|
|
 | | | |
- close
- close
- close
- close
| |||||||||
Internap Network Services 10-K 2008 Documents found in this filing:UNITED
STATES
SECURITIES
AND EXCHANGE COMMISSION
Washington,
DC 20549
FORM
10-K
For
the fiscal year ended December 31, 2007
OR
For the transition period from
to
.
Commission
file number: 000-31989
INTERNAP
NETWORK SERVICES CORPORATION
(Exact
Name of Registrant as Specified in Its Charter)
(404)
302-9700
Securities
registered pursuant to Section 12(b) of the Act:
Securities
registered pursuant to Section 12(g) of the Act: None
Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act. Yes o
No x
Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act. Yes
o
No x
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 o
Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K (§229.405) is not contained herein, and will not be contained, to
the best of registrant’s knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. o
Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company. See the definitions of “large accelerated filer,”
“accelerated filer” and “smaller reporting company” in Rule 12b-2 of the
Exchange Act. (Check one):
Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Act). Yes o
No x
The
aggregate market value of the registrant’s outstanding common stock held by
non-affiliates of the registrant was $698,160,175 based on a closing price of
$14.42 on June 30, 2007 as quoted on the NASDAQ Global Market.
As of
March 6, 2008, 49,793,430 shares of the registrant’s common stock, par
value $0.001 per share, were issued and outstanding.
DOCUMENTS
INCORPORATED BY REFERENCE
Certain
portions of the registrant’s definitive proxy statement to be filed with the
Securities and Exchange Commission relative to the registrant’s 2008 annual
meeting of stockholders, which will be filed within 120 days after the end of
the fiscal year covered by this report, are incorporated by reference in Part
III to this annual report on Form 10-K.
TABLE
OF CONTENTS
FORWARD-LOOKING
STATEMENTS
This
Annual Report on Form 10-K contains “forward-looking statements” within the
meaning of Section 21E of the Securities Exchange Act of 1934, as amended.
Forward-looking statements include statements regarding industry trends, our
future financial position and performance, business strategy, revenues and
expenses in future periods, projected levels of growth, and other matters that
do not relate strictly to historical facts. These statements are often
identified by the use of words such as “may,” “will,” “seeks,” “anticipates,”
“believes,” “estimates,” “expects,” “projects,” “forecasts,” “plans,” “intends,”
“continue,” “could,” “should,” or similar expressions or variations. These
statements are based on the beliefs and expectations of our management team
based on information currently available. Such forward-looking statements are
not guarantees of future performance and are subject to risks and uncertainties
that could cause actual results to differ materially from those contemplated by
forward-looking statements. Important factors currently known to our management
that could cause or contribute to such differences include, but are not limited
to, those set forth in this annual report under “Item 1A . Risk
Factors.” We undertake no obligation to update any forward-looking
statements as a result of new information, future events or otherwise.
As used
herein, except as otherwise indicated by context, references to “we,” “us,”
“our,” or the “Company” refer to Internap Network Services
Corporation.
PART
I
Overview
We were
incorporated as a Washington corporation in 1996 and reincorporated in Delaware
in 2001. Our principal executive offices are located at 250 Williams Street,
Suite E-100, Atlanta, Georgia 30303, and our telephone number at that location
is (404) 302-9700. Our common stock trades on the NASDAQ Global Market under the
symbol “INAP.”
We market
products and services that optimize the performance and reliability of strategic
business Internet applications for e-commerce, customer relationship management,
or CRM, multimedia streaming, Voice-over Internet-Protocol, or VoIP, virtual
private networks, or VPNs, and supply chain management. Our product and service
offerings are complemented by value-added services such as colocation and data
center services and managed security services. We also provide products and
services for storing and delivering audio and video digital media to large
audiences over the Internet through a subsidiary, VitalStream Holdings, Inc., or
VitalStream. Our content delivery network, or CDN, was purpose-built for
streaming digital media and enables content owners to monetize their digital
media assets via both subscription and advertising-based business models. Our
VitalStream subsidiary also offers: proprietary advertising selection and
advertising insertion capabilities, enabling customers to turn existing
streaming traffic into content packaged with advertising; Internet Protocol
Television, or IPTV; professional services; and small business services.
Additionally, we offer high levels of pre- and post- installation service and
consulting.
As of
December 31, 2007, we delivered services through our 50 service points across
North America, Europe, Asia, and Australia, which feature direct high-speed
connections to multiple major Internet backbones such as AT&T Inc., Sprint
Nextel Corporation, Verizon Communications Inc., Savvis, Inc., Global Crossing
Limited, Level 3 Communications, Inc., and Verio, an NTT Communications Company.
Our proprietary route optimization technology monitors the performance of
Internet networks allowing our customer traffic to be “intelligently” routed
over the optimal path in a way that maximizes performance and reliability of the
transactions by minimizing loss and delays inherent across the Internet. We
believe our unique managed multi-network approach provides better performance,
control and reliability compared to conventional Internet connectivity
alternatives. Our service level agreements, or SLAs, guarantee performance
across the entire Internet, excluding local connections, whereas providers of
conventional Internet connectivity typically only guarantee performance on their
own network. Internap serves customers in a variety of industries including
financial services, entertainment and media, travel, e-commerce, retail, and
technology. As of December 31, 2007, we provided our services
to approximately 3,800 customers in the United States and
abroad.
4
Developments
in 2007
VitalStream
Acquisition. >On February 20, 2007, we completed our acquisition of
VitalStream pursuant to an Agreement and Plan of Merger, dated October 12,
2006. As a result, we issued approximately 12.2 million shares of common
stock to VitalStream stockholders, which represented approximately 25% of
our outstanding shares. We also assumed outstanding options for the
purchase of shares of VitalStream common stock, which we converted into options
to purchase approximately 1.5 million shares of Internap common stock.
VitalStream is now a wholly-owned subsidiary of Internap.
Restructuring
Liability>.
On March 31, 2007, we incurred a restructuring and impairment charge totaling
$10.3 million. The charge was the result of a review of our business,
particularly in light of our acquisition of VitalStream, and the finalization of
our overall integration and implementation plan during the first
quarter. The charge to expense included $7.8 million for leased facilities,
representing both the net present value of costs less anticipated sublease
recoveries that will continue to be incurred without economic benefit to us and
costs to terminate leases before the end of their term. The charge also included
severance payments of $1.1 million for the termination of certain Internap
employees and $1.4 million for impairment of assets. Related expenditures are
estimated to be $10.7 million, of which $2.8 million has been paid during the
year ended December 31, 2007, and the balance continuing through December 2016,
the last date of the longest lease term. The impairment charge of $1.3 million
was related to the leases referenced above and less than $0.1 million for other
assets.
We also
incurred a $1.1 million impairment recorded for a sales order-through-billing
system, which was a result of an evaluation of the existing infrastructure
relative to our new financial accounting system and the acquisition of
VitalStream.
Write-Off
of Investment>.
In connection with the preparation of our quarterly report for the
quarter ended June 30, 2007, we wrote-off an investment, totaling $1.2 million,
representing the remaining carrying value of our investment in series D
preferred stock of Aventail Corporation, or Aventail. We made an initial cash
investment of $6.0 million in Aventail series D preferred stock pursuant to an
investment agreement in February 2000. In connection with a subsequent round of
financing by Aventail, we recognized an initial impairment loss on our
investment of $4.8 million in 2001. On June 12, 2007, SonicWall, Inc. announced
that it had entered into an agreement to acquire Aventail for approximately
$25.0 million in cash. The transaction closed on July 11, 2007, and all shares
of series D preferred stock were cancelled and the holders of series D preferred
stock did not receive any consideration for such
shares. Consequently, we recorded a write-off of our investment in
Aventail to reduce our carrying value to $0.
Rights Agreement.
>On March 15, 2007, the Board of Directors declared a dividend of one
preferred share purchase right, or a Right, for each outstanding share of common
stock, par value $0.001 per share, of the Company. The dividend was payable on
March 23, 2007 to the stockholders of record on that date. Each Right entitles
the registered holder to purchase from the Company one one-thousandth of a share
of Series B Preferred Stock of the Company, par value $0.001 per share, or the
Preferred Shares, at a price of $100.00 per one one-thousandth of a Preferred
Share, subject to adjustment. The description and terms of the Rights are set
forth in a Rights Agreement between the Company and American Stock
Transfer & Trust Company, as Rights Agent dated April 11,
2007.
Data Center
Expansion. >
On June 12, 2007, we announced that we approved an investment of up to
$40.0 million to fund the expansion of our data center facilities in several key
markets. We anticipate implementing the expansion over the next several calendar
quarters, with at least a portion of the funding to be provided under our credit
agreement, discussed below. As of December 31, 2007, we have incurred
costs of less than $10.0 million pursuant to this expansion.
5
Credit Agreement.
>On September 14, 2007, we entered into a $35.0 million credit agreement.
We discuss this agreement in note 10 to the consolidated financial statements
and the section captioned “Liquidity and Capital Resources” under “Item 2.
Managements Discussion and Analysis of Financial Condition and Results of
Operations.”
Industry
Background
The
emergence of multiple Internet networks
The
Internet originated as a restricted network designed to provide efficient and
reliable long distance data communications among the disparate computer systems
used by government-funded researchers and organizations. As the Internet
evolved, businesses began to use the Internet for functions critical to their
core business and communications. Telecommunications companies established
additional networks to supplement the original public infrastructure and satisfy
increasing demand. Currently, the Internet is a global collection of multitudes
of interconnected computer networks, forming a network of networks. These
networks were developed at great expense but are nonetheless constrained by the
fundamental limitations of the Internet’s architecture. Each network must
connect to one another, or peer, to permit its users to communicate with each
other. Consequently, many Internet network service providers, or ISPs, have
agreed to exchange large volumes of data traffic through a limited number of
public network access points and a growing number of private connections called
peering.
Peering
network access points are not centrally managed. We believe that no single
entity has the economic incentive or ability to facilitate problem resolution or
to optimize peering within the public network access points, nor the authority
to bring about centralized routing administration. Additionally, since these
arrangements are based on non-regulated agreements, disagreements between
carriers impact performance. As a consequence of the lack of coordination among
networks at these public peering points, and in order to avoid the increasing
congestion and the potential for resulting data loss at the public network
access points, a number of the ISPs have established private interfaces
connecting with their peers for the exchange of traffic. Although private
peering arrangements are helpful for exchanging traffic, they do not solve all
of the structural and economic shortcomings of the Internet.
The
problem of inefficient routing of data traffic on the Internet
An
individual ISP only controls the routing of data within its network, and its
routing practices tend to compound the inefficiencies of the Internet. When an
ISP receives a packet that is not destined for one of its own customers, it must
route that packet to another ISP to complete the delivery of the packet on the
Internet. Since the use of a public network access point or a private peering
point typically involves no economic settlement, an ISP will often route the
data to the nearest point of traffic exchange, in an effort to get the packet
off its network and onto a competitor’s network as quickly as possible to reduce
capacity and management burdens on its transport network. Once the origination
traffic leaves the network of an ISP, service level agreements with that ISP
typically do not apply since that carrier cannot control the quality of service
on another ISPs network. Consequently, in order to complete a communication,
data ordinarily passes through multiple networks and peering points without
consideration for congestion or other factors that inhibit performance. For
customers of conventional Internet connectivity providers, this transfer can
result in lost data, slower and more erratic transmission speeds, and an overall
lower quality of service, especially where the ISP is not familiar with the
performance of the destination network. Equally important, these customers have
no control over the transmission arrangements and have no single point of
contact that they can hold accountable for degradation in service levels, such
as poor data transmission performance, or service failures. As a result, it is
virtually impossible for a single ISP to offer a high quality of service across
disparate networks.
6
The
problem of poor application performance over distant network paths
The major
protocols often utilized over data networks perform poorly when network latency
is large or network paths are subject to packet and data loss. Network latency
is a measure of the time it takes data to travel between two network points. In
networks, network latency often depends on physical distance but may also depend
on conditions such as congestion. One measure of performance is effective
throughput. Throughput is defined as the rate of data transfer, typically
expressed in bits per second or megabits per second, or Mbps. It can be limited
by the size of the network connection, for example, 1.5Mbps for a standard T1
data connection, or it can be limited by the protocols reacting to certain
network conditions such as latency or packet loss. Typically, throughput is
inversely proportional to network latency. Network latency is a significant
factor when communicating over vast distances such as the global network paths
between two continents. The more distant the communicating parties are from each
other, the higher the network latency will be resulting in lower effective
throughput. This throughput may be lower than the available network capacity and
often results in poor utilization of purchased network capacity. Additionally,
many network protocols react to packet loss by requesting a retransmission of
the missing data. This retransmission is often interpreted as intermediate
network congestion by the protocol that then responds with more conservative
network usage and a further reduction of effective throughput. As a result,
business applications that must communicate over the vast distances common in
the global economy are subject to these limitations, which result in poor
application performance and poor utilization of network assets. Network
conditions vary significantly in many parts of the developing world and may also
result in poor application performance. Yet the global economy is a factor in
many businesses operating in these parts of the developing world where distances
are vast and network conditions are poor.
The
growing importance of the Internet for business-critical Internet-based
applications
Once
primarily used for e-mail and basic information retrieval, the Internet is now
used as a communications platform for an increasing number of business-critical
Internet-based applications, such as those relating to electronic commerce,
VoIP, supply chain management, customer relationship management, project
coordination, streaming media, and video conferencing and
collaboration.
Businesses
are unable to benefit from the full potential of the Internet primarily because
of performance issues discussed above. The emergence of technologies and
applications that rely on network quality and require consistent, high-speed
data transfer, such as VoIP, multimedia document distribution and streaming, and
audio and video conferencing and collaboration, are hindered by inconsistent
performance. We believe that providers who provide a consistently high quality
of service that enables businesses to successfully and cost effectively execute
their business-critical Internet-based applications over the public network
infrastructure through superior performance Internet routing services will drive
the market for Internet services.
The
growing demand for delivery of rich media content over the Internet
The
proliferation of Internet-connected devices and broadband Internet connections
coupled with increased consumption of media over the Internet including
personalized media content have created a demand for delivery of rich media
content. Increasingly, as the volume and quality of dynamic content progresses,
viewers of all ages are spending more and more time using the
Internet. Viewers now expect to be able to watch a movie or
television show online, view the latest news clips, take a virtual walk-through
of a home, hear a podcast, watch a live sporting event or concert, or
participate in an educational course just to name a few
examples. Companies that need to deliver rich media content can
either deliver the content using basic Internet connectivity or utilize a
content distribution network, or CDN. Because of the inherit
weaknesses of the Internet, delivery of rich media content is not
reliable. To overcome this problem, companies can either invest
substantial capital to build the infrastructure to bypass the public Internet or
utilize a third party’s CDN.
Our
Market Opportunity
Historically,
network service providers, or NSPs, have maintained at-will agreements to
deliver Internet traffic on a “best efforts” basis without guaranteeing various
levels of quality of service. This best efforts delivery is sub-optimal for
time-sensitive and real-time applications that require uninterrupted streams of
data such as voice and video. For companies that rely on the Internet as a
medium for commerce or relationship management, this unpredictable performance
often translates into lost revenue, decreased productivity and dissatisfied
customers.
7
The
Internet serves as a core component of many direct sales, supply chain and
collaboration strategies and has extended our customers’ ability to reach global
partners, suppliers and customers. This changing landscape, combined with an
increasingly dispersed workforce and the adoption of emerging technologies like
VoIP and streaming media, has increased the need for fast, reliable connectivity
and delivery of content rich media. We believe Internap meets this requirement
and is well positioned to help businesses leverage the Internet to attain
improved productivity, decreased transactional costs and new revenue
streams.
Services
and Technology
We offer
the following managed services and premise-based products:
High Performance Internet
Protocol, or IP
Our
managed intelligent routing service provides fast, reliable connectivity to all
major backbones and dynamically identifies the optimal path for our customers’
traffic. The service is also supported by industry leading service level
agreements with 100 percent network availability, excluding local connections.
Our team of certified network engineers supports our customers 24 hours a day,
every day of the year. We charge for these services based on a fixed-fee, usage
or a combination of both fixed fee and usage basis.
Data Center Services
We
operate data centers where customers can host their applications directly on our
network to eliminate issues associated with the quality of local connections.
Data center services also enable us to have a more flexible product offering,
such as bundling our high performance IP connectivity and managed services such
as content delivery along with hosting customers’ applications. We charge
monthly fees for data center services based on the amount of square footage that
the customer leases in our facilities. We also have relationships with various
providers to extend our Private Network Access Point, or P-NAP, model into
markets with high demand.
Flow Control Platform, or
FCP
Our FCP
is a premise-based intelligent routing hardware product for customers who
run their own multiple network architectures, known as multi-homing. The
prevalence of multi-homed networks is increasing. To operate each network at the
highest performance level, a significant amount of expertise is required to
monitor and adjust to global Internet routing, which is very dynamic in nature.
The FCP functions similarly to our P-NAP, monitoring the global Internet and
automatically adjusting routing real-time to balance the traffic across multiple
links to optimize performance. FCP can be tuned to manage network traffic on two
dimensions: cost and performance. The user can set thresholds that balance
performance against cost, for example routing all traffic across low cost
providers while specific minimum performance thresholds are met. If the
performance deteriorates, then the traffic can be routed over a better
performing but more costly provider to maintain minimum specified performance.
This option allows the customer to enjoy service with the optimized performance
and economics. Another key feature is minute-by-minute visibility reports and
logs on the performance and operation of the customer’s network. Our customers
find this information to be very useful for carrier SLA verification, monitoring
and overall network management.
8
FCP is
one of only a few of the industry’s route control appliances that analyzes and
re-routes Internet traffic flows in real-time. We offer FCP as either a one-time
hardware purchase or as a monthly subscription service. Sales of FCP also
generate annual maintenance fees and professional service fees for installation
and ongoing network configuration. Since the FCP emulates our P-NAP service in
many ways, this product affords us the opportunity to serve customers outside of
our P-NAP market footprint.
Other Products &
Services
To
complement our existing portfolio, we also offer managed Internet services via
third parties. These services include virtual private networking and managed
security services, including VeriSign, Inc. intrusion detection/prevention and
managed firewall services to more broadly support our clients’
Internet applications. These also include a continuation of Akamai Technologies,
Inc., or Akamai, CDN services through September 30, 2007.
We offer
the following products and services based on our CDN:
Next Generation Cluster
Architecture Content Delivery Network
Our CDN
is designed to optimize delivery of streaming media content. The network
incorporates high performance equipment with unparalleled 10 Gigabit uplinks to
multiple tier-1 network providers and geographic diversity. The network is
comprised of multiple data centers containing distributed server clusters. This
multi-homed network helps minimize exposure at congested peers. Our close
proximity to other backbone providers ensures we can quickly add bandwidth when
needed. Distributed clustering technology for streaming and hosting services
allows us to scale the network based on customer demand.
Our
network is protected by advanced security systems, including firewalls, proxies
and private networking to protect critical systems from intruders. We
continuously monitor for security vulnerabilities and malicious activity and
employ a staff of security experts to respond to security-related incidents.
Additionally, we provide various encryption and digital rights management
services that allow our customers to protect their content on our
network.
Streaming Service for
Flash
We worked
hand-in-hand with Adobe, which was formerly known as Macromedia, to develop a
Flash streaming platform, and are an experienced Flash video streaming service
provider. This method of delivering video on demand is reliable, interactive and
easy to use, giving our customers the opportunity to utilize their existing
Flash development environment, and streamlining their workflow. Our Flash video
streaming service permits our customers to upload files to our streaming network
without having to set up and maintain video servers.
As an
Adobe Flash Video Streaming Service provider, we can support Flash 8 and Flash
Media Server 2.0. The new video features found in the Flash Platform with the
announcement of Flash Player 8 offer enhanced capabilities for interactive
video, enabling our customers to deliver high-quality video at the smallest file
sizes while ensuring faster and smoother video playback. These enhancements
significantly improve the overall viewing experience of streaming
video.
Streaming Service for
Windows Media
Our
streaming service for windows media is ideal for businesses seeking to
distribute or sell their high-quality video online with maximum control of their
content. Windows Media is a flexible platform that enables content providers to
protect and deliver live events, corporate presentations, news, sports, music,
entertainment events, or movies with the confidence that digital media files
will stay protected, no matter how they are distributed. We have been a
Microsoft Premier Certified Hosting Service provider since October
2002.
Content Delivery
Service
Our
streaming customers often need to utilize download services as part of their
business solution. In response to this customer demand, we provide file download
services to enable our customers to download critical content including HTML,
graphics, media files, software, and podcasts to their customers.
9
Professional
Services
This
division assists our customers in building the unique solutions required for
their specialized business models. Through internal and external resources,
these services design, build and deploy custom solutions, such as video players,
graphical user interfaces, or GUIs, advertising components, control
panels for content management and reporting, authentication web services, and
Flash Communication Server applications. These solutions are fully integrated
into our CDN. We also architect, design, build, and deploy web applications that
feature video or audio streaming and interface with existing customer systems.
Fees for these services vary by project.
Authentication
Our
authentication service provides token-based authentication services. This
service protects and delivers customers’ offerings by allowing only authorized
viewers to access content, which enables customers to take greater advantage of
the Internet as a reliable and cost-effective distribution channel.
Managed
Servers
Our
managed servers are an outsourced hosting service for our customers. We provide
server hardware, bandwidth and continuous system administration, including
server and network monitoring, reporting, ongoing maintenance, security, and
backup. We charge a fixed monthly fee for standard hosting
services.
Advertising
Internap
advertising services provides customers with a one-stop solution for delivering
integrated streaming and digital advertising content on the Internet. The
solution inserts in-stream advertisements into “live” and “on-demand” Internet
streaming broadcasts to target specific listener demographics, enabling
advertisers to reach the most engaged opt-in audio and video audiences with a
seamless, in-stream advertising experience. Campaign management and advertising
results reporting complete the comprehensive solution.
Network
Access Points, Points of Presence and Data Centers
We
provide our services through our network access points across North America, and
in Europe, Asia, and Australia. Our network access points and data centers
feature direct high speed connections to multiple major ISPs, including AT&T
Inc., Sprint Nextel Corporation, Verizon Communications Inc., Savvis, Inc.,
Global Crossing Limited, Level 3 Communications, and Verio, an NTT
Communications Company, as well as Internet Initiative Japan, Inc. and KDDI
Corp. in Asia. Through our CDN points of presence, or POPs, we provide access to
the Internet for our CDN customers. As of December 31, 2007, we provided
services worldwide through 50 IP service points, 42 data center locations and 12
POPs. We directly operate eight of these sites and have operating agreements
with third parties for the remaining locations in the following
markets:
10
We are
dependent upon the ISPs noted above as well as other ISPs, telecommunications
carriers and other vendors in the United States, Europe and the Asia-Pacific
region, some of whom have experienced significant system failures and electrical
outages in the past. Users of our services may experience difficulties due to
system failures unrelated to our systems and services. If for any reason, our
vendors and providers fail to provide the required services, our business,
consolidated financial condition, results of operations or cash flows could be
materially adversely impacted.
Segments
As
discussed in note 5 to the consolidated financial statements included in
this annual report on Form 10-K, we operate in three business segments: IP
services, data center services and CDN services.
The
following is a brief description of each of our reportable business
segments.
IP
Services
Our
patented and patent-pending network performance optimization technologies
address the inherent weaknesses of the Internet, allowing enterprises to take
advantage of the convenience, flexibility and reach of the Internet to connect
to customers, suppliers and partners. Our solutions take into account the unique
performance requirements of each business application to ensure performance as
designed, without unnecessary cost. Prior to recommending appropriate network
solutions for our customers’ applications, we consider key performance
objectives including (1) performance and cost optimization, (2) application
control and speed and (3) delivery and reach. Our charges for IP services are
based on a fixed-fee, usage or a combination of both fixed fee and
usage.
Our IP
services segment also includes our flow control platform, or FCP. The FCP
provides network performance management and monitoring for companies with
multi-homed networks and redundant Internet connections. The FCP
proactively reviews customer networks for the best performing route or the most
cost-effective and routes according to our customers’ requirements. We
offer FCP as either a one-time hardware purchase or as a monthly subscription
service. Sales of FCP also generate annual maintenance fees and professional
service fees for installation and ongoing network configuration. Since the FCP
emulates our private network access points, or P-NAP, service in many ways, this
product affords us the opportunity to serve customers outside of our P-NAP
market footprint. This product represents approximately 4% of our IP services
revenue and approximately 2% of our consolidated revenue for the year ended
December 31, 2007.
Data
Center Services
Our data
center services provide a single source for network infrastructure, IP and
security, all of which are designed to maximize solution performance while
providing a more stable, dependable infrastructure, and are backed by guaranteed
service levels and our team of dedicated support professionals. We offer a
comprehensive solution at 42 service points, including eight locations managed
by us and 34 locations managed by third parties.
Data
center services also enable us to have a more flexible product offering,
including bundling our high performance IP connectivity and managed services,
such as content delivery, along with hosting customers' applications. We charge
monthly fees for data center services based on the amount of square footage that
the customer leases in our facilities. We also have relationships with various
providers to extend our P-NAP model into markets with high demand.
CDN
Services
Our CDN
services enable our customers to quickly and securely stream and distribute
video, audio, advertising, and software to audiences across the globe through
strategically located data centers. Providing capacity-on-demand to handle large
events and unanticipated traffic spikes, content is delivered with high quality
regardless of audience size or geographic location. Our MediaConsole® content
management tool provides our customers the benefit of a single, easy to navigate
system featuring Media Asset Management, Digital Rights Management, or DRM,
support, and detailed reporting tools. With MediaConsole, our customers can use
one application to manage and control access to their digital assets, deliver
advertising campaigns, view network conditions, and gain insight into habits of
their viewing audience.
11
Our CDN
and monetization services provide a complete turnkey solution for the
monetization of online media. These multi-faceted “live” and “on-demand”
advertising insertion and advertising placement solutions include a full
campaign management suite, inventory prediction tools, audience research and
metrics, and extensive reporting features to effectively track advertising
campaigns in real-time. Online advertising solutions enable our customers to
offset the costs associated with the creation, transformation, licensing, and
management of online content. Prior to our acquisition of VitalStream on
February 20, 2007, we did not offer proprietary CDN services, but instead, we
were a reseller of third party CDN services for which the results of
operations are included in Other revenues and direct costs of network, sales and
services, discussed below.
Other
Other
revenues and direct costs of network, sales and services include our
non-segmented results of operations, including certain reseller and
miscellaneous services such as third party CDN services, termination fee
revenue, other hardware sales, and consulting services.
Financial
Information about Geographic Areas
For each
of the years ended December 31, 2007, 2006 and 2005, less than 10% of our total
revenues was derived from our operations outside the United States.
Sales
and Marketing
Our sales
and marketing objective is to achieve market penetration and increase brand
recognition among business customers in key industries that use the Internet for
strategic and business-critical operations. We employ a direct sales team with
extensive and relevant sales experience with our target market. Our sales
offices are located in key cities across North America, as well as one office
each in the United Kingdom and Singapore.
Our sales
and service organization includes 116 employees in direct and channel sales,
professional services, account management, and technical
consulting. As of December 31, 2007, we had approximately 45 direct
sales representatives whose performance is measured on the basis of achievement
of quota objectives.
To
support our sales efforts and promote the Internap brand, we conduct
comprehensive marketing programs. Our marketing strategies include
on-line advertisements, participation at trade shows, an active public relations
campaign, and continuing customer communications. As of December 31,
2007, we had seven employees in our marketing department.
Research
and Development
Product
development costs are primarily related to network engineering costs associated
with changes to the functionality of our proprietary services and network
architecture. Such costs that do not qualify for capitalization as software
development costs are expensed as incurred. Research and development costs,
which are included in product development cost and are expensed as incurred,
primarily consist of compensation related to our development
and enhancement of IP routing technology, progressive download and
streaming technology for our CDN, and acceleration technologies. Research and
development costs were $3.1 million, $2.4 million and $2.9 million for the years
ended December 31, 2007, 2006, and 2005, respectively. These costs do not
include $1.6 million and $0.9 million in internal software development costs
capitalized during the years ended December 31, 2007 and 2006, respectively. We
did not capitalize any software development costs during the year ended December
31, 2005.
12
Customers
As of
December 31, 2007, we had approximately 3,800 customers. We provide
services to customers in multiple vertical industry segments including financial
services, media and communications, travel, e-commerce and retail, and
technology. However, our customer base is not concentrated in any particular
industry. In each of the past three fiscal years, no single customer has
accounted for 10 percent or more of our net sales. No significant amounts of
revenue for any of the years ended December 31, 2007, 2006 and 2005 were derived
from contracts or subcontracts terminable or renegotiation at the election of
the federal government, and we do not expect such contracts to be a significant
percentage of our total revenue in 2008.
Competition
The
market for managed services, premise-based products and content delivery is
intensely competitive and is characterized by technological change, the
introduction of new products and services, and price erosion. We believe that
the principal factors of competition for service providers in our target markets
include: speed and reliability of connectivity, quality of facilities, level of
customer service and technical support, price, and brand recognition. We believe
that we compete favorably on the basis of these factors.
Our
current and potential competition primarily consists of:
Competition
has resulted, and will continue to result, in declining prices for our
services.
Many of
our competitors have longer operating histories and presence in key markets,
greater name recognition, larger customer bases and significantly greater
financial, sales and marketing, distribution, technical, and other resources
than we have. As a result, these competitors may be able to adapt more quickly
to new or emerging technologies and changes in customer requirements or to
devote greater resources to the promotion and sale of their products. In all of
our target markets, we also may face competition from newly established
competitors, suppliers of products or services based on new or emerging
technologies, and customers that choose to develop their own network solutions.
We also may encounter further consolidation in the markets in which we compete.
In addition, competitors may develop technologies that more effectively address
our markets with services that offer enhanced features or lower costs. Increased
competition could result in pricing pressures, decreased gross margins and loss
of market share, which may materially and adversely affect our business,
consolidated financial condition, results of operations and cash
flows.
13
Intellectual
Property
We rely
on a combination of copyright, patent, trademark, trade secret, and other
intellectual property law, nondisclosure agreements, and other protective
measures to protect our proprietary rights. We also utilize unpatented
proprietary know-how and trade secrets and employ various methods to protect
such intellectual property. As of December 31, 2007, we have five patents that
extend to various dates between approximately 2019 and 2026, and eight
registered trademarks. Taken as a whole, we believe our intellectual
property rights are significant and that the loss of all or a substantial
portion of such rights could have a material adverse effect on our results of
operations. We can offer no assurances that our intellectual
property protection measures will be sufficient to prevent misappropriation of
our technology. In addition, the laws of many foreign countries do not protect
our intellectual properties to the same extent as the laws of the United States.
From time to time, third parties have or may assert infringement claims against
us or against our customers in connection with their use of our products or
services. In addition, we may desire or be required to renew or to obtain
licenses from others in order to further develop and market commercially viable
products or services effectively. We can offer no assurances that any necessary
licenses will be available on reasonable terms.
Employees
As of
December 31, 2007, we had approximately 420 full-time employees. None of our
employees are represented by a labor union, and we have not experienced any work
stoppages to date. We consider the relationships with our employees to be good.
Competition for technical personnel in the industry in which we compete is
intense. We believe that our future success depends in part on our continued
ability to hire, assimilate and retain qualified personnel. To date, we believe
that we have been successful in recruiting and retaining qualified employees,
but we can offer no assurances that we will continue to be successful in the
future.
Other
Matters
While we
are dependent upon our proprietary technology and vendors, including ISPs,
telecommunications carriers and others, we are not dependent upon raw materials.
Our business is generally not seasonal. We do not have significant
backlog orders, nor do we have any practices relating to required working
capital items.
Available
Information
Internap
files annual, quarterly and current reports, proxy statements, and other
information with the Securities and Exchange Commission, or SEC. The Company
makes its annual report on Form 10-K, quarterly reports on Form 10-Q, current
reports on Form 8-K, and all amendments to such reports filed pursuant to
Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended,
or the Exchange Act, available free of charge on or through its Internet site,
located at www.internap.com, as soon as reasonably practicable after they are
filed with or furnished to the SEC. You may read and copy any materials Internap
files with the SEC, at the SEC’s Public Reference Room at 100 F Street, N.E.,
Washington, D.C. 20549. For information on the operation of the Public Reference
Room, call the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that
contains reports, proxy and information statements, and other information
regarding issuers such as Internap that file electronically with the SEC at
http://www.sec.gov. Information on the Company’s Web site is not incorporated by
reference into this Form 10-K.
You
should carefully consider the risks described below. These risks are not the
only ones that we may face. Additional risks and uncertainties that we are
unaware of, or that we currently deem immaterial, also may become important
factors that affect us. If any of the following risks occurs, our business,
consolidated financial condition, results of operations or cash
flows could be materially and adversely affected.
14
We
have a history of losses and may not sustain profitability.
We
incurred net losses in each quarterly and annual period since we began
operations in May 1996 through the year ended December 31, 2005. For the
years ended December 31, 2007, 2006 and 2005, we recognized net loss of
$5.6 million, net income of $3.7 million and net loss of $5.0 million,
respectively. As of December 31, 2007, our accumulated deficit was
$862.0 million. Considering the competitive and evolving nature of the
industry in which we operate, we may not be able to achieve or sustain
profitability on a quarterly or annual basis, and our failure to do so could
materially and adversely affect our business, including our ability to raise
additional funds.
Our
operations have historically been cash flow negative, and we have depended on
equity and debt financings to meet our cash requirements, which may not be
available to us in the future on favorable terms.
Historically,
we have experienced negative operating cash flows and have depended upon equity
and debt financings, as well as borrowings under our credit facilities, to meet
our cash requirements in most quarterly and annual periods since we began our
operations in May 1996. We expect to meet our cash requirements for 2008 through
a combination of cash flows from operations, existing cash, cash equivalents and
investments in marketable securities, and borrowings under our credit
facilities. Our capital requirements depend on several factors, including the
rate of market acceptance of our services, the ability to expand and retain our
customer base and other factors. If our cash requirements vary materially from
those currently planned, if our cost reduction initiatives are unsuccessful or
have unanticipated adverse effects on our business or if we fail to generate
sufficient cash flows from the sales of our services, we may require additional
financing sooner than anticipated. We can offer no assurances that we will be
able to obtain additional financing on commercially favorable terms, or at all.
In addition, provisions in our credit agreement limit our ability to incur
additional indebtedness. Our business could be materially and
adversely affected by our failure to obtain such funding. We might
also be required to take other actions that could lessen the value of our stock
in order to obtain such funding, such as issuing securities with greater rights
than our common stock or borrowing money on terms that are not favorable to
us.
We
have identified a material weakness in our internal control over financial
reporting that may prevent us from accurately reporting our financial results in
a timely manner.
We must
maintain effective internal controls in order to provide reliable and accurate
financial reports and prevent fraud. In addition, Section 404 of the
Sarbanes-Oxley Act of 2002 requires that we assess the design and operating
effectiveness of our internal control over financial reporting. In
connection with our evaluation of internal control over financial reporting, we
identified a material weakness related to effective controls over the analysis
of requests for sales credits and billing adjustments to provide timely
information for management to assess the completeness, accuracy, valuation
and disclosure of sales adjustments. We may also discover additional areas
of our internal controls that need improvement. We discuss our efforts regarding
internal controls in detail in this report under Item 9A, “Controls and
Procedures.” We cannot be certain that any remedial measures we take will
sufficiently address and eliminate this material weakness. Remedying this
material weakness, any additional deficiencies, significant deficiencies, or
material weaknesses that we may identify in the future, could require us to
incur significant costs, expend significant time and management resources or
make other changes. We have not yet remediated this material weakness. As a
result, we may be required to report in our Quarterly Report on Form 10-Q for
the first quarter of 2008 or in subsequent reports filed with the Securities and
Exchange Commission that a material weakness in our internal control over
financial reporting continues to exist. Any delay or failure to design and
implement new or improved controls, or difficulties encountered in their
implementation or operation may cause us to fail to meet our financial reporting
obligations or prevent us from providing reliable and accurate financial reports
or avoiding or detecting fraud. Disclosure of this material weakness, any
failure to remediate such material weakness in a timely fashion or having or
maintaining ineffective internal controls could cause investors to lose
confidence in our reported financial information.
We
may not be able to compete successfully against current and future
competitors.
The
Internet connectivity and IP services market is highly competitive, as evidenced
by recent declines in pricing for Internet connectivity services. The content
delivery market is also intensely competitive and rapidly
changing. We expect competition from existing competitors to continue
to intensify in the future, and we may not have the financial resources,
technical expertise, sales and marketing abilities, or support capabilities to
compete successfully. Our competitors currently include: regional Bell operating
companies that offer Internet access; global, national and regional ISPs;
providers of specific applications or solutions such as content delivery,
security or storage; software-based and other Internet infrastructure providers
and manufacturers; and colocation and data center providers. In addition, ISPs
may make technological advancements, such as the introduction of improved
routing protocols to enhance the quality of their services, which could
negatively impact the demand for our products and services.
15
In
addition, more and more businesses are deciding to develop their own solutions
rather than outsource such solutions to providers like us. If we are
unable to provide services that are competitive with such in-sourced solutions,
we will lose customers and our business and financial results will
suffer.
Failure to develop new products and
services, as well as enhancements to our existing services, may cause our
operating results to suffer>.
Our
industry is constantly evolving. The process of developing new
services and the technologies that support them is expensive, time and labor
intensive and uncertain. We may fail to understand the market demand
for new services or not be able to overcome technical problems with new
services. In addition, our customers’ needs may change in ways that
we do not anticipate and these changes could eliminate our customers’ needs for
our services and render our products and services obsolete. If we fail to
develop new products and services before our competitors, we may lose market
share, resulting in a decrease in our revenues and earnings.
Many
of our current and potential customers are pursuing emerging or unproven
business models and the demand for our services and products may decline if such
models are unsuccessful.
The need
for a content delivery network is a recent technological advancement and our
customers’ business models that rely on the delivery of streaming video and
other content remain unproven. These customers will not continue to
purchase our products and services if their investment does not generate a
sufficient return. A reduction in spending on CDN services by such
customers could materially and adversely affect our financial
condition.
Pricing
pressure could decrease our revenue and threaten the attractiveness of our
premium priced services.
Pricing
for Internet connectivity services has declined significantly in recent years
and may decline in the future. An economic downturn could further contribute to
this effect. We currently charge, and expect to continue to charge, higher
prices for our high performance IP services than prices charged by our
competitors for their connectivity services. By bundling their services and
reducing the overall cost of their solutions, certain of our competitors may be
able to provide customers with reduced communications costs in connection with
their Internet connectivity services or private network services, thereby
significantly increasing the pressure on us to decrease our prices. Increased
price competition, significant price deflation and other related competitive
pressures could erode our revenue and could materially and adversely
affect our results of operations if we are unable to control or reduce our
costs. Because we rely on ISPs to deliver our services and have agreed with some
of these providers to purchase minimum amounts of service at predetermined
prices, our profitability could be adversely affected by competitive price
reductions to our customers even if accompanied with an increased number of
customers.
In
addition, in light of economic factors and technological advances, companies
that require Internet connectivity have evaluated and will continue to evaluate
the cost of such services, particularly high performance connectivity services
such as those we currently offer. Consequently, existing and potential customers
may be less willing to pay premium prices for high performance Internet
connectivity services and may choose to purchase lower quality services at lower
prices, which could materially and adversely affect our business, consolidated
financial condition, results of operations and cash flows.
Failure
to increase our revenues may cause our business and financial results to
suffer.
We have
considerable fixed expenses and we plan to continue to incur significant
expenses with the expansion of our colocation facilities. We must,
therefore, generate higher revenues to maintain
profitability. Numerous factors could affect our ability to increase
revenue, either alone or in combination with other factors,
including:
16
We
depend on a number of ISPs to provide Internet connectivity to our network
access points. If we are unable to obtain required connectivity services on a
cost-effective basis, or at all, or if such services are interrupted or
terminated, our growth prospects and business, consolidated financial condition,
results of operations and cash flows may be adversely affected.
In
delivering our services, we rely on a number of Internet networks, many of which
are built and operated by others. In order to provide high performance
connectivity services to our customers through our network access points, we
purchase connections from several ISPs. We can offer no assurances that these
ISPs will continue to provide service to us on a cost-effective basis or on
otherwise competitive terms, if at all, or that these providers will provide us
with additional capacity to adequately meet customer demand or to expand our
business. Consolidation among ISPs limits the number of vendors from which we
obtain service, possibly resulting in higher network costs to us. We may be
unable to establish and maintain relationships with other ISPs that may emerge
or that are significant in geographic areas, such as Asia and Europe, in which
we may locate our future network access points. Any of these situations could
limit our growth prospects and materially and adversely affect our business,
consolidated financial condition, results of operations and cash
flows.
We
depend on third party suppliers for services and key elements of our network
infrastructure. If we are unable to obtain products or services, such as network
access loops or local loops, on favorable terms, or at all, or in the event of a
failure of these suppliers to deliver their products and services as agreed, our
ability to provide our services on a competitive and timely basis may be
impaired and our consolidated financial condition, results of operations and
cash flows could be adversely affected.
In
addition to depending on services from third party ISPs, we depend on other
companies to supply various key elements of our infrastructure, including the
network access loops between our network access points and our ISPs and the
local loops between our network access points and our customers’ networks.
Pricing for such network access loops and local loops has risen significantly
over time, and we generally bill these charges to our customers at low or no
margin. Some of our competitors have their own network access loops and local
loops and are, therefore, not subject to similar availability and pricing
issues. In addition, we currently purchase routers and switches from a limited
number of vendors. Furthermore, we do not carry significant inventories of the
products we purchase, and we have no guaranteed supply arrangements with our
vendors. A loss of a significant vendor could delay any build-out of our
infrastructure and increase our costs. If our limited source of suppliers fails
to provide products or services that comply with evolving Internet standards or
that interoperate with other products or services we use in our network
infrastructure, we may be unable to meet all or a portion of our customer
service commitments, which could materially and adversely affect our business,
consolidated financial condition, results of operations and cash
flows.
A
failure in the redundancies in our network operations centers, network access
points or computer systems could cause a significant disruption in our IP
services, and we may experience significant disruptions in our ability to
service our customers.
Our
business depends on the efficient and uninterrupted operation of our network
operations centers, our network access points and our computer and
communications hardware systems and infrastructure. Interruptions could result
from natural or human-caused disasters, power loss, telecommunications failure,
and similar events. If we experience a problem at our network operations
centers, including the failure of redundant systems, we may be unable to provide
IP services to our customers, provide customer service and support or monitor
our network infrastructure or network access points, any of which would
seriously harm our business and operating results. Also, because we provide
continuous Internet availability under our service level agreements, we may be
required to issue a significant amount of customer credits as a result of such
interruptions in service. These credits could negatively affect our revenues and results of
operations. In addition, interruptions in service to our customers could
harm our customer relations, expose us to potential lawsuits and require
additional capital expenditures.
17
A
significant number of our network access points are located in facilities owned
and operated by third parties. In many of those arrangements, we do not have
property rights similar to those customarily possessed by a lessee or subtenant
but instead have lesser rights of occupancy. In certain situations, the
financial condition of those parties providing occupancy to us could have an
adverse impact on the continued occupancy arrangement or the level of service
delivered to us under such arrangements.
The
increased use of high power density equipment may limit our ability to fully
utilize our data centers.
Customers
continue to increase their use of high-density equipment, such as blade servers,
in our data centers, which has significantly increased the demand for power on a
per cabinet basis. The current demand for electrical power may exceed our
designed capacity in these facilities. As electrical power, not space, is
typically the primary factor limiting capacity in our data centers, our ability
to fully utilize our data centers may be limited in these
facilities. If we are unable to adequately utilize our data centers,
our ability to grow our business cost-effectively could be materially and
adversely affected.
Our
business could be harmed by prolonged electrical power outages or shortages,
increased costs of energy or general availability of electrical
resources.
Our data
centers and P-NAPs are susceptible to regional costs of power, electrical power
shortages, planned or unplanned power outages or natural disasters, and
limitations, especially internationally, on availability of adequate power
resources. Power outages could harm our customers and our business. We attempt
to limit exposure to system downtime by using backup generators and
uninterruptible power systems. We may not be able to limit our exposure
entirely, however, even with these protections in place, as has been the case
with power outages we have experienced in the past and may experience in the
future. In addition, we may not be able to pass on to our customers the
increased cost of energy caused by power shortages.
In each
of our markets, we rely on utility companies to provide a sufficient amount of
power for current and future customers. At the same time, power and cooling
requirements are growing on a per unit basis. As a result, some customers are
consuming an increasing amount of power per cabinet. We do not have long-term
power agreements in all our markets for long-term guarantees of provisioned
amounts and may face power limitations in our centers. This limitation could
have a negative impact on the effective available capacity of a given center and
limit our ability to grow our business, which could have a negative impact on
our consolidated financial condition, results of operations and cash
flows.
Any
failure of our physical infrastructure or services could lead to significant
costs and disruptions that could reduce our revenue and harm our business
reputation, consolidated financial condition, results of operations and cash
flows.
Our
business depends on providing customers with highly reliable service. We must
protect our infrastructure and our customers’ data and their equipment located
in our data centers. The services we provide in each of our data centers are
subject to failure resulting from numerous factors, including:
18
Problems
at one or more of the data centers operated by us or any of our colocation
providers, whether or not within our control, could result in service
interruptions or significant equipment damage, which could result in difficulty
maintaining our service level commitments to these customers. If we incur
significant financial commitments to our customers in connection with a loss of
power or we fail to meet other service level commitment obligations, our revenue
reserves may not be adequate. In addition, any loss of services, equipment
damage or inability to meet our service level commitment obligations could
reduce the confidence of our customers and could consequently impair our ability
to obtain and retain customers, which would adversely affect both our ability to
generate revenues and our operating results.
Furthermore,
we are dependent upon ISPs and telecommunications carriers in the United States,
Europe and the Asia-Pacific region, some of whom have experienced significant
system failures and electrical outages in the past. Users of our services may
experience difficulties due to system failures unrelated to our systems and
services. If for any reason, these providers fail to provide the required
services, our business, consolidated financial condition, results of operations
and cash flows could be materially adversely impacted.
No
prevention or defense against denial of service attacks exists. During a
prolonged denial of service attack, Internet service may not be available for
several hours, thus negatively impacting hosted customers’ on-line business
transactions. Affected customers might file claims against us under such
circumstances, and our property and liability insurance may not be adequate to
cover these claims.
Our
results of operations have fluctuated in the past and may continue to fluctuate,
which could have a negative impact on the price of our common
stock.
We have
experienced fluctuations in our results of operations on a quarterly and annual
basis. The fluctuation in our operating results may cause the market price of
our common stock to decline. We expect to experience significant fluctuations in
our operating results in the foreseeable future due to a variety of factors,
including:
19
In
addition, fluctuations in our results of operations may arise from strategic
decisions we have made or may make with respect to the timing and magnitude of
capital expenditures such as those associated with the expansion of our
colocation facilities, the deployment of additional network access points and
the terms of our network connectivity purchase agreements. These and other
factors discussed in this annual report on Form 10-K could have a material
adverse effect on our business, consolidated financial condition, results of
operations and cash flows. In addition, a relatively large portion of our
expenses are fixed in the short-term, particularly with respect to lease and
personnel expense, depreciation and amortization and interest expense. Our
results of operations, therefore, are particularly sensitive to fluctuations in
revenue. Because our results of operations have fluctuated in the past and are
expected to continue to fluctuate in the future, we can offer no assurance that
the results of any particular period are an indication of future performance in
our business operations. Fluctuations in our results of operations could have a
negative impact on our ability to raise additional capital and execute our
business plan. Our operating results in one or more future quarters may fail to
meet the expectations of securities analysts or investors, which could cause an
immediate and significant decline in the trading price of our
stock.
We
have acquired and may acquire other businesses, and these acquisitions involve
numerous risks.
We may
pursue acquisitions of complementary businesses, products, services, and
technologies to expand our geographic footprint, enhance our existing services,
expand our service offerings, and enlarge our customer base. If we complete
future acquisitions, we may be required to incur or assume additional debt, make
capital expenditures or issue additional shares of our common stock or
securities convertible into our common stock as consideration, which would
dilute our existing stockholders’ ownership interest and may adversely affect
our results of operations. Our ability to grow through acquisitions involves a
number of additional risks, including the following:
Failure
to effectively manage our growth through acquisitions could adversely affect our
growth prospects, business, consolidated financial condition, results of
operations and cash flows.
20
The
terms of our existing credit agreement impose restrictions upon us.
The terms
of our existing credit agreement impose operating and financial restrictions on
us and require us to meet certain financial tests. These restrictions may also
have a negative impact on our business, consolidated financial condition,
results of operations and cash flows by significantly limiting or prohibiting us
from engaging in certain transactions. The credit agreement contains certain
covenants, including covenants that restrict our ability to incur further
indebtedness.
The
failure to comply with any of these covenants would cause a default under the
credit agreement. Any defaults, if not waived, could result in the lender
ceasing to make loans or extending credit to us, accelerating or declaring all
or any obligations immediately due, or taking possession of or liquidating
collateral. If any of these events occur, we may not be able to borrow
sufficient funds to refinance the credit agreement on terms that are acceptable
to us, which could materially and adversely impact our business, consolidated
financial condition, results of operations and cash flows.
As of
December 31, 2007, we were in compliance with the various loan covenants
required by the credit agreement.
Our
investments in auction rate securities are subject to risks that may cause
losses and affect the liquidity of these investments.
As of
December 31, 2007, we held $7.2 million of auction rate securities classified as
short-term investments. Auction rate securities are variable rate bonds tied to
short-term interest rates with maturities on the face of the securities in
excess of 90 days and have interest rate resets through a modified Dutch
auction, at predetermined short-term intervals, usually every 7, 28 or 35
days. Although these securities are issued and rated as long term
bonds, they are priced and traded as short-term instruments because of the
liquidity provided through the interest rate resets. The underlying
assets of our auction rate securities are state-issued student and educational
loans that are substantially backed by the federal government and carried
AAA/Aaa ratings as of December 31, 2007. The Dutch auctions have in
the past provided a liquid market for these types of securities. With the
liquidity issues experienced in global credit and capital markets, auctions of
each of the auction rate securities that we hold failed subsequent to December
31, 2007, as the amount of securities submitted for sale exceeded the amount of
purchase orders. If the uncertainties in the credit and capital market continue,
these markets deteriorate further or the various rating agencies downgrade any
of the auction rare securities that we hold, we may be required to adjust the
value of these investments through an impairment charge to earnings if the fair
value of these securities has declined to below their cost and such decline is
assessed to be “other than temporary” under SFAS No. 115. Further, we may not be
able to liquidate these investments until successful auctions occur, a buyer
outside the auction process is found, the issuer calls these debt securities, or
the securities mature.
Continued
overcapacity in the Internet connectivity and IP services market may result in
our recording additional significant restructuring charges and goodwill
impairment.
We have
undertaken significant operational restructurings and have taken restructuring
and impairment charges and recorded total restructuring costs of $11.3 million
for the year ended December 31, 2007 and less than $1.0 million for the
years ended December 31, 2006 and 2005. We may incur additional restructuring
charges or adjustments in the future. Such additional restructuring charges or
adjustments could materially and adversely affect our business, net profit and
stockholders’ equity.
Adverse
experience in the CDN services market may result in our recording additional
goodwill impairment charges.
Upon
completion of our acquisition of VitalStream, we recorded $154.8 million in
goodwill. We tested this goodwill in August of 2007 as part of our
annual testing, and concluded that such goodwill had not been
impaired. We can offer no assurances, however, that this goodwill
will remain unimpaired. We may incur impairment charges in the
future, which could materially and adversely affect our net profit and
stockholders’ equity.
21
If
we are unable to deploy new network access points or do not adequately control
expense associated with the deployment of new network access points, our results
of operations could be adversely affected.
As part
of our strategy, we intend to continue to expand our network access points,
particularly into new geographic markets. We will face various risks associated
with identifying, obtaining and integrating attractive network access point
sites, negotiating leases for centers on competitive terms, cost estimation
errors or overruns, delays in connecting with local exchanges, equipment and
material delays or shortages, the inability to obtain necessary permits on a
timely basis, if at all, and other factors, many of which are beyond our control
and all of which could delay the deployment of a new network access point. We
can offer no assurance that we will be able to open and operate new network
access points on a timely or profitable basis. Deployment of new network access
points will increase operating expense, including expense associated with
hiring, training, retaining, and managing new employees, provisioning capacity
from ISPs, purchasing new equipment, implementing new systems, leasing
additional real estate, and incurring additional depreciation expense. If we are
unable to control our costs as we expand in geographically dispersed locations,
our consolidated financial condition, results of operations and cash flows could
be materially and adversely affected.
Our
international operations may not be successful.
We have
limited experience operating internationally and have only recently begun to
achieve successful international experiences. We currently have network access
points in London, England, Hong Kong, Singapore, and Sydney, Australia. We
also participate in a joint venture with NTT-ME Corporation and Nippon
Telegraph and Telephone Corporation, or NTT Holdings, that operates a network
access point in Tokyo and Osaka, Japan and maintain a marketing agreement with
Telefonica USA, which provides us with further access in Europe and access to
the Latin American market. As part of our strategy to expand our geographic
markets, we may develop or acquire network access points or complementary
businesses in additional international markets. The risks associated with
expansion of our international business operations include:
We may be
unsuccessful in our efforts to address the risks associated with our
international operations, which may limit our international sales growth and
materially and adversely affect our business and results of
operations.
22
Disputes
with vendors regarding the delivery of services may materially impact our
results of operations and cash flows.
In
delivering our services, we rely on a number of Internet network,
telecommunication and other vendors. We work directly with these vendors to
provide services such as establishing, modifying or discontinuing services for
our customers. Because of the volume of activity, billing disputes inevitably
arise. These disputes typically stem from disagreements concerning the starting
and ending dates of service, quoted rates, usage, and various other factors. We
research and discuss disputed costs, both in the vendors’ favor and our favor,
with vendors on an ongoing basis until ultimately resolved. We record the cost
and a liability based on our estimate of the most likely outcome of the dispute.
These estimates are periodically reviewed by management and modified in light of
new information or developments, if any. Because estimates regarding disputed
costs include assessments of uncertain outcomes, such estimates are inherently
vulnerable to changes due to unforeseen circumstances that could materially and
adversely affect our consolidated financial condition, results of operations and
cash flows.
We
depend upon our key employees and may be unable to attract or retain sufficient
numbers of qualified personnel.
Our
future performance depends to a significant degree upon the continued
contributions of our executive management team and other key employees. To the
extent we are able to expand our operations and deploy additional network access
points, we may need to increase our workforce. Accordingly, our future success
depends on our ability to attract, hire, train, and retain highly skilled
management, technical, sales, marketing, and customer support personnel.
Competition for qualified employees is intense, and we compete for qualified
employees with companies that may have greater financial resources than we have.
Our employment security plan with our executive officers provide that either
party may terminate their employment at any time. Consequently, we may not be
successful in attracting, hiring, training, and retaining the people we need,
which would seriously impede our ability to implement our business
strategy.
Our
senior management team has had limited time to develop a working relationship
with each other and may not be able to manage our business
effectively.
Our Chief
Operating Officer, General Counsel, Chief Technology Officer, and Chief Strategy
Officer have been hired since March 2007, and we are currently seeking a Chief
Financial Officer. This limited experience working together could
harm our management team’s ability to quickly and efficiently respond to
problems and effectively manage our business.
If
we fail to adequately protect our intellectual property, we may lose rights to
some of our most valuable assets.
We rely
on a combination of copyright, patent, trademark, trade secret, and other
intellectual property law, nondisclosure agreements, and other protective
measures to protect our proprietary rights. We also utilize unpatented
proprietary know-how and trade secrets and employ various methods to protect
such intellectual property. Taken as a whole, we believe our intellectual
property rights are significant and that the loss of all or a substantial
portion of such rights could have a material adverse effect on our results of
operations. We can offer no assurance that our intellectual property protection
measures will be sufficient to prevent misappropriation of our technology. In
addition, the laws of many foreign countries do not protect our intellectual
property to the same extent as the laws of the United States. From time to time,
third parties have or may assert infringement claims against us or against our
customers in connection with their use of our products or services.
In
addition, we rely on the intellectual property of others. We may desire or be
required to renew or to obtain licenses from these other parties in order to
further develop and market commercially viable products or services effectively.
We can offer no assurance that any necessary licenses will be available on
reasonable terms.
We
may face litigation and liability due to claims of infringement of third party
intellectual property rights.
The
Internet services industry is characterized by the existence of a large number
of patents and frequent litigation based on allegations of patent infringement.
From time to time, third parties may assert patent, copyright, trademark, trade
secret, and other intellectual property rights to technologies that are
important to our business. Any claims that our products or services infringe or
may infringe proprietary rights of third parties, with or without merit, could
be time-consuming, result in costly litigation, divert the efforts of our
technical and management personnel, or require us to enter into royalty or
licensing agreements, any of which could significantly harm our operating
results. In addition, our customer agreements generally provide for us to
indemnify our customers for expenses and liabilities resulting from claimed
infringement of patents or copyrights of third parties, subject to certain
limitations. If an infringement claim against us were to be successful, and we
were not able to obtain a license to the relevant technology or a substitute
technology on acceptable terms or redesign our products or services to avoid
infringement, our ability to compete successfully in our competitive market
would be materially impaired.
23
We may become involved in other
litigation that may adversely affect us.
In the
ordinary course of business, we are or may become involved in litigation,
administrative proceedings and governmental proceedings. Such matters
can be time-consuming, divert management’s attention and resources and cause us
to incur significant expenses. Furthermore, the results of any such
actions could have a material adverse effect on our business, consolidated
financial condition, results of operations or cash flows.
Risks
Related to Our Industry
We
cannot predict with certainty the future evolution of the high performance
Internet connectivity market, and therefore the role of our products and
services.
We face
the risk that the market for high performance Internet connectivity services
might develop more slowly or differently than currently projected, or that our
services may not achieve continued widespread market acceptance. Furthermore, we
may be unable to market and sell our services successfully and cost-effectively
to a sufficiently large number of customers. We typically charge a premium for
our services, which may affect market acceptance of our services or adversely
impact the rate of market acceptance. We believe the danger of non-acceptance is
particularly acute during economic slowdowns, which exert significant pricing
pressure on ISPs. If the Internet becomes subject to a form of central
management, or if ISPs establish an economic settlement arrangement regarding
the exchange of traffic between Internet networks, the demand for our IP
services could be materially and adversely affected.
If
we are unable to respond effectively and on a timely basis to rapid
technological change, we may lose or fail to establish a competitive advantage
in our market.
Our
industry is characterized by rapidly changing technology, industry standards and
customer needs, as well as by frequent new product and service introductions.
New technologies and industry standards have the potential to replace or provide
lower cost alternatives to our services. The adoption of such new technologies
or industry standards could render our existing services obsolete and
unmarketable. Our failure to anticipate the prevailing standard, to adapt our
technology to any changes in the prevailing standard or the failure of a common
standard to emerge could materially and adversely affect our business. Our
pursuit of necessary technological advances may require substantial time and
expense, and we may be unable to successfully adapt our network and services to
alternative access devices and technologies.
Our
network and software are subject to potential security breaches and similar
threats that could result in our liability for damages and harm our
reputation.
A number
of widespread and disabling attacks on public and private networks have occurred
recently. The number and severity of these attacks may increase in the future as
network assailants take advantage of outdated software, security breaches or
incompatibility between or among networks. Computer viruses, intrusions and
similar disruptive problems could cause us to be liable for damages under
agreements with our customers, and our reputation could suffer, thereby
deterring potential customers from working with us. Security problems or other
attacks caused by third parties could lead to interruptions and delays, or to
the cessation of service to our customers. Furthermore, inappropriate use of the
network by third parties could also jeopardize the security of confidential
information stored in our computer systems and in those of our customers and
could expose us to liability under unsolicited commercial e-mail, or “spam,”
regulations. In the past, third parties have occasionally circumvented some of
these industry-standard measures. We can offer no assurance that the measures we
implement will not be circumvented. Our efforts to eliminate computer viruses
and alleviate other security problems, or any circumvention of those efforts,
may result in increased costs, interruptions, delays or cessation of service to
our customers, which could hurt our business, consolidated financial condition,
results of operations and cash flows.
24
Terrorist
activity throughout the world and military action to counter terrorism could
adversely impact our business.
The
continued threat of terrorist activity and other acts of war or hostility may
have an adverse effect on business, financial and general economic conditions
internationally. Effects from any future terrorist activity, including cyber
terrorism, may, in turn, increase our costs due to the need to provide enhanced
security, which would adversely affect our business, consolidated financial
condition, results of operations and cash flows. These circumstances may also
damage or destroy the Internet infrastructure and may materially and adversely
affect our ability to attract and retain customers, our ability to raise capital
and the operation and maintenance of our network access points.
If
governments modify or increase regulation of the Internet, the provision of our
services could become more costly.
International
bodies and federal, state and local governments have adopted a number of laws
and regulations that affect the Internet and are likely to continue to seek to
implement additional laws and regulations. For example, a federal law regulating
spam was enacted in 2003. In addition, federal and state agencies are actively
considering regulation of various aspects of the Internet, including taxation of
transactions, and imposing access fees for voice over IP, or VoIP. The Federal
Communications Commission and state agencies also review the regulatory
requirements, if any, that should be applicable to VoIP. If we seek to offer
additional products and services, we could be required to obtain certain,
additional authorizations from regulatory agencies. We may not be able to obtain
such authorizations in a timely manner, or at all, and conditions could be
imposed upon such authorization that may not be favorable to us.
Congress
recently extended the Internet Tax Freedom Act, which placed a moratorium
against certain state and local taxation of Internet access, until
November 1, 2014. Pursuant to this moratorium, most of our services are not
subject to state and local taxation.
In
addition, laws relating to the liability of private network operators and
information carried on or disseminated through their networks are unsettled,
both in the United States and abroad. Network operators have been
sued in the past based on the content of material disseminated through their
networks. We may become subject to legal claims such as defamation,
invasion of privacy and copyright infringement in connection with content stored
on or distributed through our network. Also, our reputation could
suffer as a result of our perceived association with the type of content that
some of our customers deliver.
The
adoption of any future laws or regulations might decrease the growth of the
Internet, decrease demand for our services, impose taxes or other costly
technical requirements, regulate the Internet similar to the regulation of
traditional telecommunications services, or otherwise increase the cost of doing
business on the Internet in some other manner. Any of these actions could have a
significantly harmful effect on our customers or us. Moreover, the nature of any
new laws and regulations and the interpretation of applicability to the Internet
of existing laws governing intellectual property ownership and infringement,
copyright, trademark, trade secret, obscenity, libel, employment, personal
privacy, and other issues is uncertain and developing. We cannot predict the
impact, if any, that future regulation or regulatory changes may have on our
business.
If our ability to deliver media
files in certain formats is restricted or becomes cost-prohibitive, demand for
our services would decline and our financial results would
suffer.
Our CDN
products and services depend on our ability to deliver media content in all
major formats. If our legal right to store and deliver content in
certain formats, like Adobe Flash or Windows Media, for example, was limited, we
could not serve our customers and the demand for our services would
decline. Owners of proprietary content formats may be able to block,
restrict or impose fees or other costs on our use of such formats, leading to
additional expenses or prevent our delivery of this type of content, which could
materially and adversely affect our operating results.
25
Risks
Related to Our Capital Stock
Our
common stockholders may experience significant dilution, which could depress the
market price of our common stock.
Holders
of our stock options and warrants to purchase common stock may exercise their
options or warrants to purchase our common stock, which would increase the
number of outstanding shares of common stock in the future. As of December 31,
2007, options to purchase an aggregate of 3.2 million shares of our common
stock at a weighted average exercise price of $13.29 were outstanding, and
warrants to purchase approximately 34,000 shares of our common stock
at an exercise price of $9.50 per share were outstanding. Also, the vesting
of 0.7 million outstanding restricted stock awards will increase the weighted
average number of shares used for calculating diluted net income per share. We
issued approximately 12.2 million shares of our common stock to VitalStream’s
stockholders in connection with the acquisition in February of 2007. We also
assumed outstanding options for the purchase of shares of VitalStream
common stock, converted into options to purchase approximately 1.5 million
shares of Internap common stock. Furthermore, greater than expected capital
requirements could require us to obtain additional financing through the
issuance of securities, which could be in the form of common stock or preferred
stock or other securities having greater rights than our common stock. The
issuance of our common stock or other securities, whether upon the exercise of
options and warrants, the future vesting and issuance of stock awards to
our executives and employees, or in financing transactions, could depress the
market price of the common stock by increasing the number of shares of common
stock or other securities outstanding on an absolute basis or as a result of the
timing of additional shares of common stock becoming available on the market.
Provisions
of our charter documents, our stockholder rights plan and Delaware law may have
anti-takeover effects that could prevent a change in control even if the change
in control would be beneficial to our stockholders.
Provisions
of our certificate of incorporation, as amended, amended and restated bylaws and
Delaware law could make an acquisition more difficult, even if doing so would be
beneficial to our stockholders. In addition, our Board of Directors
recently adopted a stockholder rights plan that renders the consummation of an
acquisition without the approval of the Board of Directors more
difficult.
Our
stock price may be volatile.
The
market for our equity securities has been extremely volatile. Our stock price
could suffer in the future as a result of any failure to meet the expectations
of public market analysts and investors about our results of operations from
quarter to quarter. The following factors could cause the price of our common
stock in the public market to fluctuate significantly:
26
Changes in financial accounting
standards may adversely affect our reported results of
operations.
New
accounting pronouncements and interpretations have occurred and may occur in the
future that adversely affect on our reported results. For example,
Statement of Financial Accounting Standards No. 123 (revised 2004) “Share Based
Payment,” or SFAS No. 123R, required us to account for our stock-based awards as
a compensation expense and, as a result, our net income and net income per share
in subsequent periods has been significantly reduced.
None.
Our
principal executive offices are located in Atlanta, Georgia adjacent to our
network operations center, one of our P-NAPs and data center facilities. The
Atlanta facility consists of 120,298 square feet under a lease agreement that
expires in 2020. We lease other facilities to fulfill our real estate
requirements in metropolitan areas and specific cities where our service
points are located. We believe our existing facilities are adequate for our
current needs and that suitable additional or alternative space will be
available in the future on commercially reasonable terms as needed.
We
currently, and from time to time, are involved in litigation incidental to the
conduct of our business. Although the amount of liability that may result from
these matters cannot be ascertained, we do not currently believe that, in the
aggregate, such matters will result in liabilities material to our consolidated
financial condition, results of operations or cash flows.
None.
PART
II
Our
common stock is listed on the NASDAQ Global Market under the symbol “INAP” and
has traded on the NASDAQ Global Market since September 19, 2006. Our common
stock traded on the American Stock Exchange under the symbol “IIP” from February
18, 2004 through September 18, 2006. Our common stock traded on the NASDAQ Small
Cap Market from October 4, 2002 through February 17, 2004. The following
table presents, for the periods indicated, the range of high and low per share
sales prices for our common stock, as reported on the NASDAQ Global Market since
September 19, 2006 and on the American Stock Exchange prior to
September 19, 2006.
On
July 11, 2006, we implemented a one-for-ten reverse stock split of our
common stock. The information in the following table has been adjusted to
reflect this stock split. Our fiscal year ends on December 31.
27
As of
March 6, 2008, the number of stockholders of record of our common stock was
approximately 24,600.
We have
never declared or paid any cash dividends on our capital stock, and we do not
anticipate paying cash dividends in the foreseeable future. We are prohibited
from paying cash dividends under covenants contained in our current credit
agreement. We currently intend to retain our earnings, if any, for future
growth. Future dividends on our common stock, if any, will be at the discretion
of our board of directors and will depend on, among other things, our
operations, capital requirements and surplus, general financial condition,
contractual restrictions, and such other factors as our board of directors may
deem relevant.
The
following table provides information regarding our current equity compensation
plans as of December 31, 2007 (shares in thousands):
28
STOCK
PERFORMANCE GRAPH
The graph
set forth below compares cumulative total return to our stockholders from an
investment in our common stock with the cumulative total return of the NASDAQ
Market Index and the Hemscott Group Index, resulting from an initial assumed
investment of $100 in each on December 31, 2002, assuming the reinvestment of
any dividends, ending at December 31, of each year, 2003 - 2007,
respectively.
 29
The
consolidated statement of operations data and other financial data presented
below were prepared using our consolidated financial statements for the five
years ended December 31, 2007. You should read this selected consolidated
financial data together with the consolidated financial statements and related
notes contained in this annual report on Form 10-K and in our 2006 and 2005
annual reports on Form 10-K/A and Form 10-K, respectively, filed with the SEC,
as well as the section of this annual report and of our 2006 and 2005 annual
reports on Form 10-K/A and Form 10-K, respectively, entitled, “Management’s
Discussion and Analysis of Financial Condition and Results of
Operations.”
30
31
The
following discussion should be read in conjunction with the consolidated
financial statements and accompanying notes provided under Part II, Item 8 of
this annual report on Form 10-K.
Overview
We
deliver high performance and reliable Internet solutions through a suite of
network optimization and delivery products and services. These solutions,
combined with progressive and proactive technical support, enable companies to
confidently migrate business-critical applications, including audio and video
streaming and monetization services, to the Internet. Our suite of products and
services support a broad range of Internet applications. We currently
have approximately 3,800 customers, serving financial services, healthcare,
technology, retail, travel, and media/entertainment markets. Our customers are
located in the United States and abroad and include several Fortune 1000 and
mid-tier enterprises. Our product and service offerings are complemented by
Internet protocol, or IP, access solutions such as data center services, content
delivery networks, or CDN, and managed security. We deliver services through our
50 service points across North America, Europe and the Asia-Pacific region. Our
Private Network Access Points, or P-NAPs, feature multiple direct high-speed
connections to major Internet networks including AT&T Inc., Sprint
Nextel Corporation, Verizon Communications Inc., Savvis, Inc., Global
Crossing Limited, and Level 3 Communications, Inc.
The key
characteristic that differentiates us from our competition is our portfolio of
patented and patent-pending route optimization solutions that address the
inherent weaknesses of the Internet and overcome the inefficiencies of
traditional IP connectivity options. Our intelligent routing technology can
facilitate traffic over multiple carriers, as opposed to just one carrier's
network, to ensure highly reliable performance over the Internet.
We
believe our unique managed multi-network approach provides better performance,
control and reliability compared to conventional Internet connectivity
alternatives. Our service level agreements guarantee performance across the
entire Internet in the United States, excluding local connections, whereas
providers of conventional Internet connectivity typically only guarantee
performance on their own network.
On
October 12, 2006, we entered into a definitive agreement to acquire VitalStream
Holdings, Inc., or VitalStream, in an all-stock transaction accounted for using
the purchase method of accounting for business combinations. The transaction
closed on February 20, 2007. Our results of operations include the activities of
VitalStream from February 21, 2007 through December 31, 2007.
As
discussed in note 18 to our consolidated financial statements, we revised our
quarterly statement of operations for the quarter ended September 30, 2007 to
appropriately record (1) $0.5 million for sales adjustments, which reduced net
accounts receivable and revenue, and (2) $0.1 million for accretion of interest
income that we initially included as unrealized gain in accumulated other
comprehensive income within stockholders’ equity. The effect of these
revisions had no impact on our consolidated statement of cash
flows. We have determined that these adjustments are not material to
our consolidated financial statements for any of the affected quarterly
periods. Accordingly, we have not revised the 2007 quarterly
financial statements included in our previously filed Forms 10-Q for the
quarterly periods ended March 31, June 30 and September 30, 2007, for these
adjustments.
We
operate in three business segments: IP services, data center services and CDN
services. For additional information about these segments, see note 5 to the
consolidated financial statements included in Part II, Item 8.
The
following is a brief description of each of our reportable business
segments.
IP
Services
Our
patented and patent-pending network performance optimization technologies
address the inherent weaknesses of the Internet, allowing enterprises to take
advantage of the convenience, flexibility and reach of the Internet to connect
to customers, suppliers and partners. Our solutions take into account the unique
performance requirements of each business application to ensure performance as
designed, without unnecessary cost. Prior to recommending appropriate network
solutions for our customers’ applications, we consider key performance
objectives including (1) performance and cost optimization, (2) application
control and speed and (3) delivery and reach. Our charges for IP services are
based on a fixed-fee, usage or a combination of both fixed fee and
usage.
32
Our IP
services segment also includes our flow control platform, or FCP. The FCP
provides network performance management and monitoring for companies with
multi-homed networks and redundant Internet connections. The FCP
proactively reviews customer networks for the best performing route or the most
cost-effective and routes according to our customers’ requirements. We
offer FCP as either a one-time hardware purchase or as a monthly subscription
service. Sales of FCP also generate annual maintenance fees and professional
service fees for installation and ongoing network configuration. Since the FCP
emulates our P-NAP service in many ways, this product affords us the opportunity
to serve customers outside of our P-NAP market footprint. This product
represents approximately 4% of our IP services revenue and approximately 2% of
our consolidated revenue for the year ended December 31, 2007.
Data
Center Services
Our data
center services provide a single source for network infrastructure, IP and
security, all of which are designed to maximize solution performance while
providing a more stable, dependable infrastructure, and are backed by guaranteed
service levels and our team of dedicated support professionals. We offer a
comprehensive solution at 42 service points, including eight locations managed
by us and 34 locations managed by third parties.
Data
center services also enable us to have a more flexible product offering,
including bundling our high performance IP connectivity and managed services,
such as content delivery, along with hosting customers' applications. We charge
monthly fees for data center services based on the amount of square footage that
the customer leases in our facilities. We also have relationships with various
providers to extend our P-NAP model into markets with high demand.
CDN
Services
Our CDN
services enable our customers to quickly and securely stream and distribute
video, audio, advertising, and software to audiences across the globe through
strategically located data centers. Providing capacity-on-demand to handle large
events and unanticipated traffic spikes, content is delivered with high quality
regardless of audience size or geographic location. Our MediaConsole® content
management tool provides our customers the benefit of a single, easy to navigate
system featuring Media Asset Management, Digital Rights Management, or DRM,
support, and detailed reporting tools. With MediaConsole, our customers can use
one application to manage and control access to their digital assets, deliver
advertising campaigns, view network conditions, and gain insight into habits of
their viewing audience.
Our CDN
and monetization services provide a complete turnkey solution for the
monetization of online media. These multi-faceted “live” and “on-demand”
advertisement insertion and advertising placement solutions include a full
campaign management suite, inventory prediction tools, audience research and
metrics, and extensive reporting features to effectively track advertising
campaigns in real-time. Online advertising solutions enable our customers to
offset the costs associated with the creation, transformation, licensing, and
management of online content. Prior to our acquisition of VitalStream on
February 20, 2007, we did not offer proprietary CDN services, but instead, we
were a reseller of third party CDN services for which results of operations
are included in Other revenues and direct costs of network, sales and services,
discussed below.
Other
Other
revenues and direct costs of network, sales and services include our
non-segmented results of operations, including certain reseller and
miscellaneous services such as third party CDN services, termination fee
revenue, other hardware sales, and consulting services.
Highlights
and Outlook
33
Developments
in 2007
34
We
accounted for the acquisition using the purchase method of accounting in
accordance with SFAS No. 141, “Business Combinations.” Our results of
operations include the activities of VitalStream from February 21, 2007 through
December 31, 2007.
Restructuring
Liability>.
On March 31, 2007, we incurred a restructuring and impairment
charge totaling $10.3 million. The charge was the result of a review of our
business, particularly in light of our acquisition of VitalStream, and our plan
to finalize the overall integration and implementation plan before the end of
the first quarter. The charge to expense included $7.8 million for leased
facilities, representing both the net present value of costs less anticipated
sublease recoveries that will continue to be incurred without economic benefit
to us and costs to terminate leases before the end of their term. The charge
also included severance payments of $1.1 million for the termination of certain
Internap employees and $1.4 million for impairment of assets. Related
expenditures are estimated to be $10.7 million, of which $3.7 million has been
paid during the year ended December 31, 2007, and the balance continuing through
December 2016, the last date of the longest lease term. The impairment charge of
$1.3 million was related to the leases referenced above and less than $0.1
million for other assets.
We also
incurred a $1.1 million impairment recorded for a sales order-through-billing
system, which was a result of an evaluation of the existing infrastructure
relative to our new financial accounting system and the acquisition of
VitalStream.
Write-Off
of Investment>.
In connection with the preparation of our quarterly report for the
quarter ended June 30, 2007, we wrote-off an investment, totaling $1.2 million,
representing the remaining carrying value of our investment in series D
preferred stock of Aventail Corporation, or Aventail. We made an initial cash
investment of $6.0 million in Aventail series D preferred stock pursuant to an
investment agreement in February 2000. In connection with a subsequent round of
financing by Aventail, we recognized an initial impairment loss on our
investment of $4.8 million in 2001. On June 12, 2007, SonicWall, Inc. announced
that it had entered into an agreement to acquire Aventail for approximately
$25.0 million in cash. The transaction closed on July 11, 2007, all shares of
series D preferred stock were cancelled and the holders of series D preferred
stock did not receive any consideration for such
shares. Consequently, we recorded a write-off of our investment in
Aventail to reduce our carrying value to $0.
Rights
Agreement. >On March 15, 2007, the Board of Directors declared a dividend
of one preferred share purchase right, or a Right, for each outstanding share of
common stock, par value $0.001 per share, of the Company. The dividend was
payable on March 23, 2007 to the stockholders of record on that date. Each Right
entitles the registered holder to purchase from the Company one one-thousandth
of a share of Series B Preferred Stock of the Company, par value $0.001 per
share, or the Preferred Shares, at a price of $100.00 per one one-thousandth of
a Preferred Share, subject to adjustment. The description and terms of the
Rights are set forth in a Rights Agreement between the Company and American
Stock Transfer & Trust Company, as Rights Agent dated April 11, 2007.
Data Center
Expansion. >
On June 12, 2007, we announced that we approved an investment of up to
$40.0 million to fund the expansion of our data center facilities in several key
markets. We anticipate implementing the expansion over the next several calendar
quarters, with at least a portion of the funding to be provided under our credit
agreement, discussed below. Through December 31, 2007, we have spent less than
$10.0 million.
Credit Agreement.
>On September 14, 2007, we entered into a $35.0 million credit agreement.
We discuss this agreement in note 10 to the consolidated financial statements
and the section captioned “Liquidity and Capital Resources” under “Item 2.
Managements Discussion and Analysis of Financial Condition and Results of
Operations.” At December 31, 2007, the outstanding balance was $19.8
million, of which we used $4.4 million to repay prior debt, approximately $7.8
million for capital expenditures and the balance for general corporate and other
purposes. The availability under the revolving credit facility and
term loan was $1.1 million and $10.0 million, respectively at December 31,
2007.
35
Critical
Accounting Policies and Estimates
The
discussion and analysis of our financial condition and results of operations are
based upon our consolidated financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States.
The preparation of these financial statements requires management to make
estimates and judgments that affect the reported amounts of assets, liabilities,
revenue, and expense, and related disclosure of contingent assets and
liabilities. On an ongoing basis, we evaluate our estimates, including those
summarized below. We base our estimates on historical experience and on various
other assumptions that are believed to be reasonable under the circumstances,
the results of which form the basis for making judgments about the carrying
values of assets and liabilities that are not readily apparent from other
sources. Actual results may differ materially from these estimates under
different assumptions or conditions.
Management
believes the following critical accounting policies affect the judgments and
estimates used in the preparation of our consolidated financial
statements.
Revenue
recognition>. The
majority of our revenue is derived from high performance IP services, related
data center services, CDN services, and other ancillary products and services
throughout the United States. Our IP services revenue is derived from the sale
of high performance Internet connectivity services at fixed rates or usage-based
pricing to our customers that desire a DS-3 or faster
connection. Slower T-1 and fractional DS-3 connections are provided
at fixed rates. Data center revenue includes both physical space for
hosting customers’ network and other equipment plus associated services such as
redundant power and network connectivity, environmental controls and
security. Data center revenue is based on occupied square feet and
both allocated and variable-based usage. CDN revenue includes three
components, none of which are sold separately: (1) data storage; (2)
streaming/delivery and (3) a user interface/reporting tool. We
provide the CDN service components via internally developed and acquired
technology that resides on our network. CDN revenue is based on
either fixed rates or usage-based pricing. All of the foregoing
revenue arrangements have contractual terms and in many instances, include
minimum usage commitments. Other ancillary products and services
include our Flow Control Platform, or FCP, product, server management and
installation, virtual private networking, managed security, data backup, remote storage and
restoration.
We
recognize revenue in accordance with the Securities
and Exchange Commission’s Staff Accounting Bulletin No. 104,
Revenue Recognition,
or
SAB No. 104, and
the Financial Accounting Standards Board’s,
or FASB, Emerging
Issues Task Force Issue No. 00-21,
Revenue Arrangements with Multiple Deliverables,
or EITF No. 00-21. Revenue
is recognized when persuasive evidence of an arrangement exists, the
product or service has been delivered, the fees are fixed or determinable and
collectibility is probable. For most of our IP, data center and CDN
revenue, services are delivered ratably over the contract term. Contracts and
sales or purchase orders are used to determine the existence of an arrangement.
We test for availability or connectivity to verify delivery of our services. We
assess whether the fee is fixed or determinable based on the payment terms
associated with the transaction and whether the sales price is subject to refund
or adjustment. Because the software component of our FCP is more than
incidental to the product as a whole, we recognize associated FCP revenue in
accordance with the American Institute of Certified Public Accountants’ (AICPA)
Statement of Position 97-2, Software
Revenue Recognition.
We
derive revenue from the sale of IP services, data center services and
CDN services to customers
under contracts that generally commit the customer to a minimum monthly level of
usage on a calendar month basis and provide the rate at which the customer must
pay for actual usage above the monthly minimum. For these services, we recognize
the monthly minimum as revenue each month provided that an enforceable contract
has been signed by both parties, the service has been delivered to the customer,
the fee for the service is fixed or determinable and collection is reasonably
assured. Should a customer’s usage of our services exceed the monthly minimum,
we recognize revenue for such excess in the period of the usage. We record the
installation fees as deferred revenue and recognize as revenue ratably over the
estimated life of the customer arrangement. We also derive revenue from services
sold as discrete, non-recurring events or based solely on usage. For these
services, we recognize revenue after both parties have signed an enforceable
contract, the fee is fixed or determinable, the event or usage has occurred and
collection is reasonably assured.
36
We also enter into multiple-element arrangements
or bundled services, such as combining IP services with data center, CDN services or both. When we enter into such arrangements,
we account for each element
separately over its respective service period or at the time of delivery,
provided that there is objective evidence of fair value for the separate
elements. Objective evidence of fair value includes the price charged for the
element when sold separately. If we cannot objectively determine the fair value
of each element, we recognize the total value of the arrangement ratably over
the entire service period to the extent that we have begun to provide the
services, and other revenue recognition criteria have been
satisfied.
Deferred
revenue consists of revenue for services to be delivered in the future and
consist primarily of advance billings, which are amortized over the respective
service period. Revenue associated with billings for installation of customer
network equipment are deferred and amortized over the estimated life of the
customer relationship, which was two to three years for each of the three years
in the period ended December 31, 2007. Revenue for installation
services is deferred and amortized because the installation service is integral
to our primary service offering and does not have value to a customer on a
stand-alone basis. Deferred post-contract customer support associated with sales
of our FCP solution and similar products are amortized ratably over the contract
period, which is generally one year.
Customer
credit risk>.
We routinely review the creditworthiness of our customers. If we determine that
collection of service revenue is uncertain, we do not recognize revenue
until collection is probable. Additionally, we maintain allowances
for doubtful accounts resulting from the inability of our customers to make
required payments on accounts receivable. The allowance for doubtful accounts is
based upon specific and general customer information, which also includes
estimates based on management's best understanding of the customer’s ability to
pay. A customer’s ability to pay takes into consideration payment history, legal
status (i.e., bankruptcy) and the status of services we are
providing. Once we have exhausted all collection efforts, we write the
uncollectible balance off against the allowance for doubtful accounts.
We record
an amount for sales adjustments, which reduces net accounts receivable and
revenue. The amount for sales adjustments is based upon specific and general
customer information, including outstanding promotional credits, customer
disputes, credit adjustments not yet processed through the billing system, and
historical activity.
Accounting
for leases and leasehold improvements>.
We record leases as capital or operating leases and account for leasehold
improvements in accordance with SFAS No. 13, “Accounting for Leases” and related
literature. We record rent expense for operating leases in accordance with FASB
Technical Bulletin (FTB) No. 88-1, “Issues Relating to Accounting
for Leases.” This FTB requires lease agreements that include periods of free
rent or other incentives, specific escalating lease payments, or both, to be
recorded on a straight-line or other systematic basis over the initial lease
term and those renewal periods that are reasonably assured. The difference
between rent expense and rent paid is recorded as deferred rent in non-current
liabilities in the consolidated balance sheets.
Investments>. We account for investments
without readily determinable fair values at historical cost, as determined by
our initial investment. The recorded value of cost-basis investments is
periodically reviewed to determine the propriety of the recorded basis. When a
decline in the value that is judged to be other than temporary has occurred,
based on available data, the cost basis is reduced and an investment loss is
recorded. We incurred a charge during the three months ended June 30, 2007,
totaling $1.2 million, representing the write-off of the remaining carrying
value of our investment in series D preferred stock of Aventail Corporation, or
Aventail. See note 6 to the consolidated financial statements for further
discussion of this investment and the recorded loss.
37
We
account for investments that provide us with the ability to exercise significant
influence, but not control, over an investee using the equity method of
accounting. Significant influence, but not control, is generally deemed to exist
if we have an ownership interest in the voting stock of the investee of between
20% and 50%, although other factors, such as minority interest protections, are
considered in determining whether the equity method of accounting is
appropriate. As of December 31, 2007, Internap Japan Co, Ltd. (Internap Japan),
our joint venture with NTT-ME Corporation of Japan and NTT Holdings, qualifies
for equity method accounting. We record our proportional share of the income and
losses of Internap Japan one month in arrears on the consolidated balance sheets
as a component of non-current investments and as a separate caption on
the consolidated statement of operations.
Pursuant
to our formal investment policy, investments in marketable securities include
high credit quality corporate debt securities, auction rate securities,
commercial paper, and U.S. Government Agency debt securities. Auction rate
securities are variable rate bonds tied to short-term interest rates with
maturities on the face of the securities in excess of 90 days and have interest
rate resets through a modified Dutch auction, at predetermined short-term
intervals, usually every 7, 28 or 35 days. Auction rate securities
generally trade at par and are callable at par on any interest payment date at
the option of the issuer. Interest received during a given period is
based upon the interest rate determined through the auction
process. Although these securities are issued and rated as long term
bonds, they are priced and traded as short-term instruments because of the
liquidity provided through the interest rate reset. All of our marketable
securities are classified as available for sale and are recorded at fair value
with changes in fair value reflected in other comprehensive income.
Goodwill.>
We account for goodwill under SFAS No. 142, “Goodwill and Other Intangible
Assets.” This statement requires an impairment-only approach to accounting for
goodwill. The SFAS No. 142 goodwill impairment model is a two-step process. As a
first step, it requires a comparison of the book value of net assets to the fair
value of the related operations that have goodwill assigned to them. If the fair
value is determined to be less than book value, a second step is performed to
compute the amount of the impairment. In this process, a fair value for goodwill
is estimated, based in part on the fair value of the operations used in the
first step, and is compared to the carrying value for goodwill. Any shortfall of
the fair value below carrying value represents the amount of goodwill
impairment. SFAS No. 142 requires goodwill to be tested for impairment annually
at the same time every year and when an event occurs or circumstances change
such that it is reasonably possible that impairment may exist. We selected
August 1 as our annual testing date. We also assess on a quarterly basis whether
any events have occurred or circumstances have changed that would indicate an
impairment could exist.
Accrued
liabilities>.
Similar to accruals for disputed telecommunications costs above, it is necessary
for us to estimate other significant costs such as utilities and sales, use,
telecommunications, and other taxes. These estimates are often necessary either
because invoices for services are not received on a timely basis from our
vendors or by virtue of the complexity surrounding the costs. In every instance
in which an estimate is necessary, we record the related cost and liability
based on all available facts and circumstances, including but not limited to
historical trends, related usage, forecasts, and quotes. Management periodically
reviews and modifies estimates in light of new information or developments, if
any. Because estimates regarding accrued liabilities include assessments of
uncertain outcomes, such estimates are inherently vulnerable to changes due to
unforeseen circumstances that could materially and adversely affect our results
of operations and cash flows.
38
Restructuring
liability>. When
circumstances warrant, we may elect to exit certain business activities or
change the manner in which we conduct ongoing operations. When we make such a
change, management will estimate the costs to exit a business or restructure
ongoing operations. The components of the estimates may include estimates and
assumptions regarding the timing and costs of future events and activities that
represent management's best expectations based on known facts and circumstances
at the time of estimation. Management periodically reviews its restructuring
estimates and assumptions relative to new information, if any, of which it
becomes aware. Should circumstances warrant, management will adjust its previous
estimates to reflect what it then believes to be a more accurate representation
of expected future costs. Because management's estimates and assumptions
regarding restructuring costs include probabilities of future events, such
estimates are inherently vulnerable to changes due to unforeseen circumstances,
changes in market conditions, regulatory changes, changes in existing business
practices, and other circumstances that could materially and adversely affect
our results of operations. A 10% change in our restructuring estimates in a
future period, compared to the $10.1 million restructuring liability at December
31, 2007 would result in an $1.0 million expense or benefit in the statement of
operations during the period in which the change in estimate
occurred.
Deferred
taxes>.
We record a valuation allowance to reduce our deferred tax assets to the amount
that is more likely than not to be realized. Historically, we have
recorded a valuation allowance equal to our net deferred tax assets. Although we
consider the potential for future taxable income and ongoing prudent and
feasible tax planning strategies in assessing the need for the valuation
allowance, in the event we determine we would be able to realize our deferred
tax assets in the future in excess of our net recorded amount, an adjustment to
reduce the valuation allowance would increase income in the period such
determination was made.
For the year ended December 31, 2007,
the tax provision includes
a net benefit of $3.5 million related to the release of the valuation allowance associated with
U.K. deferred tax assets. The gross amount of
U.K. deferred tax assets was $4.4 million,
which was offset by a reserve of $0.9 million. The net tax provision benefit of
$3.5 million reduced our loss for the year ended December 31,
2007.
The reduction in valuation allowance was due to
the existence of
sufficient positive
evidence as of December 31,
2007 to indicate that
our net operating losses in the U.K. would more likely than not be realized in the
future. The evidence primarily consists of the results of prior performance
in the U.K. and the expectation of future
performance based on historical results. We will continue to assess in the future the recoverability of
U.S. and other deferred tax assets, and whether or not the valuation
allowance should be reduced relative to the U.S. and other deferred tax assets outside
the U.K.
Stock-based
compensation.> We account for stock-based instruments issued to employees
in exchange for their services under the fair value recognition provisions of
SFAS No. 123 (revised 2004), “Share-Based Payment,” or SFAS No. 123R, and
related interpretations. Under SFAS No. 123R, share-based compensation cost is
measured at the grant date based on the calculated fair value of the award. The
expense is recognized over the employee’s requisite service period, generally
the vesting period of the award. Prior to the adoption of SFAS No. 123R on
January 1, 2006, we utilized the disclosure only provisions of SFAS No. 123,
“Accounting for Stock-Based Compensation,” and accounted for stock-based
compensation plans under the recognition and measurement provisions of APB
Opinion No. 25, “Accounting for Stock Issued to Employees,” and related
interpretations. Accordingly, we did not recognize any expense for options to
purchase our common stock granted with an exercise price equal to fair market
value at the date of grant and did not recognize any expense in connection with
purchases under our employee stock purchase plans for any periods prior to
January 1, 2006.
We
elected to adopt SFAS No.
123R
using the modified prospective application
method.
Under this method, compensation
cost
recognized during the period includes:
(1) compensation cost for all
share-based payments granted prior to, but not yet vested as of January 1,
2006, based on the grant date fair value estimated in accordance with the
original provisions of SFAS No.
123
amortized over the awards’ vesting period, and (2) compensation cost
for all share-based payments granted subsequent to January 1, 2006, based
on the grant-date fair value estimated in accordance with the provisions of SFAS
No.
123R
amortized on a straight-line basis over the awards’ vesting period. The fair
value of stock options is estimated at the date of grant using the Black-Scholes
option pricing model with weighted average assumptions for the activity under
our stock plans. Option pricing model input assumptions such as expected term,
expected volatility, and risk-free interest rate, impact the fair value
estimate. Further, the forfeiture rate impacts the amount of aggregate
compensation. These assumptions are subjective and generally require significant
analysis and judgment to develop.
39
The
expected term represents the weighted average period of time that granted
options are expected to be outstanding, giving consideration to the vesting
schedules and our historical exercise patterns. Because our options are not
publicly traded, assumed volatility is based on the historical volatility of our
stock. The risk-free interest rate is based on the U.S. Treasury yield curve in
effect at the time of grant for periods corresponding to the expected life of
the options. We have also used historical data to estimate option exercises,
employee termination and stock option forfeiture rates. Changes in any of these
assumptions could materially impact our results of operations in the period the
change is made.
Recent
Accounting Pronouncements
In September 2006, the FASB issued SFAS
No. 157, “Fair Value Measurements,” or SFAS No. 157. SFAS No. 157 defines fair value,
establishes a framework for measuring fair value under generally accepted accounting
principles, or GAAP, and
expands disclosures about fair value measurements. SFAS No. 157 is
effective for fiscal years beginning after December 15, 2007. In February
2008, the FASB issued Staff
Position, or FSP, FAS
157-1, which provides supplemental guidance on the application of SFAS
No. 157, and FSP FAS 157-2, which delays the effective date of SFAS
No. 157 for nonfinancial assets and nonfinancial liabilities. We are
currently in the process of evaluating the impact that the adoption of SFAS
No. 157 will have on our financial position, results of operations and cash
flows.
In February 2007, the FASB issued SFAS
No. 159, “The Fair Value Option for Financial Assets and Financial
Liabilities,” or SFAS NO. 159. SFAS No. 159 permits companies to
choose to measure, on an instrument-by-instrument basis, many financial
instruments and certain other assets and liabilities at fair value that are not
currently required to be measured at fair value. SFAS No. 159 is effective
as of the beginning of a fiscal year that begins after November 15, 2007.
While we will not elect to adopt fair value accounting to any assets or
liabilities allowed by SFAS No. 159, we are currently in the process of
evaluating SFAS No. 159 and its potential impact to us.
In December 2007, the FASB issued SFAS
No. 141 (revised 2007), “Business Combinations,” or SFAS No. 141R. SFAS No. 141R
replaces SFAS No. 141, “Business Combinations.” SFAS No. 141R establishes principles and
requirements for how an acquiror recognizes and measures in its
financial statements the identifiable assets acquired, the liabilities assumed,
any noncontrolling interest in the acquiree, and the goodwill acquired or a gain
from a bargain purchase. SFAS No. 141R also determines disclosure
requirements to enable the evaluation of the nature and financial effects of the
business combination. SFAS
No. 141R applies
prospectively to business combinations for which the acquisition date is on or
after the beginning of a fiscal year that begins on or after December 15,
2008 and has implications for acquisitions that occur
prior to this date. We are currently in the process of evaluating the impact
that the adoption of SFAS
No. 141R will have on
our financial position, results of operations and cash
flows.
In December 2007, the FASB issued
SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements,” or SFAS No.
160. SFAS No. 160
amends Accounting Research
Bulletin 51, “Consolidated Financial
Statements,” or ARB 51, and requires all entities to report
noncontrolling (minority) interests in subsidiaries within equity in the
consolidated financial statements, but separate from the parent shareholders’
equity. SFAS No. 160 also requires any acquisitions or dispositions of
noncontrolling interests that do not result in a change of control to be
accounted for as equity transactions. Further, SFAS No. 160 requires that a
parent recognize a gain or loss in net income when a subsidiary is
deconsolidated. SFAS No. 160 is effective for fiscal years beginning on or
after December 15, 2008. We do not expect the adoption of SFAS No. 160 will
have a significant, if any,
impact on our financial
position, results of
operations and cash flows.
40
Revenues.>
Revenues are generated primarily from the sale of IP services, data center
services and CDN services. Our revenues typically consist of monthly recurring
revenues from contracts with terms of one year or more. These contracts usually
have fixed minimum commitments based on a certain level of usage with additional
charges for any usage over a specified limit. We also provide premise-based
route optimization products and other ancillary services, such as server
management and installation services, virtual private networking services,
managed security services, data back-up, remote
storage, restoration services, and professional services.
Direct costs of
network, sales and services. >Direct costs of network, sales and services
are comprised primarily of:
To the
extent a network access point is located a distance from the respective ISP, we
may incur additional local loop charges on a recurring basis. Connectivity costs
vary depending on customer demands and pricing variables while network access
point facility costs are generally fixed in nature. Direct costs of network,
sales and services do not include compensation, depreciation or
amortization.
Direct costs of
amortization of acquired technologies.> Direct costs of amortization of
acquired technologies are for technologies acquired through business
combinations that are an integral part of the services and products we sell. The
cost of the acquired technologies is amortized over original lives of three to
eight years.
Direct costs of
customer support>. Direct costs of customer support consist primarily of
compensation and other personnel costs for employees engaged in connecting
customers to our network, installing customer equipment into network access
point facilities, and servicing customers through our network operations
centers. In addition, facilities costs associated with the network operations
center are included in direct costs of customer support.
Product
development costs. >Product development costs consist principally of
compensation and other personnel costs, consultant fees and prototype costs
related to the design, development and testing of our proprietary technology,
enhancement of our network management software and development of internal
systems. Costs for software to be sold, leased or otherwise marketed are
capitalized upon establishing technological feasibility and ending when the
software is available for general release to customers. Costs associated with
internal use software are capitalized when the software enters the application
development stage until the software is ready for its intended use. All other
product development costs are expensed as incurred.
Sales and
marketing costs. >Sales and marketing costs consist of compensation,
commissions and other costs for personnel engaged in marketing, sales and field
service support functions, as well as advertising, tradeshows, direct response
programs, new service point launch events, management of our web site, and other
promotional costs.
General and
administrative costs. >General and administrative costs consist primarily
of compensation and other expense for executive, finance, human resources and
administrative personnel, professional fees, and other general corporate
costs.
41
The
following table sets forth, as a percentage of total revenue, selected statement
of operations data for the periods indicated:
Revenues>
Revenues
for the years ended December 31, 2007, 2006 and 2005 are summarized as follows
(in thousands):
Segment
information.> We have three business segments: IP services, data center
services and CDN services. IP services include managed and premise-based high
performance IP and route optimization technologies. Data center services include
hosting of customer applications directly on our network to eliminate issues
associated with the quality of local connections. Data center services are
increasingly bundled with our high performance IP connectivity services. CDN
services include products and services for storing, delivering and monetizing
digital media to large global audiences over the Internet. Prior to our
acquisition of VitalStream on February 20, 2007, we did not offer proprietary
CDN services, but instead, we were a reseller of third party CDN services
for which revenues and direct costs are included in other revenues and direct
costs of network, sales and services, discussed below.
42
Our
reportable segments are strategic business units that offer different products
and services. As of December 31, 2007, our customer base
totaled approximately 3,800 customers across more than 20 metropolitan
markets.
IP
services>. Revenue for IP services increased $10.1 million, or 9%, to
$119.9 million for the year ended December 31, 2007, compared to $109.7 million
for the year ended December 31, 2006. The increase in IP revenue is driven by an
increase in demand, partially offset by a decline in pricing, and an increase in
sales of our premise-based FCP products and other large hardware sales. We
continue to experience increasing demand for our traditional IP services, with
IP traffic for the year ended December 31, 2007 increasing approximately 35%
from the year ended December 31, 2006. The increase in IP traffic has resulted
from both existing and new customers requiring greater overall capacity due to
growth in the usage of their applications, as well as in the nature of
applications consuming greater amounts of bandwidth. In particular, we have
continued to add high-traffic customers through competitive IP pricing and
minimum commitments during the year ended December 31, 2007. New IP services
customers added approximately $1.7 million of revenue. Ongoing industry-wide
pricing declines over the last 12 months, however, offset a portion of our gains
in customers and IP traffic. The blended rate in megabits per second, or Mbps, decreased
approximately 23% annually from December 31, 2006 to December 31, 2007. We
recorded approximately $0.5 million of sales adjustments in the fourth quarter
of 2007 related predominantly to disputes over contractual service
periods.
Revenue
for IP services increased $4.7 million, or 5%, to $109.7 million for the year
ended December 31, 2006, compared to $105.0 million for the year ended December
31, 2005. This change is due to the increase in demand for IP traffic, partially
offset by declining prices. During the year ended December 31, 2006, IP traffic
over our networks increased approximately 83% from the year ended December 31,
2005. The increase in IP traffic has come as both existing and new customers
require greater overall capacity due to growth in the usage of their
applications as well as in the nature of applications consuming greater amounts
of bandwidth. In particular, we added a number of high-traffic customers through
competitive IP pricing and minimum commitments during the year ended December
31, 2006.
Data center
services.> Data center services are a significant source of revenue growth
for our business. Revenue for data center services increased $26.9 million, or
48%, to $83.1 million for the year ended December 31, 2007, compared to $56.2
million for the year ended December 31, 2006. During the year ended December 31,
2007, we (1) implemented a broad-based rate increase, generating additional
revenue of approximately $8.0 million, (2) began executing a data center growth
initiative and (3) completed the build-out of our Seattle
facility. The overall increase in revenue has resulted from both new
and existing customers, with new customers adding approximately $1.7 million of
revenue during 2007. The remaining increase is largely due to existing customers
using more space within our facilities, and the design and installation revenue
from new customers. We
have also structured our data center business to accommodate larger, global
customers and ensure a platform for robust traffic growth.
Revenue
for data center services increased $19.2 million, or 52%, to $56.2 million for
the year ended December 31, 2006, compared to $37.0 million for the year ended
December 31, 2005. The revenue increase is primarily attributable to growth in
new and existing data center customers. Revenue growth is facilitated in part by
the continued expansion of our available data center space and our continued
efforts to bundle our IP and data center services. The demand for data center
services has outpaced industry-wide supply, which has allowed us to increase the
overall pricing for the data center component of our pricing
models.
CDN
services>. Revenue for our CDN services segment was $17.7 million for the
year ended December 31, 2007. This activity represents the operations from our
acquisition of VitalStream, which we completed on February 20,
2007. Revenue for the year was slightly lower than originally anticipated as we
completed the integration of the VitalStream business with and into our network
and infrastructure. As previously noted, we did not offer proprietary
CDN services prior to our acquisition of VitalStream, but instead, we were a
reseller of third party CDN services, which is included in Other revenue,
below. We expect CDN to be an area of significant growth and have upgraded and
expanded related infrastructure, including in Europe and Asia, to serve the
expected industry-wide demand, particularly in those regions. In December 2007,
we extended our 100% uptime SLA to CDN services. In the
second half of 2007, the Company experienced platform instability in its CDN
business, which caused an increase in customer dissatisfaction and a higher than
historical amount of customer disputes over service billings. In the fourth
quarter of 2007, we recorded a total of appoximately $1.4 million in sales and
billing adjustments related to both service interruptions and disputes over
contractual service periods. These sales and billing adjustments have been
recorded against revenue. We have substantially completed integrating our
combined networks through technological improvements and systems integration
with operational stability achieved late in the year and expect this integration
to result in a decrease in performance-related adjustments in 2008.
43
Other>.
Other revenues primarily include reseller and miscellaneous services such
as third party CDN services, termination fee revenue, referral fees for other
hardware sales, and consulting services. Other revenues decreased substantially
as the revenue streams from our acquisition of VitalStream replaced the activity
of the former third party CDN service provider.
Direct
Costs of Network, Sales and Services (exclusive of depreciation and
amortization)
IP
services>. Direct costs of IP network, sales and services, exclusive of
depreciation and amortization, increased $3.9 million, or 10%, to $43.7 million
for the year ended December 31, 2007, compared to $39.7 million for the year
ended December 31, 2006. For the year ended December 31, 2006 compared to the
year ended December 31, 2005, the related direct costs increased $1.4 million,
or 4%, to $39.7 million as of December 31, 2006, compared to $38.4 million as of
December 31, 2005. While IP services revenue has increased, the
direct costs of IP network, sales and services has continued to be approximately
36% of IP services revenue for each of the last three years, even as we have had
a change in the mix of revenue with traditionally higher margin IP services,
lower margin high volume customers, and FCP and other hardware
sales. Connectivity costs vary based upon customer traffic and other
demand-based pricing variables. Costs for IP services are especially subject to
ongoing negotiations for pricing and minimum commitments. As our IP traffic
continues to grow, we expect to have greater bargaining power for lower
bandwidth rates and more opportunities to proactively manage network costs, such
as utilization and traffic optimization among network service
providers.
Data
center services.> The direct costs of data center services, exclusive of
depreciation and amortization, increased $13.0 million, or 28%, to $59.4 million
for the year ended December 31, 2007, compared to $46.5 million for the year
ended December 31, 2006. For the year ended December 31, 2006 compared to the
year ended December 31, 2005, the related direct costs increased $11.2 million,
or 32%, to $46.5 million as of December 31, 2006, compared to $35.2 million as
of December 31, 2005. As data center services revenue has increased, direct
costs of data center services as a percentage of corresponding revenue have
decreased to approximately 72%, 83% and 95% for the year ended December 31,
2007, 2006 and 2005, respectively. This trend is the result of an increase in
total occupancy at higher rates, as discussed with revenues above, while
substantial direct costs are subject to previously negotiated
rates. Direct costs of data center services, exclusive of
depreciation and amortization, have substantial fixed cost components, primarily
for rent, but also significant demand-based pricing variables, such as
utilities, which are highest in the summer for cooling the
facilities.
The
growth in data center services largely follows our expansion of data center
space. The demand for data center services is outpacing industry-wide supply,
which contributes to our improvement of data center direct costs as a percentage
of data center revenue. At December 31, 2007, we had approximately 179,000
square feet of data center space with a utilization rate of approximately
75%, as compared to approximately 149,000 square feet of data center space
with a utilization rate of approximately 79% at December 31, 2006. At December
31, 2005, we had approximately 124,000 square feet of data center space with a
utilization rate of approximately 76%. Our recent data center expansion has
resulted in the lower utilization rate as of December 31, 2007 compared to
December 31, 2006. However, the recent expansion should provide us lower costs
per occupied square foot in future periods, enabling us to increase revenue
compared to relatively lower direct costs of data center services. At
December 31, 2007, 104,000 square feet, or approximately 58% of total square
feet, was in data centers operated by us versus data centers operated by our
vendors, or partner sites. Additionally, approximately 62% of our available
square feet as of December 31, 2007 are in data centers operated by
us.
CDN
services>. Direct costs of network, sales and services, exclusive of
depreciation and amortization, for our CDN services segment were $6.6 million
for the year ended December 31, 2007. Direct costs of CDN network, sales and
services were approximately 37% of CDN services revenue for the year
ended December 31, 2007, which was a little more favorable than our initial
expectations. This activity represents the operations from our acquisition of
VitalStream, which was completed on February 20, 2007. The direct costs include
the benefit of lower rates throughout the year as we have migrated VitalStream’s
former contracts and terms to our own. Direct costs of CDN network sales and
services also includes an allocation of $0.7 million from direct costs of IP
network sales and services based on the average cost of actual usage by the CDN
segment. As previously noted, we did not offer proprietary CDN
services prior to our acquisition of VitalStream, but instead, we were a
reseller of third party CDN services, which is included in Other direct
costs, below. We expect CDN to be an area of significant growth and are
expanding related infrastructure, including in Europe and Asia, to serve the
expected industry-wide demand, particularly in those regions.
44
Other>.
Other direct costs of network, sales and services, exclusive of depreciation and
amortization primarily include reseller and miscellaneous services such as third
party CDN services and consulting services. These costs decreased substantially
as the revenue streams from our acquisition of VitalStream replaced the
activity of the former third party CDN service provider.
Other
Operating Expenses
Other
than direct costs of network, sales and services, compensation and
facilities-related costs have the most pervasive impact on operating
expenses. Compensation and benefits comprise the largest expenses
after direct costs of network, sales and services. Cash-basis compensation and
benefits increased $12.0 million to $53.4 million for the year ended December
31, 2007 from $41.4 million for the year ended December 31, 2006. Stock-based
compensation increased $2.8 million to $8.7 million for the year ended December
31, 2007 from $5.9 million for the year ended December 31, 2006. All of the
increases in compensation and benefits are primarily due to increased headcount,
largely attributable to the additional employees resulting from the VitalStream
acquisition. For the year ended December 31, 2007, the additional
VitalStream employees accounted for $6.6 million of the increase in cash-basis
compensation and $1.3 million of the increase in stock-based compensation.
Compensation also increased due to the hiring of other employees throughout the
Company, including at the senior management level. Total headcount increased to
420 at December 31, 2007 compared to 330 at December 31, 2006.
As
discussed in note 2 of the consolidated financial statements, we adopted SFAS
No. 123R on January 1, 2006. Accordingly, total operating costs and expense and
net income for 2007 and 2006 includes stock-based compensation expense in the
following amounts:
Total
unrecognized compensation costs related to non-vested stock-based compensation
as of December 31, 2007 was $26.9 million with a weighted-average remaining
recognition period of 2.8 years.
Cash-basis
compensation and benefits decreased $1.5 million to $41.4 million for the year
ended December 31, 2006 from $42.9 million for the year ended December 31, 2005,
which reflects a net decrease in salaries and wages and a decrease in employee
benefits, partially offset by a net increase in commissions. The decreases in
compensation and benefits reflect a consistent headcount of approximately 330
full-time employees for both 2006 and 2005, but favorable experience on
self-insured medical claims in 2006, while the increase in commissions is
revenue driven. Compensation for the year ended December 31, 2006 also includes
an increase of $1.8 million in employee bonuses over the year ended December 31,
2005.
Prior to
the adoption of SFAS No. 123R on January 1, 2006, we utilized the
disclosure-only provisions of SFAS No. 123 and accounted for stock-based
compensation plans under the recognition and measurement provisions of APB
Opinion No. 25 and related interpretations. Accordingly, we did not recognize
any expense for options to purchase our common stock with an exercise price
equal to fair market value at the date of grant for any periods prior to January
1, 2006.
45
Pro forma
stock-based compensation expense as previously reported for 2005 was $9.7
million. The decrease of $3.8 million in recorded stock-based compensation
expense for the year ended December 31, 2006 compared to the pro forma
stock-based compensation expense for the year ended December 31, 2005 is due
primarily to cancellations of outstanding stock options and the difference
between estimated and actual forfeitures. SFAS No. 123R requires compensation
expense to be recorded net of estimated forfeitures with a subsequent adjustment
to reflect actual forfeitures as they occur. Previously, forfeitures of unvested
stock options were accounted for on a pro forma basis as they were incurred,
generally resulting in higher pro forma stock compensation than under the
current provisions of SFAS No. 123R. In addition, a significant number of
unvested stock options were forfeited upon the resignation of Mr. Gregory
Peters, our former Chief Executive Officer, thus reducing the number of
outstanding stock options for determining comparative stock-based compensation
expense for the year ended December 31, 2006.
Overall,
facility and related costs, including repairs and maintenance, communications
and office supplies but excluding direct costs of network, sales and services,
increased $1.0 million, or 17%, to $7.0 million for the year ended December 31,
2007 compared to $6.0 million for the year ended December 31, 2006. The increase
is primarily due to $0.7 million of VitalStream post-acquisition operating
costs.
Facility and related costs
decreased $0.9 million, or 13%, to $6.0 million for the year ended December 31,
2006 compared $6.9 million for the year ended December 31, 2005. Facility costs
decreased $0.7 million in sales and marketing and $0.9 million in general and
administrative primarily through consolidation and cost containment
efforts.
Other
significant operating costs are discussed with the financial statement captions
below:
Direct
costs of amortization of acquired technologies
Direct
costs of amortization of acquired technologies increased $3.7 million from $0.5
million for the year ended December 31, 2006 to $4.2 million for the year ended
December 31, 2007. The increase in amortization expense is due to the
amortization of the post-acquisition intangible technology assets of
VitalStream.
Direct costs of
customer support>
Direct
costs of customer support increased 43% from $11.6 million for the year ended
December 31, 2006 to $16.5 million for the year ended December 31, 2007. The
increase of more than $4.9 million was primarily due to compensation of
employees and facilities-related costs as discussed above. VitalStream employees
accounted for $1.7 million of added cash-basis compensation and benefits and
$0.5 million of additional stock-based compensation for the year ended December
31, 2007. Other increases in cash-basis and stock-based compensation amounted to
$1.3 million and $0.3 million, respectively, whereas facilities-related costs
increased $0.6 million.
Direct
costs of customer support increased 8% from $10.7 million for the year ended
December 31, 2005 to $11.6 million for the year ended December 31, 2006. The
increase of $0.9 million was primarily due to increases in costs related to
stock-based compensation of $1.1 million, offset by decreased compensation and
employee benefits of $0.7 million, as discussed above. In addition, facilities
and related expenses increased $0.7 million based on more accurate data for
allocation of costs, primarily from sales and marketing.
Product
development
Product
development costs for the year ended December 31, 2007 increased 47% to $6.6
million from $4.5 million for the year ended December 31, 2006. The increase of
$2.1 million is primarily attributable to the addition of VitalStream employees
and facilities-related costs. For the year ended December 31, 2007, the
additional VitalStream employees accounted for $1.0 million of additional
cash-basis compensation and benefits costs and $0.3 million of additional
stock-based compensation costs. In addition, facilities-related costs amounted
to $0.3 million of this increase.
46
Product
development costs for the year ended December 31, 2006 decreased 8% to $4.5
million from $4.9 million for the year ended December 31, 2005. The decrease of
$0.4 million is attributable to decreases in costs related to compensation and
employee benefits of $0.5 million, outside professional services of $0.5 million
and training expenses of $0.1 million. The decreases were offset by an increase
in stock-based compensation expense of $0.6 million for the year ended December
31, 2006, as discussed above. The decrease in compensation and employee benefits
partially reflects the redeployment of technical resources from product support
to internal network support, which is accounted for in general and
administrative expense. The decrease in outside professional services is
primarily due to a specific project in 2005.
Sales
and marketing
Sales and
marketing costs for the year ended December 31, 2007 increased 16% to $31.5
million from $27.2 million for the year ended December 31, 2006. The increase of
more than $4.3 million is primarily comprised of VitalStream employee costs.
Cash-basis compensation, benefits and commissions related to VitalStream
employees accounted for $2.8 million and stock-basis compensation for these
employees amounted to $0.4 million for the year ended December 31,
2007.
Sales and
marketing costs for the year ended December 31, 2006 increased 5% to $27.2
million from $25.9 million for the year ended December 31, 2005. The net
increase of $1.3 million was primarily due to increases in stock-based
compensation expense of $2.1 million and commissions of $1.6 million, offset by
decreases in compensation and employee benefits expenses of $1.4 million, all of
which were discussed above. Also, as discussed with direct costs of customer
support above, facilities and related expenses decreased $0.7 million largely
due to more accurate data allocations of expenses to direct costs of customer
support. Outside professional services decreased $0.3 million and travel,
entertainment and training expenses decreased $0.2 million. The decreases in
outside professional services and training are the result of better utilization
of internal resources while the decrease in travel and entertainment resulted
from an effort to reduce less-essential travel. All of these reductions were
partially offset by an increase of $0.3 million in marketing and advertising
efforts during the year ended December 31, 2006.
General and
administrative>
General
and administrative costs for the year ended December 31, 2007 increased 47% to
$32.5 million from $22.1 million for the year ended December 31, 2006. The
increase of $10.4 million is primarily due to increases in cash-basis
compensation and benefits, professional services and stock-based compensation.
Cash-basis compensation and benefits for the year ended December 31, 2007
increased $3.6 million, including $1.0 million for the additional VitalStream
employees. As discussed earlier, the other cause for the increase in cash-basis
compensation is the hiring of other employees throughout the Company, including
at the senior management level. The overall increase in head-count caused us to
accrue employee bonuses $0.3 million higher during 2007 than we did for 2006 and
caused higher self-insured medical claims of $0.6 million compared to 2006.
Professional services for the year ended December 31, 2007 increased $2.0
million primarily due to consultation fees on our information technology
systems, compliance activities for domestic and international tax and financial
statement requirements, recruiting fees and contract labor to fill a number of
open job requisitions, and legal fees, including those associated with new proxy
disclosure requirements and ongoing litigation. Bad debt expense increased
approximately $1.7 million to $2.2 million for the year ended December 31,
2007. The increase in bad debt expense is due primarily to our
integration of VitalStream with their legacy customers causing bad debt expense
to be greater than our historical expense. Stock-based compensation
costs increased $1.7 million for the year ended December 31, 2007 due to annual
grants of stock options and unvested restricted common stock to non-employee
directors, the stock options assumed in the VitalStream acquisition and initial
grants and awards to new members of senior management.
General
and administrative costs for the year ended December 31, 2006 increased 10% to
$22.1 million from $20.1 million for the year ended December 31, 2005. The
increase of $2.0 million primarily reflects a $2.4 million increase in taxes
(non-income based), licenses, fees, a $2.1 million increase in stock-based
compensation expense, and a $1.1 million increase in compensation and employee
benefits. These increases were offset by decreases in outside professional
services of $0.9 million, bad debt expense of $0.9 million, facility and related
expense of $0.9 million, a reduction of insurance and administrative expense of
$0.3 million, and a reduction of training expense of $0.2 million. Part of the
increase in cash-basis compensation and benefits is the redeployment of
technical resources from product support as noted under the caption product
development above.
47
The
increases in compensation and benefits, including stock-based compensation, and
the decrease in facility-related costs are discussed above. In addition, the
decrease in outside professional services can be attributed to a number of
factors, including focused cost control and better utilization of internal
resources. Professional services for the year ended December 31, 2006 also
includes $0.6 million related to an abandoned corporate development
project.
Restructuring
and asset impairment
As
discussed in note 4 to the financial statements, we incurred a restructuring and
asset impairment charge of $10.3 million during the three months ended March 31,
2007. The charge was the result of a review of our business, particularly in
light of our acquisition of VitalStream and our plan to finalize the overall
integration and implementation plan before the end of the first quarter. The
charge to expense included $7.8 million for leased facilities, representing both
the costs less anticipated sublease recoveries that will continue to be incurred
without economic benefit to us and costs to terminate leases before the end of
their term. The charge also included severance payments of $1.1 million for the
termination of certain employees and $1.4 million for impairment of assets. Net
related expenditures were estimated to be $10.7 million, of which $2.8 million
has been paid during the year ended December 31, 2007, and the balance
continuing through December 2016, the last date of the longest lease
term. These expenditures are expected to be paid out of operating
cash flows. Cost savings from the restructuring were estimated to be
approximately $0.8 million per year through 2016, primarily for rent
expense.
We
incurred a $1.1 million impairment charge during the three months ended March
31, 2007 for the sales order-through-billing system, which was a result of an
evaluation of the existing infrastructure relative to our new financial
accounting system and the acquisition of VitalStream.
Depreciation
and amortization
For the
year ended December 31, 2007, depreciation and amortization, including other
intangible assets but excluding acquired technologies, increased 40% to $22.2
million compared to $15.9 million for the year ended December 31, 2006. The
increase of $6.4 million primarily relates to post-acquisition depreciation and
amortization of VitalStream property and equipment and acquired amortizable
intangible assets, excluding amortization of acquired technologies. The
VitalStream property and equipment and acquired amortizable intangible assets
account for $5.8 million of the expense for the year ended December 31,
2007. The remaining increase in depreciation and amortization relates
to the expansion of P-NAPs and on-going expansion of data center facilities. The
restructuring and asset impairment described above initially reduced
depreciation and amortization by approximately $0.4 million per year, decreasing
to $0 in 2009. The amortization of acquired technologies is included in its own
caption and discussed above.
Depreciation
and amortization, including other intangible assets, for the year ended December
31, 2006 increased 8% to $15.9 million compared to $14.7 million for the year
ended December 31, 2005. The increase of $1.2 million was primarily attributed
to an increased depreciable base of assets as we upgraded our P-NAP facilities
and continue to expand our data center facilities.
48
Write-off
of investment
We
incurred a charge of $1.2 million representing the write-off of the remaining
carrying value of our investment in series D preferred stock of Aventail
Corporation, or Aventail. We made an initial cash investment of $6.0 million in
Aventail series D preferred stock pursuant to an investment agreement in
February 2000. In connection with a subsequent round of financing by Aventail,
we recognized an initial loss on our investment of $4.8 million in 2001. On June
12, 2007, SonicWall, Inc. announced that it entered into an agreement to acquire
Aventail for approximately $25.0 million in cash. The transaction closed on July
11, 2007, and all shares of series D preferred stock were cancelled and the
holders of series D preferred stock did not receive any consideration for such
shares. The write-off is included in non-operating (income) expense in the
accompanying consolidated statement of operations.
Income
taxes
The
provision for income taxes was a net benefit of $3.1 million for the year ended
December 31, 2007 and expense of $0.1 million for the year ended December 31,
2006. For the year ended December 31, 2007,
the tax provision includes
a $4.4 million benefit related to the release of the valuation allowance associated with
our U.K. deferred tax assets. The U.K. benefit is offset by a reserve of $0.9
million and a U.S. deferred tax liability relating to the
VitalStream acquisition.
The reduction in valuation allowance was due to
the existence
of sufficient positive
evidence as of December 31,
2007 to indicate that
our net operating losses in the U.K. would more likely than not be realized in the
future. The evidence primarily consists of the results of prior performance
in the U.K. and the expectation of future
performance based on historical results. We will continue to assess in the future the recoverability of
U.S. and other deferred tax assets, and whether or not the valuation
allowance should be reduced relative to the U.S. and other deferred tax assets outside
the U.K.
Cash
Flows for the Years Ended December 31, 2007, 2006 and 2005
Net
cash from operating activities.
Net cash
provided by operating activities was $27.6 million for the year ended December
31, 2007. Our net loss, adjusted for non-cash items, generated cash
from operations of $32.1 million while changes in operating assets and
liabilities, excluding effects of the VitalStream acquisition, represented a use
of cash from operations of $4.5 million. The primary non-cash
adjustment was $26.4 million for depreciation and amortization, which includes
the amortizable intangible assets acquired through the acquisition of
VitalStream on February 20, 2007 and the expansion of our P-NAP and data center
facilities throughout 2007. Non-cash adjustments also include $8.7 million for
stock-based compensation expense, which is discussed above in the section
captioned “Results of Operations.” The change in working capital includes an
increase in accounts receivable of $15.8 million. The increase in accounts
receivable results in quarterly days sales outstanding at December 31, 2007
increasing to 54 days from 38 days as of December 31, 2006. This
increase in accounts receivable is largely due to revenue growth and also, in
part, our day sales outstanding trending up from lower than historical levels at
December 31, 2006. We have also experienced some collection delays on
certain larger, high credit quality customers that tend to pay over longer terms
and in conjunction with the migration of some former VitalStream and other
customers to Internap billing and systems platforms. We expect our quarterly
days sales outstanding to improve over the next several quarters. The change in
working capital also includes a net increase in accounts payable of $7.9 million
due to the growth of our business, primarily attributed to the acquisition of
VitalStream and our data center growth initiative. A portion of the increase is
also caused by the implementation near year-end of a new telecommunications
expense management system for our direct costs. We do not expect this
implementation to have an impact on our accounts payable balance in the future.
We anticipate continuing to generate cash flows from our results of operations,
that is net income (loss) adjusted for non-cash items and manage changes in
operating assets and liabilities towards a net $0 change over time in subsequent
periods. We also expect to use cash flows from operating activities
to fund a portion of our capital expenditures and other requirements, to repay
our outstanding debt as it becomes due and to meet our other commitments and
obligations as they become due.
49
Net cash
provided by operating activities was $29.6 million for the year ended December
31, 2006, and was primarily due to net income of $3.7 million adjusted for
non-cash items of $25.4 million offset by changes in working capital items of
$0.5 million. The changes in working capital items include net use of cash for
accounts receivable of $1.7 million, inventory, prepaid expense and other assets
of $1.8 million, and accrued restructuring of $1.5 million. These were offset by
net sources of cash in accounts payable of $3.0 million, accrued liabilities of
$1.4 million and deferred revenue of $1.1 million. The increase in receivables
at December 31, 2006 compared to December 31, 2005 was related to the 18%
increase in revenue. Quarterly days sales outstanding at December 31, 2006
decreased to 38 days from 43 days as of December 31, 2005. The
increase in payables is primarily related to the timing of payments with the
2006 balance being consistent with our normal operating expenses and payment
terms.
Net cash
provided by operating activities was $5.5 million for the year ended December
31, 2005, and was primarily due to the net loss of $5.0 million adjusted for
non-cash items of $19.7 million offset by changes in working capital items of
$9.3 million. The changes in working capital items include net use of cash for
accounts payable of $5.4 million, accounts receivable of $3.6 million, accrued
restructuring of $1.9 million, and $0.2 million of inventory, prepaid expense
and other assets. These were offset by net sources of cash in accrued
liabilities of $0.8 million and deferred revenue of $1.0 million. The increase
in receivables at December 31, 2005 compared to December 31, 2004 was related to
the 6% increase in revenue. The decrease in payables is primarily related to a
general decrease in expenses when compared to last year.
Net cash
used in investing activities for the year ended December 31, 2007 was $36.4
million primarily due to capital expenditures of $30.3 million and net purchases
of short-term investments of $6.1 million. Our capital expenditures were
principally for the expansion of our data center facilities, CDN infrastructure
and upgrading our P-NAP facilities and were funded from both cash from
operations and borrowings from the new credit agreement we entered into on
September 14, 2007. We discuss the credit agreement in greater detail in the
section below captioned “Liquidity.” Our forecast for capital
expenditures in 2008 ranges from $45 - $50 million. However, our
credit agreement, discussed below, limits us to unfunded capital expenditures of
$25.0 million per year. Investing activities for the year ended December 31,
2007 also includes purchases and sales of auction rate securities. While we have
noted auction rate reset failures in the market and have experienced our own
auction rate reset failures subsequent to year-end, we do not expect to incur
any significant liquidity constraints in the current auction rate securities
market and anticipate that, based on the nature of the underlying assets, we
will be able to recover the full cost basis of the assets within one
year.
Net cash
used in investing activities for the year ended December 31, 2006 was $10.4
million primarily due to capital expenditures of $13.4 million. Our capital
expenditures were principally for upgrading our P-NAP facilities and the
expansion of our data center facilities.
Net cash
used in investing activities for the year ended December 31, 2005 was $9.4
million primarily due to capital expenditures of $10.2 million. Our capital
expenditures were principally comprised of leasehold improvements related to the
upgrade of several data center facilities.
Net
cash from financing activities.
Net cash
provided by financing activities for the year ended December 31, 2007 was $15.2
million. Cash provided by financing activities was primarily due to proceeds
from note payable of $19.7 million, net of discount, and proceeds from stock
compensation plan activity of $8.6 million, partially offset by the repayment of
prior outstanding debt of $11.3 million and payments on capital leases of $1.6
million. The proceeds from note payable were a result of entering into the new
credit agreement on September 14, 2007. As a result of these
activities, we had balances of $19.8 million in a note payable (net of discount)
and $1.3 million in capital lease obligations as of December 31, 2007 with $3.2
million in the note payable and capital leases scheduled as due within the next
12 months. While we anticipate funding a large portion of our capital
expenditures by drawing down on our credit facility, we expect to meet most of
our cash requirements, including repayment of debt as it becomes due, through
cash from operations, and as needed, cash on hand and short-term
investments. We may also utilize our revolving line of credit if we
consider it economically favorable to do so.
50
Net cash
provided by financing activities for the year ended December 31, 2006 was $2.0
million. Cash provided by financing activities was primarily due to proceeds
from stock options, employee stock purchase plan and exercise of warrants of
$6.8 million offset by principal payments on a note payable of $4.4 million and
payments on capital lease obligations of $0.5 million. As a result of these
activities, we had balances of $7.7 million in a note payable and $0.4 million
in capital lease obligations as of December 31, 2006 with $4.7 million in the
note payable and capital leases scheduled as due within the next 12
months.
Net cash
used in financing activities for the year ended December 31, 2005 was $5.5
million. Cash used in financing activity included principal payments on notes
payable of $6.5 million and payments on capital lease obligations of $0.5
million. These payments were partially offset by proceeds received from the
exercise of stock options of $1.5 million. As a result of these activities, we
had balances of $12.0 million in notes payable and $0.8 million in capital lease
obligations as of December 31, 2005.
We
recorded a net loss of $5.6 million of the year ended December 31, 2007 and net
income of $3.7 million for the year ended December 31, 2006. As of December 31,
2007, our accumulated deficit was $862.0 million. Our net loss for the year
ended December 31, 2007 includes $13.0 million in charges for restructuring,
asset impairment, write-off of an investment, and acquired in-process research
and development, none of which we expect to incur on a regular basis. We cannot
guarantee that we will return to profitability given the competitive and
evolving nature of the industry in which we operate. We may not be able to
sustain or increase profitability on a quarterly basis, and our failure to do so
would adversely affect our business, including our ability to raise additional
funds.
We expect
to meet our cash requirements in 2008 through a combination of net cash provided
by operating activities, existing cash, cash equivalents and short-term
investments in marketable securities, and borrowings under our credit agreement,
especially for capital expenditures. We expect to incur these capital
expenditures primarily for the expansion of our P-NAP and data center
facilities. We may also utilize our revolving line of credit, particularly if we
consider it economically favorable to do so. Our capital requirements depend
on a number of factors, including the continued market acceptance of our
services and products, the ability to expand and retain our customer base and
other factors. If our cash requirements vary materially from those currently
planned, if our cost reduction initiatives have unanticipated adverse effects on
our business or if we fail to generate sufficient cash flows from the sales of
our services and products, we may require greater or additional financing sooner
than anticipated. We can offer no assurance that we will be able to obtain
additional financing on commercially favorable terms, or at all, and provisions
in our existing credit agreement limit our ability to incur additional
indebtedness. We believe we have sufficient cash to operate our business for the
foreseeable future.
Short-term
investments. >Short-term investments primarily consist of high
credit quality corporate debt securities, auction rate securities whose
underlying assets are state-issued student and educational loans which are
substantially backed by the federal government, commercial paper, and U.S.
Government Agency debt securities. At December 31, 2007, our balance in
short-term investments was $19.6 million, of which $7.2 million were auction
rate securities carrying AAA/Aaa ratings as of December 31,
2007. Auction rate securities are variable rate bonds tied to
short-term interest rates with maturities on the face of the securities in
excess of 90 days and have interest rate resets through a modified Dutch
auction, at predetermined short-term intervals, usually every 7, 28 or 35
days. They generally trade at par and are callable at par on any
interest payment date at the option of the issuer. Interest received
during a given period is based upon the interest rate determined through the
auction process. Although these securities are issued and rated as
long-term bonds, they are priced and traded as short-term instruments because of
the liquidity provided through the interest rate reset. We have also
noted auction rate reset failures in the market and have experienced our own
auction rate reset failures subsequent to year-end, however, we do not expect to
incur any significant liquidity constraints and anticipate that, based on the
nature of the underlying assets, we will be able to recover the full cost basis
of the assets within one year. We expect to hold the auction rate securities
until liquidity improves or the borrower calls the underlying securities. All
short-term investments either (1) have original maturities greater than 90 days
but less than one year or (2) are auction rate securities expected to be
liquidated within one year, are classified as available for sale, and reported
at fair value.
51
Credit agreement.
> On September 14, 2007, we entered into a $35.0 million credit
agreement, or the Credit Agreement, with Bank of America, N.A., as
administrative agent, and lenders who may become a party to the Credit Agreement
from time to time. VitalStream Holdings, Inc., VitalStream, Inc.,
PlayStream, Inc., and VitalStream Advertising Services, Inc., four of our
subsidiaries, are guarantors of the Credit Agreement.
The
Credit Agreement replaced the prior credit agreement, a $5.0 million
revolving credit facility and a $17.5 million term loan, which was evidenced by
a Loan and Security Agreement between the Company and Silicon Valley Bank that
was last amended on December 27, 2005. We paid off and terminated
this prior credit agreement concurrently with the execution of the Credit
Agreement.
Our
obligations under the Credit Agreement are pledged, pursuant to a pledge and
security agreement and an intellectual property security agreement by a security
interest granted in substantially all of our assets including the capital stock
of our domestic subsidiaries and 65% of the capital stock of our foreign
subsidiaries.
The
Credit Agreement provides for a four-year revolving credit facility, or the
Revolving Credit Facility, in the aggregate amount of up to $5.0 million which
includes a $5.0 million sub-limit for letters of credit. With the
prior approval of the administrative agent, we may increase the total
commitments by up to $15.0 million for a total commitment under the Revolving
Credit Facility of $20.0 million. The Revolving Credit Facility is
available to finance working capital, capital expenditures and other general
corporate purposes. As December 31, 2007, no amounts were outstanding on the
Revolving Credit Facility.
The
Credit Agreement also provides for a four-year term loan, or the Term Loan, in
the amount of $30.0 million. We borrowed $20.0 million concurrently
with the closing and used a portion of the proceeds from the Term Loan to pay
off our prior credit facility. We intend to use the remaining
proceeds to fund capital expenditures related to the expansion of our data
center facilities.
The
interest rate on the Revolving Credit Facility and Term Loan is a tiered
LIBOR-based rate that depends on our 12-month trailing EBITDA. As of December
31, 2007, the interest rate was 7.075%.
We will
only pay interest on the Term Loan during the first 12 months of its four-year
term. Commencing on the last day of the first calendar quarter after
the first anniversary of the closing, the outstanding amount of the Term Loan
will amortize on a straight-line schedule with the payment of 1/16 of the
original principal amount of the Term Loan due quarterly. We will pay
all unpaid amounts at maturity, which is September 14, 2011.
The
Credit Agreement includes customary representations, warranties, negative and
affirmative covenants, including certain financial covenants relating to net
funded debt to EBITDA ratio and fixed charge coverage ratio, as well as
customary events of default and certain default provisions that could result in
acceleration of the Credit Agreement. As of December 31, 2007, we
were in compliance with the
financial and other covenants.
The net
proceeds received from the Term Loan were reduced by $0.3 million for fees paid
to Bank of America and its agents. We treated these fees as a debt discount and
will amortize the fees to interest expense using the interest method over the
term of the loan. We recorded less than $0.1 million of related amortization
during the year ended December 31, 2007. As of December 31, 2007, the balance on
the Term Loan, net of the discount, was $19.8 million. We incurred other costs
of less than $0.1 million in connection with entering into the Credit Agreement,
which were recorded as debt issue costs and will amortize over the term of the
Credit Agreement.
52
As a
result of the transactions discussed above, we recorded a loss on extinguishment
of debt of less than $0.1 million during the year ended December 31, 2007. The
loss on extinguishment of debt is included in Other, net in the non-operating
(income) expense section of the consolidated statements of
operations.
Also
during the year ended December 31, 2007, we paid off the term loans and line of
credit issued pursuant to the loan and security agreement assumed in the
VitalStream acquisition.
Capital
leases.> Our future minimum lease payments on remaining capital lease
obligations at December 31, 2007 totaled $1.4 million.
Commitments and
other obligations.> We have commitments and other obligations that are
contractual in nature and will represent a use of cash in the future unless
there are modifications to the terms of those agreements. Network commitments
primarily represent purchase commitments made to our largest bandwidth vendors
and contractual payments to license data center space used for resale to
customers. Our ability to improve cash used in operations in the future would be
negatively impacted if we do not grow our business at a rate that would allow us
to offset the service commitments with corresponding revenue
growth.
Common
and preferred stock. >Our
Certificate of Incorporation includes designation for 3.5 million shares of
preferred stock, which includes 0.5 million shares of series B preferred stock.
As of December 31, 2007, no shares of preferred stock were issued or
outstanding.
We issued
approximately 12.2 million shares of our common stock to the former stockholders
of VitalStream in connection with the acquisition, which closed on February 20,
2007.
On July
10, 2006, we implemented a one-for-ten reverse stock split and amended our
Certificate of Incorporation to reduce our authorized shares from 600 million to
60 million. We began trading on a post-reverse split basis on July 11, 2006. All
share and per share information herein (including shares outstanding, earnings
per share and warrant and stock option data) have been retroactively adjusted
for all periods presented to reflect this reverse split.
53
In June
2006, our stockholders approved a measure to reprice certain outstanding options
under our existing equity incentive plans. Options with an exercise price per
share greater than or equal to $13.00 were eligible for the repricing. The
repricing was implemented through an exchange program under which eligible
participants were offered the opportunity to exchange their eligible options for
new options to purchase shares. Each new option had substantially the same terms
and conditions as the eligible options cancelled except as follows:
As discussed
in note 15 to the consolidated financial statements, warrants to purchase
approximately 34,000 shares of our common stock at a weighted exercise price of
$9.50 per share were outstanding as of December 31, 2007.
Short-term
investments in marketable securities>. Short-term investments primarily
consist of high credit quality corporate debt securities, auction rate
securities whose underlying assets are state-issued student and educational
loans which are substantially backed by the federal government, commercial
paper, and U.S. Government Agency debt securities. All of our investments have
original maturities greater than 90 days but less than one year, except for
investments in auction rate securities, further discussed below. All short-term
investments are classified as available for sale and reported at fair value. Due
to the short-term nature of our investments in marketable securities, we do not
believe there is any material exposure to market risk changes in interest
rates. We estimate that a change in the effective yield of 100
basis points would change our interest income by less than $0.2 million per
year.
Auction
rate securities are variable rate bonds tied to short-term interest rates with
maturities on the face of the securities in excess of 90 days and have interest
rate resets through a modified Dutch auction, at predetermined short-term
intervals, usually every 7, 28 or 35 days. Auction rate securities
generally trade at par and are callable at par on any interest payment date at
the option of the issuer. Interest received during a given period is
based upon the interest rate determined through the auction
process. Although these securities are issued and rated as long term
bonds, they are priced and traded as short-term instruments because of the
liquidity provided through the interest rate resets. Uncertainties in
the credit markets may affect the liquidity of our holdings in auction rate
securities. We did not experience any unsuccessful auction rate
resets during the year ended or the initial rate resets immediately following
December 31, 2007, however, we have experienced failures on each of our
subsequent auction rate resets. Nevertheless, we continue to receive
interest every 28-35 days. While our investments are of high credit quality, at
this time we are uncertain as to whether or when the liquidity issues relating
to these investments will worsen or improve. We do not expect to incur any
significant liquidity constraints and anticipate that, based on the nature of
the underlying assets, we will be able to recover the full cost basis of the
assets within one year. Therefore, we do not believe that adjusting
the fair value of our portfolio of auction rate securities is necessary at this
time. We expect to hold the auction rate securities until liquidity improves or
the borrower calls the underlying securities. In the meantime, we believe we
have sufficient liquidity through our cash balances, other short-term
investments and available credit. As of December 31, 2007, we have a total of
$7.2 million invested in auction rate securities.
54
Other
investments>. We have invested $4.1 million in Internap Japan, our joint
venture with NTT-ME Corporation and NTT Holdings. We account for this investment
using the equity-method and to date we have recognized $3.3 million in
equity-method losses, representing our proportionate share of the aggregate
joint venture losses and income. Furthermore, the joint venture investment is
subject to foreign currency exchange rate risk. The market for services offered
by Internap Japan has not been proven and may never materialize.
| |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||