, excluding capital lease obligations and our credit facility, are
as follows: $3.3 million in 1999, $2.5 million in 2000, $4.4 million in 2001,
$3.3 million in 2002, $1.5 million in 2003 and $971.1 million thereafter. At
June 30, 1999, the carrying value of our debt obligations excluding capital
lease obligations was $986.1 million and the fair value was $1,012.4 million.
The weighted-average interest rate of our debt obligations at June 30, 1999
was 10.5%. Our investments are generally fixed rate short-term investment
grade and government securities denominated in U.S. dollars. At June 30,
1999, all of our investments in debt securities are due to mature within
twelve months and the carrying value of all of our investments approximates
fair value. At June 30, 1999, $144.5 million of our cash and short-term
investments were restricted in accordance with the terms of our financing
arrangements and certain acquisition holdback agreements. We actively monitor
the capital and investing markets in analyzing our capital raising and
investing decisions.
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<PAGE>
PART II. OTHER INFORMATION
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
On May 4, 1999, we completed a public offering of 9,200,000 shares of our 6 3/4%
Series C Cumulative Convertible Preferred Stock ("Series C Preferred Stock") for
net proceeds of approximately $358.2 million after underwriting discounts and
commissions and other offering expenses. The Series C Preferred Stock has a
liquidation preference of $50 per share. The Series C Preferred stock accrues
dividends at an annual rate of 6 3/4%, payable quarterly in arrears, commencing
on August 15, 2002, in cash, or at our option, in shares of our common stock or
a combination thereof.
At closing, the purchasers of the Series C Preferred Stock deposited
approximately $85.8 million into an account established with a deposit agent
("Deposit Account"). The Deposit Account is not an asset of ours. Funds in the
Deposit Account will be paid to the holders of the Series C Preferred Stock each
quarter in the amount of $0.84375 per share in cash or may be used, at our
option, to purchase shares of our common stock at 95% of the market price of the
common stock on that date for delivery to holders of Series C Preferred Stock in
lieu of cash payments. The funds placed in the Deposit Account by the purchasers
of the Series C Preferred Stock will, together with the earnings on those funds,
be sufficient to make payments, in cash or stock, through May 15, 2002. Until
the expiration of the Deposit Account, we will accrete a return to preferred
shareholders each quarter from the date of issuance at an annual rate of
approximately 6 3/4% of the liquidation preference per share. Such amount will
be recorded as a deduction from net income to determine net income available to
common shareholders. Upon the expiration of the Deposit Account, which is
expected to occur on May 15, 2002 unless earlier terminated, the Series C
Preferred Stock will begin to accrue dividends at an annual rate of 6 3/4% of
the liquidation preference payable in cash or, at our option, in shares of our
common stock at 95% of the market price of the common stock on that date. Under
certain circumstances, we can elect to terminate the Deposit Account prior to
May 15, 2002, at which time the remaining funds in the Deposit Account would be
distributed to us and the Series C Preferred Stock would begin to accrue
dividends.
Each share of Series C Preferred Stock is convertible at any time at the option
of the holders thereof into shares of our common stock at an initial conversion
price of $62.3675 per share, subject to adjustment upon the occurrence of
specified events, equal to an initial conversion ratio of 0.8017 shares of our
common stock for each share of Series C Preferred Stock. The Series C Preferred
Stock is redeemable, at our option, at a redemption premium of 101.929% of the
liquidation preference (plus accumulated and unpaid dividends) on or after
November 15, 2000 but prior to May 15, 2002 if the trading price for the Series
C Preferred Stock exceeds $124.74 per share for a specified period. Except in
the circumstances described in the preceding sentence, we may not redeem the
Series C Preferred Stock prior to May 15, 2002. Beginning on May 15, 2002, we
may redeem shares of the Series C Preferred Stock initially at a redemption
premium of 103.857% and thereafter at prices declining to 100% on May 15, 2006
(plus in each case, accumulated and unpaid dividends).
In the event of a change in control of PSINet and if the market price of our
common stock at such time is less than the conversion price of the Series C
Preferred Stock, then the holders of the Series C Preferred Stock will have the
right to convert their shares into shares of our common stock at the greater of
(i) the market price per share ending on the date on which a change of control
event occurs, or (ii) $38.73.
Reference is made to the Certificate of Amendment to PSINet's Certificate of
Incorporation dated April 30, 1999 which sets forth the designations, rights,
preferences, privileges, limitations and restrictions of the Series C Preferred
Stock for a more complete description of the Series C Preferred Stock, a copy of
which was filed as Exhibit 3.1 to our Current Report on Form 8-K dated May 7,
1999 and is incorporated herein by reference.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
(a) The Annual Meeting of Shareholders of the Company was held on May 17, 1999.
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<PAGE>
(b) Proxies representing 50,871,211 shares were received (total shares
outstanding as of the Record Date were 56,238,444). The matters voted upon at
the Annual Meeting and the results of the voting as to each such matter are set
forth below:
The election of David N. Kunkel, William L. Schrader and Ian P. Sharp as
directors of the Company for terms expiring in 2001:
<TABLE>
<CAPTION>
<S> <C>
Votes for Mr. Kunkel 50,301,903
Votes withheld from Mr. Kunkel 70,985
Votes for Mr. Schrader 50,305,321
Votes withheld from Mr. Schrader 67,567
Votes for Mr. Sharp 50,367,283
Votes withheld from Mr. Sharp 5,605
</TABLE>
The approval of amendments to the Company's Executive Stock Incentive Plan
and Strategic Stock Incentive Plan:
<TABLE>
<CAPTION>
<S> <C>
Votes for 44,220,006
Votes against 6,545,321
</TABLE>
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, 1999:
<TABLE>
<CAPTION>
<S> <C>
Votes for 50,658,319
Votes against 177,644
</TABLE>
There were no broker non-votes in respect of the foregoing matters.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
The following Exhibits are filed herewith:
<TABLE>
<CAPTION>
<S> <C>
Exhibit 10.1 Fourth Amendment dated as of July 15, 1999 to the Credit
Agreement, dated as of September 29, 1998, among PSINet, the
Lenders party thereto, The Chase Manhattan Bank, as
Administrative Agent, Fleet National Bank, as Syndication
Agent, and The Bank of New York, as Documentation Agent.
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, 1999
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, 1999
Exhibit 27 Financial Data Schedule*
Exhibit 99.1 Risk Factors
</TABLE>
* Not deemed filed for purposes of Section 11 of the Securities Act of
1933, Section 18 of the Securities Exchange Act of 1934 and Section
323 of the Trust Indenture Act of
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<PAGE>
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
We filed a Current Report on Form 8-K dated April 27, 1999 under which we filed
exhibits to our Registration Statement on Form S-3, File No. 333-75579, relating
to our recent equity offerings.
We filed a Current Report on Form 8-K dated May 7, 1999 under which we filed
final forms of certain documents as exhibits to our Registration Statement on
Form S-3, File No. 333-75579, relating to our recent equity offerings.
We filed a Current Report on Form 8-K dated July 14, 1999 under which we filed a
press release relating to our recent offering of 11% senior notes and an
amendment to our credit facility as an exhibit.
We filed a Current Report on Form 8-K dated July 21, 1999 under which we filed a
press release relating to our recent offering of 11% senior notes.
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<PAGE>
PSINET INC.
FORM 10-Q
JUNE 30, 1999
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 16, 1999 By: /s/ William L. Schrader
- --------------- -----------------------------------------
Date William L. Schrader
Chairman, Chief Executive Officer
and Director
August 16, 1999 By: /s/ Edward D. Postal
- --------------- -----------------------------------------
Date Edward D. Postal
Senior Vice President and
Chief Financial Officer
(Principal Financial Officer)
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<PAGE>
EXHIBIT INDEX
The following Exhibits are filed herewith:
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION OF EXHIBIT LOCATION
------ ---------------------- --------
<C> <S> <C>
10.1 Fourth Amendment dated as of July 15, 1999 to the Credit Filed herewith
Filed herewith Agreement, dated as of September 29, 1998,
among PSINet, the Lenders party thereto, The Chase
Manhattan Bank, as Administrative Agent, Fleet National
Bank, as Syndication Agent, and The Bank of New York, as
Documentation Agent.
11.1 Calculation of Basic and Diluted Loss per Share and Weighted Filed herewith
Average Shares Used in Calculation for the Three Months
Ended June 30, 1999
11.2 Calculation of Basic and Diluted Loss per Share and Weighted Filed herewith
Average Shares Used in Calculation for the Six Months Ended
June 30, 1999
27 Financial Data Schedule Filed herewith
99.1 Risk Factors Filed herewith
</TABLE>
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<PAGE>
Exhibit 10.1
FOURTH AMENDMENT dated as of July 15, 1999
(this "AMENDMENT"), to the Credit Agreement, dated as
of September 29, 1998 (as amended, supplemented or
otherwise modified from time to time, the "CREDIT
AGREEMENT"), among PSINET INC., a corporation
organized under the laws of the State of New York
(the "BORROWER"), the several banks and other
financial institutions and entities from time to time
parties thereto (the "LENDERS"), THE CHASE MANHATTAN
BANK, as administrative agent (the "ADMINISTRATIVE
AGENT") for the Lenders, Fleet National Bank, as
syndication agent for the Lenders, and The Bank of
New York as documentation agent for the Lenders.
WHEREAS, pursuant to the Credit Agreement, the Lenders have
agreed to make certain loans to the Borrower; and
WHEREAS the Borrower has requested that certain provisions of
the Credit Agreement be modified in the manner provided for in this Amendment,
and the Lenders are willing to agree to such modifications as provided for in
this Amendment.
NOW, THEREFORE, the parties hereto hereby agree as follows:
1. DEFINED TERMS. Capitalized terms used and not defined
herein shall have the meanings given to them in the Credit Agreement, as amended
hereby.
2. AMENDMENTS TO THE CREDIT AGREEMENT.
Section 6.01 of the Credit Agreement is hereby amended by
deleting clause (ix) thereof in its entirety and substituting the following
therefor:
(ix) Indebtedness permitted by Section 10.08(b)(iii) of the Senior
Note Indenture, in an aggregate principal amount not to exceed the
lesser of (x) the product of (A) two and (B) the net cash proceeds
received by the Borrower since the date of such indenture from sales of
its capital stock in
<PAGE>
public offerings or to strategic investors and (y) $1,600,000,000 less
the aggregate principal amount of the 1998 High Yield Notes.
3. NO OTHER AMENDMENTS; CONFIRMATION. Except as expressly
amended, waived, modified and supplemented hereby, the provisions of the Credit
Agreement are and shall remain in full force and effect.
4. REPRESENTATIONS AND WARRANTIES. The Borrower hereby
represents and warrants to the Administrative Agent and the Lenders as of the
date hereof as follows:
(a) No Default or Event of Default has occurred and is
continuing.
(b) The execution, delivery and performance by the Borrower of
this Amendment have been duly authorized by all necessary corporate and other
action and do not and will not require any registration with, consent or
approval of, notice to or action by, any person (including any governmental
agency) in order to be effective and enforceable. The Credit Agreement as
amended by this Amendment constitutes the legal, valid and binding obligation of
the Borrower, enforceable against it in accordance with its terms, subject only
to the operation of the Bankruptcy Code and other similar statutes for the
benefit of debtors generally and to the application of general equitable
principles.
(c) All representations and warranties of the Borrower
contained in the Credit Agreement (other than representations or warranties
expressly made only on and as of the Effective Date) are true and correct as of
the date hereof.
5. EFFECTIVENESS. This Amendment shall become effective only
upon the satisfaction in full of the following conditions precedent: The
Administrative Agent shall have received counterparts hereof, duly executed and
delivered by the Borrower and the Required Lenders; and
6. EXPENSES. The Borrower agrees to reimburse the
Administrative Agent for its out-of-pocket expenses in connection with this
Amendment, including the reasonable fees, charges and disbursements of Cravath,
Swaine & Moore, counsel for the Administrative Agent.
7. GOVERNING LAW; COUNTERPARTS. (a) This Amendment and the
rights and obligations of the parties hereto shall be governed by, and construed
and interpreted in accordance with, the laws of the State of New York.
<PAGE>
(b) This Amendment may be executed by one or more of the
parties to this Amendment on any number of separate counterparts, and all of
said counterparts taken together shall be deemed to constitute one and the same
instrument. This Amendment may be delivered by facsimile transmission of the
relevant signature pages hereof.
IN WITNESS WHEREOF, the parties hereto have caused this
Amendment to be duly executed and delivered by their respective proper and duly
authorized officers as of the day and year first above written.
PSINET INC.
by
/s/ D.N. Kunkel
-----------------------------------
Name: D.N. Kunkel
Title: Executive Vice President
THE CHASE MANHATTAN BANK,
individually and as Administrative Agent,
by
/s/ John J. Huber
-----------------------------------
Name: John J. Huber III
Title: Managing Director
FLEET NATIONAL BANK,
individually and as Syndication Agent,
by
/s/ Andrew C. Wigren
-----------------------------------
Name: Andrew C. Wigren
Title: Assistant Vice President
THE BANK OF NEW YORK,
individually and as Documentation Agent,
by
/s/ Gerry Granovsky
-----------------------------------
<PAGE>
Name: Gerry Granovsky
Title: Vice President
BANKBOSTON, N.A.,
by
/s/ Cindy Chen
-----------------------------------
Name: Cindy Chen
Title: Director
<PAGE>
EXHIBIT 11.1
PSINET INC.
CALCULATION OF BASIC AND DILUTED LOSS PER SHARE AND WEIGHTED AVERAGE SHARES
USED IN CALCULATION (UNAUDITED) (1)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
JUNE 30, 1999
-------------
<S> <C>
Weighted average shares outstanding:
Common stock:
Shares outstanding at beginning of period ................................ 56,322,112
Weighted average shares issued during the three months ended June 30, 1999
(8,355,385 shares) ....................................................... 5,633,730
---------
61,955,842
---------
---------
Net loss available to common shareholders ......................................... $(61,990,000)
---------
---------
Basic and diluted loss per share .................................................. $ (1.00)
---------
---------
</TABLE>
(1) For a description of basic and diluted loss per share, see Note 1 of the
Notes to Consolidated Financial Statements included in the Company's Annual
Report on Form 10-K for the year ended December 31, 1998 as filed with the
Securities and Exchange Commission.
<PAGE>
EXHIBIT 11.2
PSINET INC.
CALCULATION OF BASIC AND DILUTED LOSS PER SHARE AND WEIGHTED AVERAGE SHARES
USED IN CALCULATION (UNAUDITED) (1)
<TABLE>
<CAPTION>
SIX MONTHS ENDED
JUNE 30, 1999
-------------
<S> <C>
Weighted average shares outstanding:
Common stock:
Shares outstanding at beginning of period........................................................ 52,083,639
Weighted average shares issued during the six months ended June 30, 1999
(12,593,858 shares) ............................................................................. 5,573,481
-------------
57,657,120
-------------
-------------
Net loss available to common shareholders ................................................................. $(121,250,000)
-------------
-------------
Basic and diluted loss per share............................................................................... $(2.10)
-------------
-------------
</TABLE>
(1) For a description of basic and diluted loss per share, see Note 1 of the
Notes to Consolidated Financial Statements included in the Company's Annual
Report on Form 10-K for the year ended December 31, 1998 as filed with the
Securities and Exchange Commission.
<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, 1999
AND THE CONSOLIDATED BALANCE SHEET AS OF JUNE 30, 1999 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-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> JUN-30-1999
<CASH> 659,704
<SECURITIES> 201,156
<RECEIVABLES> 70,993
<ALLOWANCES> 12,397
<INVENTORY> 0
<CURRENT-ASSETS> 952,330
<PP&E> 775,525
<DEPRECIATION> 154,838
<TOTAL-ASSETS> 2,013,459
<CURRENT-LIABILITIES> 283,829
<BONDS> 1,141,730
0
362,434
<COMMON> 648
<OTHER-SE> 166,845
<TOTAL-LIABILITY-AND-EQUITY> 2,013,459
<SALES> 228,668
<TOTAL-REVENUES> 228,668
<CGS> 162,341
<TOTAL-COSTS> 162,341
<OTHER-EXPENSES> 134,184
<LOSS-PROVISION> 6,289
<INTEREST-EXPENSE> 61,486
<INCOME-PRETAX> (116,903)
<INCOME-TAX> 450
<INCOME-CONTINUING> (116,453)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (116,453)
<EPS-BASIC> (2.10)
<EPS-DILUTED> (2.10)
</TABLE>
<PAGE>
RISK FACTORS
BEFORE YOU INVEST IN OUR SECURITIES, YOU SHOULD BE AWARE THAT THERE ARE
VARIOUS RISKS ASSOCIATED WITH US AND, INCLUDING THE ONES LISTED BELOW. YOU
SHOULD CAREFULLY CONSIDER THESE RISK FACTORS, AS WELL AS THE OTHER INFORMATION
CONTAINED IN OUR FORM 10-Q AND OUR OTHER PERIODIC REPORTS AND DOCUMENTS FILED
WITH THE SECURITIES AND EXCHANGE COMMISSION, IN EVALUATING PSINET AND OUR
BUSINESS.
WE HAVE SIGNIFICANT INDEBTEDNESS AND WE MAY NOT BE ABLE TO MEET OUR OBLIGATIONS
We are highly leveraged and have significant debt service requirements. As of
June 30, 1999, after giving pro forma effect to the issuance in July 1999 of
$1.2 billion aggregate principal amount of 11% senior notes, our total
indebtedness would have been $2.4 billion, representing 81% of total
capitalization. For the three and six months ended June 30, 1999, our
interest expense was $31.9 million and $61.5 million, respectively. After
giving pro forma effect to the 11% senior notes offering, our interest
expense for the three and six months ended June 30, 1999 would have been
$65.0 million and $127.7 million, respectively.
Our high level of indebtedness could have several important effects on our
future operations, which, in turn, could have important consequences for the
holders of our securities, including the following:
- a substantial portion of our cash flow from operations must be used to
pay interest on our indebtedness and, therefore, will not be available
for other business purposes
- covenants contained in the agreements evidencing our debt obligations
require us to meet many financial tests, and other restrictions limit
our ability to borrow additional funds or to dispose of assets and may
affect our flexibility in planning for, and reacting to, changes in
our business, including possible acquisition activities and capital
expenditures; and
- our ability to obtain additional financing in the future for working
capital, capital expenditures, acquisitions, general corporate
purposes or other purposes may be impaired.
Our ability to meet our debt service obligations and to reduce our total
indebtedness depends on our future operating performance and on economic,
financial, competitive, regulatory and other factors affecting our operations.
Many of these factors are beyond our control and our future operating
performance could be adversely affected by some or all of these factors. We
historically have been unable to generate sufficient cash flow from operations
to meet our operating needs and have relied on equity, debt and capital lease
financings to fund our operations. However, based on our current level of
operations, management believes that existing working capital, existing credit
facilities, capital lease financings and proceeds of future equity or debt
financings will be adequate to meet our presently anticipated future
requirements for working capital, capital expenditures and scheduled payments of
interest on our debt. We cannot assure you, however, that our business will
generate sufficient cash flow from operations or that future working capital
borrowings will be available in an amount sufficient to enable us to service our
debt, or to make necessary capital expenditures. In addition, we cannot assure
you that we will be able to raise additional capital for any refinancing of our
debt in the future.
WE HAVE EXPERIENCED CONTINUING LOSSES, NEGATIVE CASH FLOW AND FLUCTUATIONS IN
OPERATING RESULTS
Our 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, we must, among other things, respond to
competitive developments, continue to attract and retain qualified persons,
continue to upgrade our management and financial systems, and continue to
upgrade our technologies and commercialize our network services incorporating
such technologies. We cannot assure you that we will be successful in addressing
such risks, and the failure to do so could have a material adverse effect on our
business, financial condition, results of operations and ability to pay when due
principal, interest and other amounts in respect of our debt. Although we have
experienced revenue growth on an annual basis with revenue increasing from $84.4
million in 1996 to $121.9 million in 1997 to $259.6 million in 1998 and $228.7
million for the first six months of 1999, we have incurred losses and
experienced negative EBITDA during those periods. We may continue to operate at
a net loss and may experience negative EBITDA as we continue our acquisition
program and the expansion of our
1
<PAGE>
global network operations. We have incurred net losses available to common
shareholders of $55.1 million in 1996, $46.0 million in 1997, $264.9 million
in 1998 and $121.2 million for the first six months of 1999. We have incurred
negative EBITDA of $28.0 million, $21.2 million and $42.1 million for each of
the years ended December 31, 1996, 1997 and 1998, respectively, and had
positive EBITDA of $0.2 million for the three months ended June 30, 1999. At
June 30, 1999, we had an accumulated deficit of $548.8 million. We cannot
assure you that we will be able to achieve or sustain profitability or
sustain positive EBITDA. Our 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 our control. These factors, include, among
others:
- general economic conditions and specific economic conditions in the
Internet access industry;
- user demand for Internet services;
- capital expenditures and other costs relating to the expansion of
operations of our network;
- the introduction of new services by us or our competitors;
- the mix of services sold and the mix of channels through which those
services are sold;
- pricing changes and new product introductions by us and our
competitors;
- delays in obtaining sufficient supplies of sole or limited source
equipment and telecom facilities; and
- potential adverse regulatory developments.
As a strategic response to a changing competitive environment, we may elect from
time to time to make pricing, service or marketing decisions that could have a
material adverse effect on our business, results of operations and cash flow.
WE WILL DEPEND ON THE CASH FLOWS OF OUR SUBSIDIARIES IN ORDER TO SATISFY OUR
DEBT OBLIGATIONS
We are an operating entity which also conducts a significant portion of our
business through our subsidiaries. Our operating cash flow and consequently our
ability to service our debt is therefore partially dependent upon our
subsidiaries' earnings and their distributions of those earnings to us. It may
also be dependent upon loans, advances or other payments of funds to us by those
subsidiaries. Our subsidiaries are separate legal entities and have no
obligation, contingent or otherwise, to pay any amount due pursuant to our
senior notes or to make any funds available for that purpose. Our subsidiaries'
ability to make payments may be subject to the availability of sufficient
surplus funds, the terms of such subsidiaries' indebtedness, applicable laws and
other factors.
WE MAY NOT BE ABLE TO FUND THE EXPANSION WE WILL NEED TO REMAIN COMPETITIVE
In order to maintain our competitive position and continue to meet the
increasing demands for service quality, availability and competitive pricing, we
expect to make significant capital expenditures. At June 30, 1999, we were
obligated to make future payments that total $73.9 million for acquisitions of
global fiber-based telecommunications bandwidth, including indefeasible rights
of use or other rights. We also expect that there will be additional costs, such
as connectivity and equipment charges, in connection with taking full advantage
of such acquired bandwidth and indefeasible rights of use. We currently believe
that our capital expenditures in 1999 will be greater than those in 1998 and
that as a result of our completion of the offering of the 11% senior notes and
recent equity offerings, we will accelerate our capital expenditures. This may
occur as we continue to execute our expansion strategy in the 20 largest global
telecommunications markets and beyond.
We historically have been unable to generate sufficient cash flow from
operations to meet our operating needs and have relied on equity, debt and
capital lease financings to fund our operations. However, we believe that we
will have a reasonable degree of flexibility to adjust the amount and timing
of capital expenditures in response to market conditions, competition, our
then existing financing capabilities and other factors. We also believe that
working capital generated from the use of acquired bandwidth, together with
other existing working capital from existing credit facilities, from capital
lease financings, from the proceeds of our recent debt and equity offerings
and from proceeds of future equity or debt financings will be sufficient to
meet the presently anticipated working capital and capital expenditure
requirements of our operations. We cannot assure you, however, that
2
<PAGE>
we will have sufficient additional capital and/or obtain financing on
satisfactory terms to enable us to meet our capital expenditures and working
capital requirements.
We may need to raise additional funds in order to take advantage of
unanticipated opportunities, more rapid international expansion or acquisitions
of complementary businesses. In addition, we may need to raise additional funds
to develop new products or otherwise respond to changing business conditions or
unanticipated competitive pressures. We cannot assure that we will be able to
raise such funds on favorable terms. In the event that we are unable to obtain
such additional funds on acceptable terms, we may determine not to enter into
various expansion opportunities.
WE FACE RISKS ASSOCIATED WITH ACQUISITIONS AND STRATEGIC ALLIANCES AND
INVESTMENTS RELATING TO DIFFICULTIES IN INTEGRATING COMBINED OPERATIONS,
INCURRENCE OF ADDITIONAL DEBT TO FINANCE ACQUISITIONS AND OPERATIONS OF ACQUIRED
BUSINESSES, POTENTIAL DISRUPTION OF OPERATIONS AND RELATED NEGATIVE IMPACT ON
EARNINGS, AND INCURRENCE OF SUBSTANTIAL EXPENSES THAT COULD ADVERSELY AFFECT OUR
FINANCIAL CONDITION
Growth through acquisitions represents a principal component of our business
strategy. Over the 22 months ended July 31, 1999, we acquired 32 ISPs primarily
in 14 of the 20 largest global telecommunications markets. We expect to continue
to acquire assets and businesses principally relating to or complementary to our
current operations. We may also seek to develop strategic alliances and
investments (including venture capital investments) both domestically and
internationally. Any such future acquisitions or strategic alliances and
investments would be accompanied by the risks commonly encountered in
acquisitions, strategic alliances or investments. Such risks include, among
other things:
- the difficulty of integrating the operations and personnel of the
companies, particularly in non-U.S. markets;
- the potential disruption of our ongoing business;
- the inability of management to maximize our financial and strategic
position by the successful incorporation of licensed or acquired
technology and rights into our service offerings; and
- the inability to maintain uniform standards, controls, procedures and
policies and the impairment of relationships with employees and
customers as a result of changes in management.
We cannot assure you that we will be successful in overcoming these risks or any
other problems encountered in connection with such acquisitions, strategic
alliances or investments. We believe that after eliminating redundant network
architecture and administrative functions and taking other actions to integrate
the operations of acquired companies we will be able to realize cost savings.
However, we cannot assure you that our integration of acquired companies'
operations will be successfully accomplished. Our inability to improve the
operating performance of acquired companies' businesses or to integrate
successfully the operations of acquired companies could have a material adverse
effect on our business, financial condition and results of operations. In
addition, as we proceed with acquisitions in which the consideration consists of
cash, a substantial portion of our available cash will be used to consummate
such acquisitions.
As with each of our recent acquisitions, the purchase price of many of the
businesses that might become attractive acquisition candidates for us likely
will significantly exceed the fair values of the net assets of the acquired
businesses. As a result, material goodwill and other intangible assets would be
required to be recorded which would result in significant amortization charges
in future periods. In addition, 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 our business, financial condition and results of operations
and could cause substantial fluctuations in our quarterly and yearly operating
results. Furthermore, in connection with acquisitions or strategic alliances, we
could incur substantial expenses, including the expenses of integrating the
business of the acquired company or the strategic alliance with our existing
business.
3
<PAGE>
We expect that competition for appropriate acquisition candidates may be
significant. We may compete with other telecommunications companies with similar
acquisition strategies, many of which may be larger and have greater financial
and other resources than we have. 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. We cannot assure you that we will be able to successfully identify and
acquire suitable companies on acceptable terms and conditions.
OUR GROWTH AND EXPANSION MAY STRAIN OUR ABILITY TO MANAGE OUR OPERATIONS AND OUR
FINANCIAL RESOURCES
Our rapid growth has placed a strain on our administrative, operational and
financial resources and has increased demands on our systems and controls. We
have approximately 600 points-of-presence and we plan to continue to expand the
capacity of existing points-of-presence as customer-driven demand dictates. In
addition, we have completed a number of acquisitions of companies and
telecommunications bandwidth during 1998 and the first half of 1999 and plan to
continue to do so. We anticipate that our Carrier and Internet Service Provider
Services business unit, as well as other business growth, may require continued
enhancements to and expansion of our network. The process of consolidating the
businesses and implementing the strategic integration of these acquired
businesses with our existing business may take a significant amount of time. It
may also place additional strain on our resources and could subject us to
additional expenses. We cannot assure you that we will be able to integrate
these companies successfully or in a timely manner. In addition, we cannot
assure you that our existing operating and financial control systems and
infrastructure will be adequate to maintain and effectively monitor future
growth.
Our continued growth may also increase our need for qualified personnel. We
cannot assure you that we will be successful in attracting, integrating and
retaining such personnel. The following risks, associated with our growth, could
have a material adverse effect on our business, results of operations and
financial condition:
- our inability to continue to upgrade our networking systems or our
operating and financial control systems;
- our inability to recruit and hire necessary personnel or to
successfully integrate new personnel into our operations;
- our inability to successfully integrate the operations of acquired
companies or to manage our growth effectively; or
- our inability to adequately respond to the emergence of unexpected
expansion difficulties.
WE FACE RISKS ASSOCIATED WITH OUR ACQUISITIONS OF BANDWIDTH FROM NETWORK
SUPPLIERS, INCLUDING OUR STRATEGIC ALLIANCE WITH IXC COMMUNICATIONS INC.,
RELATING TO OUR DEPENDENCE ON THEIR ABILITY TO SATISFY THEIR OBLIGATIONS TO US,
THE POSSIBILITY THAT WE MAY NEED TO INCUR SIGNIFICANT EXPENSES TO UTILIZE
BANDWIDTH AND THEIR ABILITY TO BUILDOUT THEIR NETWORKS UNDER CONSTRUCTION THAT
COULD ADVERSELY AFFECT OUR ABILITY TO UTILIZE ACQUIRED BANDWIDTH
We are subject to a variety of risks relating to our recent acquisitions of
fiber-based telecommunications bandwidth from our various global network
suppliers, including our strategic alliance with IXC Communications Inc., and
the delivery, operation and maintenance of such bandwidth. Such risks include,
among other things, the following:
- the risk that financial, legal, technical and/or other matters may
adversely affect such suppliers' ability to perform their respective
operation, maintenance and other services relating to such bandwidth,
which may adversely affect our use of such bandwidth;
- the risk that we will not have access to sufficient additional capital
and/or financing on satisfactory terms to enable us to make the
necessary capital expenditures to take full advantage of such
bandwidth;
- the risk that such suppliers may not continue to have the necessary
financial resources to enable them to complete, or may otherwise elect
not to complete, their contemplated buildout of their respective fiber
optic telecommunications systems; and
4
<PAGE>
- the risk that such buildout may be delayed or otherwise adversely
affected by presently unforeseeable legal, technical and/or other
factors.
We cannot assure you that we will be successful in overcoming these risks or any
other problems encountered in connection with our acquisitions of bandwidth.
CONTINUED INTERNATIONAL EXPANSION IS A KEY COMPONENT OF OUR BUSINESS STRATEGY
AND, IF WE ARE UNABLE TO COMPLETE THIS EXPANSION, OUR FINANCIAL CONDITION MAY BE
ADVERSELY AFFECTED
A key component of our business strategy is our continued expansion into
international markets. Revenue from our non-U.S. operations continues to
increase as a percentage of consolidated results, comprising 51% of revenue in
the second quarter of 1999. By comparison, our non-U.S. operations comprised 31%
of revenue in the second quarter of 1998 and 40% for all of 1998. We may need to
enter into joint ventures or other strategic relationships with one or more
third parties in order to conduct our foreign operations successfully. However,
we cannot assure that we will be able to obtain the permits and operating
licenses required for us 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 our ability to continue to expand our international presence,
there are risks inherent in doing business on an international level. Such risks
include:
- unexpected changes in or delays resulting from regulatory
requirements, tariffs, customs, duties and other trade barriers;
- difficulties in staffing and managing foreign operations;
- longer payment cycles and problems in collecting accounts receivable;
- fluctuations in currency exchange rates and foreign exchange controls
which restrict or prohibit repatriation of funds;
- technology export and import restrictions or prohibitions;
- delays from customs brokers or government agencies;
- the introduction of free ISP services for consumer customers;
- seasonal reductions in business activity during the summer months in
Europe and other parts of the world; and potentially adverse tax
consequences, which could adversely impact the success of our
international operations.
We cannot assure you that such factors will not have an adverse effect on our
future international operations and, consequently, on our business, financial
condition and results of operations. In addition, we cannot assure you that laws
or administrative practice relating to taxation, foreign exchange, foreign
ownership or other matters of countries within which we operate will not change.
Any such change could have a material adverse effect on our business, financial
condition and results of operations.
In particular, we have also recently made significant investments in Japan,
which has been experiencing a severe economic recession. Other countries in
which we operate may also experience economic difficulties and uncertainties.
These economic difficulties and uncertainties could have a material adverse
effect on our business, financial condition and results of operations.
OUR FINANCIAL RESULTS AND OUR FINANCIAL POSITION MAY BE ADVERSELY AFFECTED BY
CURRENCY AND EXCHANGE RISKS
During the year ended December 31, 1998 and the six months ended June 30, 1999,
40% and 51%, respectively, of our revenue was derived from operations outside
the United States and at June 30, 1999, 30% of our assets were in operations
outside of the United States. We anticipate that a significant percentage of our
future revenue and operating expenses will continue to be generated from
operations outside the United States and we expect to continue to invest in
non-U.S. businesses. Consequently, a substantial portion of our revenue,
operating expenses, assets and liabilities will be subject to significant
foreign currency and exchange risks. Obligations of customers and of PSINet in
foreign currencies will be subject to unpredictable and indeterminate
fluctuations in the event that such currencies change in value relative to U.S.
dollars. Furthermore, those customers and PSINet may be subject to exchange
control regulations which might restrict or prohibit the
5
<PAGE>
conversion of such currencies into U.S. dollars. Although we have not entered
into hedging transactions to limit our foreign currency risks, as a result of
the increase in our foreign operations, we may implement such practices in the
future. We cannot assure you that the occurrence of any of these factors will
not have a material adverse effect on our business, financial position or
results of operations.
WE DEPEND ON KEY PERSONNEL AND COULD BE AFFECTED BY THE LOSS OF THEIR SERVICES
Competition for qualified employees and personnel in the Internet services
industry is intense and there are a limited number of persons with knowledge of
and experience in the Internet service industry. The process of locating such
personnel with the combination of skills and attributes required to carry out
our strategies is often lengthy. Our success depends to a significant degree
upon our ability to attract and retain qualified management, technical,
marketing and sales personnel and upon the continued contributions of such
management and personnel. In particular, our success is highly dependent upon
the personal abilities of our senior executive management, including William L.
Schrader, our Chairman of the Board and Chief Executive Officer and the founder
of PSINet, Harold S. Wills, our President and Chief Operating Officer, and
Edward D. Postal, our Senior Vice President and Chief Financial Officer. We have
employment agreements with Messrs. Wills and Postal. The loss of the services of
any one of them could have a material adverse effect on our business, financial
condition or results of operations.
WE DEPEND ON SUPPLIERS AND COULD BE AFFECTED BY CHANGES IN SUPPLIERS OR DELAYS
IN DELIVERY OF THEIR PRODUCTS AND SERVICES
We have few long-term contracts with our suppliers. We are dependent on third
party suppliers for our leased-line connections or bandwidth. Some of these
suppliers are or may become competitors of ours, and such suppliers are not
subject to any contractual restrictions upon their ability to compete with us.
If these suppliers change their pricing structures, we may be adversely
affected. Moreover, any failure or delay on the part of our network providers to
deliver bandwidth to us or to provide operations, maintenance and other services
with respect to such bandwidth in a timely or adequate fashion could adversely
affect us.
We are also dependent on third party suppliers of hardware components. Although
we attempt to maintain a minimum of two vendors for each required product, some
components used by us in providing our networking services are currently
acquired or available from only one source. We have from time to time
experienced delays in the receipt of hardware components and telecommunications
facilities, including delays in delivery of PRI telecommunications facilities,
which connect dial-up customers to our 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 us. Our 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 our desire to maintain good
relationships with the suppliers. As our suppliers revise and upgrade their
equipment technology, we may encounter difficulties in integrating the new
technology into our network.
Many of the vendors from whom we purchase telecommunications bandwidth,
including the regional Bell operating companies, competitive local exchange
carriers and other local exchange carriers, currently are subject to tariff
controls and other price constraints which in the future may be changed. In
addition, recently enacted legislation will produce changes in the market for
telecommunications services. These changes may affect the prices which we are
charged by the regional Bell operating companies and other carriers, which could
have a material adverse effect on our business, financial condition and results
of operations. Moreover, we are subject to the effects of other potential
regulatory actions which, if taken, could increase the cost of our
telecommunications bandwidth through, for example, the imposition of access
charges.
THE TERMS OF OUR FINANCING ARRANGEMENTS MAY RESTRICT OUR OPERATIONS
Our financing arrangements are secured by substantially all of our assets and
stock of some of our subsidiaries. These financing arrangements require that we
satisfy many financial covenants. Our ability to satisfy these financial
covenants may be affected by events beyond our control and, as a result, we
cannot assure you that we will be able to continue to satisfy such covenants.
These financing arrangements also currently prohibit us from paying dividends
and repurchasing our capital stock without the lender's consent. Our failure to
comply with the covenants and restrictions in these financing arrangements could
lead to a default under the terms of these
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agreements. In the event of a default under the financing arrangements, our
lenders would be entitled to accelerate the indebtedness outstanding thereunder
and foreclose upon the assets securing such indebtedness. They would also be
entitled to be repaid from the proceeds of the liquidation of those assets
before the assets would be available for distribution to the holders of our
securities. In addition, the collateral security arrangements under our existing
financing arrangements may adversely affect our ability to obtain additional
borrowings.
OUR FINANCIAL CONDITION MAY BE ADVERSELY AFFECTED IF OUR SYSTEMS AND THOSE OF
OUR SUPPLIERS FAIL BECAUSE OF YEAR 2000 PROBLEMS
The commonly referred to Year 2000 or Y2K problem results from the fact that
many existing computer programs and systems use only two digits to identify the
year in the date field. These programs were designed and developed without
considering the impact of a change in the century designation. If not corrected,
computer applications that use a two-digit format could fail or create erroneous
results in any computer calculation or other processing involving the Year 2000
or a later date. We have identified two main areas of Y2K risk:
1. Internal computer systems or embedded chips could be disrupted or
fail, causing an interruption or decrease in productivity in our
operations; and
2. Computer systems or embedded chips of third parties including, without
limitation, financial institutions, suppliers, vendors, landlords,
customers, international suppliers of telecommunications services and
others, could be disrupted or fail, causing an interruption or
decrease in our ability to continue our operations.
We have developed detailed plans for implementing, testing and completing any
necessary modifications to our key computer systems and equipment with embedded
chips to ensure that they are Y2K compliant. We have engaged a third party
consultant to perform an assessment of our U.S. internal systems (e.g.,
accounting, billing, customer support and network operations) to determine the
status of their Y2K compliance. The assessment of these systems has been
completed and, while some minor changes are necessary, we believe that no
material changes or modifications to our internal systems are required to
achieve Y2K compliance. Our U.S. chief information officer has developed a test
bed of our U.S. internal systems to implement and complete testing of the
requisite minor changes. We anticipate that our U.S. internal systems will be
Y2K ready by September 30, 1999. We are in the process of completing an
inventory of our internal systems that we use outside of the United States to
determine the status of their Y2K compliance. Each international office has
plans in place to test, upgrade or, if necessary, replace components of its
internal systems to ensure they are Y2K compliant. We anticipate that our
international operations will be Y2K compliant during the fourth quarter of
1999. To help ensure that our network operations and services to our customers
are not interrupted due to the Y2K problem, we have established a network
operations team that meets weekly to examine our network on a worldwide basis.
This team of operational staff have conducted inventories of our network
equipment (software and hardware) and have found no material Y2K compliance
issues. We believe that all equipment currently being purchased for use in the
PSINet network is Y2K compliant. Any existing equipment that is not Y2K
compliant is planned to be made Y2K compliant through minor changes to the
software or hardware or, in limited instances, replacement of the equipment. We
anticipate that our network will be Y2K compliant by September 30, 1999. In
addition to administering the implementation of necessary upgrades for Y2K
compliance, our network team is developing a contingency plan to address any
potential problems that may occur with our network as we enter the year 2000. We
believe that, as a result of our detailed assessment and completed
modifications, the Y2K issue will not pose significant operational problems for
us. However, if the requisite modifications and conversions are not made, or not
completed in a timely fashion, it is possible that the Y2K problem could have a
material impact on our operations.
Our cost of addressing Y2K issues has been minor to date, less than 5% of our
information technology and network operations budgets, but this amount may
increase if additional outside consultants or personnel resources are required
or if important operational equipment must be remediated or replaced. Our
estimated total costs related to Y2K issues for 1999 is not expected to exceed
$2.0 million. These costs include equipment, consulting fees, software and
hardware upgrades, testing, remediation and, in limited instances, replacement
of equipment. The risk that Y2K issues could present to us include, without
limitation, disruption, delay or cessation of operations, including operations
that are subject to regulatory compliance. In each case,
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the correction of the problem could result in substantial expense and disruption
or delay of our operations. The total cost of Y2K assessments and remediation is
funded through cash on hand and available from other sources and we are
expensing these costs, as appropriate. The financial impact of making all
required systems changes or other remediation efforts cannot be known precisely,
but it is not expected to be material to our financial position, results of
operations, or cash flows. We have not canceled any principal information
technology projects as a result of our Y2K effort, although we have rescheduled
some internal tasks to accommodate this effort.
In addition, we have identified, prioritized and are communicating with our
suppliers, vendors, customers, lenders and other material third parties to
determine their Y2K status and any probable impact on us. To date, our inquiries
have not revealed any significant Y2K noncompliance issue affecting our material
third parties. We will continue to monitor and evaluate our long-term
relationships with our material third parties based on their responses to our
inquiries and on information learned from other sources. If any of our material
third parties are not Y2K ready and their non-compliance causes a material
disruption to any of their respective businesses, our business could be
materially adversely affected. Disruptions could include, among other things:
- the failure of a material third party's business;
- a financial institution's inability to take and transfer funds;
- an interruption in delivery of supplies from vendors;
- a loss of voice and data connections;
- a loss of power to our facilities; and
- other interruptions in the normal course of our operations, the nature
and extent of which we cannot foresee.
We will continue to evaluate the nature of these risks, but at this time we
are unable to determine the probability that any such risk will occur, or if
it does occur, what the nature, length or other effects, if any, of such a
risk may have on us. If any of our material third parties experience
significant failures in their computer systems or operations due to Y2K
non-compliance, it could affect our ability to process transactions or
otherwise engage in similar normal business activities. For example, while we
expect our internal systems, U.S. and non-U.S., to be Y2K ready in stages
during 1999, we and our customers who communicate internationally will be
dependent upon the Y2K-readiness of many non-U.S. providers of
telecommunication services and their vendors and suppliers. If these
providers and others are not Y2K ready, we and our customers will not be able
to send and receive data and other electronic transmissions, which would have
a material adverse effect on our revenues and business and that of our
customers. While many of these risks are outside our control, we have
identified and contacted our critical third party vendors and suppliers and
are establishing contingency plans to remedy any potential interruption to
our operations.
While we believe that we are adequately addressing the Y2K issue, we can not
assure you that our Y2K compliance effort will prevent every potential
interruption or that the cost and liabilities associated with the Y2K issue will
not materially adversely impact our business, prospects, revenues or financial
position. We are uncertain as to our most reasonably likely worst case Y2K
scenario and have not yet completed a contingency plan to handle a worst case
scenario. We expect to have such contingency plan in place by September 30,
1999.
IF WE BECOME SUBJECT TO PROVISIONS OF THE INVESTMENT COMPANY ACT, OUR
BUSINESS OPERATIONS MAY BE RESTRICTED
We have significant amounts of cash invested in short term investment grade and
government securities, which investments could conceivably subject us to the
provisions of the Investment Company Act of 1940. We do not propose to engage in
investment activities in a manner or to an extent which would require us to
register as an investment company under the Investment Act of 1940. The
Investment Company Act of 1940 places restrictions on the capital structure and
business activities of companies registered thereunder.
Accordingly, we will seek to limit our holding of "investment securities" (as
defined in such Act) to an amount which is less than 40% of the value of our
total assets as calculated pursuant to the Investment Company Act of 1940. The
Investment Company Act of 1940 permits a company to avoid becoming subject to
such Act for a period of up to one year despite the holding of investment
securities in excess of such amount if, among other
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things, its board of directors has adopted a resolution which states that it is
not the company's intention to become an investment company. Our Board of
Directors has adopted such a resolution that would become effective in the event
we are deemed to fall within the definition of an investment company.
Application of the provisions of the Investment Company Act of 1940 would have a
material adverse effect on us.
WE FACE A HIGH LEVEL OF COMPETITION IN THE INTERNET SERVICES INDUSTRY
The market for Internet connectivity and related services is extremely
competitive. We anticipate 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
established businesses from different industries.
Our current and prospective competitors include 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. We believe that our network, products and customer
service distinguish us from these competitors. However, some of these
competitors have significantly greater market presence, brand recognition and
financial, technical and personnel resources than we do. We compete with all of
the major long distance companies, also known as interexchange carriers,
including AT&T, MCIWorldCom, Sprint and Cable & Wireless/IMCI, which also offer
Internet access services. The recent sweeping reforms in the federal regulation
of the telecommunications industry have created greater opportunities for local
exchange carriers, including the regional Bell operating companies, to enter the
Internet connectivity market. We believe that there is a move toward horizontal
integration through acquisitions of, joint ventures with, and the wholesale
purchase of connectivity from ISPs to address the Internet connectivity
requirements of the current business customers of long distance and local
carriers. The WorldCom/MFS/UUNet consolidation, the WorldCom/MCI merger, the
ICG/NETCOM merger, Cable & Wireless' purchase of the internetMCI assets, the
Intermedia/DIGEX merger, GTE's acquisition of BBN, Global Crossing's recently
announced plans to acquire Frontier Corp and Frontier's prior acquisition of
Global Center, Qwest Communication's recently announced plans to acquire US West
and AT&T's purchase of IBM's global communications network are indicative of
this trend. Accordingly, we expect to 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. This bundling of services may have an
adverse effect on our ability to compete effectively with the telecommunications
providers and may result in pricing pressure on us that could have a material
adverse effect on our 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 and
Microsoft Network, have all entered the Internet access business by engineering
their current proprietary networks to include Internet access capabilities. We
compete to a lesser extent with these on-line service providers. However,
America Online's acquisition of Netscape Communications Corporation and related
strategic alliance with Sun Microsystems will enable it to offer a broader array
of Internet protocol-based services and products that could significantly
enhance its ability to appeal to the business marketplace and, as a result,
compete more directly with us.
Recently, there have been several announcements regarding the planned
deployment of broadband services for high speed Internet access by cable and
telephone companies. These services would include new technologies such as
cable modems and xDSL. These providers have initially targeted the
residential consumer. However, it is likely that their target markets will
expand to encompass business customers, which is our target market. This
expansion could adversely affect the pricing of our service offerings.
Moreover, there has recently been introduced a number of free ISP services,
particularly in non-U.S. markets, and some ISPs are offering free personal
computers to their subscribers. While these services have been offered
primarily to dial-up consumer customers, they could be extended to dial-up
business customers as well. These trends could have a material adverse effect
on our business, financial condition and results of operations.
As a result of the increase in the number of competitors and the vertical and
horizontal integration in the industry, we currently encounter and expect to
continue to encounter significant pricing pressure and other
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competition. Advances in technology as well as changes in the marketplace and
the regulatory environment are constantly occurring, and we cannot predict the
effect that ongoing or future developments may have on us or on the pricing of
our products and services. Increased price or other competition could result in
erosion of our market share and could have a material adverse effect on our
business, financial condition and results of operations. We cannot assure you
that we will have the financial resources, technical expertise or marketing and
support capabilities to continue to compete successfully.
As we continue to expand our operations outside the United States, we will
encounter new competitors and competitive environments. In some cases, we will
be forced to compete with and buy services from government-owned or subsidized
telecommunications providers. Some of these providers may enjoy a monopoly on
telecommunications services essential to our business. We cannot assure you that
we will be able to purchase such services at a reasonable price or at all. In
addition to the risks associated with our previously described competitors,
foreign competitors may pose an even greater risk, as they may possess a better
understanding of their local markets and better working relationships with local
infrastructure providers and others. We cannot assure you that we can obtain
similar levels of local knowledge. Failure to obtain that knowledge could place
us at a significant competitive disadvantage.
TECHNOLOGY TRENDS AND EVOLVING INDUSTRY STANDARDS COULD RESULT IN OUR
COMPETITORS DEVELOPING OR OBTAINING ACCESS TO BANDWIDTH AND TECHNOLOGIES THAT
CARRY MORE INFORMATION FASTER THAN OUR BANDWIDTH AND TECHNOLOGY AND,
CONSEQUENTLY, RENDER OUR BANDWIDTH OR TECHNOLOGY OBSOLETE
Our 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.
Our future success will depend, in part, on our ability to effectively use and
develop leading technologies.
We cannot assure you that we will be successful in responding to changing
technology or market trends. In addition, services or technologies developed by
others may render our services or technologies uncompetitive or obsolete.
Furthermore, changes to our services in response to market demand may require
the adoption of new technologies that could likewise render many of our assets
technologically uncompetitive or obsolete. As we accept bandwidth from IXC and
our other existing global network suppliers or acquire bandwidth or equipment
from other suppliers that may better meet our needs than existing bandwidth or
equipment, many of our assets could be determined to be obsolete or excess. The
disposition of obsolete or excess assets could have a material adverse effect on
our business, financial condition and results of operations.
Even if we do respond successfully to technological advances and emerging
industry standards, the integration of new technology may require substantial
time and expense, and we cannot assure you that we will succeed in adapting our
network infrastructure in a timely and cost-effective manner.
WE MAY BE LIABLE FOR INFORMATION DISSEMINATED THROUGH OUR NETWORK
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 ISP was protected by a provision of the Communications
Decency Act from liability for material posted on its system. However, the
findings in that particular case may not be applicable in other circumstances
with differing facts. Other courts have held that online service providers and
ISPs may, under some circumstances, be subject to damages for copying or
distributing copyrighted materials. However, in an effort to protect certain
qualified ISPs, the Digital Millennium Copyright Act was signed into law in
October 1998. Under certain circumstances, this Act may provide qualified ISPs
with a "safe harbor" from liability for copyright infringement if the ISP does
not have knowledge of any transfer of potentially infringing material. We cannot
assure you that we would be protected by the terms, provisions and
interpretations of this Act. 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. However, on October 21, 1998, new federal legislation
was enacted that requires limitations on access to pornography and other
material deemed "harmful to minors." This legislation has been attacked in court
as a violation of the First Amendment. We are unable to predict the outcome of
this case at this time. The imposition upon ISPs or web server hosts of
potential liability for materials carried on or disseminated through
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their systems could require us to implement measures to reduce our exposure to
such liability. Such measures may require that we spend substantial resources or
discontinue some product or service offerings. Any of these actions could have a
material adverse effect on our business, operating results and financial
condition.
We carry errors and omissions insurance with a policy limit of $5.0 million,
subject to deductibles and exclusions. Such coverage may not be adequate or
available to compensate us 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 our business, financial condition and results of
operations.
The law relating to the regulation and liability of ISPs in relation to
information carried or disseminated also is undergoing a process of development
in other countries. For example a recent court decision in England held an ISP
liable for certain allegedly defamatory content carried through its network
under factual circumstances in which the ISP had been notified by the
complainant about the offending message which the ISP had failed to delete when
asked to do so by the complainant. Decisions, laws, regulations and other
activities regarding regulation and content liability may significantly affect
the development and profitability of companies offering on-line and Internet
access services, including us.
One particular area of uncertainty in this regard results from the entry into
effect of European Union Directive 95/46/EC on the protection of individuals
with regard to the processing of personal data and on the free movement of such
data ("EU Directive"). That Directive imposes obligations in connection with the
protection of personal data collected or processed by third parties. Under some
circumstances, we may be regarded as subject to the EU Directive's requirements.
The United States and the European Union currently are negotiating the
application of the EU Directive to U.S. companies.
FCC REGULATIONS MAY LIMIT THE SERVICES WE CAN OFFER
Consistent with our growth and acquisition strategy, we are now engaged in, or
will soon be engaged in, activities that subject us to varying degrees of
federal, state and local regulation. The FCC exercises jurisdiction over all
facilities of, and services offered by, telecommunications 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.
Our Internet operations are not currently subject to direct regulation by the
FCC or any other governmental agency, other than regulations applicable to
businesses generally. However, the FCC has recently indicated that some services
offered over the Internet, such as phone-to-phone Internet protocol telephony,
may be functionally indistinguishable from traditional telecommunications
service offerings and their non-regulated status may have to be re-examined. We
are unable to predict what regulations may be adopted in the future, or to what
extent existing laws and regulations may be found applicable, or the impact such
new or existing laws may have on our business. We can not assure you that new
laws or regulations relating to Internet services, or existing laws found to
apply to them, will not have a material adverse effect on us. Although the FCC
has recently decided not to allow local telephone companies to impose per-minute
access charges on Internet service providers, and that decision has been upheld
by the reviewing court, further regulatory and legislative consideration of this
issue is likely. In addition, some telephone companies are seeking relief
through state regulatory agencies. Such rules, if adopted, would affect our
costs of serving dial-up customers and could have a material adverse effect on
our business, financial condition and results of operations.
In addition to our Internet activities, we have recently focused attention on
acquiring telecommunications assets and facilities, which is a regulated
activity. Our wholly-owned subsidiary, PSINetworks Company, has received an
international Section 214 authorization from the FCC to provide global
facilities-based and global resale telecommunications services. Our wholly-owned
subsidiary, PSINet Telecom UK Limited, has received an international facilities
license from DTI and OFTEL, the responsible telecommunications regulatory bodies
in the United Kingdom. Currently, the FCC and OFTEL do not closely regulate the
charges or practices of non-dominant carriers, such as our subsidiaries.
Nevertheless, these regulatory agencies have the power to impose more stringent
regulatory requirements on us and to change our regulatory classification, which
may adversely affect our business.
Our subsidiaries have also received competitive local exchange carrier, or CLEC,
certification in New
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York, Virginia, Colorado and Texas, and have applied for CLEC certification in
Maryland and California. We are considering the financial, regulatory and
operational implications of becoming a competitive local exchange carrier in
other states. As a provider of domestic basic telecommunications services,
particularly competitive local exchange services, we could become subject to
further regulation by the FCC and/or another regulatory agency, including state
and local entities.
An important issue for CLECs is the right to receive reciprocal compensation for
the transport and termination of Internet traffic. Most states have required
incumbent local exchange carriers to pay competitive local exchange carriers
reciprocal compensation. In October 1998, the FCC determined that dedicated
Digital Subscriber Line service is an interstate service and properly tariffed
at the interstate level. In February 1999, the FCC concluded that at least a
substantial portion of dial-up ISP traffic is jurisdictionally interstate. The
FCC also concluded that its jurisdictional decision does not alter the exemption
from access charges currently enjoyed by ISPs. The FCC established a proceeding
to consider an appropriate compensation mechanism for interstate Internet
traffic. Pending the adoption of that mechanism, the FCC saw no reason to
interfere with existing interconnection agreements and reciprocal compensation
arrangements. The FCC order has been appealed and briefing will be completed in
September 1999. In light of the FCC's order, state commissions that previously
addressed this issue and required reciprocal compensation to be paid for ISP
traffic, may reconsider and may modify their prior rulings. Several incumbent
local exchange carriers are seeking to overturn prior orders, or seek refunds
of, or authority to escrow, payments that they claim are inconsistent with the
FCCs' February 1999 order. In response to these and other challenges, some state
commissions have opened inquiries as to the appropriate compensation mechanisms
in the context of ISP traffic. Of the state commissions that have considered the
issue since the FCC's February 1999 order, the majority of these states have
upheld the requirement to pay reciprocal compensation for ISP traffic. We cannot
assure you that any future court, state regulatory or FCC decision on this
matter will favor our position. An unfavorable result may have an adverse impact
on our potential future revenues as a CLEC, as well as increasing our costs for
PRIs generally.
IF WE EXPERIENCE SYSTEM FAILURE OR SHUTDOWN, WE MAY NOT BE ABLE TO DELIVER
SERVICES
Our success depends upon our ability to deliver reliable, high-speed access to
the Internet and upon the ability and willingness of our telecommunications
providers to deliver reliable, high-speed telecommunications service through
their networks. Our network, and other networks providing services to us, are
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. We have
designed our network to minimize the risk of such system failure, for instance,
with redundant circuits among POPs to allow traffic rerouting. In addition, we
perform lab and field testing before integrating new and emerging technology
into the network, and we engage in capacity planning. Nonetheless, we cannot
assure you that we will not experience failures or shutdowns relating to
individual POPs or even catastrophic failure of the entire network.
We carry business personal property insurance at both scheduled locations and
unscheduled locations to protect us against losses due to property damage and
business interruption. Such coverage, however, may not be adequate or available
to compensate us for all losses that may occur. In addition, we generally
attempt to limit our liability to customers arising out of network failures by
contractually disclaiming all such liability. In respect of many services, we
have also contractually limited liability to a usage credit based upon the
amount of time that the system was not operational. We cannot assure you,
however, that such limitations will be enforceable. In any event, significant or
prolonged system failures or shutdowns could damage our reputation and result in
the loss of customers.
ALTHOUGH WE HAVE IMPLEMENTED NETWORK SECURITY MEASURES, OUR NETWORK MAY BE
SUSCEPTIBLE TO VIRUSES, BREAK-INS OR DISRUPTIONS
We have implemented many network security measures, such as limiting physical
and network access to our routers. Nonetheless, our network's infrastructure is
potentially vulnerable to computer viruses, break-ins and similar disruptive
problems caused by our 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 our 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 our
customers. This could, in turn, deter potential customers and adversely affect
our existing customer relationships. Security problems represent
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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 us.
The security services that we offer in connection with our customers' networks
cannot assure complete protection from computer viruses, break-ins and other
disruptive problems. Although we attempt to limit contractually our liability in
such instances, the occurrence of such problems may result in claims against us
or liability on our part. Such claims, regardless of their ultimate outcome,
could result in costly litigation and could have a material adverse effect on
our business or reputation or on our ability to attract and retain customers for
our 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
our customer base and revenues.
RISK ASSOCIATED WITH DEPENDENCE ON TECHNOLOGY AND WITH PROPRIETARY RIGHTS
Our success and ability to compete is dependent in part upon our technology and
technical expertise and, to a lesser degree, on our proprietary rights. In order
to establish and protect our technology, we rely on a combination of copyright,
trademark and trade secret laws and contractual restrictions. Nevertheless, we
cannot assure you that such measures are adequate to protect our proprietary
technology. It may be possible for a third party to copy or otherwise obtain and
use our products or technology without authorization or to develop similar
technology independently. In addition, our products may be licensed or otherwise
utilized in foreign countries where laws may not protect our proprietary rights
to the same extent as do laws in the United States. It is our policy to require
employees and consultants and, when obtainable, suppliers to execute
confidentiality agreements upon the commencement of their relationships with us.
Nonetheless, we cannot assure you that these precautions will be adequate to
prevent misappropriation of our technology or that our competitors will not
independently develop technologies that are substantially equivalent or superior
to our technology.
In addition, we are also subject to the risk of adverse claims and litigation
alleging infringement by us of the intellectual property rights of others. From
time to time, we have received claims that we have infringed other parties'
proprietary rights. While we do not believe that we have infringed the
proprietary rights of other parties, we cannot assure you that third parties
will not assert infringement claims in the future with respect to our current or
future products. Such claims may require that we enter into license arrangements
or may result in protracted and costly litigation, regardless of the merits of
such claims. We cannot assure you that any necessary licenses will be available
or that, if available, such licenses can be obtained on commercially reasonable
terms.
We have recently introduced new enterprise service offerings, including
value-added, Internet protocol-based enterprise communication services and
xDSL-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 xDSL-based services, in particular, to achieve significant market coverage
could have a material adverse effect on our business, financial condition and
results of operations. If we introduce new or enhanced services with
reliability, quality or compatibility problems, it could significantly delay or
hinder market acceptance of such services, which could adversely affect our
ability to attract new customers and subscribers. Our services may contain
undetected errors or defects when first introduced or as enhancements are
introduced. Despite testing by us or our customers, we cannot assure you that
errors will not be found in new services after commencement of commercial
deployment. Such errors could result in additional development costs, loss of or
delays in market acceptance, diversion of technical and other resources from our
other development efforts and the loss of credibility with our customers and
subscribers. Any such event could have a material adverse effect on our
business, financial condition and results of operations.
Additionally, if we are unable to match our network capacity to customer demand
for our services, our network could become congested during periods of peak
customer demand. Such congestion could adversely affect the quality of service
we are able to provide. Conversely, due to the high fixed cost nature of our
infrastructure, if our network is under-utilized, it could adversely affect our
ability to provide cost-efficient services. Our failure to match network
capacity to demand could have a material adverse effect on our business,
financial condition or results of operations.
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THE MARKET PRICE AND TRADING VOLUME OF OUR STOCK MAY BE VOLATILE
The market price and trading volume of our common stock and convertible
preferred stock has been and may continue to be highly volatile. Factors such as
variations in our revenue, earnings and cash flow and announcements of new
service offerings, technological innovations, strategic alliances and/or
acquisitions involving our competitors or price reductions by us, our
competitors or providers of alternative services could cause the market price of
our common stock and convertible preferred 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 our common stock and
convertible preferred stock.
WE DO NOT ANTICIPATE THAT WE WILL PAY CASH DIVIDENDS ON OUR COMMON STOCK
We have never declared or paid any cash dividends on our common stock and do not
anticipate paying cash dividends on our common stock in the foreseeable future.
In addition, our debt securities and credit facility contain limitations on our
ability to declare and pay cash dividends.
FORWARD-LOOKING STATEMENTS
Some of the information contained in the periodic report with which this Exhibit
99.1 is filed may contain forward-looking statements. Such statements can be
identified by the use of forward-looking terminology such as "believes,"
"expects," "may," "will," "should," or "anticipates" or similar words, or by
discussions of strategy that involve risks and uncertainties. These statements
may discuss our future expectations or contain projections of our results of
operations or financial condition or expected benefits to us resulting from
acquisitions or transactions. We cannot assure you that the future results
indicated, whether expressed or implied, will be achieved. The risk factors
noted in this section and other factors noted throughout the report with which
this Exhibit 99.1 is filed, including risks and uncertainties, could cause our
actual results to differ materially from those contained in any forward-looking
statement.
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