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Internap Network Services 10-Q 2009
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 whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
INTERNAP NETWORK SERVICES CORPORATION
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2009
TABLE OF CONTENTS
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
This Quarterly Report on Form 10-Q 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 the use of words such as “may,” “will,” “seeks,” “anticipates,” “believes,” “estimates,” “expects,” “projects,” “forecasts,” “plans,” “intends,” “continue,” “could,”
“should” or similar expressions or variations. These statements are based on the beliefs and expectations of our management team based on information currently available. Such forward-looking statements are not guarantees of future performance and are subject to risks and uncertainties that could cause actual results to differ materially from those contemplated by forward-looking statements. Important factors currently known to us that could cause or contribute to such differences include, but are
not limited to, those set forth in this Form 10-Q 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.
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PART I – FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
INTERNAP NETWORK SERVICES CORPORATION
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
2
INTERNAP NETWORK SERVICES CORPORATION
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
3
INTERNAP NETWORK SERVICES CORPORATION
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
4
INTERNAP NETWORK SERVICES CORPORATION
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF
STOCKHOLDERS’ EQUITY AND COMPREHENSIVE LOSS
(In thousands)
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
5
INTERNAP NETWORK SERVICES CORPORATION
UNAUDITED CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Internap Network Services Corporation (“we,” “us” or “our”) delivers services through 74 Internet protocol, or IP, service points of presense, or POPs, and 49 data centers across North America, Europe and the Asia-Pacific region. Our Private Network Access
Points, or P-NAPs, feature multiple direct high-speed connections to major Internet backbones, also referred to as network service providers, including AT&T Inc.; Verizon Communications Inc.; Global Crossing Limited; Level 3 Communications, Inc.; and Sprint Nextel Corporation. As described in note 2, we operate in two business segments: IP services and data center services. These segments reflect a change from our historical segments, which also included content delivery network, or CDN, services as
a separate segment.
We have prepared our unaudited condensed consolidated financial statements pursuant to the rules and regulations of the Securities and Exchange Commission, or SEC, which include all of our accounts and those of our wholly owned subsidiaries. We have condensed or omitted certain information and
note disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States, or U.S. GAAP, pursuant to such rules and regulations. The unaudited condensed consolidated financial statements reflect all adjustments, which consist of normal recurring adjustments, necessary for a fair statement of our financial position as of September 30, 2009 and our operating results, cash flows and changes in stockholders’ equity for the interim periods
presented. We derived the balance sheet at December 31, 2008 from our audited financial statements as of that date. These financial statements and the related notes should be read in conjunction with our financial statements and notes thereto contained in our Annual Report on Form 10-K for the year ended December 31, 2008 filed with the SEC.
The preparation of financial statements in accordance with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and revenues and expenses in the financial statements. Examples of estimates subject to possible revision based
upon the outcome of future events include, among others, the provision for doubtful accounts, network cost accruals, income taxes, sales, use and other taxes, recoverability of long-lived assets and goodwill, depreciation of property and equipment, the valuation of investments, restructuring allowances and stock-based compensation. Actual results could differ from those estimates.
The results of operations for the three and nine months ended September 30, 2009 are not necessarily indicative of the results that may be expected for any future periods or for the year ending December 31, 2009 or subsequent years.
In addition to reclassifications for changes in our segments, discussed in note 2 below, we also have reclassified other prior period amounts to conform to the current period presentation.
We operate in two business segments: IP services and data center services. IP services represent our IP transit activities and include our high-performance Internet connectivity, CDN services and flow control platform, or FCP, products. Data center 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.
During the three months ended June 30, 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 2008 to conform to the current period presentation.
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INTERNAP NETWORK SERVICES CORPORATION
UNAUDITED CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
The following table shows operating results for our business segments, along with reconciliations from segment profit to loss before income taxes and equity in (earnings) loss of equity-method investment (in thousands):
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INTERNAP NETWORK SERVICES CORPORATION
UNAUDITED CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Segment profit is segment revenues less direct costs of network, sales and services, exclusive of depreciation and amortization and does not include direct costs of customer support, direct costs of acquired technologies or any other depreciation or amortization associated with direct costs. Depreciation and amortization associated
with direct costs, including amortization of acquired technologies, was $6.3 million and $8.4 million for the three months ended September 30, 2009 and 2008, respectively, and $24.1 million and $20.4 million for the nine months ended September 30, 2009 and 2008, respectively. Depreciation and amortization associated with direct costs also included impairment charges of $4.1 million for the nine months ended September 30, 2009 and $1.9 million for each of the three and nine months ended September 30, 2008. Other
operating expenses including, depreciation and amortization, also included product development costs of $1.6 million and $2.1 million for the three months ended September 30, 2009 and 2008, respectively, and $5.0 million and $6.4 million for the nine months ended September 30, 2009 and 2008, respectively.
The following table presents selected segment financial information as of September 30, 2009 and December 31, 2008, related to goodwill and total assets (in thousands):
Following our decision to consolidate our business segments, we completed an assessment of goodwill and other intangible assets for impairment as of June 1, 2009, which, as further discussed in note 3, resulted in aggregate impairment charges of $51.5 million for goodwill and $4.1 million for
acquired developed CDN advertising technology. We subsequently reallocated the remaining goodwill of the former CDN services segment (after our June 1, 2009 impairment charge) to the IP services and the data center services segments.
Goodwill
We test goodwill for impairment at least annually as of August 1 of each calendar year. As discussed in note 2, during the three months ended June 30, 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. Our assessment of goodwill for impairment includes comparing the fair value of our reporting units to the net book 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 net book value, goodwill is not impaired and no further testing is necessary. If the net book 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 the affected reporting unit were being acquired 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 balance sheet, we record an impairment charge for the difference. We did not identify an impairment as a result of the annual impairment test.
The decision to consolidate segments required acceleration of our 2009 annual impairment test of goodwill to June 1, 2009, the date we changed how we view and manage our business. As a result of our assessment using an earlier measurement date of June 1, 2009, we recorded an aggregate goodwill impairment charge of $51.5 million during the
three months ended June 30, 2009. This charge included $48.0 million for goodwill related to our former CDN services segment and $3.5 million to adjust goodwill in our IP services segment related to our FCP products. We present the aggregate goodwill impairment charge in “Goodwill impairment and restructuring” in the accompanying statements of operations for the nine months ended September 30, 2009.
The goodwill impairment in our former CDN services segment was primarily due to declines in CDN services revenues and operating results compared to our expectations and declining multiples of comparable companies. The CDN services goodwill arose from our acquisition of VitalStream Holdings, Inc., or VitalStream, in February 2007,
which we initially recorded at a value of $154.7 million, representing 72% of the $214.0 million purchase price. These declines in CDN services revenues and operating results were primarily attributable to continued pricing pressures, which were partially offset by traffic increases. This was combined with higher costs of sales related to traffic mix, as well as a weakened economy and steadily increasing levels of customer churn. This led to a renewed emphasis on and dedication of our internal resources within
our IP services to strengthen our services offering and leverage our entire IP backbone and cost structure. Similarly, the goodwill impairment in our 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. The impairment charges did not impact our current cash balance or result
in violation of any covenants of our debt instruments.
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INTERNAP NETWORK SERVICES CORPORATION
UNAUDITED CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
The changes in the carrying amount of goodwill for the year ended December 31, 2008 and nine months ended September 30, 2009 are as follows (in thousands):
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 we perform the valuation. These estimates and assumptions primarily include, but are not limited to, the discount
rate, terminal growth rate, earnings before interest, taxes, depreciation and amortization, or EBITDA, 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. The following is a description of the valuation methodologies we used to derive the fair value of the former CDN
services segment:
We will continue to perform our annual impairment testing as of August 1 of each calendar year absent any impairment indicators or other changes that may cause more frequent analysis.
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INTERNAP NETWORK SERVICES CORPORATION>
UNAUDITED CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Other Intangible Assets In conjunction with reorganizing our business segments and the associated review of our long-term financial outlook, we also performed an analysis of the potential impairment and re-assessed the remaining asset lives of other identifiable intangible assets. The analysis and re-assessment
of other identifiable intangible assets resulted in:
We include the impairment charge of $4.1 million for acquired developed CDN advertising technology in “Direct costs of amortization of acquired technologies” in the accompanying statements of operations. The change in estimates of remaining useful lives for certain of our intangible
assets related to acquired CDN customer relationships, trade names and non-compete agreements resulted in an increase to our net loss of $1.1 million and $1.6 million, or $0.02 and $0.03 per share, for the three and nine months ended September 30, 2009, respectively. The impairment charges and changes in estimated remaining useful lives of CDN intangible assets did not impact our cash balances or result in violation of any covenants of our debt instruments. We continue to believe that our remaining intangible
assets are not impaired.
The components of our amortizing intangible assets are as follows (in thousands):
On March 31, 2009, we implemented a restructuring plan to reduce our workforce by 45 employees, representing 10% of our total workforce at that time. The reductions were primarily in back-office functions as well as the elimination of certain senior management positions. We recorded $0.9 million
of associated non-recurring severance during the nine months ended September 30, 2009. Substantially all of these charges were cash expenditures, most of which we have paid. Following the March 2009 reduction in force, we incurred an additional $0.1 million related to two leased facilities. Due to the short remaining terms of these leases, we do not expect to earn any sublease income in future periods. All amounts related to these leases are due within the next 12 months.
During the nine months ended September 30, 2009, we reviewed and made adjustments in sublease income assumptions for certain properties included in our previously-disclosed 2007 and 2001 restructuring plans. We made the adjustments to extend the period during which we do not anticipate receiving
sublease income from these properties given our belief that it will take longer to find sublease tenants and the increased availability of space in each of these markets. The related analyses were based on discounted cash flows using the same credit-adjusted risk-free rate that we used to measure the initial restructuring liability for leases that were part of the 2007 restructuring plan and undiscounted cash flows for leases that were part of the 2001 restructuring plan. The new assumptions resulted in an increase
to our restructuring accrual of $2.1 million, which we recorded as an addition to restructuring expense and an increase to the related liability.
10
INTERNAP NETWORK SERVICES CORPORATION
UNAUDITED CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
We report all of these charges and adjustments to the restructuring liability in “Goodwill impairment and restructuring” in the accompanying statements of operations. The following table displays the activity and balances for the restructuring activity for the nine months ended
September 30, 2009 (in thousands):
During the three and nine months ended September 30, 2009, we granted 0.2 million and 2.0 million stock options, respectively, and 0.1 million and 0.9 million shares of unvested restricted common stock, respectively. During the nine months ended September 30, 2009, these grants included 1.1
million stock options and 0.4 million shares of unvested restricted common stock granted in conjunction with annual performance evaluations. The unvested restricted common stock included reissuance of 0.2 million shares of treasury stock, having a cost of $0.6 million. We acquire shares of treasury stock from time-to-time as payment of taxes due from employees for stock-based compensation, including less than $0.1 million for both the three months ended September 30, 2009 and 2008, and $0.3 million
for both the nine months ended September 30, 2009 and 2008. Total stock-based compensation was $1.1 million and $1.9 million for the three months ended September 30, 2009 and 2008, respectively, and $4.4 million and $6.4 million for the nine months ended September 30, 2009 and 2008, respectively. Stock-based compensation for the nine months ended September 30, 2009 also included $0.8 million of expense associated with the resignation of our former president and chief executive officer, which resulted in a modification
of his stock options and restricted common stock, as discussed below. We use the Black-Scholes option valuation model to determine our equity-classified stock-based compensation expense.
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. Mr. Cooney’s employment letter provides for (1) an annual base salary of $0.6 million, (2) a cash signing bonus of $0.3
million (under certain circumstances, Mr. Cooney will be obligated to reimburse us for one half of the signing bonus if his employment terminates prior to March 1, 2011), (3) an option to purchase 0.6 million shares of our common stock at a purchase price of $2.24, the closing price on the day of commencement of work, 25% of which will vest on March 16, 2010 and the remainder to vest in 36 equal monthly installments thereafter, (4) a new hire grant of 0.3 million shares of restricted stock, which will vest in
four equal annual installments, (5) a grant of 0.2 million shares of restricted stock on each of the first and second anniversary of his commencement of work, both such grants to vest in four equal annual installments, (6) an annual incentive bonus based upon criteria established by our board of directors, with a target level of 100% of base salary and a maximum level of 200% of base salary and (7) customary benefits including vacation. The fair value of Mr. Cooney’s stock-based compensation
awards was $2.4 million, including the restricted stock that may be issued on the first and second anniversaries of his commencement of work. We record all executive transition costs with general and administrative costs and expenses in the accompanying statements of operations.
Pursuant to the terms of a separation agreement with Mr. DeBlasio, he received (1) a cash payment of $0.9 million, one half of which we paid in March 2009 and the remainder in September 2009, (2) full vesting of all equity awards previously granted to him, which had an incremental value
of $0.8 million and (3) if he so elects, continued health, dental and vision insurance coverage under our group health plan until September 16, 2010. Mr. DeBlasio has until March 16, 2010 to exercise any stock options that were vested as of March 16, 2009.
11
INTERNAP NETWORK SERVICES CORPORATION
UNAUDITED CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
At the end of each interim reporting period, we estimate the effective income tax rate expected to be applicable for the full year. We use the effective income tax rate to provide for income taxes on a year-to-date basis. We reflect the tax effect of any tax law changes and certain other
discrete events in the period in which they occur.
Our overall effective income tax rate, as a percentage of pre-tax ordinary income, was less than (1%) for both the nine months ended September 30, 2009 and 2008. The nominal negative effective income tax rate was attributable to permanent tax items, including goodwill and acquired developed
CDN advertising technology impairments recorded during the nine months ended September 30, 2009, along with changes in our valuation allowance, and state and United Kingdom income tax expense.
The annual effective tax rate for 2009 could change due to a number of factors including, but not limited to, our geographic profit mix between the United States, the United Kingdom and other foreign jurisdictions, enactments of new tax laws, new interpretations of existing tax law and rulings
by and settlements with taxing authorities.
We continue to maintain a valuation allowance against our deferred tax assets of $131.2 million. The total deferred tax assets primarily consist of net operating loss carryforwards, particularly in the United States. We may recognize deferred tax assets in the United States and/or foreign jurisdictions
in future periods when we estimate them to be realizable. Based on an analysis of our projected future pre-tax income in the United States, we do not have sufficient positive evidence for the release of our valuation allowance against our deferred tax assets in the United States within the next 12 months; therefore, we continue to maintain the full valuation allowance in the United States and all foreign jurisdictions, other than the United Kingdom. We will continue to monitor the need for a valuation allowance
on the deferred tax assets in the United Kingdom. Based on historic profitability and assumptions of future earnings, we may partially or fully reserve the benefit of the United Kingdom deferred tax assets in a future period.
For the nine months ended September 30, 2009, there were no new material uncertain tax positions. Also, we do not expect the total amount of unrecognized tax benefits to significantly increase or decrease within the next 12 months.
We compute basic net loss per share by dividing net loss attributable to our common stockholders by the weighted average number of shares of common stock outstanding, including participating securities outstanding as discussed below, during the period. We have excluded all outstanding options
and unvested restricted stock awards as such securities are anti-dilutive for all periods presented.
On January 1, 2009, we adopted a recently-issued accounting standard related to whether instruments granted in share-based payment transactions are participating securities for calculating earnings per share. This new accounting standard causes all unvested share-based payment awards that
contain non-forfeitable rights to dividends or dividend equivalents (whether paid or unpaid) to be participating securities. The new accounting standard further requires participating securities to be included in the computation of earnings per share pursuant to the two-class method. Under the two-class method, earnings (after any dividends) are allocated to common stock and participating securities to the extent that each security may share in earnings. While our unvested restricted stock awards participate
in any dividends equally with common stock, no losses are attributed to the awards. Upon adoption, we adjusted all prior-period earnings per share data presented retrospectively. The adoption of this new accounting standard did not have any impact on our basic or diluted net loss per share for the three or nine months ended September 30, 2009 or 2008.
We calculated basic and diluted net loss per share for the three and nine months ended September 30, 2009, and 2008 as follows (in thousands, except per share amounts):
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INTERNAP NETWORK SERVICES CORPORATION
UNAUDITED CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
On January 1, 2008, we adopted a new accounting standard as it related to financial assets and liabilities measured on a recurring basis, and on January 1, 2009, we adopted the new standard for nonfinancial assets and liabilities that we recognize or disclose at fair value in the
financial statements on a nonrecurring basis. The major categories of nonfinancial assets and liabilities that we measure at fair value include reporting units measured at fair value in the first step of a goodwill impairment test. Our adoption for measuring nonfinancial assets and liabilities beginning in 2009 did not have a material impact on our consolidated financial statements.
The new accounting standard describes a fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable, that may be used to measure fair value. The fair value hierarchy is summarized as follows:
We also adopted an optional accounting standard to record certain financial assets and financial liabilities at fair value. The accounting standard permitted us to choose to measure, on an instrument-by-instrument basis, many financial instruments and certain other assets and liabilities at
fair value that are not currently required to be measured at fair value. We applied this optional accounting standard to rights, or the ARS Rights, from one of our investment providers to sell at par value our auction rate securities originally purchased from the investment provider at anytime during a two-year period beginning June 30, 2010. We discuss the ARS Rights below.
The following table represents the fair value hierarchy for our financial assets (cash equivalents and investments in marketable securities) measured at fair value on a recurring basis as of September 30, 2009 (in thousands):
Our Level 3 assets consist of auction rate securities and the corresponding ARS Rights. Auction rate securities are variable rate bonds tied to short-term interest rates with maturities on the face of the securities in excess of 90 days and have interest rate resets through a modified Dutch
auction, at predetermined short-term intervals, usually every seven, 28 or 35 days. The securities have historically traded at par value and are callable at par value on any interest payment date at the option of the issuer. Interest received during a given period is based upon the interest rate determined through the auction process. The underlying assets of our auction rate securities are state-issued student and educational loans that are substantially backed by the federal government and carried
AAA/Aaa ratings as of September 30, 2009. Although these securities are issued and rated as long-term bonds, they have historically been priced and traded as short-term instruments because of the liquidity provided through the interest rate resets.
While we continue to earn and accrue interest on our auction rate securities at contractual rates, these investments are not actively trading at the present time and therefore do not currently have a readily determinable market value. Accordingly, the estimated fair value of auction rate securities
no longer approximates par value. Given that observable auction rate securities market information was not available to determine the fair value of our auction rate securities, we estimated the fair value of the auction rate securities based on a wide array of market evidence related to each security’s collateral, ratings and insurance to assess default risk, credit spread risk and downgrade risk that we believe market participants would use in pricing the securities in a current transaction. These assumptions
could change significantly over time based on market conditions.
Beginning in early 2008, auctions failed to attract sufficient buyers and, as a result, the auction rate securities lost their liquidity. Accordingly, we changed the classification of the auction rate securities to non-current investments. In conjunction with our acceptance of the ARS Rights
in November 2008, we changed the investment classification of our auction rate securities from available for sale to trading. As a result, we included changes in fair value in earnings in “Non-operating expense (income)” in the accompanying statements of operations. We intend to exercise the ARS Rights within the next 12 months and, therefore, have reclassified both the underlying securities and the corresponding ARS Rights from non-current to current as of September 30, 2009. The investment classification
of the underlying securities and the corresponding ARS Rights continues to be trading.
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INTERNAP NETWORK SERVICES CORPORATION
UNAUDITED CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
The following table summarizes changes in fair value of our Level 3 financial assets for the nine months ended September 30, 2009 (in thousands):
The following table summarizes our nonfinancial assets measured at fair value on a nonrecurring basis as of September 30, 2009 (in thousands):
We wrote down goodwill and other intangible assets with carrying amounts of $91.0 million and $31.1 million, respectively, to their fair values of $39.5 million and $27.0 million (before additional amortization expense of $3.6 million), respectively. We included the aggregate impairment
charge of $55.6 million in the net loss for the nine months ended September 30, 2009.
Market risk associated with our variable rate revolving line of credit and fixed rate other liabilities relates to the potential negative impact to future earnings and reduction in fair value, respectively, from an increase in interest rates. The following table presents information about our
revolving line of credit and other liabilities at September 30, 2009 and December 31, 2008 (in thousands):
We estimate the fair values of our revolving line of credit and other liabilities based on current market rates of interest.
We currently, and from time-to-time, are involved in litigation incidental to the conduct of our business. Although we cannot ascertain the amount of liability that may result from these matters, we do not currently believe that, in the aggregate, such matters will result in liabilities
material to our consolidated financial statements.
Recently Issued Accounting Pronouncements That We Have Adopted
In June 2009, the Financial Accounting Standards board (“FASB”) issued authoritative guidance codifying U.S. GAAP. While the guidance was not intended to change U.S. GAAP, it did change the way we reference these accounting principles in our unaudited condensed notes to consolidated financial statements. This guidance was effective
for interim and annual reporting periods ending after September 15, 2009. Our adoption of this authoritative guidance as of September 30, 2009 changed how we reference U.S. GAAP in our disclosures.
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INTERNAP NETWORK SERVICES CORPORATION
UNAUDITED CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
On January 1, 2009, we adopted new accounting guidance for business combinations as issued by the FASB. The new accounting guidance establishes principles and requirements for how an acquirer in a business combination recognizes and measures in its financial statements the identifiable
assets acquired, liabilities assumed and any noncontrolling interests in the acquiree, as well as the goodwill acquired and determination of the useful life of intangible assets. The new guidance also amends provisions related to the initial recognition and measurement, subsequent measurement and accounting and disclosures for assets and liabilities arising from contingencies in business combinations. In addition, the new guidance amends the factors that an acquirer should consider in developing the renewal or
extension assumptions used to determine the useful life of a recognized intangible asset. Significant changes from previous guidance resulting from this new guidance include expanded definitions of “business” and “business combination,” expanded disclosure regarding the determination of intangible asset useful lives and the elimination of the distinction between contractual and non-contractual contingencies, including initial recognition and measurement. For all business combinations (whether
partial, full or step acquisitions): (1) the acquirer must record 100% of all assets and liabilities of the acquired business, including goodwill, generally at their fair values; (2) the acquirer must recognize contingent consideration at its fair value on the acquisition date; (3) for certain arrangements, the acquirer must recognize changes in fair value in earnings until settlement; and (4) the acquirer must expense acquisition-related transaction and restructuring costs rather than treat them as part of the
cost of the acquisition. The new accounting guidance also establishes disclosure requirements to enable users to evaluate the nature and financial effects of the business combination. The adoption of this accounting guidance did not have a material impact on our consolidated financial statements, although it could have a material impact on any business combinations we enter into in 2009 or future periods.
On January 1, 2009, we adopted new accounting guidance as issued by the FASB for the determination of whether instruments granted in share-based payment transactions are participating securities. This guidance provides that unvested share-based payment awards that contain nonforfeitable rights
to dividends are participating securities that we must include in the computation of earnings per share pursuant to the two class method. The adoption of this accounting guidance did not have an impact on net loss per share for the three or nine months ended September 30, 2009. See note 7 for additional information.
On January 1, 2009, we adopted new accounting guidance as issued by the FASB which clarifies the accounting for certain transactions and impairment considerations involving equity method investments. The adoption of this accounting guidance did not have a material impact on our consolidated
financial statements.
On January 1, 2009, we adopted new accounting guidance as issued by the FASB which previously delayed the effective date by one year for nonfinancial assets and liabilities that we recognize or disclose at fair value in the financial statements on a non-recurring basis. The major categories of nonfinancial assets and liabilities that
we measure at fair value include reporting units in the first step of a goodwill impairment test. The adoption of this accounting guidance did not have a material impact on our consolidated financial statements. See note 8 for additional information.
On July 1, 2009, we adopted three related sets of accounting guidance as issued by the FASB. The accounting guidance sets forth rules related to determining the fair value of financial assets and financial liabilities when the activity levels have significantly decreased in relation to the normal market, guidance related to the determination
of other-than-temporary impairments to include the intent and ability of the holder as an indicator in the determination of whether an other-than-temporary impairment exists and interim disclosure requirements for the fair value of financial instruments. The adoption of the three sets of accounting guidance did not have a material impact on our consolidated financial statements.
On July 1, 2009, we adopted new accounting guidance related to subsequent events as issued by the FASB. The new requirement establishes the accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. It requires the disclosure of the date through
which an entity has evaluated subsequent events and the basis for that date, that is, whether that date represents the date the financial statements were issued or were available to be issued. The adoption of this accounting guidance did not have a material impact on our consolidated financial statements.
Recently Issued Accounting Pronouncements That We Have Not Yet Adopted
In June 2009, the 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. The provisions of this new accounting guidance is effective for interim and annual reporting periods ending after November 15, 2009 and will become effective for us beginning in the first quarter of 2010. We are currently evaluating the impact of this accounting guidance on our
consolidated financial statements.
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INTERNAP NETWORK SERVICES CORPORATION
UNAUDITED CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
In September 2009, the FASB issued new accounting guidance related to revenue recognition of multiple element arrangements. The new guidance states that if vendor specific objective evidence or third party evidence for deliverables in an arrangement cannot be determined, companies will be required to develop a best estimate of the selling
price to separate deliverables and allocate arrangement consideration using the relative selling price method. The accounting guidance will be applied prospectively and will become effective during the first quarter of 2011. Early adoption is allowed. We are currently evaluating the impact of this accounting guidance on our consolidated financial statements.
In September 2009, the FASB issued new accounting guidance related to certain revenue arrangements that include software elements. Previously, companies that sold tangible products with “more than incidental” software were required to apply software revenue recognition guidance. This guidance often delayed revenue recognition
for the delivery of the tangible product. Under the new guidance, tangible products that have software components that are “essential to the functionality” of the tangible product will be excluded from the software revenue recognition guidance. The new guidance includes factors to help companies determine what is “essential to the functionality.” Software-enabled products will not be subject to other revenue recognition guidance and will likely follow the guidance for multiple deliverable
arrangements issued by the FASB in September 2009, noted above. The new guidance is to be applied on a prospective basis for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with early application permitted. If a company elects earlier application and the first reporting period of adoption is not the first reporting period in the company’s fiscal year, the guidance must be applied through retrospective application from the beginning of the company’s
fiscal year and the company must disclose the effect of the change to those previously reported periods. We are currently evaluating the impact of this accounting guidance on our consolidated financial statements.
In addition to the accounting pronouncements described above, we have adopted and considered other recent accounting pronouncements that either did not have a material effect on our consolidated financial statements or are not relevant to our business. We do not expect other recently issued
accounting pronouncements that are not yet effective will have a material effect on our consolidated financial statements.
We have evaluated all subsequent events through November 5, 2009, which represents the filing date of this Quarterly Report on Form 10-Q with the SEC, to ensure that this Form 10-Q includes appropriate disclosure of events both recognized in the financial statements as of September 30,
2009, and events which occurred subsequent to September 30, 2009 but were not recognized in the financial statements. As of November 5, 2009, there were no subsequent events which required recognition or disclosure.
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INTERNAP NETWORK SERVICES CORPORATION
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with the unaudited condensed consolidated financial statements and accompanying notes provided under Part I, Item 1 of this Quarterly Report on Form 10-Q.
Overview
We are an Internet solutions company providing a suite of network optimization and delivery products and services that manage, deliver and distribute applications and content with a 100% availability service level agreement. With a global platform of data centers and managed Internet services,
we help our customers innovate their business, improve service levels and lower the cost of information technology operations. These solutions, combined with progressive and proactive technical support, enable our customers to migrate business-critical applications from private to public networks.
We deliver services through 74 Internet protocol, or IP, service points of presence, or POPs, and 49 data centers across North America, Europe and the Asia-Pacific region. Our Private Network Access Points, or P-NAPs, feature multiple direct high-speed connections to major Internet backbones,
also referred to as network service providers or NSPs, including AT&T Inc.; Verizon Communications Inc.; Global Crossing Limited; Level 3 Communications, Inc.; and Sprint Nextel Corporation. We operate in two business segments: IP services and data center services, as further described below and in note 2 to the accompanying consolidated financial statements. These segments reflect a change from our historical segments, which also included content delivery network, or 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,” along with the associated operating results for our business segments.
Our intelligent routing technology can facilitate traffic over multiple carriers, as opposed to just one carrier’s network, to ensure highly-reliable performance over the Internet. 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 guarantee performance across a broader segment of the Internet in the United States, excluding local connections, whereas providers of conventional Internet connectivity typically only
guarantee performance on their own network.
We currently have approximately 3,000 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.
Segments
During the three months ended June 30, 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 2008 to conform to the current period presentation.
IP Services. IP services represent our IP transit activities and include our high-performance Internet connectivity, CDN services and FCP products.
Our patented and patent-pending network route optimization solutions address the inherent weaknesses of the Internet, allowing enterprises to take advantage of the convenience, flexibility and reach of the Internet to connect to customers, suppliers and partners. Our solutions take into account
the unique performance requirements of each business application to ensure performance as designed, without unnecessary cost. When recommending an appropriate network solution for our customers’ applications, we consider key objectives such as bandwidth capacity needed, expected bandwidth usage, location of services and cost objectives.
Our CDN services enable our customers to quickly and securely stream and distribute video, audio and software to audiences across the globe through strategically located data centers. Providing capacity-on-demand to handle large events and unanticipated traffic spikes, we deliver high-quality
content regardless of audience size or geographic location.
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INTERNAP NETWORK SERVICES CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)
Our FCP product is 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 and ongoing network configuration. This product represents less than 5% of our IP services revenue for each of the three and nine months ended September 30, 2009 and 2008.
Data Center Services. Data center 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.
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 the 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 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, including nine locations that we operate and 40 locations operated by third parties. We
charge monthly fees for data center services based on the amount of square footage and power that customers use in our facilities. We have relationships with various providers to extend our IP services into markets with high demand.
Goodwill and Other Intangible Assets
We test goodwill for impairment at least annually as of August 1 of each calendar year. Our assessment of goodwill for impairment includes comparing the fair value of our reporting units to the net book 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 net book value, goodwill is not impaired and no further testing is necessary. If the net book 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 the affected reporting unit were being acquired 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 balance sheet, we record an impairment charge for the difference. We did not identify any additional impairment as a result of the annual August 1, 2009 impairment test following our June 1, 2009 impairment, described below.
As previously discussed, during the three months ended June 30, 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 decision to consolidate segments required acceleration of our 2009 annual impairment test of goodwill to June 1, 2009, the date we changed how we view and manage our business. As a result of our assessment using an earlier measurement date of June 1, 2009, we recorded an aggregate goodwill impairment charge of $51.5 million during the three months ended June 30, 2009. This charge included $48.0 million for goodwill related to our former CDN services segment and $3.5 million to adjust goodwill
in our IP services segment related to our FCP products. We present the aggregate goodwill impairment charge in “Goodwill impairment and restructuring” in the accompanying statements of operations for the nine months ended September 30, 2009.
The goodwill impairment in our former CDN services segment was primarily due to declines in CDN services revenues and operating results compared to our expectations and declining multiples of comparable companies. The CDN services goodwill arose from our acquisition of VitalStream Holdings, Inc., or VitalStream, in February 2007,
which we initially recorded at a value of $154.7 million, representing 72% of the $214.0 purchase price. These declines in CDN services revenues and operating results were primarily attributable to continued pricing pressures, which were partially offset by traffic increases. This was combined with higher costs of sales related to traffic mix, as well as a weakened economy and steadily increasing levels of customer churn. This led to a renewed emphasis on and dedication of our internal resources within our IP
services to strengthen our services offering and leverage our entire IP backbone and cost structure. Similarly, the goodwill impairment in our IP services segment was due to declines in our FCP products revenues and operating results. The decline in FCP products revenues was primarily attributable to lower sales associated with a reduced marketing effort as we reevaluated our equipment sales strategy for FCP products. The impairment charges did not impact our current cash balance or result in violation
of any covenants of our debt instruments.
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INTERNAP NETWORK SERVICES CORPORATION>
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)
In conjunction with reorganizing our business segments and the associated review of our long-term financial outlook, we also performed an analysis of the potential impairment and re-assessed the remaining asset lives of other identifiable intangible assets as of June 1, 2009. The analysis
and re-assessment of other identifiable intangible assets resulted in:
We include the impairment charge of $4.1 million for acquired developed CDN advertising technology in “Direct costs of amortization of acquired technologies” in the accompanying statements of operations. The change in estimates of remaining useful lives for certain of our intangible
assets related to acquired CDN customer relationships, trade names and non-compete agreements resulted in an increase to our net loss of $1.1 million and $1.6 million, or $0.02 and $0.03 per share, for the three and nine months ended September 30, 2009, respectively. The impairment charges and changes in estimated remaining useful lives of CDN intangible assets did not impact our cash balances or result in violation of any covenants of our debt instruments. We continue to believe that our remaining intangible
assets are not impaired.
Restructuring
On March 31, 2009, we implemented a restructuring plan to reduce our workforce by 45 employees, representing 10% of our total workforce at that time. The reductions were primarily in back-office functions as well as the elimination of certain senior management positions. We recorded $0.9 million
of associated non-recurring severance during the nine months ended September 30, 2009. Substantially all of these charges were cash expenditures, most of which we have paid. Following the March 2009 reduction in force, we incurred an additional $0.1 million expense related to two leased facilities affected by the reduction in force. Due to the short remaining terms of these leases, we do not expect to earn any sublease income in future periods. All amounts related to these leases are due within the next
12 months.
During the nine months ended September 30, 2009, we reviewed and made adjustments in sublease income assumptions for certain properties included in our previously-disclosed 2007 and 2001 restructuring plans. We made the adjustments to extend the period during which we do not anticipate receiving
sublease income from these properties given our belief that it will take longer to find sublease tenants and an increase in availability of space in each of these markets. The related analyses were based on discounted cash flows using the same credit-adjusted risk-free rate that we used to measure the initial restructuring liability for leases that were part of the 2007 restructuring plan and undiscounted cash flows for leases that were part of the 2001 restructuring plan. The new assumptions resulted in an increase
to our restructuring accrual of $2.1 million, which we recorded as an addition to restructuring expense and an increase to the related liability.
Recent Accounting Pronouncements
Recent accounting pronouncements are summarized in note 10 to the accompanying consolidated financial statements.
Results of Operations
Revenues.> 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, virtual private networking services, managed security services, data back-up, remote storage, restoration services and professional services.
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INTERNAP NETWORK SERVICES CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)
Direct Costs of Network, Sales and Services.> Direct costs of network, sales and services are comprised primarily of:
To the extent a network access point is located a distance from the respective 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 centers in direct costs of customer support.
Direct Costs of Amortization of Acquired Technologies.> Direct costs of amortization of acquired technologies are for technologies acquired through business combinations that are an integral part of the services and products
we sell. We amortize the cost of the acquired technologies over useful lives of three to eight years. The weighted average of remaining life at September 30, 2009 was approximately five years. These direct costs also include impairment of the acquired developed CDN advertising technology in the nine months ended September 30, 2009 and both the three and nine months ended September 30, 2008, as discussed below.
Sales and Marketing Costs.> Sales and marketing costs consist of compensation, commissions and other costs for personnel engaged in marketing, sales and field service support functions, as well as advertising, tradeshows,
direct response programs, new service point launch events, management of our external web site and other promotional costs.
General and Administrative Costs.> 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 for software to be sold, leased or otherwise marketed once we establish technological feasibility until the software is available for general release to customers. 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.
Three and Nine Months Ended September 30, 2009 and 2008
Following is a summary of our results of operations and financial condition, which is followed by more in-depth discussion and analysis.
Total revenues were $64.4 million for the three months ended September 30, 2009, a decrease of $1.0 million, or 1.5%, compared to $65.4 million for the three months ended September 30, 2008. Data center services revenues were $33.5 million and IP services revenues were $30.9 million for the three months ended September 30, 2009. For the three
months ended September 30, 2009, data center services revenues increased $3.6 million, or 12%, while IP services revenues decreased $4.6 million, or 13% compared to the same period in 2008. The decrease in IP services revenues was driven by a decline in IP pricing for new and renewing customers and the loss of older customers who paid higher effective prices, partially offset by an increase in overall traffic.
Total operating costs and expenses, excluding goodwill impairment and restructuring disclosed separately, were $66.2 million and $66.7 million for the three months ended September 30, 2009 and 2008, respectively. We experienced period-to-period increases in direct costs of network, sales and services for data center services and depreciation
and amortization, primarily from our expansion of data center space. These increases were largely offset by lower direct costs of amortization after impairment of acquired developed CDN advertising technology as of June 1, 2009. In the three months ended September 30, 2009, we also reduced our direct costs of network, sales and services for IP services, the provision for doubtful accounts and outside professional services compared to the same period in 2008. Total operating costs and expenses also included separately
disclosed goodwill impairment and restructuring of $100.4 million in each of the three and nine months ended September 30, 2008 and $54.6 million in the nine months ended September 30, 2009.
Our financial position and liquidity remain strong. We ended the quarter with more than $67.8 million in cash and cash equivalents and $23.3 million in debt obligations, including $3.3 million for capital leases. Net cash flows provided by operations were $27.2 million. Quarterly days sales outstanding at September 30, 2009 were 34 days,
down from 40 days at December 31, 2008. 20
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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)
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