Internap Network Services 10-K 2010
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
For the fiscal year ended December 31, 2009
For the transition period from ________ to ________.
Commission file number: 000-31989
INTERNAP NETWORK SERVICES CORPORATION
(Exact Name of Registrant as Specified in Its Charter)
(Registrant’s telephone number, including area code)
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 whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o 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/A or any amendment to this Form 10-K/A. x
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 $173,352,170 based on a closing price of $3.49 on June 30, 2009, as quoted on the NASDAQ Global Market.
As of February 19, 2010, 50,950,851 shares of the registrant’s common stock, par value $0.001 per share, were issued and outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Part III—Portions of the registrant’s definitive Proxy Statement for the Annual Meeting of Stockholders to be filed with Securities and Exchange Commission within 120 days after the end of our 2009 fiscal year. Except as expressly incorporated by reference, the registrant’s Proxy Statement shall not be deemed to be a part of this report on Form 10-K.
TABLE OF CONTENTS
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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, or the Exchange Act. 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 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 our beliefs and expectations after consideration of 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 us that could cause or contribute to such differences include, but are not limited to, those set forth in this Form 10-K 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,” “Internap” or the “Company” refer to Internap Network Services Corporation.
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 is (404) 302-9700. Our common stock trades on the NASDAQ Global Market under the symbol “INAP.” Our website address is www.internap.com.
We are an Internet solutions and data center company providing a suite of network optimization and delivery services and products that manage, deliver and distribute applications and content with a 100% availability service level agreement, as well as a global provider of secure and reliable data center services. We help our customers innovate their business, improve service levels and lower the cost of information technology operations. Our services and products, combined with progressive and proactive technical support, enable our customers to migrate business-critical applications from private to public networks.
We provide services through 73 Internet Protocol, or IP, service points, which include 20 content delivery network, or CDN, points of presences, or POPs, and 47 data centers across North America, Europe and the Asia-Pacific region. We also have two additional international standalone CDN POPs and two additional domestic standalone data center locations through which we provide IP services by extension. However, through December 31, 2009, neither revenues generated nor long-lived assets located outside the United States were significant (all less than 10%).
Our Private Network Access Points, or P-NAPs, feature multiple direct high-speed connections to major Internet backbones, also referred to as network service providers, or NSPs, such as Verizon Communications Inc.; Global Crossing Limited; Level 3 Communications, Inc.; XO Holdings Inc.; and Cogent Communications Group, Inc. We operate in two business segments: IP services and data center services. These segments reflect a change from our historical segments, which also included CDN services as a separate segment. We now operate our IP services and the majority of our CDN services on a combined basis while we operate the managed hosting portion of our CDN services as part of our data center services. We discuss the determination of and changes in our business segments below in “Segments” and in notes 2 and 4 to the accompanying consolidated financial statements.
Our intelligent routing technology facilitates traffic over multiple carriers, as opposed to just one carrier’s network, to ensure highly-reliable performance over the Internet. Our data center, or colocation, services allow us to expand the reach of our high performance IP services to customers who wish to take advantage of locating their network and application assets in secure, high-performance facilities. We believe that 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 multiple networks and a broader segment of the Internet in the United States, excluding local connections, than providers of conventional Internet connectivity which typically only guarantee performance on their own network.
On February 20, 2007, we closed the acquisition of VitalStream in an all-stock transaction accounted for using the purchase method of accounting for business combinations. Our results of operations include the activities of VitalStream from February 21, 2007 through December 31, 2009.
We currently have approximately 2,900 customers across more than 25 metropolitan markets, serving a variety of industries, including entertainment and media, financial services, healthcare, travel, e-commerce, retail and technology.
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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 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 and routing protocols. Each network must connect to one another 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 and private network access points.
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 over the Internet. An ISP will often route the data from private connections, or peered 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 own transport network. Once the origination traffic leaves the network of an ISP, SLAs with that ISP typically do not apply since that carrier cannot control the quality of service on the network of another ISP. Consequently, 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. The quality of service can be further degraded by basic routing protocols that make assumptions about the “best” path or network to route traffic to, without consideration of the performance of that network. Equally important, 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.
The Problem of Poor Application Performance over Distant Network Paths
The major application protocols often utilized over data networks perform poorly under congestion when network latency is high or network paths are subject to packet and data loss. These applications may timeout, reset or cause user frustration and abandonment of an activity or session. Network latency, a measure of time it takes data to travel between two network points, 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, potentially resulting in lower effective throughput. Additionally, longer distances typically result in more network hops, or data transition points, and may increase the likelihood of encountering congestion. As a result, business application performance and resultant user experience may degrade.
The Growing Importance of the Internet for Business-Critical Internet-Based Applications
The Internet is used as a communications platform for an increasing number of business-critical Web- and Internet-based applications, such as those relating to electronic commerce, Voice over IP, or VoIP, supply chain management, customer relationship management, project coordination, streaming media and video conferencing and collaboration. Businesses are redesigning their information technology operations models to take advantage of new, more cost-effective application delivery models, such as software-as-a-service, hosting and cloud computing. In all cases, these new delivery models rely on the Internet as the primary means of communicating with customers and users, and result in enhanced expectations of performance, availability and transparent delivery for the business application to work as expected.
Businesses often 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, video conferencing and streaming, multimedia document distribution and streaming and audio and video conferencing and collaboration, are hindered by inconsistent performance. We believe that companies 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 lead the market for Internet services. We believe that our patented route optimization technologies facilitate such superior performance by mitigating the factors that inhibit efficient movement of traffic as described above.
The Growing Demand for Secure and Reliable Data Center Environments
Businesses and organizations continue to move more data, applications and operations online, creating a demand for secure and reliable data center environments. Many companies do not have the capital dollars or the time to manage ongoing data center space and power requirements for their business. As a result, we provide companies secure, offsite environments for their equipment or an outsourced hosting service for their applications and business-critical websites. Our data centers improve a company’s ability to directly connect to NSPs, which avoids local loops and mitigates online risk. As our customers’ business models evolve to leverage rich media content, we help them stream it globally, and as their media library grows we provide scalable, secure storage for their content.
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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 delivery network, or CDN. Because of the inherent 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, ISPs have maintained at-will agreements to deliver Internet traffic on a “best efforts” basis without guaranteeing various levels of quality of service on other networks. 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.
We believe we are well positioned through our patented and patent-pending network route optimization technologies and data center services to help businesses overcome the inherent limitations and unpredictable performance of the Internet. This is especially relevant for companies that use the Internet as a core component of their business operations such as direct sales, supply chain and collaboration strategies or rely on the Internet to reach global partners, suppliers and customers. This changing landscape, combined with an increasingly dispersed workforce and the adoption of emerging technologies, including VoIP and streaming media, has increased the need for fast, reliable connectivity and delivery of content-rich media. Additionally, the emergence of bandwidth-intensive video and the general and rapid increase of digital information creation and delivery will further drive the need for highly-available and performance-optimized network transport service.
Our suite of technology services and products increase reliability, decrease network latency and optimize routing to enable customers to effectively leverage the Internet to promote productivity, decrease transactional costs and generate new revenue streams.
During the year ended December 31, 2009, we changed how we view and manage our business. We now operate our IP services and the majority of our CDN services on a combined basis while we operate the managed hosting portion of our CDN services as part of our data center services. The change from our historical segments reflects management’s views of the business and aligns our segments with our operational and organizational structure. We have integrated the primary components of our CDN services with our IP services in the IP services segment. This includes integration of our CDN POPs into our P-NAPs along with combining engineering and operations teams and internal financial reporting. In addition, a single manager reports directly to our chief executive officer for the integrated IP services. Historically, CDN services also included managed hosting, or maintaining network equipment on behalf of customers. Since these CDN services are a hosting activity, they are more similar to our data center services, and therefore we have included these services in our data center services segment. We have reclassified financial information for prior periods to conform to the current period presentation.
We discuss the determination of and changes in our business segments below in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Segment Information.”
IP services represent our IP transit activities and include our high-performance Internet connectivity, CDN services and flow control platform, or FCP, products.
Our patented and patent-pending network route optimization technologies address the inherent weaknesses of the Internet, allowing businesses to take advantage of the convenience, flexibility and reach of the Internet to connect to customers, suppliers and partners, and to adopt new information technology delivery models, in a reliable and predictable manner. Our services and products take into account the unique performance requirements of each business application to ensure performance as designed, without unnecessary cost. When recommending an appropriate network solution for our customers’ applications, we consider key performance objectives such as bandwidth capacity needed, expected bandwidth usage, location of services and cost objectives. Our fees for IP services are based on a fixed-fee, usage or a combination of both.
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Our CDN services enable our customers to quickly and securely stream and distribute rich media and content, such as video, audio software and applications to audiences across the globe through strategically located data POPs. Providing capacity-on-demand to handle large events and unanticipated traffic spikes, we deliver high-quality content regardless of audience size or geographic location and the analytic tool to allow our customers to refine their marketing programs.
Our FCP products are a premise-based intelligent routing hardware product for customers who run their own multiple network architectures, known as multi-homing. The FCP functions similarly to our P-NAP. 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.
Data Center Services
Data center, or colocation, services primarily include physical space for hosting customers’ network and other equipment plus associated services such as redundant power and network connectivity, environmental controls and security and the managed hosting portion of CDN services. Throughout this Annual Report on Form 10-K, we refer to data center services and colocation services interchangeably.
Our data center services allow us to expand the reach of our high performance IP services to customers who wish to take advantage of locating their network and application assets in secure, high-performance facilities. 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 content delivery, along with hosting customers’ applications. Our data center services provide a single source for network infrastructure, IP connectivity 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 also provide a managed hosting solution that leverages our IP services. With this service, our customers own and manage the software applications and content, while we provide and maintain the hardware, operating system, colocation and bandwidth.
We use a combination of facilities operated by us and by third parties, referred to as company-controlled facilities and partner sites, respectively. We offer a comprehensive solution at 49 service points, consisting of nine company-controlled facilities and 40 partner sites, summarized below. We charge monthly fees for data center services based on the amount of square footage and power that the customers use. We also have relationships with various data center providers to extend our P-NAP model into markets with high demand.
During 2009, we established Statement on Auditing Standards No. 70, or SAS 70, Type II compliance over controls and processes in our company-controlled data centers. SAS 70 Type II compliance provides assurances that controls and processes around our data center security and environmental protection have been suitably designed and are operating effectively to protect and safeguard customers’ equipment and data. The underlying providers for several of our partner data centers also maintain SAS 70 Type II compliance.
Other revenues and direct costs of network, sales and services during the year ended December 31, 2007 consisted of third-party CDN services. Throughout 2007, other revenues and direct costs of network, sales and services decreased steadily as the revenue streams from our acquisition of VitalStream replaced the activity of the former third-party CDN service provider.
Network Access Points, Points of Presence and Data Centers
We provide our services through our network access points across North America, Europe and the Asia-Pacific region. Our P-NAPs and data centers feature multiple direct high-speed connections to major Internet backbones, also referred to as network service providers or NSPs, such as Verizon Communications Inc.; Global Crossing Limited; Level 3 Communications, Inc.; XO Holdings Inc.; and Cogent Communications Group, Inc. We provide access to the Internet for our CDN customers through our CDN POPs. As of December 31, 2009, we provided services worldwide through 73 IP service points, which includes 20 CDN POPs and 47 data centers. We also have two additional international standalone CDN POPs and two additional domestic standalone data center locations through which we provide IP services by extension. We directly operate nine of these data center sites and have operating agreements with third parties for the remaining locations. We have P-NAPs, CDN POPs and/or data centers in the following markets, some of which have multiple sites:
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We are dependent upon the NSPs noted above as well as other ISPs, telecommunications carriers and vendors in the United States, Europe and Asia-Pacific region.
Financial Information about Geographic Areas
For each of the three years in the period ended December 31, 2009, we derived less than 10% of our total revenues from 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 an office in the United Kingdom, or U.K.
Our sales and service organization includes approximately 82 employees in direct and channel sales, professional services, account management and technical consulting. As of December 31, 2009, we had approximately 48 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 advertising, participation at trade shows, direct response programs, new service point launch events, an active public relations campaign and continuing customer communications. As of December 31, 2009, we had four employees in our marketing department.
Research and Development
Research and development costs, which we include in general and administrative cost and expense as incurred, primarily consist of compensation related to our development and enhancement of IP routing technology, progressive download and streaming technology for our CDN, acceleration and cloud technologies. Acceleration technologies improve the performance (throughput) of applications that depend upon IP for network transport. Cloud technologies enable the delivery of on-demand, scalable service consumption with self-service and automated subscription, management, provisioning and billing capabilities. Product development costs, which we also include in general and administrative cost and expense as incurred, are primarily related to network engineering costs associated with changes to the functionality of our proprietary services and network architecture. Research and development costs were $3.8 million, $5.0 million and $3.1 million during the years ended December 31, 2009, 2008 and 2007, respectively. These costs do not include $0.9 million, $1.4 million and $1.6 million in internal software development costs capitalized during the years ended December 31, 2009, 2008 and 2007, respectively. We also expense as incurred those costs that do not qualify for capitalization as software development costs.
As of December 31, 2009, we had approximately 2,900 customers. We provide services to customers in multiple vertical industry segments including entertainment and media, financial services, healthcare, travel, e-commerce, retail and technology; however, our customer base is not concentrated in any particular industry. In each of the past three years, no single customer accounted for 10% or more of our net revenues. Similarly, in each of the past three years, we did not derive any significant amounts of revenue from contracts or subcontracts terminable or renegotiable at the election of the federal government, and we do not expect such contracts to be a significant percentage of our total revenue in 2010.
The market for our services 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:
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Competition has resulted, and will likely continue to result, in price pressure on 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 introduce emerging technologies on a broader scale and adapt to 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 services or products based on new or emerging technologies and customers that choose to develop their own network services or products. 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.
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, 2009, we had 19 patents (14 issued in the United States and five issued internationally) that extend to various dates between 2017 and 2026, and 14 registered trademarks in the United States. 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 impact 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 rights 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 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.
As of December 31, 2009, we had approximately 390 employees, substantially all of whom are 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 industries 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. We can offer no assurances that we will be successful in recruiting and retaining qualified employees in the future.
We operate in a changing environment that involves numerous known and unknown risks and uncertainties that could have a materially adverse impact on our operations. The risks described below highlight some of the factors that have affected, and in the future could affect, our operations. You should carefully consider these risks. These risks are not the only ones we may face. Additional risks and uncertainties of which we are unaware or that we currently deem immaterial also may become important factors that affect us. If any of the events or circumstances described in the followings risks occurs, our business, consolidated financial condition, results of operations, cash flows, or any combination of the foregoing, could be materially and adversely affected.
Our risks are described in detail below; however, the more significant risks we face can be summarized into several broad categories, including:
The future evolution of the technology industry in which we operate is difficult to predict, highly competitive and requires continual innovation, strategic planning, capital investment, demand planning and space utilization management to remain viable. We face on-going challenges to develop new services and products to maintain current customers and obtain new ones, whether in a cost-effective manner or at all. In addition, technological advantages typically devalue rapidly creating constant pressure on pricing and cost structures and hinder our ability to maintain or increase margins.
We are dependent on numerous suppliers, vendors and other third-party providers across a wide spectrum of products and services to operate our business. These include real-estate, network capacity and access points, network equipment and supplies, power and other vendors. In many cases the suppliers of these products and services are not only vendors, they are also competitors. While we maintain contractual agreements with these suppliers, we have limited ability to guarantee they will meet their obligations, or that we will be able to continue to obtain the products and services necessary to operate our business in sufficient supply, or at an acceptable cost.
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Our business model involves designing, deploying, and maintaining a complex set of network infrastructures at considerable capital expense. We invest significant resources to help maintain the integrity of our infrastructure and support our customers; however, we face constant challenges related to our network infrastructure, including capital forecasting, demand planning, space utilization management, physical failures, obsolesce, maintaining redundancies, security breaches, power demand, and other risks.
Our financial results have fluctuated over time and we have a history of losses, including in each of the past three years. We have also incurred significant charges related to impairments and restructuring efforts, which, along with other factors, may contribute to volatility in our stock price.
Risks Related to our Industry
We cannot predict with certainty the future evolution of the market for technology and products, and may be unable to respond effectively and on a timely basis to rapid technological change.
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 or products obsolete and unmarketable to a sufficiently large number of customers. 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. If the Internet becomes subject to a form of central management, or if NSPs 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. Likewise, technological advances in computer processing, storage, capacity, component size or advances in power management could change which could result in a decreased demand for our data center services.
If we are unable to develop new and enhanced services and products that achieve widespread market acceptance, or if we are unable to improve the performance and features of our existing services and products or adapt our business model to keep pace with industry trends, our business and operating results could be adversely affected.
Our industry is constantly evolving. The process of expending research and development to create new services and products, 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 and products or not be able to overcome technical problems with new services. The demand for top research and development talent is high, and there is significant competition for these scarce resources.
Our future success may depend on our ability to respond to the rapidly changing needs of our customers by expending research and development in a cost-effective manner to acquire talent, develop and introduce new services, products and product upgrades on a timely basis. New product development and introduction involves a significant commitment of time and resources and is subject to a number of risks and challenges, including:
In addition, if we cannot adapt our business models to keep pace with industry trends, our revenue could be negatively impacted. If we are not successful in managing these risks and challenges, or if our new services, products and product upgrades are not technologically competitive or do not achieve market acceptance, we may lose market share, resulting in a decrease in our revenues and earnings.
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Our capital investment strategy for data center expansion may contain erroneous assumptions causing our return on invested capital to be materially lower than expected.
Our strategic decision to invest capital in expanding our data center space in 2010 and beyond is based on significant assumptions relative to expected growth of this market, our competitor’s plans, current and expected occupancy rates and similar factors. We have no way of ensuring the data or models used to deploy capital into existing markets, or to create new markets, will be accurate. Errors or imprecision in these estimates, especially those related to customer demand, could cause actual results to differ materially from expected results and have a material negative impact on revenue in future periods.
Our management of existing data center space or estimation of future data center space needs may be inaccurate, leading to lost revenue through missed sales opportunities or additional expenses through unnecessary carrying costs for our data center space.
Adding data center space involves significant capital outlays well ahead of planned usage. We strive to maintain accurate records related to data center space by classification; however, we may not be able to ensure accuracy of existing data center space nor be able to accurately project future space needs due to significant estimates and assumptions required for these projections. Errors or imprecision in these estimates could cause actual results to differ materially for expected results and correspondingly have a material negative impact on revenue in future periods.
We may not be able to compete successfully against current and future competitors.
The IP services and data center services markets are highly competitive, as evidenced by recent declines in pricing for Internet connectivity services and the significant capital invested in data center expansions by our competitors. We expect competition to continue to intensify in the future, and we may not have the financial resources, technical expertise, sales and marketing abilities, capital or support capabilities to compete successfully. Our competitors currently include: NSPs that offer Internet access; global, national and regional NSPs and ISPs; providers of specific applications or service offerings such as content delivery, security or storage; software-based and other Internet infrastructure providers and manufacturers; and colocation and data center providers. In addition, NSPs and 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 services and products.
In addition, we expect that we will face additional competition as we expand our product offerings, including competition from technology and telecommunications companies. A number of telecommunications companies, NSPs and ISPs have offered or expanded their network services. Further, the ability of some of these potential competitors to bundle other services and products with their network services could place us at a competitive disadvantage. Various companies also are exploring the possibility of providing, or are currently providing, high-speed, intelligent data services that use connections to more than one network or use alternative delivery methods, including the cable television infrastructure, direct broadcast satellites and wireless local loop. Many of our existing and future competitors may have greater market presence, engineering and marketing capabilities and financial, technological and personnel resources than we have. As a result, our competitors may have significant advantages over us and may be able to respond more quickly to emerging technologies and ensuing customer demands. Increased competition and technological advancements by our competitors could materially and adversely affect our business, consolidated financial condition, results of operations and cash flows.
Failure to retain existing customers or add new customers may cause declines in revenue.
In addition to adding new customers, we must sell additional services to existing customers as well as encourage them to increase their usage levels to increase our revenue. If our existing and prospective customers do not perceive our services to be of sufficiently high value and quality, we may not be able to retain our current customers or attract new customers. Our customers have no obligation to renew their contracts for our services after the expiration of their initial commitment, and these service agreements may not be renewed at the same or higher price or level of service, if at all. Moreover, under some circumstances, some of our customers have the right to cancel their service agreements prior to the expiration of the terms of their agreements. Due to the significant upfront costs of managing data centers, if our customers fail to renew or cancel their service agreements, we may not be able to recover the initial costs associated with the expansion of our facilities.
Our customers’ renewal rates may decline or fluctuate as a result of a number of factors, including:
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If our customers do not renew their service agreements with us or if they renew on less favorable terms, our revenue may decline and our business may suffer. Similarly, our customer agreements often provide for minimum commitments that may be significantly below our customers’ historical usage levels. Consequently, even if we have agreements with our customers to use our services, these customers could significantly curtail their usage without incurring any incremental fees under our agreements. In this event, our revenue would be lower than expected and our operating results could suffer.
We have a long sales cycle for our services and products and the implementation efforts required by customers to activate our services and products can be substantial.
Our services and products are complex and require substantial sales efforts and technical consultation to implement. A customer’s decision to use datacenter space or acquire IP services typically involves a significant commitment of resources. Some customers may be reluctant to enter into an agreement with us due to their inability to accurately forecast future demand, delay in decision-making or inability to obtain necessary internal approvals to commit resources. We may expend time and resources pursuing a particular sale or customer that does not result in revenue. Delays due to the length of our sales cycle may harm our ability to meet our forecasts and materially and adversely affect our revenues and operating results.
We may lose customers if they elect to develop IP or content delivery services or products internally.
Our customers and potential customers may decide to develop their own IP or content delivery services or products rather than outsource to services providers like us. These in-house services or products could be perceived to be superior to our services and products. In addition, our customers could decide to host their Internet applications internally, bypassing outside vendors like us. This is particularly true as our customers increase their operations and expend greater resources on delivering their content using third-party services. If we fail to offer IP, data center or CDN services that compete favorably with in-sourced services, if we fail to differentiate our services and products or if competitors introduce new products or services that compete with or surpass the quality or the price/performance of our services, we may lose customers or fail to attract customers that may consider pursuing this in-sourced approach, and our business and financial results would suffer as a result.
In addition, our customers’ business models may change in ways that we do not anticipate and these changes could reduce or eliminate our customers’ needs for our services or products. If this occurred, we could lose customers or potential customers, and our business and financial results would suffer. As a result of these or similar potential developments, in the future it is possible that competitive dynamics in our market may require us to reduce our prices, which could harm our revenue, gross margin and operating results.
Pricing pressure may continue to decrease our revenue and threaten the attractiveness of our premium-priced IP services.
Pricing for Internet connectivity services has declined significantly in recent years and may continue to decline. We currently charge, and expect to continue to charge, premium prices for our high-performance IP services compared to the prices charged by our competitors for their connectivity services. By bundling their services and reducing the overall cost of their service offerings, 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 has eroded, and could continue to 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 NSPs 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 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.
In addition, prices for content delivery services have similarly fallen in recent years from technological improvements and intensified competition and may continue to fall in the future. If the price that we are able to charge customers to deliver their content falls to a greater extent than we anticipate, if we overestimate future demand for our services or if our costs to deliver our services do not fall commensurate with any future price declines, we may not be able to achieve acceptable rates of return on our infrastructure investments, and our gross profit and results of operations may suffer dramatically.
We may acquire other businesses, and these acquisitions involve integration and other risks that could harm our business.
We may pursue acquisitions of complementary businesses, products, services and technologies to expand our geographic footprint, enhance our existing services, expand our service offerings or 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.
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If we fail to identify and acquire needed companies or assets, if we acquire the wrong companies or assets or if we fail to address the risks associated with integrating an acquired company, we would not be able to effectively manage our growth through acquisitions which could adversely affect our results.
If governments modify or increase regulation of the Internet, or goods or services necessary to operate the Internet or our data centers, 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. In addition, federal and state agencies are actively considering regulation of various aspects of the Internet, including taxation of transactions, imposition of access fees for VoIP, enhanced data privacy and retention legislation and various energy regulations. 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.
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 or otherwise increase the cost of doing business on the Internet. Any of these actions could significantly harm 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 are uncertain and developing. Additionally, potential laws and regulations not specifically directed at the Internet, but targeted at goods or services necessary to operate the Internet, could have a negative impact on us. Of specific concern are the legal, political and scientific developments regarding climate change. These factors may impact the delivery of our services or products by driving up the cost of power, which is a significant cost of operating our data centers and other service points.
We cannot predict the impact, if any, that future regulation or regulatory changes may have on our business.
Risks Related to our Business
We depend on third-party suppliers for key elements of our network infrastructure. If we are unable to obtain these items on a cost-effective basis, or at all, or if such services are interrupted, limited or terminated, our growth prospects and business operations may be adversely affected.
In delivering our services, we rely on a number of Internet networks, many of which are built and operated by third parties. To provide high performance connectivity services to our customers through our network access points, we purchase connections from several NSPs. We can offer no assurances that these NSPs 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 NSPs 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 NSPs that may emerge or that are significant in geographic areas, such as Asia, India 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.
We also depend on other companies to supply various key elements of our infrastructure, including the network access loops between our network access points and our NSP, local loops between our network access points and our customers’ networks and certain end-user access networks. Pricing for such network access loops and local loops has risen significantly over time and operators of these networks may take measures, such as the deployment of a variety of filters, that could degrade, disrupt or increase the cost of our or our customers’ access to certain of these end-user access networks by restricting or prohibiting the use of their networks to support or facilitate our services, or by charging increased fees to us, our customers or end-users in connection with our services. Some of our competitors have their own network access loops and local loops and are, therefore, not subject to the same or similar availability and pricing issues.
In addition, we currently purchase routers and switches from a limited number of vendors. 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 results.
We depend on third-party suppliers for key elements of our data center infrastructure. If we are unable to obtain datacenter facilities on a cost-effective basis, or at all, our growth prospects and business operations may be adversely affected.
In establishing data center facilities, we rely on a number of vendors to provide physical space, convert or build space to data center specifications, provide power, internal cabling and wiring, climate control and system redundancy. Physical space is typically obtained through long-term lease arrangements, while multiple other vendors are utilized to perform leasehold improvements necessary to make the physical space available for occupancy. The demand for premium data center space in several key markets has outpaced supply over recent years and the imbalance is projected to continue over the near term. This has increased, and will continue to increase, our costs to add data center space. If we are not able to contain data center expansion costs, or are not able to pass these costs on to our customers, our results will be adversely affected.
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Our business operations depend on contracts with vendors and suppliers who may not meet their contractual obligations.
We maintain contracts with third-party vendors that govern our IP capacity, P-NAPs, data center space and various other services and products. Tracking, monitoring and managing these contract and vendor relationships is critical to our business operations; however, we have limited control over the performance of these contracts by the vendors related to the terms, conditions or contractual obligations contained therein. Even if these contracts contain terms favorable to us in the event of a breach, there is no guarantee the damages due us under the contract would cover the losses suffered or would even be paid. Also, each contract contains specific terms and conditions that may change over time based on contract expiration, assignment, assumption or renegotiation. There is no guarantee that these changes would be favorable to us, and to the event they were not, our operations could be materially impacted.
In addition, these contracts may contain clauses, provisions, triggers, rights, options or obligations that result in favorable or non-favorable impacts on us depending on actions taken, or not taken. While we intend to pursue all contractual provisions favorable to our business, the appropriate actions under a particular contract may require estimates, judgments and assumptions to be made concerning future events for which we have limited basis for estimation. We cannot guarantee that we will take the appropriate action under a particular contract to maximize the benefit to us, which could have a material, adverse impact on operations.
Our inability to renew our data center leases on favorable terms could negatively impact our financial results.
Our leased data centers have lease terms that expire between 2010 and 2023. The majority of these leases provide us with the opportunity to renew the lease at our option for periods generally ranging from five to 10 years. Many of these options however, if renewed, provide that rent for the renewal period will be equal to the fair market rental rate at the time of renewal. If the fair market rental rates are significantly higher than our current rental rates, we may be unable to offset these costs by charging more for our services, which could have a negative impact on our financial results. Conversely, if rental rates drop significantly in the near term, we would not be able to take advantage of the drop in rates until the expiration of the lease as we would be bound by the terms of the existing lease agreement.
If we are unable to deploy new service points (network access points and/or data center space) or do not adequately control expenses associated with the deployment of new service points, our results of operations could be adversely affected.
As part of our strategy, we may continue to expand our network access points and/or data center space, particularly into new geographic markets. We face various risks associated with identifying, obtaining and integrating new service points, negotiating leases for data 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 new service points. We can offer no assurance that we will be able to open and operate new service points on a timely or profitable basis. Deployment of new service points will increase operating expenses, including expenses associated with hiring, training, retaining and managing new employees, provisioning capacity from NSPs, purchasing new equipment, implementing new systems, leasing additional real estate and incurring additional depreciation expense. In addition, delays in opening and operating new service points could have a material, negative impact on our financial results.
Any failure of the physical infrastructure in our data service centers could lead to significant costs and disruptions that could 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:
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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. Most of our customers have service level agreements that require us to meet minimum performance obligations. As a result, service interruptions or equipment damage in our data centers could impact our ability to maintain performance obligations in our service level agreements to these customers and we could face claims related to such failures. We have in the past given credits to our customers as a result of service interruptions due to equipment failures. Because our data centers are critical to many of our customers’ businesses, service interruptions or significant equipment damage in our data centers also could result in lost profits or other indirect or consequential damages to our customers. We cannot guarantee that a court would enforce any contractual limitations on our liability in the event that a customer brings a lawsuit against us as the result of a problem at one of our data centers.
Any loss of services, equipment damage or inability to meet performance obligations in our service level agreements could reduce the confidence of our customers and could result in lost customers or an inability to attract new customers, which would adversely affect both our ability to generate revenues and our operating results.
Furthermore, we are dependent upon NSPs and telecommunications carriers in the United States, Europe and 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.
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 which could impact our ability to service our customers.
While we maintain multiple layers of redundancy in or operating facilities, 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 SLAs, 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 potentially harm our customer relations, require us to issue credits, expose us to potential lawsuits or necessitate additional capital expenditures.
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.
Our network and software are subject to potential security breaches and similar threats that could result in liability and harm our reputation.
A number of widespread and disabling attacks on public and private networks have occurred. 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, and negatively impact hosted customers’ on-line business transactions. Affected customers might file claims against us under such circumstances, and our insurance may not be adequate to cover these claims.
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-power density equipment, which has significantly increased the demand for power. The current demand for electrical power may exceed our designed capacity in these facilities. As electrical power, rather than 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.
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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 and supply of power, electrical power shortages, planned or unplanned power outages and availability of adequate power resources. Power outages could harm our customers and our business. While we attempt to limit exposure to system downtime by using backup generators, uninterruptible power systems and other redundancies, we may not be able to limit our exposure entirely. Even with these protections in place we have experienced power outages in the past and may in the future. In addition, our energy costs have increased and may continue to increase for a variety of reasons including increased pressure on legislators to pass green legislation. As energy costs increase, we may not be able to pass on to our customers the increased cost of energy, which could harm our business and operating results.
In each of our markets, we rely on utility companies to provide a sufficient amount of power for current and future customers. Because we rely on third parties to provide power, we cannot ensure that these third parties will deliver such power in adequate quantities or on a consistent basis. 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 data center and limit our ability to grow our business, which could have a negative impact on our relationships with our customers as well as our consolidated financial condition, results of operations and cash flows.
Risks Related to our Capital Stock and Other Business Risks
We have a history of losses and may not sustain profitability.
We have a history of quarterly and annual period net losses, including for each of three years in the period ended December 31, 2009. At December 31, 2009, our accumulated deficit was $1,036.5 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.
We may incur additional goodwill and other intangible asset impairment charges, restructuring charges or both.
As more fully described in notes 8 and 9 to the accompanying consolidated financial statements, we have recently recorded significant impairment and restructuring charges and made changes in estimates that resulted in acceleration of amortization expense related to certain intangible assets.
The assumptions, inputs and judgments used in performing the valuation analysis and assessments are inherently subjective and reflect estimates based on known facts and circumstances at the time the valuation is performed. The use of different assumptions, inputs and judgments or changes in circumstances could materially affect the results of the valuation and assessments. Due to the inherent uncertainty involved in making these estimates, actual results could differ from our estimates.
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, we 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 our best expectations based on known facts and circumstances at the time of estimation. Should circumstances warrant, we will adjust our previous estimates to reflect what we then believe to be a more accurate representation of expected future costs. Because our estimates and assumptions regarding impairment and restructuring charges include probabilities of future events, such as expected operating results, future economic conditions, the ability to find a sublease tenant within a reasonable period of time or the rate at which a sublease tenant will pay for the available space, such estimates are inherently vulnerable to changes due to unforeseen circumstances that could materially and adversely affect our results of operations. Adverse changes in any of these factors could result in an additional impairment and restructuring charges in the future.
Our results of operations have fluctuated in the past and likely will continue to fluctuate, which could negatively impact the price of our common stock.
We have experienced fluctuations in our results of operations on a quarterly and annual basis. Fluctuation in our operating results may cause the market price of our common stock to decline. We expect to experience continued fluctuations in our operating results in the foreseeable future due to a variety of factors, including:
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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 data center facilities, the deployment of additional network access points and the terms of our network connectivity purchase agreements. 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. 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.
Failure to sustain or increase our revenues may cause our business and financial results to suffer.
We have considerable fixed expenses, and we expect to continue to incur significant expenses, particularly with the expansion of our data center facilities. We incur a substantial portion of these expenditures upfront, and are only able to recover these costs over time. We must, therefore, at least sustain or generate higher revenues to maintain profitability. Although revenue from our data center services segment is growing, this segment has lower margins than our IP services segment. If we are unable to increase our margins in the data center services segment, our business may suffer.
Numerous factors could affect our ability to increase revenue, either alone or in combination with other factors, including:
Our common stockholders may experience significant dilution, which could depress the market price of our common stock.
Holders of our stock options may exercise those options to purchase our common stock, which would increase the number of shares of our common stock that are outstanding in the future. As of December 31, 2009, options to purchase an aggregate of 4.3 million shares of our common stock at a weighted average exercise price of $7.16 were outstanding. Also, the vesting of 1.1 million outstanding shares of restricted stock will increase the weighted average number of shares used for calculating diluted net loss per share. 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, the future vesting and issuance of stock awards to our executives and employees or in financing transactions, could depress the market price of our 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.
Any failure to meet our debt obligations and other long-term commitments would damage our business.
As of December 31, 2009, our total long-term debt, including capital leases, was $23.2 million. If we use more cash than we generate in the future, our level of indebtedness could adversely affect our future operations by increasing our vulnerability to adverse changes in general economic and industry conditions and by limiting or prohibiting our ability to obtain additional financing for future capital expenditures, acquisitions and general corporate and other purposes. In addition, if we are unable to make interest or principal payments when due, we would be in default under the terms of our long-term debt obligations, which would result in all principal and interest becoming due and payable which, in turn, would seriously harm our business.
We also have other long-term commitments for operating leases and service contracts totaling $226.7 million over the next 15 years with a minimum of $36.2 million payable in 2010. If we are unable to make payments when due, we would be in breach of contractual terms of the agreements, which may result in disruptions of our services which, in turn, would seriously harm our business.
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Our existing credit agreement puts limitations upon us.
Our existing credit agreement, which expires in September 2011, puts operating and financial limitations on us and requires us to meet certain financial covenants. These limitations may negatively impact our business, consolidated financial condition, results of operations and cash flows by limiting or prohibiting us from engaging in certain transactions. Our credit agreement contains certain covenants, including those that limit our ability to incur further indebtedness, make acquisitions or investments, make certain capital expenditures and create liens on our assets, in addition to covenants that require us to maintain minimum liquidity levels.
If we do not satisfy these covenants, we would be in default under the credit agreement. Any defaults, if not waived, could result in our 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.
Finally, our ability to access the capital markets may be limited at a time when we would like or need to do so, which could have an impact on our flexibility to pursue expansion opportunities and maintain our desired level of revenue growth in the future.
Our ability to use U.S. net operating loss carryforwards might be limited.>
As of December 31, 2009, we had net operating loss carryforwards of $179.5 million for U.S. federal tax purposes. These loss carryforwards expire between 2020 and 2026. To the extent these net operating loss carryforwards are available, we intend to use them to reduce the corporate income tax liability associated with our operations. Section 382 of the U.S. Internal Revenue Code generally imposes an annual limitation on the amount of net operating loss carryforwards that might be used to offset taxable income when a corporation has undergone significant changes in stock ownership. To the extent our use of net operating loss carryforwards is significantly limited, our income could be subject to corporate income tax earlier than it would if we were able to use net operating loss carryforwards, which could result in lower profits.
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:
● changes in expectations of future financial performance or changes in estimates of securities analysts;
● announcements by us or our competitors of acquisitions, investments or strategic alliances.
We previously identified a material weakness in our internal control over financial reporting. Although we have remediated this weakness, any additional control deficiencies could 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.
We must maintain effective internal controls to provide reliable and accurate financial reports and prevent fraud. These controls are designed and implemented to help ensure reliable financial statement reporting, including accurate reserves, estimates, judgments and disclosures. In connection with our evaluation of internal control over financial reporting for the year ended December 31, 2007, we identified a material weakness related to effective controls over the analysis of requests for sales credits and billing adjustments. We remediated this weakness during the year ended December 31, 2008; however, any additional control 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. 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.
Our business requires the continued development of effective and efficient business support systems to support our customer growth and related services.
The growth of our business depends on our ability to continue to develop effective, efficient business support policies, processes and systems. This is a complicated undertaking requiring significant resources and expertise. Business support systems are needed for:
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If the number of customers that we serve or our services portfolio increases, we may need to develop additional business support systems on a schedule sufficient to meet proposed service rollout dates. The failure to continue to develop effective and efficient business support systems could harm our ability to implement our business plans and meet our financial goals and objectives.
We depend upon our key employees and may be unable to attract or retain sufficient numbers of qualified personnel.
Our future performance depends 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, research and development, 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 provides 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.
Additionally, changes in our senior management team during the past several years, both through voluntary and involuntary separation, have resulted in loss of valuable company intellectual capital and in paying significant severance and hiring costs. With reduced staffing, or staffing new to the organization, we may not be able to maintain an adequate separation of duties in key areas of monitoring, oversight and review functions and may not have adequate succession plans in place to mitigate the impact of future personnel losses. If we continue to experience similar levels of turnover in our senior management team, the execution of our corporate strategy could be affected and the costs of such changes could negatively impact our operations.
Our international operations may not be successful.
We have limited experience operating internationally and have only recently begun to achieve some success in our international operations. We currently have network access points or CDN POPs in Amsterdam, Hong Kong, London, Mumbai, Singapore, Sydney and Toronto. We also participate in a joint venture with NTT-ME Corporation and Nippon Telegraph and Telephone Corporation, or NTT Holdings, that operates network access points in Tokyo and Osaka, Japan. 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.
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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. 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 impact 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 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, or at all.
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 services or products 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 impact 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 services or products to avoid infringement, our ability to compete successfully in our market would be materially impaired.
We are currently subject to a securities class action lawsuit and a derivative action lawsuit, the unfavorable outcomes of which could have a material adverse impact on our financial condition, results of operations and cash flows.
In November 2008, a putative securities class action lawsuit was filed against us and our former chief executive officer and in November 2009, a putative derivative lawsuit was filed purportedly on our behalf against certain of our directors and officers. While we are, and will continue to, vigorously contest these lawsuits, we cannot determine the final resolution of these lawsuits or when they might be resolved. In addition to the expenses incurred in defending this litigation and any damages that may be awarded in the event of an adverse ruling, our management’s efforts and attention may be diverted from the ordinary business operations to address these claims. Regardless of the outcome, this litigation may have a material adverse impact on our results because of defense costs, including costs related to our indemnification obligations, diversion of resources and other factors. We discuss these lawsuits further in “Legal Proceedings” below.
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. The results of any such actions could have a material adverse impact on our business, consolidated financial condition, results of operations and cash flows.
Provisions of our charter documents 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 and Bylaws, as well as provisions of Delaware law, could discourage, delay or prevent a merger, acquisition or other change in control of our company. These provisions are intended to protect stockholders’ interests by providing our board of directors a means to attempt to deny coercive takeover attempts or to negotiate with a potential acquirer in order to obtain more favorable terms. Such provisions include a board of directors that is classified so that only one-third of directors stand for election each year. These provisions could also discourage proxy contests and make it more difficult for stockholders to elect directors and take other corporate actions.
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Our principal executive offices are located in Atlanta, Georgia adjacent to our network operations center, one of our P-NAPs and data center facilities. Our Atlanta facility, included in the table below, 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. The following table shows the number and gross square footage of our facilities in our top markets as of December 31, 2009, and includes both company-controlled facilities and partner sites:
We have entered into leases or will expand our presence in 2010 for additional space in Seattle, Northern California and Houston, which are not included in the table above.
Securities Class Action Litigation
On November 12, 2008, a putative securities fraud class action lawsuit was filed against us and our former chief executive officer, James P. DeBlasio, in the United States District Court for the Northern District of Georgia, captioned Catherine Anastasio and Stephen Anastasio v. Internap Network Services Corp. and James P. DeBlasio, Civil Action No. 1:08-CV-3462-JOF. The complaint alleges that we and the individual defendant violated Section 10(b) of the Exchange Act and that the individual defendant also violated Section 20(a) of the Exchange Act as a “control person” of Internap. Plaintiffs purport to bring these claims on behalf of a class of our investors who purchased our stock between March 28, 2007 and March 18, 2008.
Plaintiffs allege generally that, during the putative class period, we made misleading statements and omitted material information regarding (a) integration of VitalStream, (b) customer issues and related credits due to services outages, and (c) our previously reported 2007 revenue that we subsequently reduced in 2008 as announced on March 18, 2008. Plaintiffs assert that we and the individual defendant made these misstatements and omissions in order to keep our stock price high. Plaintiffs seek unspecified damages and other relief.
On August 12, 2009, the Court granted plaintiffs leave to file an Amended Class Action Complaint (“Amended Complaint”). The Amended Complaint added a claim for violation of Section 14(a) of the Exchange Act based on alleged misrepresentations in our proxy statement in connection with our acquisition of VitalStream. The Amended Complaint also added our former Chief Financial Officer, David A. Buckel, as a defendant and lengthened the putative class period.
On September 11, 2009, we and the individual defendants filed motions to dismiss. Those motions are currently pending before the Court. On November 6, 2009, plaintiffs filed a Corrected Amended Class Action Complaint. On December 7, 2009, plaintiffs filed a motion for leave to file a Second Amended Class Action Complaint to add allegations regarding, inter alia, an alleged failure to conduct due diligence in connection with the VitalStream acquisition and additional statements from purported confidential witnesses. We opposed plaintiffs’ motion for leave to file the Second Amended Class Action Complaint and that motion is also currently pending before the Court.
Derivative Action Litigation
On November 12, 2009, stockholder Walter M. Unick filed a putative derivative action purportedly on behalf of Internap against certain of our directors and officers in the Superior Court of Fulton County, Georgia, captioned Unick v. Eidenberg, et al., Case No. 2009cv177627. This action is based upon substantially the same facts alleged in the securities class action litigation described above. The complaint seeks to recover damages in an unspecified amount. On January 28, 2010, the Court entered the parties’ agreed order staying the matter until the motions to dismiss are resolved in the securities class action litigation.
While we intend to vigorously contest these lawsuits, we cannot determine the final resolution of the lawsuits or when they might be resolved. In addition to the expenses incurred in defending this litigation and any damages that may be awarded in the event of an adverse ruling, our management’s efforts and attention may be diverted from the ordinary business operations to address these claims. Regardless of the outcome, this litigation may have a material adverse impact on our results because of defense costs, including costs related to our indemnification obligations, diversion of resources and other factors.
We currently, and from time to time, are involved in other 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.
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ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES>
Our common stock is listed on the NASDAQ Global Market under the symbol “INAP.” The following table presents, for the periods indicated, the range of high and low per share sales prices of our common stock, as reported on the NASDAQ Global Market. Our fiscal year ends on December 31.
As of February 17, 2010, we had approximately 1,000 stockholders of record of our common stock.
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 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, 2009 (shares in thousands):
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STOCK PERFORMANCE GRAPH
The following graph compares, for the five-year period ended December 31, 2009, the cumulative total stockholder return on our common stock with that of the NASDAQ Market Index and the Hemscott Group Index. The graph assumes that $100 was invested on December 31, 2004 and assumes reinvestment of any dividends. The information in the following table has been adjusted to reflect the one-for-10 reverse stock split implemented in July 2006. Our fiscal year ends on December 31. The stock price performance on the following graph is not necessarily indicative of future stock price performance.
This performance graph shall not be deemed “filed” for purposes of Section 18 of the Exchange Act or otherwise subject to the liabilities under that Section and shall not be deemed to be incorporated by reference into any filing we make under the Securities Act of 1933, as amended, or the Exchange Act.
COMPARISON OF FIVE-YEAR CUMULATIVE TOTAL RETURN AMONG INTERNAP NETWORK SERVICES CORPORATION, NASDAQ MARKET INDEX AND HEMSCOTT GROUP INDEX
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ISSUER PURCHASES OF EQUITY SECURITIES
The following table sets forth information regarding our repurchases of securities for each calendar month in the quarter ended December 31, 2009:
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We have derived the selected financial data shown below for each of the five years in the period ended December 31, 2009 from our consolidated financial statements. The following data should be read in conjunction with the accompanying consolidated financial statements and related notes contained and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in this Annual Report on Form 10-K (in thousands, except per share data).
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Investments in marketable securities and other related assets include auction rate securities and corresponding rights of $7,000, $7,027 and $7,150 as of December 31, 2009, 2008 and 2007. We classified these as short-term investments as of December 31, 2009 and 2007 and as non-current investments as of December 31, 2008.
The following discussion should be read in conjunction with the accompanying consolidated financial statements and notes provided under Part II, Item 8 of this Annual Report Form 10-K. Certain prior year disclosures within the following discussion have been reclassified to conform to the current year presentation.
We are an Internet solutions and data center company providing a suite of network optimization and delivery services and products that manage, deliver and distribute applications and content with a 100% availability service level agreement, as well as a global provider of secure and reliable data center services. We help our customers innovate their business, improve service levels and lower the cost of information technology operations. Our services and products, combined with progressive and proactive technical support, enable our customers to migrate business-critical applications from private to public networks.
Financial Highlights and Outlook
We continue to experience pricing pressure for our IP services, which has resulted in part in decreased IP services revenue year-over-year. We historically have priced our IP services at a premium compared to the services offered by conventional Internet connectivity service providers. Due to competitive forces, however, we have been required to lower pricing of our IP services, although this decrease in pricing has been offset by an increase in demand for our IP services. Our IP traffic has increased as a result of our 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. We expect that we will continue to experience pricing pressure as well as gains in IP traffic for the reasons noted.
Data center services continue to be a source of revenue growth for our business, and we expect this trend to continue. We have expanded the sites that we operate and expect to add additional space in the future as part of our data center growth initiative. The growth in data center revenues and direct costs of data center services largely follows our expansion of data center space, and we believe the demand for data center services continues to outpace industry-wide supply. We experienced a net increase in customers in this segment.
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During the year ended December 31, 2009, we changed how we view and manage our business. We now operate our IP services and the majority of our CDN services on a combined basis while we operate the managed hosting portion of our CDN services as part of our data center services. The change from our historical segments reflects our view of the business and aligns our segments with our operational and organizational structure. We have reclassified financial information for prior periods to conform to the current period presentation.
Impairments and Restructuring
Goodwill. >Goodwill is not amortized. Instead, we assess goodwill for impairment at a reporting unit level on an annual basis. Our decision to consolidate segments as of June 1, 2009 required us to assess goodwill for impairment as of that date, which was earlier than the date of our annual assessment (August 1). As a result of this assessment, we recorded an aggregate goodwill impairment charge of $51.5 million during the year ended December 31, 2009 related to our former CDN services segment and FCP products in the IP services segment. The goodwill impairment in 2009 was in addition to a $99.7 million goodwill impairment charge in 2008 in our former CDN services segment. The goodwill impairments in our former CDN services segment were primarily due to declines in CDN services revenues and operating results compared to our expectations and declining multiples of our own and comparable companies. The CDN services goodwill and technology arose from our acquisition of VitalStream in February 2007. Similarly, the goodwill impairment for our FCP products in the IP services segment was due to declines in our FCP products revenues and operating results. The declines in FCP products revenues were primarily attributable to lower sales associated with a reduced marketing effort as we reevaluated our equipment sales strategy for FCP products. At December 31, 2009, the carrying value of our goodwill was $39.5 million. We further discuss goodwill in note 8 to the accompanying consolidated financial statements.
Other Intangible Assets. >We assess other intangible assets for impairment in conjunction with our assessment of goodwill or whenever events or changes in circumstances indicate that the carrying amounts may not be recoverable. In conjunction with the goodwill impairments discussed above, we recorded impairments of other intangible assets of $4.1 million and $2.7 million in 2009 and 2008, respectively, and made changes in estimates that resulted in acceleration of amortization expense related to certain intangible assets, as more fully described in note 8 to the accompanying consolidated financial statements. At December 31, 2009, the carrying value of other intangible assets was $20.8 million.
Restructuring. >During the year ended December 31, 2009, we made adjustments in sublease income assumptions for certain properties included in our previously-disclosed 2007 and 2001 restructuring plans, implemented a restructuring plan to reduce our workforce by 45 employees and ceased use of four smaller facilities. We recorded total restructuring charges of $3.2 million in our accompanying consolidated statements of operations for the year ended December 31, 2009. The adjustments in sublease income assumptions for certain properties included in our 2007 and 2001 restructuring plans extended the period during which we do not anticipate receiving sublease income from those properties given our expectation that it will take longer to find sublease tenants and the increased availability of space in each of these markets where we have unused space. The workforce reduction of 45 employees in March 2009 represented 10% of our total workforce at that time and was primarily in back-office functions as well as the elimination of certain senior management positions. We further discuss restructuring activities in note 9 to the accompanying consolidated financial statements.
Cash flow from operations was $37.5 million during the year ended December 31, 2009 compared to $38.0 million and $27.5 million during the same periods in 2008 and 2007, respectively. We expect to meet our cash requirements in 2010 through a combination of net cash provided by operating activities and existing cash, cash equivalents and short-term investments in marketable securities. This includes a plan to commit $50.0 million in capital expenditures over the next nine to 18 months to grow our data center business in key markets. We may also utilize additional borrowings under our credit agreement, especially for capital expenditures, particularly if we consider it economically favorable to do so.
On March 16, 2009, J. Eric Cooney became our president and chief executive officer and a member of our board of directors following the resignation of James P. DeBlasio. Pursuant to the terms of a separation agreement with Mr. DeBlasio, he received a cash payment of $0.9 million and full vesting of all equity awards previously granted to him, which had an incremental value of $0.8 million. Mr. DeBlasio has until March 16, 2010 to exercise any stock options that were vested as of March 16, 2009. We recorded all executive transition costs with general and administrative costs and expenses in the accompanying statements of operations.
Rights Agreement and Preferred Stock
As previously disclosed in the Current Report on Form 8-K filed by us with the Securities and Exchange Commission, or the SEC, on November 23, 2009, we approved the termination of the Preferred Stock Rights Agreement between us and American Stock Transfer and Trust Company, as Rights Agent, dated as of April 11, 2007, or the Rights Agreement. Originally scheduled to expire on March 23, 2017, we amended the Rights Agreement to accelerate its expiration which occurred on the close of business on December 31, 2009. In connection with the expiration of the Rights Agreement, we filed a Certificate of Elimination with the Secretary of State of the State of Delaware on February 26, 2010, to eliminate our series B preferred stock. The Certificate of Elimination removed the previous designation of 0.5 million shares of series B preferred stock and caused such shares of series B preferred stock to resume their status as undesignated shares of our preferred stock.
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Restated Certificate of Incorporation
As a result of the termination of the Rights Agreement and the filing of the Certificate of Elimination related to our previously-designated series B preferred stock, we filed a Restated Certificate of Incorporation with the Secretary of State of the State of Delaware on February 26, 2010. We previously filed our original Certificate of Incorporation in 2001 and subsequently amended it on a number of occasions (most recently with the filing of the Certificate of Elimination described above). As permitted by the Delaware General Corporation Law, our board of directors determined to restate our Certificate of Incorporation, as amended, to consolidate and integrate into a single instrument all of the provisions of our Certificate of Incorporation, as amended. The Restated Certificate of Incorporation simply restates and integrates but does not further amend our Certificate of Incorporation, as amended, and no stockholder vote was required.
Payment of Annual Performance Bonuses and Increases in Base Salary
On February 24, 2010, our compensation committee approved bonuses for employees (including executive officers) under our 2009 Short-Term Incentive Plan, which we previously filed as Exhibit 10.1 to our Current Report on Form 8-K, filed with the SEC on August 21, 2009. These bonuses were awarded based upon achievement of individual objectives and progress toward the fulfillment of long-term strategic objectives. We will pay the bonuses in cash on or before March 15, 2010.
In addition, our compensation committee approved an increase in the base salary of certain executive officers effective April 1, 2010, as follows: Mr. Kilguss, from $275,000 to $290,000; Mr. Dobb, from $272,800 to $280,000 and Mr. Thompson, from $225,000 to $230,000.
2010 Long-Term Incentive Grants
On February 24, 2010, our compensation committee approved grants under our 2010 long-term incentive program. Under the program, named executive officers and other key contributors are eligible for the award of options to purchase common stock and restricted common stock. Of each award, 80% of the total grant is in the form of options to purchase common stock and 20% of the total grant is in the form of time-based restricted common stock. The options to purchase common stock vest 25% after one year and in equal monthly increments for three years thereafter. The time-based restricted common stock vests in four equal annual installments on the anniversary of the grant date. The options have an exercise price of $5.03 per share (our fair market value on February 26, 2010, the grant date) and a 10-year term. Our compensation committee made the following grants under the program:
2010 Short-Term Incentive Plan
On February 24, 2010, our compensation committee approved the 2010 Short Term Incentive Plan. Under the plan, all full time exempt and eligible non-exempt employees (including executive officers) may be eligible for the award of a cash bonus after our 2010 fiscal year end. The cash bonus of each participant will be determined based on achievement of corporate and individual/business unit objectives, with a target award level expressed as a percentage of salary. The corporate objectives are based on revenue and earnings before interest, taxes, depreciation and amortization, or EBITDA. The personal/business unit objectives are individualized for each participant.
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The table below identifies the target incentives as a percentage of base salary and the split between corporate and personal/business unit objectives for executive officers.
Our compensation committee may amend, modify, terminate or suspend operation of the plan at any time. Our compensation committee recommends to our full board of directors any changes to the compensation of our president and chief executive officer. If a participant is not an employee on the date awards from the plan are paid (other than by reason of death or disability), the participant forfeits all rights to any payments.
The above description is qualified in its entirety by reference to the full text of the 2010 Short Term Incentive Plan, which is being filed as Exhibit 10.35 to this Annual Report on Form 10-K.
Critical Accounting Policies and Estimates
This discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which we have prepared in accordance with accounting principles generally accepted in the United States of America, or GAAP. 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 we believe 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.
In addition to our significant accounting policies summarized in note 2 to our accompanying consolidated financial statements, we believe the following policies are the most sensitive to judgments and estimates in the preparation of our consolidated financial statements.
We generate revenues primarily from the sale of IP services and data center 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 recognize the monthly minimum as revenue each month provided that we have entered into an enforceable contract, we have delivered the service to the customer, the fee for the service is fixed or determinable and collection is reasonably assured. If a customer’s usage of our services exceeds the monthly minimum, we recognize revenue for such excess in the period of the usage.
We record an amount for service level agreements and other sales adjustments, which reduces net revenues and accounts receivable. We identify adjustments for service level agreements within the billing period and reduce revenues accordingly. We base the amount for sales adjustments upon specific customer information, including customer disputes, credit adjustments not yet processed through the billing system and historical activity.
We routinely review the collectability of our accounts receivable and payment status of our customers. If we determine that collection of revenue is uncertain, we do not recognize revenue until collection is reasonably assured. Additionally, we maintain an allowance 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 general customer information, which primarily includes our historical cash collection experience and the aging of our accounts receivable. We assess the payment status of customers by reference to the terms under which we provide services or goods, with any payments not made on or before their due date considered past-due. Once we have exhausted all collection efforts, we write the uncollectible balance off against the allowance for doubtful accounts.
Goodwill and Other Intangible Assets
We assess goodwill for impairment at a reporting unit level on an annual basis. As discussed in “—Results of Operations—Segment Information” below and in notes 2 and 4 to our accompanying consolidated financial statements, we changed how we view and manage our business beginning June 1, 2009. We now operate our IP services and the majority of our CDN services on a combined basis while we operate the managed hosting portion of our CDN services as part of our data center services. Our decision to consolidate segments as of June 1, 2009 required us to assess goodwill for impairment as of that date, which was earlier than the date of our annual assessment (August 1). Our newly-combined IP services operating segment continues to be comprised of two reporting units: services and products. Similarly, our data center services operating segment continues to be a single reporting unit; however, it does not have any recorded goodwill.
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Our assessment of goodwill for impairment includes comparing the fair value of our reporting units to the carrying value. We estimate fair value using a combination of discounted cash flow models and market approaches. If the fair value of a reporting unit exceeds its carrying value, goodwill is not impaired and no further testing is necessary. If the carrying value of a reporting unit exceeds its fair value, we perform a second test to measure the amount of impairment to goodwill, if any. To measure the amount of any impairment, we determine the implied fair value of goodwill in the same manner as if we were acquiring the affected reporting unit in a business combination. Specifically, we allocate the fair value of the affected reporting unit to all of the assets and liabilities of that unit, including any unrecognized intangible assets, in a hypothetical calculation that would yield the implied fair value of goodwill. If the implied fair value of goodwill is less than the goodwill recorded on our consolidated balance sheet, we record an impairment charge for the difference.
We base the impairment analysis of goodwill on estimated fair values. The assumptions, inputs and judgments used in performing the valuation analysis are inherently subjective and reflect estimates based on known facts and circumstances at the time the valuation is performed. These estimates and assumptions primarily include, but are not limited to, discount rates; terminal growth rates; projected revenues and costs; EBITDA for expected cash flows; market comparables and capital expenditures forecasts. The use of different assumptions, inputs and judgments, or changes in circumstances, could materially affect the results of the valuation. Due to the inherent uncertainty involved in making these estimates, actual results could differ from our estimates and could result in additional non-cash impairment charges in the future. Following is a description of the valuation methodologies we used to derive the fair value of our former CDN services and the FCP products reporting units as of our assessment date of June 1, 2009:
We used similar valuation methodologies to derive the fair values of our other reporting units. After consolidating the former CDN services reporting unit with the IP services unit, the fair value of our IP services reporting unit exceeded the carrying value by 18% as of the valuation date. The portion of goodwill from the former CDN services reporting unit allocated to data center services was immediately impaired so that data center services continues to not have any recorded goodwill. Adverse changes in expected operating results and/or unfavorable changes in other economic factors used to estimate fair values could result in an additional non-cash impairment charge in the future.
We perform our annual goodwill impairment test as of August 1 of each calendar year absent any impairment indicators or other changes that may cause more frequent analysis. We did not identify an impairment as a result of our annual August 1, 2009 impairment test. We also assess on a quarterly basis whether any events have occurred or circumstances have changed that would indicate an impairment could exist. We have considered the likelihood of triggering events that might cause us to re-assess goodwill on an interim basis and concluded that none had occurred subsequent to August 1, 2009.
Other intangible assets, including developed technologies and patents, have finite lives and we have recorded these assets at cost less accumulated amortization. We calculate amortization on a straight-line basis over the estimated economic useful life of the assets, which are three to eight years for developed technologies and 15 years for patents. We assess other intangible assets for impairment in conjunction with our assessment of goodwill or whenever events or changes in circumstances indicate that the carrying amounts may not be recoverable. Our assessment for other intangible assets is based on estimated future cash flows directly associated with the asset or asset group. If we determine that the carrying value is not recoverable, we may record an impairment charge, reduce the estimated remaining useful life, or both.
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In addition to impairment of other intangible assets during the years ended December 31, 2009 and 2008, we also made changes in estimates that resulted in acceleration of amortization expense related to certain acquired CDN intangible assets. Changes in estimates reflect historical churn for acquired CDN customers and the decreased value of acquired CDN trade names and noncompete agreements to our business. These acquired CDN intangible assets either have a remaining estimated economic useful life of less than one year at December 31, 2009 or were fully amortized during 2009. Additional information is included in note 8 to the accompanying consolidated financial statements. Similar to goodwill as noted above, adverse changes in expected operating results and/or unfavorable changes in other economic factors used to estimate fair values could result in additional non-cash impairment charges or acceleration of amortization in the future. We believe that our remaining intangible assets are not impaired.
None of the impairment charges or changes in estimated remaining asset lives had any impact on our cash balances or covenants in our credit agreement.
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, we 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 our best expectations based on known facts and circumstances at the time of estimation. Should circumstances warrant, we will adjust our previous estimates to reflect what we then believe to be a more accurate representation of expected future costs. Because our estimates and assumptions regarding restructuring charges include probabilities of future events, such as our ability to find a sublease tenant within a reasonable period of time or the rate at which a sublease tenant will pay for the available space, such estimates are inherently vulnerable to changes due to unforeseen circumstances that could materially and adversely affect our results of operations. If the amount of time that we expect it to take to find sublease tenants in all of the vacant space already in restructuring were to increase by three months and assuming no other changes to the properties in restructuring, we would record an additional $0.3 million in restructuring charges in the consolidated statement of operations during the period in which the change in estimate occurred. We monitor market conditions at each period end reporting date and will continue to assess our key assumptions and estimates used in the calculation of our restructuring accrual.
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 net income in the period such determination was made. We may recognize deferred tax assets in future periods if and when we estimate them to be realizable, such as establishing our expected continuing profitability or that of certain of our foreign subsidiaries.
Based on an analysis of our projected future U.S. pre-tax income, we do not have sufficient positive evidence within the next 12 months to release the valuation allowance currently recorded against our U.S. deferred tax assets. However, if we experience subsequent changes in stock ownership as defined by Section 382 of the Internal Revenue Code, we may have additional limitations on the future utilization of our U.S. net operating losses.
We measure stock-based compensation cost at the grant date based on the calculated fair value of the award. We recognize the expense over the employee’s requisite service period, generally the vesting period of the award. We estimate the fair value of stock options at the grant date 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.
The expected term represents the weighted average period of time that we expect granted options 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 term 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. A 10% increase in stock-based compensation would result in additional expense of $0.6 million.
Recent Accounting Pronouncements
In June 2009, the Financial Accounting Standards Board, or FASB, issued new accounting guidance which amends the evaluation criteria to identify the primary beneficiary of a variable interest entity, or VIE, and requires ongoing reassessment of whether an enterprise is the primary beneficiary of the VIE. The new guidance significantly changes the consolidation rules for VIEs including the consolidation of common structures, such as joint ventures, equity method investments and collaboration arrangements. The guidance is applicable to all new and existing VIEs. This accounting guidance is effective for us beginning in the first quarter of 2010.
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We have concluded that our joint venture in Internap Japan Co., Ltd. is an equity-method investment under the voting-interest model, not a VIE and, accordingly, this new accounting guidance will not impact our consolidated financial statements.
Additional recent accounting pronouncements are summarized in note 2 to the accompanying consolidated financial statements. Currently, we do not expect any recent accounting pronouncements that we have not yet adopted will have a material impact on our consolidated financial statements.
Results of Operations
We generate revenues primarily from the sale of IP services and data center 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 CDN services and premise-based route optimization products and other ancillary services, such as server management and installation services, also referred to as managed hosting, virtual private networking services, managed security services, data back-up, remote storage, restoration services and professional consulting 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 at a distance from the respective Internet service provider, 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 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, we include facilities costs associated with the network operations center in direct costs of customer support.
Direct Costs of Amortization
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. We amortize the cost of the acquired technologies over original lives of three to eight years. The carrying value of acquired technologies at December 31, 2009 was $18.4 million and the weighted average remaining life was approximately five years. These direct costs also include impairment of the acquired CDN advertising technology during both of the years ended December 31, 2009 and 2008, as discussed below in “—Other Operating Costs and Expenses—Impairments and Restructuring.”
Sales and Marketing
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 external website and other promotional costs.
General and Administrative
General and administrative costs consist primarily of compensation and other expense for executive, finance, product development, human resources and administrative personnel, professional fees and other general corporate costs. General and administrative costs also include 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. We capitalize costs associated with internal use software when the software enters the application development stage until the software is ready for its intended use. We expense all other product development costs as incurred.
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Summary of Results of Operations>
Following is a summary of our results of operations and financial condition, which is followed by more in-depth discussion and analysis.
During the year ended December 31, 2009, total revenues were $256.3 million, representing an increase of nearly 1% over the same period in 2008. Data center services revenue was the primary growth driver during the year ended December 31, 2009, increasing 14% compared with 2008. Data center services revenue comprised 51% of total revenues during the year ended December 31, 2009, compared to 45% during the same period in 2008. Total segment profit was $113.2 million for the year ended December 31, 2009, a decrease of $4.9 million, or 4%, from the same period in 2008, primarily as a result of the increase in data center revenues as a percentage of total revenues. We reported a net loss during the year ended December 31, 2009 of $69.7 million, which included: (a) $51.5 million in impairment charges for goodwill, (b) $4.1 million in impairment charges for other intangible assets (recorded in direct costs of amortization of acquired technologies) and (c) $3.2 million of restructuring charges.
At December 31, 2009, we had $73.9 million in cash and cash equivalents and $23.2 million in total debt and capital leases. We have continued to improve our net cash position from net cash flows provided by operating activities. The outstanding balance on our credit facility was $20.0 million at December 31, 2009, with $3.6 million of letters of credit issued and $11.4 million of available credit. Quarterly days sales outstanding were 27 days at December 31, 2009.
The following table sets forth selected consolidated statements of operations data during the periods presented, including comparative information between the periods (dollars in thousands):