UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended January 31, 2002
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission file number: 0-27597
NAVISITE, INC.
(Exact name of registrant as specified in its charter)
Delaware 52-2137343
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation)
400 Minuteman Road
Andover, Massachusetts 01810
(Address of principal executive (Zip Code)
offices)
(978) 682-8300
(Registrant's telephone number, including area code)
----------------
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
As of March 15, 2002 there were 88,015,675 shares outstanding of the
registrant's common stock, par value $.01 per share.
Page 1 of 30
NAVISITE, INC.
Form 10-Q for the Quarter ended January 31, 2002
INDEX
Page
Number
------
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of January 31, 2002 (unaudited)
and July 31, 2001.................................................... 3
Consolidated Statements of Operations for the three and six months
ended January 31, 2002 and 2001 (unaudited).......................... 4
Consolidated Statements of Cash Flows for the six months
ended January 31, 2002 and 2001 (unaudited).......................... 5
Notes to Interim Consolidated Financial Statements (unaudited)....... 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations.................................. 11
Item 3. Quantitative and Qualitative Disclosures About
Market Risk ......................................................... 26
PART II. OTHER INFORMATION
Item 1. Legal Proceedings............................................ 26
Item 2. Changes in Securities and Use of Proceeds.................... 26
Item 3. Defaults Upon Senior Securities.............................. 27
Item 4. Submission of Matters to a Vote of Security Holders.......... 27
Item 5. Other Information............................................ 28
Item 6. Exhibits and Reports on Form 8-K............................. 28
SIGNATURE ............................................................ 29
EXHIBIT INDEX ........................................................ 30
Page 2 of 30
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements.
NAVISITE, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except par value and share value)
January 31, July 31,
-------------------------------
2002 2001
-------------- ---------------
(unaudited)
ASSETS
Current assets:
Cash and cash equivalents $ 31,668 $ 22,214
Accounts receivable, less allowance for doubtful accounts of $3,078 and
$6,859 at January 31, 2002 and July 31, 2001, respectively 7,245 10,933
Due from CMGI and affiliates 4,774 4,362
Assets held for sale 3,459 -
Prepaid expenses and other current assets 1,737 2,184
-------------- ---------------
Total current assets 48,883 39,693
Property and equipment, net 61,619 63,410
Other assets 4,093 3,718
Restricted cash 4,400 5,051
Goodwill, net of accumulated amortization of $734 and $631 at January 31,
2002 and July 31, 2001, respectively 291 394
-------------- ---------------
Total assets $ 119,286 $ 112,266
============== ===============
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Capital lease obligations, current portion $ 2,169 $ 42
Due to CMGI 3,149 14,821
Due to Sun Microsystems 1,874 -
Accounts payable 5,282 10,341
Accrued expenses 26,163 19,299
Deferred revenue 2,277 3,818
Software vendor payable, current portion 468 837
Customer deposits 256 218
-------------- ---------------
Total current liabilities 41,638 49,376
Software vendor payable, less current portion - 79
Convertible notes payable to CMGI, net of a discount of $6,290
and $10,227 at January 31, 2002 and July 31, 2001, respectively 3,710 69,773
Convertible notes payable to Compaq Financial Services, net of a discount
of $34,655 20,438 -
-------------- ---------------
Total liabilities 65,786 119,228
Commitments and contingencies
Stockholders' equity (deficit):
Preferred Stock, $.01 par value, 5,000 shares authorized; 0 shares issued
and outstanding at January 31, 2002 and July 31, 2001, respectively - -
Common Stock, $.01 par value, 395,000 shares authorized; 88,011 and 61,868
shares issued and outstanding at January 31, 2002 and July 31, 2001,
respectively 880 619
Additional paid-in capital 339,384 208,064
Accumulated deficit (286,764) (215,645)
-------------- ---------------
Total stockholders' equity (deficit) 53,500 (6,962)
-------------- ---------------
Total liabilities and stockholders' equity (deficit) $ 119,286 $ 112,266
============== ===============
See accompanying notes to interim consolidated financial statements.
Page 3 of 30
NAVISITE, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
(in thousands, except share and per share data)
Three months ended Six months ended
January 31, January 31,
---------------------------- -----------------------
2002 2001 2002 2001
----------- ---------------- ----------- ----------
Revenue:
Revenue $11,747 $16,984 $25,230 $32,001
Revenue, related parties 3,927 10,694 9,723 21,732
----------- ---------------- ----------- ----------
Total revenue 15,674 27,678 34,953 53,733
Cost of revenue 20,307 33,770 41,684 65,827
Impairment of long-lived assets 7,226 - 34,585 -
----------- ---------------- ----------- ----------
Total cost of revenue 27,533 33,770 76,269 65,827
Gross deficit (11,859) (6,092) (41,316) (12,094)
Operating expenses:
Product development 1,945 3,797 3,922 6,693
Selling and marketing 2,502 11,163 5,138 19,292
General and administrative 7,086 9,824 13,921 15,787
----------- ---------------- ----------- ----------
Total operating expenses 11,533 24,784 22,981 41,772
----------- ---------------- ----------- ----------
Loss from operations (23,392) (30,876) (64,297) (53,866)
Other income (expense):
Interest income 168 819 332 1,693
Interest expense (3,576) (1,753) (7,185) (2,702)
Other income (expense), net 21 (120) 31 (120)
----------- ---------------- ----------- ----------
Loss before cumulative effect of change
in accounting principle (26,779) (31,930) (71,119) (54,995)
Cumulative effect of change in
accounting principle - - - (4,295)
----------- ---------------- ----------- ----------
Net loss $ (26,779) $ (31,930) $ (71,119) $(59,290)
=========== ================ =========== ==========
Basic and diluted net loss per
common share:
Before cumulative effect of change
in accounting principle $ (0.31) $ (0.54) $ (0.96) $ (0.94)
Cumulative effect of change in
accounting principle - - - (0.07)
----------- ---------------- ----------- ----------
Basic and diluted net loss per
common share $ (0.31) $ (0.54) $ (0.96) $ (1.01)
=========== ================ =========== ==========
Basic and diluted weighted
average number of common
shares outstanding 85,464 58,707 73,768 58,621
=========== ================ =========== ==========
See accompanying notes to interim consolidated financial statements.
Page 4 of 30
NAVISITE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
(in thousands)
Six months ended
January 31,
---------------------------------
2002 2001
---------------- ----------------
(in thousands)
Cash flows from operating activities:
Net loss $ (71,119) $ (59,290)
Adjustments to reconcile net loss to net cash
used for operating activities:
Depreciation and amortization 10,999 7,467
Provision for bad debts 3,230 5,177
Amortization of deferred compensation - 1,051
Amortization of beneficial conversion feature to
interest expense 1,616 -
Interest on debt paid in stock 2,542 -
(Gain)/loss on disposal of assets (126) 120
Loss on impairment of long-lived assets 34,585 -
Amortization of interest related to stock warrants
issued with the notes to CMGI 1,172 538
Cumulative effect of change in accounting principle - 4,295
Changes in operating assets and liabilities:
Accounts receivable 1,214 (7,976)
Due from CMGI and affiliates (2,709) 770
Due to CMGI 4,537 3,737
Prepaid expenses and other current assets 447 (2,737)
Other assets (476) -
Accounts payable (5,059) 4,652
Accrued expenses and deferred revenue 2,571 (8,957)
Customer deposits 38 -
---------------- ----------------
Net cash used by operating activities (16,538) (51,153)
Cash flows from investing activities:
Purchases of property and equipment (3,299) (22,134)
Proceeds from sale of property and equipment 164 13,884
Restricted cash 651 (579)
---------------- ----------------
Net cash used by investing activities (2,484) (8,829)
Cash flows from financing activities:
Issuance of convertible notes payable 30,000 80,000
Proceeds from exercise of stock options and
employee stock purchase plan 34 783
Payments of capital lease obligations (1,110) (29,607)
Payments of software vendor obligations (448) (410)
---------------- ----------------
Net cash provided by financing activities 28,476 50,766
---------------- ----------------
Net increase (decrease) in cash 9,454 (9,216)
Cash, beginning of period 22,214 77,947
---------------- ----------------
Cash, end of period $ 31,668 $ 68,731
================ ================
Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest $ 812 $ 1,099
================ ================
See accompanying notes to interim consolidated financial statements.
Page 5 of 30
NAVISITE, INC.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
January 31, 2002
1. Basis of Presentation
The accompanying interim consolidated financial statements have been
prepared by NaviSite, Inc. (NaviSite or the Company) in accordance with
accounting principles generally accepted in the United States of America and
pursuant to the rules and regulations of the Securities and Exchange Commission.
Certain information and footnote disclosures normally included in financial
statements prepared in accordance with accounting principles generally accepted
in the United States of America have been condensed or omitted pursuant to such
rules and regulations. It is suggested that the financial statements be read in
conjunction with the audited financial statements and the accompanying notes
included in the Company's Form 10-K which was filed with the Securities and
Exchange Commission on October 30, 2001.
The information furnished reflects all adjustments, which, in the
opinion of management, are of a normal recurring nature and are considered
necessary for a fair presentation of results for the interim periods. Such
adjustments consist only of normal recurring items. It should also be noted that
results for the interim periods are not necessarily indicative of the results
expected for the full year or any future period.
The preparation of these interim consolidated financial statements in
conformity with accounting principles generally accepted in the United States of
America requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities and disclosures of contingent assets
and liabilities at the date of the financial statements and the reported amounts
of revenues and expenses during the reporting period. Actual results could
differ from those estimates.
2. Principles of Consolidation
The accompanying financial statements include the accounts of the
Company and its wholly owned subsidiary, ClickHear, Inc. (ClickHear), after
elimination of all significant intercompany balances and transactions.
3. Cash and Cash Equivalents
Cash equivalents consist of a money market fund that invests in high
quality short-term debt obligations, including commercial paper, asset-backed
commercial paper, corporate bonds, U.S. government agency obligations, taxable
municipal securities and repurchase agreements.
During the fiscal 2002 first quarter, the letter of credit related to
the LaJolla, California facility was not renewed and the landlord drew down the
related $555,000 of restricted cash.
During the fiscal 2002 first quarter, non-cash financing activities
included a $35 million obligation to Compaq Financial Services Corporation, a
wholly-owned subsidiary of Compaq Computer Corporation (CFS), incurred for the
purchase of equipment previously held under operating lease agreements with a
fair value, based on a third-party appraisal, of $9.6 million. Since the fair
market value of the equipment purchased was less than the associated obligation,
the Company recorded an impairment charge in the first quarter of fiscal 2002 in
the amount of $25.4 million. See Note 6.
During the fiscal 2002 second quarter, non-cash financing activities
included the conversion of the $80.0 million face value convertible note payable
to CMGI, Inc. (CMGI), including interest of $1.5 million, and $16.2 million of
amounts due to CMGI into 24,629,900 shares of the Company's common stock. In
addition, 1,003,404 shares of common stock were issued in satisfaction of
accrued interest associated with the $65.1 million notes payable to CMGI and
CFS.
Page 6 of 30
4. Property and Equipment
January 31, July 31,
------------------------
2002 2001
------------ -----------
(in thousands)
Office furniture and equipment $ 5,905 $ 5,318
Computer equipment 27,479 18,178
Software licenses 16,356 16,657
Leasehold improvements 44,856 45,452
------------ -----------
Less: Accumulated depreciation 94,596 85,605
and amortization (32,977) (22,195)
------------ -----------
$ 61,619 $ 63,410
============ ===========
During the fiscal 2002 second quarter, the Company performed a physical
inventory of its customer dedicated equipment. As a result of this inventory,
the Company recorded an impairment charge of $1.9 million for obsolete equipment
and for equipment no longer on hand and identified certain excess assets not in
use. The Company approved a plan whereby the excess assets not in use would be
disposed of within the next twelve months. These assets are classified as assets
held for sale on the Company's balance sheet as of January 31, 2002 and have
been valued at their estimated fair value less costs to sell. The majority of
the assets held for sale were acquired during the first and second quarters of
fiscal year 2002 in conjunction with the buyout of equipment previously held
under certain operating leases.
In the second quarter of fiscal year 2002, the Company recorded a $3.2
million charge representing the future remaining minimum lease payments related
to certain idle equipment held under various operating leases. The equipment had
previously been rented to former customers, and upon the loss of the customer
the equipment became idle. Based on the Company's forecasts, the equipment will
not be utilized before the related operating leases expire and/or the equipment
becomes obsolete.
In the second quarter of fiscal year 2002, the Company evaluated the
current and forecasted utilization of its purchased software licenses. As a
result of this evaluation, during the second quarter of fiscal year 2002, the
Company recorded a $365,000 impairment for software licenses that would not be
utilized before the licenses expired and/or became obsolete.
In the second quarter of fiscal year 2002, the Company finalized an
agreement with an equipment lessor whereby the Company purchased all equipment
previously held under operating lease for $4.3 million. The fair market value of
the equipment at the time of purchase was $2.3 million. The $2.0 million
difference between the fair market value of the equipment, based on a
third-party appraisal, and the purchase price was previously recorded as an
asset impairment charge for the three-month period ended October 31, 2001.
In the second quarter of fiscal year 2002, the Company purchased
certain equipment with a fair market value of $1.2 million, previously leased
by the Company from two equipment vendors under operating lease agreements,
for $2.7 million, of which $848,000 was paid in the second quarter of fiscal
year 2002 and two payments of $937,000 are payable in February 2002 and May
2002. As the fair market value of the equipment, based on a third-party
appraisal, was less than the consideration given, the Company has recorded an
asset impairment charge for the three-month period ended January 31, 2002 of
$408,000.
In the second quarter of fiscal year 2002, the Company modified the
payment amounts and terms of certain operating leases with two equipment vendors
such that the modified leases qualify as capital leases. One of the resulting
capital leases is payable in 24 monthly payments of $38,000, starting in
December 2001. The second capital lease has total payments of $2.6 million, of
which $1.0 million was paid in the second quarter of fiscal year 2002 and $1.6
million is payable in January 2003. The equipment under both capital leases was
capitalized at the fair market value of the equipment at the time of the
modification, $1.0 million, which was lower than the present value of the future
minimum lease payments based on the Company's estimated incremental borrowing
rate of 12%. As the fair market value of the equipment, based on a third-party
appraisal, was less than the consideration given, the Company has recorded an
asset impairment charge for the three-month period ended January 31, 2002 of
$1.3 million.
5. Accrued Expenses
January 31, July 31,
-----------------------------
2002 2001
------------ ----------------
(in thousands)
Accrued payroll, benefits and commissions $ 3,536 $ 2,772
Accrued accounts payable 7,077 3,078
Accrued lease payments 8,454 6,030
Accrued restructuring 3,393 5,236
Accrued interest 1,636 5
Other 2,067 2,178
------------ ----------------
$ 26,163 $ 19,299
============ ================
In July 2001, the Company announced a plan, approved by the Board of
Directors, to restructure its operations and consolidate its data centers, which
resulted in a charge of approximately $8.0 million, of which approximately $5.2
million was accrued for as of July 31, 2001. Of the total restructuring charge,
approximately $1.8 million was related to employee termination benefits. The
Company terminated 126 employees on July 31, 2001.
The restructuring charge also included approximately $6.2 million of
costs related to the closing of the Company's two
Page 7 of 30
original data centers. The components of the facility closing costs included
approximately $3.8 million of lease costs and other contractual obligations, to
be paid over the term of the respective agreements through 2002, and
approximately $2.4 million of write-offs of leasehold improvements, which were
recorded as of July 31, 2001. The Company expects that the accrued restructuring
amounts at January 31, 2002 will be settled in cash over the remaining
contractual period extending through May 2003. Details of activity in the
restructuring accrual for the six-month period ended January 31, 2002 follows:
Balance at Balance at
July 31, 2001 Activity January 31, 2002
------------------ --------------- ----------------
(in thousands)
Severance/Employee Costs $ 1,408 $ (1,160) $ 248
Facility Closing Costs 3,828 (683) 3,145
---------------- --------------- ----------------
Total $ 5,236 $ (1,843) $ 3,393
================ =============== ================
6. Agreements with CMGI and CFS
In connection with an agreement dated October 29, 2001 among the
Company, CMGI and CFS, the Company purchased certain equipment with a fair
market value of $9.6 million, previously leased by the Company from CFS under
operating lease agreements expiring through 2003, in exchange for a note payable
in the face amount of approximately $35 million. As the fair market value of the
equipment, based on a third-party appraisal, was less than the associated debt
obligation, the Company recorded an asset impairment charge in the first quarter
of fiscal 2002 of $25.4 million. The Company recorded the assets purchased and
associated impairment charge effective August 1, 2001 with a corresponding
obligation to CFS. Based on the terms of the $35 million obligation, interest
accrues commencing on November 8, 2001. The Company recognized $1.1 million and
$1.0 million of interest expense for the first and second quarter of fiscal
2002, respectively.
On November 8, 2001, in connection with the October 29, 2001 agreement,
the Company received $20 million and $10 million in cash from CFS and CMGI,
respectively, in exchange for six-year convertible notes payable in the face
amounts of $20 million and $10 million to CFS and CMGI, respectively, making the
total notes payable issued by the Company to CFS and CMGI approximately $55
million and $10 million, respectively. The notes require payment of interest
only, at 12% per annum, for the first three years from the date of issuance and
then repayment of principal and interest, on a straight-line basis, over the
next three years until maturity on the sixth anniversary of the date of
issuance. At the Company's option, the Company may make interest payments (i)
100% in shares of the Company's common stock, in the case of amounts owed to
CMGI, through December 2007 and (ii) approximately 16.67% in shares of the
Company's common stock, in the case of amounts owed to CFS, through December
2003. The convertible notes payable are secured by substantially all of the
assets of the Company and cannot be prepaid.
Page 8 of 30
The principal balances of these notes may be converted into the
Company's common stock at the option of the holders at any time prior to or at
maturity at a conversion rate of $0.26 per share. The conversion rate of $0.26
results in beneficial conversion rights for both CMGI and CFS. The intrinsic
value of the beneficial conversion rights amounted to $6.5 million and
$36.0 million for CMGI and CFS, respectively. The value of the beneficial
conversion rights are being amortized into interest expense over the life of
the convertible notes payable. CMGI also converted its $80 million in aggregate
principal outstanding under its existing notes payable as an additional
component of interest expense, plus the accrued interest thereon, into
approximately 14.7 million shares of the Company's common stock. CMGI
also converted approximately $16.2 million in other amounts due by the Company
to CMGI into approximately 9.9 million shares of the Company's common stock.
In the second quarter of fiscal year 2002, the Company issued 1,003,404
shares of common stock in satisfaction of accrued interest associated with the
$65.1 million notes payable to CMGI and CFS.
Holders of the convertible notes payable are entitled to both demand
and piggyback registration rights, and CFS is entitled to anti-dilution
protection under certain circumstances. The agreement with CFS and CMGI also
contains certain restrictive covenants, including but not limited to limitations
on the issuance of additional debt, the sale of equity securities to affiliates
and certain acquisitions and dispositions of assets. At January 31, 2002, the
Company was not in compliance with several of these covenants. Subsequent to
January 31, 2002, the Company received a waiver from CFS and CMGI for the
non-compliance.
7. Revenue Recognition
Effective August 1, 2000, the Company adopted SEC Staff Accounting
Bulletin No. 101 - Revenue Recognition in Financial Statements (SAB 101). Under
SAB 101, installation fees are recognized over the life of the related customer
contract. Prior to fiscal year 2001, the Company recognized installation fees at
the time that the installation occurred. The cumulative effect of the change in
accounting for installation services on all prior periods resulted in a $4.3
million increase in net loss for the quarter ended October 31, 2000 and is
reflected as a cumulative effect of change in accounting principle. For the
three and six-month periods ended January 31, 2002, revenue has been reduced by
$20,000 and $1,000, respectively, than was previously recognized in the fourth
quarter of 2001 in connection with the implementation of SAB 101.
8. Legal Matters
On or about June 13, 2001, Stuart Werman and Lynn McFarlane filed a
lawsuit against the Company, BancBoston Robertson Stephens, Inc., an underwriter
of the Company's initial public offering in October 1999, Joel B. Rosen, the
Company's then Chief Executive Officer, and Kenneth W. Hale, the Company's then
Chief Financial Officer. The suit was filed in the United States District Court
for the Southern District of New York. The suit generally alleges that the
defendants violated federal securities laws by not disclosing certain actions
allegedly taken by Robertson Stephens in connection with the Company's initial
public offering. The suit alleges specifically that Robertson Stephens, in
exchange for the allocation to its customers of shares of the Company's common
stock sold in the Company's initial public offering, solicited and received from
its customers undisclosed commissions on transactions in other securities and
required its customers to purchase additional shares of the Company's common
stock in the aftermarket at pre-determined prices. The suit seeks unspecified
monetary damages and certification of a plaintiff class consisting of all
persons who acquired shares of the Company's common stock between October 22,
1999 and December 6, 2000.
On or about June 21, 2001, David Federico filed in the United States
District Court for the Southern District of New York a lawsuit against the
Company, Mr. Rosen, Mr. Hale, FleetBoston Robertson Stephens, Inc. and other
underwriter defendants including J.P. Morgan Chase, First Albany Companies,
Inc., Bank of America Securities, LLC, Bear Stearns & Co., Inc., B.T.
Alex.Brown, Inc., Chase Securities, Inc., CIBC World Markets, Credit Suisse
First Boston Corp., Dain Rauscher, Inc., Deutsche Bank Securities, Inc., The
Goldman Sachs Group, Inc., J.P. Morgan & Co., J.P. Morgan Securities, Lehman
Brothers, Inc., Merrill Lynch, Pierce, Fenner & Smith, Inc., Morgan Stanley Dean
Witter & Co., Robert Fleming, Inc. and Salomon Smith Barney, Inc. The suit
generally alleges that the defendants violated the anti-trust laws and the
federal securities laws by conspiring and agreeing to raise and increase the
compensation received by the underwriter defendants by requiring those who
received allocation of initial public offering stock to agree to purchase shares
of manipulated securities in the after-market of the initial public offering at
escalating price levels designed to inflate the price of the manipulated stock,
thus artificially creating an appearance of demand and high prices for that
stock, and initial public offering stock in general, leading to further stock
offerings. The suit also alleges that the defendants arranged for the
underwriter defendants to receive undisclosed and excessive brokerage
commissions and that, as a consequence, the underwriter defendants successfully
increased investor interest in the manipulated initial public offering
securities and increased the underwriter defendants' individual and collective
underwritings, compensation and revenues. The suit further alleges that the
defendants violated the federal securities laws by issuing and selling
securities pursuant to the initial public offering without disclosing to
investors that the underwriter defendants in the offering, including the lead
underwriters, had solicited and received excessive and undisclosed commissions
from certain investors. The suit seeks unspecified monetary damages and
certification of a plaintiff class consisting of all persons who acquired shares
of the Company's common stock between October 22, 1999 and June 12, 2001.
The Company believes that the allegations are without merit and it
intends to vigorously defend against the plantiffs' claims. As the litigation is
in an initial stage, the Company is not able to predict the possible outcome of
the suits and their ultimate effect, if any, on its financial condition.
Page 9 of 30
The Company is also subject to other legal proceedings and claims which
arise in the ordinary course of its business. In the opinion of management, the
amount of ultimate liability with respect to these actions will not materially
affect the consolidated financial position or results from operations of the
Company.
9. Net Loss Per Common Share
Basic earnings (loss) per share is computed using the weighted average
number of common shares outstanding during the period. Diluted earnings (loss)
per share is computed using the weighted average number of common and dilutive
common equivalent shares outstanding during the period using the as-if-converted
method for convertible notes payable or the treasury stock method for options,
unless such amounts are anti-dilutive.
For the three and six-month periods ended January 31, 2002 and 2001,
net loss per basic and diluted share is based on weighted average common shares
and excludes any common stock equivalents, as they would be anti-dilutive due to
the reported loss. For the three and six-month periods ended January 31, 2002,
276,501 and 349,292, respectively, of dilutive shares related to employee stock
options and 250 million shares issuable related to convertible debt were
excluded as they had an anti-dilutive effect due to the net loss.
10. New Accounting Pronouncements
In June 2001, the FASB issued Statement of Financial Accounting
Standards (SFAS) No. 141, Business Combinations, and SFAS No. 142, Goodwill and
Other Intangible Assets. SFAS No. 141 will apply to all business combinations
that the Company enters into after June 30, 2001, and eliminates the
pooling-of-interest method of accounting. SFAS No. 142 is effective for fiscal
years beginning after December 15, 2001. Under SFAS Nos. 141 and 142, goodwill
and intangible assets deemed to have indefinite lives will no longer be
amortized but will be subject to annual impairment tests in accordance with the
Statements. Other intangible assets will continue to be amortized over their
useful lives.
The Company is required to adopt these Statements for accounting for
goodwill and other intangible assets beginning the first quarter of fiscal year
2003. Unamortized goodwill at January 31, 2002 amounts to $291,000. The Company
intends to continue to perform an impairment analysis of the remaining goodwill
through the end of fiscal year 2002. Upon adoption on August 1, 2002, the
Company will perform the required impairment test of goodwill and does not
expect the implementation of these standards to have a material impact on its
financial condition or results of operations.
SFAS No. 143, Accounting For Asset Retirement Obligations, issued in
August 2001, addresses financial accounting and reporting for obligations
associated with the retirement of tangible long-lived assets and for the
associated retirement costs. SFAS No. 143, which applies to all entities that
have a legal obligation associated with the retirement of a tangible long-lived
asset, is effective for fiscal years beginning after June 15, 2002. The Company
does not expect the implementation of SFAS No. 143 to have a material impact on
its financial condition or results of operations.
SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived
Assets, issued in October 2001, addresses financial accounting and reporting for
the impairment or disposal of long-lived assets. SFAS No. 144, which applies to
all entities, is effective for fiscal years beginning after December 15, 2001.
The Company does not expect the implementation of SFAS No. 144 to have a
material impact on its financial condition or results of operations.
11. Subsequent Events
Subsequent to January 31, 2002, the Company signed an agreement (the
"Engage Agreement") with Engage, Inc. ("Engage"), a related party, whereby
Engage's contract with the Company was terminated. Pursuant to the Engage
Agreement, the Company will receive cash payments of $1.2 million in March 2002,
$1.2 million in April 2002, and $1.2 million in July 2002, for a total of $3.6
million. For the three and six-month periods ended January 31, 2002, Engage
represented less than 1% and 4%, respectively, of the Company's total revenue.
As a result of the Engage Agreement, the Company will recognize approximately
$2.3 million of non-recurring revenue in the third quarter of fiscal year 2002.
Subsequent to January 31, 2002, the Company modified certain operating
leases with a lessor such that the modified leases qualify as capital leases. No
gain or loss was recognized on this modification. In addition to the lease
modifications, subsequent to January 31, 2002, the Company returned equipment
held under certain operating leases with the same lessor and incurred a breakage
fee of $397,000.
At January 31, 2002, we were not in compliance with several of the
covenants of our convertible notes payable with CFS and CMGI. Subsequent to
January 31, 2002, we received a waiver from both CFS and CMGI for the
non-compliance and we are currently in compliance with the covenants of the
convertible notes payable with CFS and CMGI.
We currently continue to be in default with an operating lease,
aggregating $270,000 of future lease payments. However, we have received a
letter from the lessor stating that it will not accelerate payments or repossess
equipment while our payments maintain a current status.
Page 10 of 30
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations.
This Form 10-Q contains forward-looking statements within the meaning
of Section 21E of the Securities Exchange Act of 1934, as amended, that involve
risks and uncertainties. All statements other than statements of historical
information provided herein are forward-looking statements and may contain
information about financial results, economic conditions, trends and known
uncertainties. Our actual results could differ materially from those discussed
in the forward-looking statements as a result of a number of factors, which
include those discussed in this section and elsewhere in this report and the
risks discussed in our other filings with the Securities and Exchange
Commission. Readers are cautioned not to place undue reliance on these forward-
looking statements, which reflect management's analysis, judgment, belief or
expectation only as of the date hereof. We undertake no obligation to publicly
reissue these forward-looking statements to reflect events or circumstances that
arise after the date hereof.
Overview
We provide outsourced Web hosting and managed application services for
companies conducting business on the Internet, including enterprises and other
businesses deploying Internet applications. Our goal is to help customers focus
on their core competencies by outsourcing the management and hosting of their
Web operations and applications, allowing customers to fundamentally improve the
efficiency of their Web operations. We also provide related professional and
consulting services. Our focus on enhanced management services, beyond basic
co-location services, allows us to meet the expanding needs of businesses as
their Web sites and Internet applications become more complex. We believe that
we are the leader of "Always On Managed Hosting" and that there are a relatively
small number of companies that combine a highly scalable and developed
infrastructure with experience, intellectual property, skill sets, processes and
procedures for delivering managed hosting services. We define "Always On Managed
Hosting" as a combination of high availability infrastructure, high performance
monitoring systems and proactive problem resolution management processes
designed to recognize patterns and identify and address potentially crippling
problems before they are able to cause downtime in customers' web operations.
The cost for our services varies from customer to customer based on the number
of managed servers and the nature, extent and level of services provided.
We were incorporated in Delaware in December 1998 and are a 77.33%
owned subsidiary of CMGI. In July 1998, our predecessor, NaviSite Internet
Services Corporation, acquired Servercast Communications, L.L.C., a Delaware
limited liability company and developer and integrator of Internet applications,
for $1.0 million in notes, plus $25,000 of bridge notes receivable and $20,000
in acquisition costs. We acquired Servercast principally for its expertise in
application management, online advertising, e-commerce, content management and
streaming media. In February 2000, we acquired ClickHear, Inc. for consideration
valued at approximately $4,693,000, including approximately $50,000 of direct
costs of the acquisition. We acquired ClickHear principally for its expertise in
streaming media management and development.
Since January 31, 2000, our corporate headquarters has been located at
400 Minuteman Road, Andover, Massachusetts. Before this date, our corporate
headquarters were shared with CMGI and several other CMGI affiliates. CMGI
allocated rent, facility maintenance and service costs among these affiliates
based upon headcount within each affiliate and within each department of each
affiliate. Other services provided by CMGI to us included support for enterprise
services, human resources and benefits and Internet marketing and business
development. Actual expenses could have varied had we been operating on a stand-
alone basis. Costs are allocated to us on the basis of the fair market value for
the facilities used and the services provided. Through July 31, 2001, we
operated two data centers in California and two data centers in Andover,
Massachusetts. On July 31, 2001, we announced the closure of our two original
data centers, one in Andover, Massachusetts and one in Scotts Valley,
California.
We derive our revenue primarily from managed hosting services, but
within that framework, from a variety of services, including: Web site and
Internet application hosting, which includes access to our state-of-the-art data
centers, a range of bandwidth services, Content Distribution Network services,
advance back-up options, managed storage and monitoring services; enhanced
server management, which includes custom reporting, hardware options, network
and application load balancing, system security, and the services of our
technical account managers; specialized application management, which includes
management of e-commerce and other sophisticated applications support services,
including scalability testing, streaming services for managed hosting customers,
databases and transaction processing services. We also derive revenue from
related consulting and other professional services. Revenue also includes income
from the rental of equipment to customers, termination fees and one-time
installation fees. Revenue is recognized in the period in which the services are
performed. Installation fees are recognized ratably over the period of the
customer contract. Previous to fiscal year 2001, installation revenue was
recognized at the time installation services were provided. Our customer
contracts generally are a one to two year commitment.
We have incurred significant net losses and negative cash flows from
operations since our inception and, as of January 31, 2002, had an accumulated
deficit of approximately $287 million. These losses have been funded primarily
by CMGI through the issuance of common stock, preferred stock and convertible
debt and by our initial public offering and related exercise of the
underwriters' over-allotment option in October 1999 and November 1999,
respectively, as well as by the sale-leaseback of certain assets and through the
issuance of convertible debt to Compaq Financial Services Corporation, a wholly
owned subsidiary of Compaq Computer Corporation (CFS). Since the beginning of
fiscal year 2002 we have implemented labor efficiencies, restructured our major
operating leases and obligations and eliminated excess capacity in order to
accelerate our path to profitability. Although we expect that we will continue
to incur operating losses and negative cashflows from operations for at least
the remainder of this fiscal year, we have systematically reduced our run-rate
cash expenses and have lowered our revenue requirement for EBITDA break-even.
Page 11 of 30
Recent Developments
We are currently evaluating our business model whereby we would provide
integrated managed hosting services in data centers owned by third parties in
addition to our own data centers. We believe that this approach could augment
our existing management expertise, software and operating processes with
third-party infrastructure and geographic reach. As a result of the evaluation,
we may restructure our business, which could result in, among other things: a
change in our asset lives, impairment charges and decreased capital
requirements. The evaluation is in the preliminary stages, and the outcome is
uncertain at this point in time.
During the second quarter of fiscal year 2002, we made the decision to
discontinue our practice, on a prospective basis, of obtaining equipment under
lease arrangements and subsequently renting the equipment to our customers. The
decision was made for two reasons. First, many of our enterprise customers can
acquire hardware equipment with a lower cost of capital. Second, it eliminates
additional credit and financial risk associated with an early customer contract
termination. This decision will reduce revenue potential from future customers
and impact overall revenues as existing equipment leases terminate and are not
renewed. We will continue to service our customers' equipment needs as the
single point of procurement and management.
In the second quarter of fiscal year 2002, we recorded a $3.2 million
charge representing the future remaining minimum lease payments related to
certain idle equipment held under various operating leases. The equipment had
previously been rented to former customers, and upon the loss of the customer
the equipment became idle. Based our forecasts, the equipment will not be
utilized before the related operating leases expire and/or the equipment becomes
obsolete.
In the second quarter of fiscal year 2002, we evaluated the current and
forcasted utilization of our purchased software licenses. As a result of this
evaluation, during the second quarter of fiscal year 2002, we recorded a
$365,000 impairment for software licenses that would not be utilized before the
licenses expired and/or become obsolete.
In the second quarter of fiscal year 2002, we finalized an agreement
with an equipment lessor whereby we purchased all equipment previously held
under operating lease with the equipment lessor for $4.3 million. The fair
market value of the equipment at the time of purchase was $2.3 million. The $2.0
million difference between the fair market value of the equipment, based on a
third-party appraisal, and the purchase price was previously recorded as an
asset impairment charge for the three-month period ended October 31, 2001.
In the second quarter of fiscal year 2002, we purchased certain
equipment with a fair market value of $1.2 million, previously leased by us from
two equipment vendors under operating lease agreements totalling $2.7 million,
of which $848,000 was paid in the second quarter of fiscal year 2002 and two
payments of $937,000 are payable in February 2002 and May 2002. As the fair
market value of the equipment, based on a third-party appraisal, was less than
the consideration given, we have recorded an asset impairment charge for the
three-month period ended January 31, 2002 of $408,000.
In the second quarter of fiscal year 2002, we modified the payment
amounts and terms of certain operating leases with two equipment vendors such
that the modified leases qualify as capital leases. One of the resulting capital
leases is payable in 24 monthly payments of $38,000, starting in December 2001.
The second capital lease has total payments of $2.6 million, of which $1.0
million was paid in the second quarter of fiscal year 2002 and $1.6 million is
payable in January 2003. The equipment under both capital leases was capitalized
at the fair market value of the equipment at the time of the modification, $1.0
million, which was lower than the present value of the minimum lease payments
based on our estimated incremental borrowing rate of 12%. As the fair market
value of the equipment, based on a third-party appraisal, was less than the
consideration given, we have recorded an asset impairment charge for the
three-month period ended January 31, 2002 of $1.3 million.
Page 12 of 30
At January 31, 2002, we were not in compliance with several of the
covenants of our convertible notes payable with CFS and CMGI. Subsequent to
January 31, 2002, we received a waiver from both CFS and CMGI for the
non-compliance and we are currently in compliance with the covenants of the
convertible notes payable with CFS and CMGI.
In March 2002, we modified certain operating leases with a lessor such
that the modified leases qualify as capital leases. No gain or loss was
recognized on this modification. In addition to the lease modifications,
subsequent to January 31, 2002, we returned certain equipment held under
operating leases with the same lessor and incurred a breakage fee of $397,000.
We currently continue to be in default with an operating lease,
aggregating $270,000 of future lease payments. However, we have received a
letter from the lessor stating that it will not accelerate payments or repossess
equipment while our payments maintain a current status.
THREE-MONTH PERIOD ENDED JANUARY 31, 2002 COMPARED TO THE THREE-MONTH PERIOD
ENDED JANUARY 31, 2001
Revenue
Total revenue was approximately $15.7 million for the three-month
period ended January 31, 2002, a decrease of 43.4% from approximately $27.7
million for the same period in 2001. The decrease is due primarily to a decrease
in revenue from CMGI and CMGI affiliates of approximately $6.8 million, or
63.3%, combined with a decrease of approximately $5.2 million of revenue from
unaffiliated customers. Revenue from unaffiliated customers decreased to
approximately $11.7 million or 74.9% of total revenue for the three-month period
ended January 31, 2002, from approximately $16.9 million or 61.4% of total
revenue for the same period in 2001. The number of unaffiliated customers
decreased 54.1% to 164 at January 31, 2002 from 357 as of January 31, 2001.
During the three-month period ended January 31, 2002, we lost 44 customers,
which would have generated approximately $2.5 million or 15.9% of revenue for
that period. The number of CMGI and CMGI affiliated customers decreased 68.2% to
seven at January 31, 2002 from 22 as of January 31, 2001.
Our revenue from sales to related parties principally consists of sales
of services to CMGI and other customers that are CMGI affiliates. In general, in
pricing the services provided to CMGI and its affiliates, we have: negotiated
the services and levels of service to be provided; calculated the price of the
services at those service levels based on our then-current, standard prices;
and, in exchange for customer referrals provided to us by CMGI, discounted these
prices by 10%. In the three months ended January 31, 2002, we sold services to
CMGI and CMGI affiliates totaling approximately $3.9 million, or 25.1% of
revenue. Three of these customers accounted for approximately 11%, 6% and 4% of
revenue, respectively.
During the three-month period ended January 31, 2002, we recognized
$164,000 in revenue related to contract terminations with customers, which
compares with $0 for the same three-month period in 2001. Revenue from contract
terminations is non-recurring in nature. Subsequent to January 31, 2002, we
signed an agreement with Engage, a related party, whereby Engage's contract with
us was terminated. In the second quarter of fiscal year 2002, Engage represented
less than 1% of our total revenue. As a result of the termination of the Engage
contract, we will recognize approximately $2.3 million of non-recurring revenue
in the third quarter of fiscal year 2002.
As we manage out non-productive customers, we continue to focus our
sales and marketing efforts on generating revenues from new un-affiliated
enterprise customers.
While we will continue to service our customers' equipment needs as the
single point of procurement and management, beginning in the third quarter of
fiscal year 2002, we will no longer rent equipment on behalf of customers. While
this practice is expected to reduce the revenue potential from new customers and
new revenue potential from our current customer base, it is expected to reduce
financial and credit risk and improve overall margins. Revenue from equipment
rental accounted for approximately 23% of our revenue for the three-month period
ended January 31, 2002.
Cost of Revenue
Cost of revenue consists primarily of salaries and benefits for
operations personnel, bandwidth fees and related Internet connectivity charges,
equipment costs and related depreciation and costs to run our two data centers,
such as rent and utilities.
Cost of revenue decreased 18.5% to approximately $27.5 million for the
three-month period ended January 31, 2002, from approximately $33.8 million for
the same period in 2001. Included in the cost of revenue for the three-month
period ended January 31, 2002 are asset impairment charges of approximately $7.2
million. Excluding the $7.2 million non-recurring charge related to impaired
assets, cost of
Page 13 of 30
revenue for the three-month period ended January 31, 2002 would have been
approximately $20.3 million, a decrease of approximately $13.5 million or 39.9%
as compared to the same period in 2001. The dollar value decrease in cost of
revenue is primarily due to a decrease in head count, salaries and related
costs, to approximately $4.7 million, or 29.9% of revenue, for the three months
ended January 31, 2002, from approximately $10.5 million, or 38.1% of revenue,
for the same period in 2001. The decrease in aggregate costs resulted from the
realization of labor efficiencies and headcount reductions; and a decrease in
equipment costs to approximately $10.1 million for the three months ended
January 31, 2002, from approximately $15.5 million for the same period in 2001.
The decrease in equipment costs resulted from the buyout of certain operating
leases, offset by a $7.2 million asset impairment charge.
During the second quarter of fiscal year 2002, we incurred a $7.2
million charge related to: (1) the purchase of certain equipment in excess of
fair market value that was previously held under operating leases; (2) the
modification of payment terms of certain operating leases that resulted in above
market capital leases; (3) the identification of certain leased assets that
will not provide future value to us; and (4) the identification of
obsolete equipment and software and for equipment no longer on hand. The impact
of these actions and the removal of depreciation expense related to assets
held for sale on cost of sales for the third and fourth quarters of fiscal year
2002 is estimated to be a reduction in expense of $2.7 million and $2.3 million,
respectively.
Subsequent to January 31, 2002, we reorganized our cost of revenue
personnel and consolidated end-to-end service responsibility into an integrated
Service Delivery organization. As a result, implementation of various
technologies including network storage, back-up, and security for both our
internal network and solutions we offer our customers are now performed by the
Service Delivery organization.
As our business grows, we would expect the dollar value of these
expenses to increase, but decline on a percentage of revenue basis. We also
expect to achieve economies of scale as a result of spreading increased volume
over our fixed assets, increasing productivity and using new technological
tools. For fiscal year 2002, we anticipate that the cost of revenue, excluding
asset impairment charges, will decrease in absolute dollars from fiscal 2001
levels. The anticipated decrease is a result of our fiscal 2001 restructuring
efforts which are expected to result in labor efficiencies with corresponding
decreased labor costs and reduced equipment and infrastructure expenses going
forward.
Gross Deficit
The gross deficit increased to approximately (75.7%) of total revenue
for the three-month period ended January 31, 2002, from approximately (22%) of
total revenue for the same period in 2001. Excluding the $7.2 million charge
related to asset impairment, the gross deficit increased to approximately
(29.6%). This increase in the gross deficit, net of the asset impairment charge,
for the three-month period ended January 31, 2002, as compared to the same
period in 2001, is the result of our decreased revenue levels, offset by our
restructuring efforts. These restructuring efforts have resulted in lower labor
costs through increased efficiencies and headcount reductions and reduced
equipment expenses resulting from the buyout of certain operating leases. We
typically make up-front fixed investments in both equipment and personnel and
the costs are leveraged across our data centers. We anticipate that our gross
margins will improve, based on current estimates and expectations and barring
unforeseen circumstances, as we achieve higher operational efficiencies and
implement further cost reduction initiatives.
Operating Expenses
Product Development. Product development expenses consist mainly of
salaries and related costs. Our product development staff focuses on Internet
applications, solutions and network architecture. This group identifies
new Internet application software, equipment and network infrastructure and
develops and incorporates these new capabilities into our suite of service
offerings.
Product development expenses decreased 48.8% to approximately $1.9
million for the three-month period ended January 31, 2002, from approximately
$3.8 million for the same period in 2001. As a percentage of revenue, product
development expenses decreased slightly to 12.4% in the three-month period ended
January 31, 2002, from 13.7% for the same period in 2001. The dollar value
decrease in product development expenses is primarily related to a reduction in
usage of outside consultants combined with a reduction in headcount costs
resulting from the decrease in product development personnel as of January 31,
2002 to 17 from 59 employees for the same period in 2001, offset by a small
increase in equipment and software costs.
In the third and fourth quarters of fiscal 2002, we expect our product
development expenses to decrease as we narrow the focus of our investments in
mobile infrastructure and web services technologies. Additionally, we continue
to augment our own product development capabilities by working with and
leveraging key technology and go-to-market partners.
Selling and Marketing. Selling and marketing expenses consist primarily
of salaries and related benefits, commissions and marketing expenses such as
channel programs, advertising, product literature, trade shows, marketing and
direct mail programs. Selling and marketing expenses decreased 77.6% to
approximately $2.5 million for the three-month period ended January 31, 2002,
from approximately $11.2 million for the same period in 2001. As a percentage of
revenue, selling and marketing expenses decreased to 16.0% of total revenue for
the three-month period ended January 31, 2002 from 40.3% of total revenue for
the same period in 2001. The dollar value decrease is due primarily to reduced
headcount, related salaries and commissions, and decreased expenses for
marketing programs, advertising and product literature.
For fiscal 2002, we expect selling and marketing expenses to decline in
dollar terms as compared to fiscal 2001. We continue to make targeted
investments in areas that promote brand recognition and increase new customer
acquisitions. We intend to accomplish this by adding capabilities in our direct
sales and marketing organizations, building leveraged distribution channels with
selected technology and system integration partners and increasing spending in
targeted public relations and marketing programs.
Page 14 of 30
General and Administrative. General and administrative expenses include
the costs of financial, leasing, human resources, IT and administrative
personnel, professional services, bad debt, and corporate overhead. Also
included are intercompany charges from CMGI for human resource support and
business development. As our business grows, we expect the dollar value of these
expenses to increase, but decline on a percentage of revenue basis, as we hire
additional personnel and incur additional costs related to the growth of our
business, however, if this growth does not materialize, we would expect the
dollar value of these expenses to remain constant or decline and to remain
constant or increase on a percentage of revenue basis as we manage our costs to
expected revenue levels.
General and administrative expenses decreased 27.9% to approximately
$7.1 million for the three-month period ended January 31, 2002, from
approximately $9.8 million for the same period in 2001. As a percentage of
revenue, general and administrative expenses increased to 45.2% of total revenue
for the three-month period ended January 31, 2002 from 35.5% of total revenue
for the same period in 2001. The dollar value decrease in general and
administrative expenses is primarily due to an increase in intercompany charges
in the amount of $931,000 and legal and other professional fees in the amount of
$827,000, offset by a decrease in headcount related expenses and salaries in the
amount of $1.4 million as well as a decrease in bad debt expense in the amount
of $2.4 million. For fiscal year 2002, we are anticipating a decrease in general
and administrative expense resulting from the fiscal year 2001 restructuring,
lower labor levels and decreased bad debt expense.
Interest Income
Interest income decreased to approximately $168,000 for three-month
period ended January 31, 2002, from approximately $819,000 for the same period
in 2001. The decrease is due primarily to the lower average cash on hand due to
operating requirements during the fiscal year.
Interest Expense
Interest expense increased to approximately $3.6 million for the
three-month period ended January 31, 2002, from approximately $1.8 million from
the same period in 2001. This increase is due primarily to interest on the $65.1
million face value notes payable due to CMGI and CFS in the amount of
$1.8 million, and the amortization of the beneficial conversion feature of the
notes payable to CMGI and CFS in the amount of $1.6 million.
SIX-MONTH PERIOD ENDED JANUARY 31, 2002 COMPARED TO THE SIX-MONTH PERIOD ENDED
JANUARY 31, 2001
Revenue
Total revenue decreased 35.0% to approximately $34.9 million for the
six-month period ended January 31, 2002, from approximately $53.7 million for
the same period in 2001. The decrease is due primarily to a decrease in revenue
from CMGI and CMGI affiliates of approximately $12.1 million, or 55.3%, combined
with a decrease of approximately $6.8 million of revenue from unaffiliated
customers. Revenue from unaffiliated customers decreased to approximately $25.2
million or 72.2% of total revenue for the six-month period ended January 31,
2002, from approximately $32 million or 59.6% of total revenue for the same
period in 2001. The number of unaffiliated customers decreased 54.1% to 164 at
January 31, 2002 from 357 as of January 31, 2001. During the six-month period
ended January 31, 2002, we lost 121 customers, which would have generated
approximately $7.9 million or 22.6% of revenue for that period. The number of
CMGI and CMGI affiliated customers decreased 68.2% to seven at January 31, 2002
from 22 as of January 31, 2001. We will continue to focus our efforts to expand
our revenues with new unaffiliated enterprise customers over the near term.
However, there can be no assurance that we will be successful or that the
industry trend towards outsourcing IT functions and Web hosting applications
will continue in the future.
Our revenue from sales to related parties principally consists of sales
of services to CMGI and other customers that are CMGI affiliates. In general, in
pricing the services provided to CMGI and its affiliates, we have: negotiated
the services and levels of service to be provided; calculated the price of the
services at those service levels based on our then-current, standard prices;
and, in exchange for customer referrals provided to us by CMGI, discounted these
prices by 10%. In the six-month period ended January 31, 2002, we sold services
to CMGI and CMGI affiliates totaling approximately $9.7 million, or 27.8% of
revenue. Four of these customers accounted for approximately 10%, 5%, 4% and 4%
of revenue, respectively. As of January 31, 2002, CMGI owned approximately
77.33% of our outstanding common stock.
During the six-month period ended January 31, 2002, we recognized
$164,000 in revenue related to contract terminations with customers, which
compares with $0 for the same six-month period in 2001. Revenue from contract
terminations is non-recurring in nature. Subsequent to January 31, 2002, we
signed an agreement with Engage, a related party, whereby Engage's contract with
us was terminated. For the six-month period ended January 31, 2002, Engage
represented $1.48 million or 4% of our total revenue. As a result of the
termination of the Engage contract, we will recognize approximately $2.3 million
of non-recurring revenue in the third quarter of fiscal year 2002.
As we manage out non-productive customers, we continue to focus our
sales and marketing efforts on generating revenues from new un-affiliated
enterprise customers.
While we will continue to service our customers' equipment needs as the
single point of procurement and management, beginning in the third quarter of
fiscal year 2002, we will no longer rent equipment for the incremental equipment
needs for both current and new customers. This practice will reduce the revenue
from new customers and impact overall revenue as existing equipment leases
terminate and are not renewed. Equipment rental accounted for approximately 24%
of our revenue for the six-month period ended January 31, 2002.
Page 15 of 30
Cost of Revenue
Cost of revenue consists primarily of salaries and benefits for
operations personnel, bandwidth fees and related Internet connectivity charges,
equipment costs and related depreciation and costs to run our two data centers,
such as rent and utilities. Included in the cost of revenue for the six-month
period ended January 31, 2002 are asset impairment charges of approximately
$34.6 million as described below. Cost of revenue increased 15.9% to
approximately $76.3 million for the six-month period ended January 31, 2002,
from approximately $65.8 million for the same period in 2001. Excluding the
$34.6 million asset impairment charge, cost of revenue for the six-month period
ended January 31, 2002 would have been approximately $41.7 million, a decrease
of approximately $24.1 million or 36.7% as compared to the same period in 2001.
As a percentage of revenue, cost of revenue, excluding the asset impairment
charge, decreased to 119.3% for the six-month period ended January 31, 2002,
from 122.5% for the same period in 2001. The dollar value increase in cost of
revenue is primarily due to the $34.6 million asset impairment charge related to
the buyout of certain operating leases. This is offset by a decrease in head
count, salaries and related costs, to approximately $9.3 million, or 26.7% of
revenue, for the six-month period ended January 31, 2002, from approximately $21
million, or 39.1% of revenue, for the same period in 2001, resulting from the
realization of labor efficiencies and headcount reductions; and a decrease in
equipment costs to approximately $20.0 million for the six-month period ended
January 31, 2002, from approximately $29.2 million for the same period in 2001,
resulting from the buyout of certain operating leases.
During the six-month period ended January 31, 2002, we realized a $34.6
million non-recurring charge related to: (1) the purchase of certain equipment
that was previously held under operating leases; (2) the modification of payment
terms of certain operating leases that resulted in above market capital leases;
(3) the identification of certain leased assets that will not provide future
value to us; and (4) the identification of obsolete equipment and software and
for equipment no longer on hand. The impact of these actions and the removal of
depreciation expense related to assets held for sale on cost of sales for the
third and fourth quarters of fiscal year 2002 is estimated to be a reduction in
expense of $2.7 million and $2.3 million, respectively.
Subsequent to January 31, 2002, we reorganized our cost of revenue
personnel and consolidated end-to-end service responsibility into an integrated
Service Delivery organization. As a result, implementation of various
technologies including network storage, back-up, and security for both our
internal network and solutions we offer our customers are now performed by the
Service Delivery organization.
As our business grows, we would expect the dollar value of these
expenses to increase, but decline on a percentage of revenue basis. We also
expect to achieve economies of scale as a result of spreading increased volume
over our fixed assets, increasing productivity and using new technological
tools. For fiscal year 2002, we anticipate that the cost of revenue, excluding
asset impairment charges, will decrease in absolute dollars from fiscal 2001
levels. The anticipated decrease is a result of our fiscal 2001 restructuring
efforts, which are expected to result in labor efficiencies with corresponding
decreased labor costs and reduced equipment and infrastructure expenses going
forward.
Gross Deficit
The gross deficit increased to approximately (118.2%) of total revenue
for the six-month period ended January 31, 2002, from approximately (22.5%) of
total revenue for the same period in 2001. Excluding the $34.6 million asset
impairment charge, the gross deficit improved to (19.3%). This improvement in
the gross deficit, for the six-month period ended January 31, 2002, as compared
to the same period in 2001, is a direct result of our restructuring efforts.
These restructuring efforts have resulted in lower labor costs through increased
efficiencies and headcount reductions and reduced equipment expenses resulting
from the buyout of certain operating leases. We typically make up-front fixed
investments in both equipment and personnel and the costs are leveraged across
our data centers. We anticipate that our gross deficit will improve, based on
current estimates and expectations and barring unforeseen circumstances, as we
achieve higher operational efficiencies and implement further cost reduction
initiatives.
Operating Expenses
Product Development. Product development expenses consist mainly of
salaries and related costs. Our product development staff focuses on Internet
applications, solutions and network architecture. This group identifies
new Internet application software, equipment and network infrastructure and
develops and incorporates these new capabilities into our suite of service
offerings.
Page 16 of 30
For fiscal year 2002, we expect product development expenses to decline
on a percentage of revenue basis. Product development expenses decreased 41.4%
to approximately $3.9 million for the six-month period ended January 31, 2002,
from approximately $6.7 million for the same period in 2001. As a percentage of
revenue, product development expenses decreased slightly to 11.2% in the
six-month period ended January 31, 2002, from 12.5% for the same period in 2001.
The dollar value decrease in product development expenses is primarily related
to a reduction in usage of outside consultants combined with a reduction in
headcount costs resulting from the decrease in product development personnel as
of January 31, 2002 to 17, from 59 employees for the same period in 2000, offset
by an increase in equipment and software costs.
In the third and fourth quarters of fiscal 2002, we expect our product
development expenses to decrease as we narrow the focus of our investments in
mobile infrastructure and web services technologies. Additionally, we continue
to augment our own product development capabilities by working with and
leveraging key technology and go-to-market partners.
Selling and Marketing. Selling and marketing expenses consist primarily
of salaries and related benefits, commissions and marketing expenses such as
advertising, product literature, trade shows, marketing and direct mail
programs. For fiscal 2002, we expect selling and marketing expenses to decline
in dollar terms as compared to fiscal 2001. We continue to make targeted
investments in areas that promote brand recognition and increase new customer
acquisitions. We intend to accomplish this by adding capabilities in our direct
sales and marketing organizations, building leveraged distribution channels with
selected technology and system integration partners and increasing spending in
targeted public relations and marketing programs.
Selling and marketing expenses decreased 73.4% to approximately $5.1
million for the six-month period ended January 31, 2002, from approximately
$19.3 million for the same period in 2001. As a percentage of revenue, selling
and marketing expenses decreased to 14.7% of total revenue for the six-month
period ended January 31, 2002 from 35.9% of total revenue for the same period in
2001. The dollar value decrease is due primarily to reduced headcount, related
salaries and commissions, and decreased expenses for marketing programs,
advertising and product literature.
General and Administrative. General and administrative expenses include
the costs of financial, leasing, human resources, IT and administrative
personnel, professional services, bad debt, and corporate overhead. Also
included are intercompany charges from CMGI for human resource support and
business development. As our business grows, we expect the dollar value of these
expenses to increase, but decline on a percentage of revenue basis, as we hire
additional personnel and incur additional costs related to the growth of our
business, however, if this growth does not to materialize, we would expect the
dollar value of these expenses to remain constant or decline and to remain
constant or increase on a percentage of revenue basis as we manage our costs to
expected revenue levels.
General and administrative expenses decreased 11.8% to approximately
$13.9 million for the six-month period ended January 31, 2002, from
approximately $15.8 million for the same period in 2001. As a percentage of
revenue, general and administrative expenses increased to 39.8% of total revenue
for the six-month period ended January 31, 2002 from 29.4% of total revenue for
the same period in 2001. The dollar value decrease in general and administrative
expenses is primarily due to an increase in intercompany charges in the amount
of $1.9 million and legal and other professional fees in the amount of $2.0
million, offset by a decrease in headcount related expenses and salaries in the
amount of $3.7 million as well as a decrease in bad debt expense in the amount
of $1.7 million. For fiscal year 2002, we are anticipating a decrease in general
and administrative expense resulting from the fiscal year 2001 restructuring,
lower labor levels and decreased bad debt expense.
Interest Income
Interest income decreased to approximately $332,000 for six-month
period ended January 31, 2002, from approximately $1.7 million for the same
period in 2001. The decrease is due primarily to the lower average cash on hand
due to operating requirements during the fiscal year.
Interest Expense
Interest expense increased to approximately $7.2 million for the
six-month period ended January 31, 2002, from approximately $2.7 million from
the same period in 2001. This increase is due primarily to: 1) interest on the
$80.0 million face value note payable to CMGI in the amount of $1.5 million and
the amortization of the related warrants in the amount of $1.2 million; interest
on the $65.1 million face value notes payable due to CMGI and CFS in the amount
of $2.9 and the amortization of the beneficial conversion feature of the notes
payable to CMGI and CFS in the amount of $1.6 million.
Liquidity and Capital Resources
Since our inception, our operations have been funded primarily by CMGI
through the issuance of common stock, preferred stock and convertible debt, the
issuance of preferred stock and convertible debt to strategic investors, our
initial public offering and related exercise of the underwriters' over-allotment
option in October 1999 and November 1999, respectively.
Our cash and cash equivalents increased to $31.7 million at January 31,
2002 from $22.2 million at July 31, 2001 and we had working capital of $7.2
million at January 31, 2002. Net cash used by operating activities for the six-
month period ended January 31, 2002 amounted to $16.5 million, resulting
primarily from the net loss, increases in amounts due from CMGI and affiliates
and
Page 17 of 30
other assets, and a decrease in accounts payable, partially offset by a decrease
in accounts reveivable, increases in accrued expenses and deferred revenue,
amounts due to CMGI, bad debt expense, and depreciation and amortization and
asset impairment charges.
Net cash used by investing activities was $2.5 million for the six-
month period ended January 31, 2002, which was primarily associated with the
acquisition of property and equipment and the reduction of restricted cash. Net
cash provided by financing activities was $28.5 million for the six-month period
ended January 31, 2002, which was primarily associated with the proceeds of the
$30.0 million convertible notes payable from CFS and CMGI, respectively, offset
by repayment of capital lease and financed software obligations.
In connection with an agreement dated October 29, 2001 among NaviSite,
CMGI and CFS, we purchased certain equipment with a fair market value of $9.6
million, previously leased by us from CFS under operating lease agreements
expiring through 2003, in exchange for a note payable in the face amount of
approximately $35 million. As the fair market value of the equipment, based on a
third-party appraisal, was less than the associated debt obligation, we have
recorded an asset impairment charge in the first quarter of fiscal 2002 of $25.4
million. We recorded the assets purchased and associated impairment charge
effective August 1, 2001 with a corresponding obligation to CFS. Based on the
terms of the $35 million obligation, interest accrues commencing on November 8,
2001. We recorded $1.1 million and $1.0 million of interest expense for the
first and second quarters of fiscal year 2002, respectively.
On November 8, 2001, in connection with the October 29, 2001 agreement,
we received $20 million and $10 million in cash from CFS and CMGI, respectively,
in exchange for six-year convertible notes payable in the face amounts of $20
million and $10 million to CFS and CMGI, respectively, making the total notes
payable issued by us to CFS and CMGI approximately $55 million and $10 million,
respectively. The notes require payment of interest only, at 12% per annum, for
the first three years from the date of issuance and then repayment of principal
and interest, on a straight-line basis, over the next three years until maturity
on the sixth anniversary of the date of issuance. At our option, we may make
interest payments (i) 100% in shares of NaviSite common stock, in the case of
amounts owed to CMGI, through December 2007 and (ii) approximately 16.67% in
shares of NaviSite common stock, in the case of amounts owed to CFS, through
December 2003. The convertible notes payable are secured by substantially all of
the assets of NaviSite and cannot be prepaid.
In the second quarter of fiscal year 2002, the Company issued 1,003,404
shares of common stock in satisfaction of accrued interest associated with the
$65.1 million notes payable to CMGI and CFS.
The principal balances of the notes may be converted into NaviSite
common stock at the option of the holders at any time prior to or at maturity at
a conversion rate of $0.26 per share. The conversion rate of $0.26 results in
beneficial conversion rights for both CMGI and CFS. The intrinsic value of the
beneficial conversion rights amounted to $6.5 million and $36.0 million for CMGI
and CFS, respectively. The intrinsic value of the beneficial conversions rights
are being amortized into interest expense over the life of the convertible notes
payable as an additional component of interest expense. CMGI also converted its
$80 million in aggregate principal outstanding under its existing notes payable,
plus the accrued interest thereon, into approximately 14.7 million shares of
NaviSite common stock. CMGI also converted approximately $16.2 million in other
amounts due by NaviSite to CMGI into approximately 9.9 million shares of
NaviSite common stock.
Holders of the convertible notes payable are entitled to both demand
and piggyback registration rights, and CFS is entitled to anti-dilution
protection under certain circumstances. The agreement with CFS also contains
certain restrictive covenants, including but not limited to limitations on the
issuance of additional debt, the sale of equity securities to affiliates and
certain acquisitions and dispositions of assets. At January 31, 2002, we were
not in compliance with several of these covenants. Subsequent to January 31,
2002, we received a waiver from CFS and CMGI for the non-compliance.
Subsequent to January 31, 2002, we signed an agreement with Engage,
Inc., a related party, whereby Engage's contract with us was terminated.
Pursuant to our agreement with Engage, we will receive cash payments of $1.2
million in March 2002, $1.2 million in April 2002, and $1.2 million in July
2002, for a total of $3.6 million. For the three and six-month periods ended
January 31, 2002, Engage represented less than 1% and 4%, respectively, of our
total revenue. As a result of our agreement with Engage, we will recognize
approximately $2.3 million of non-recurring revenue in the third quarter of
fiscal year 2002.
In March 2002, we modified certain operating leases with a lessor such
that the modified leases qualify as capital leases. No gain or loss was
recognized on this modification. In addition to the lease modifications,
subsequent to January 31, 2002, we returned certain equipment held under
certain operating leases with the same lessor and incurred a breakage fee
of $397,000.
We currently continue to be in default with an operating lease,
aggregating $270,000 of future lease payments. However, we have received a
letter from the lessor stating that it will not accelerate payments or
repossess equipment while our payments maintain a current status.
We currently anticipate that our available cash resources at January
31, 2002 will be sufficient to meet our anticipated needs, barring unforeseen
circumstances, for working capital and capital expenditures over the next twelve
months. Our projected cash usage could be significantly impacted by: (1) our
ability to maintain our current revenue levels; (2) our ability to achieve our
projected operating results; (3) our ability to collect accounts receivables in
a timely manner; (4) our ability to collect amounts due from Engage related to
the termination of our contract with them; (5) our ability to achieve expected
cash expense reductions; (6) our common stock being delisted from the Nasdaq
National Market and/or listed on the Nasdaq SmallCap Market; and (7) our ability
to sell our assets which are held for sale at their fair-market value. However,
we may need to raise additional funds in order to develop new, or enhance
existing, services or products, to respond to competitive pressures, to acquire
complementary businesses, products or technologies or to continue as a going
concern. In addition, on a long-term basis, we may require additional external
financing for working capital and capital expenditures through credit
facilities, sales of additional equity or other financing vehicles. Under our
arrangement with CFS, we must obtain their consent in order to issue debt
securities or sell shares of our common stock to affiliates. We may not receive
their consent. If additional funds are raised through the issuance of equity or
convertible debt securities, the percentage ownership of our stockholders will
be reduced and our stockholders may experience additional dilution. We cannot
assure you that additional financing will be available on terms favorable to us,
if at all. If adequate
Page 18 of 30
funds are not available or are not available on acceptable terms, our ability to
fund our expansion, take advantage of unanticipated opportunities, develop or
enhance services or products or otherwise respond to competitive pressures would
be significantly limited.
Contractual Obligations and Commercial Commitments
In the normal course of its business, the Company enters into contracts
related to the leasing of facilities and equipment and the purchase of minimum
amounts of bandwidth. In addition, the Company has $65.1 million of long-term
debt outstanding at January 31, 2002. Future payments required under these
long-term obligations are as follows:
Payment Due by Period
(in thousands)
Less than After
Contractual Obligations Total 1 year 1 - 3 years 4 - 5 years 5 years
--------- ---------- ------------- ------------- ---------
Short-term debt $ 468 $ 468 $ -- $ -- $ --
Long-term debt 65,093 65,093
Interest on debt 28,325 2,750 5,500 6,050 14,025
Capital leases 4,043 4,043 -- -- --
Operating leases 2,978 1,164 1,419 395 --
Bandwidth commitments 5,059 3,151 1,713 196 --
Level 3 agreement 3,030 2,618 412 -- --
Maintenance for hardware and software 2,233 540 1,080 612 --
Property leases 29,274 2,438 4,740 5,470 16,626
--------- ---------- ------------- ------------- ---------
Total $140,503 $ 17,172 $ 14,864 $ 12,723 $ 95,744
========= ========== ============= ============= =========
Critical Accounting Policies
The Company prepares its consolidated financial statements in
accordance with accounting principles generally accepted in the United States of
America. As such, management is required to make certain estimates, judgments
and assumptions that they believe are reasonable based on the information
available. These estimates and assumptions affect the reported amounts of assets
and liabilities at the date of the financial statements and the reported amounts
of revenues and expenses for the periods presented. The significant accounting
policies which management believes are the most critical to aid in fully
understanding and evaluating the Company's reported financial results include
revenue recognition, allowance for doubtful accounts and impairment of
long-lived assets.
Revenue Recognition. We provide outsourced web hosting and managed
application services and related professional and consulting services. Revenue
consists of monthly fees for web site and internet application management,
application rentals, and hosting. Revenues related to monthly fees for web site
and internet application management, application rentals and hosting are
recognized over the term of the customer contract based on actual usage and
services. Fees charged for the installation of customer equipment are generally
received in advance and are deferred and recognized as revenue over the life of
the related customer contract, typically 12 to 24 months. In the event a
customer terminates their agreement prior to its stated maturity, all deferred
revenue related to installation services is automatically recognized upon the
effective date of the termination, and we generally charge cancellation fees
that are also recognized upon the effective date of the termination.
Cancellation fees are calculated as the customer's remaining base monthly fees
obligation times the number of months remaining in the contract term.
Existing customers are subject to ongoing credit evaluations based on
payment history and other factors. If it is determined subsequent to our initial
evaluation and at any time during the arrangement that collectibility is not
reasonably assured, revenue is recognized as cash is received. Due to the nature
of our service arrangements, we provide written notice of termination of
services, typically 90 days in advance of disconnecting a customer. Revenue for
services rendered during this notification period is recognized on a cash basis
as collectibility is not considered probable at the time the services are
provided.
Allowance for Doubtful Accounts. We perform periodic credit evaluations
of our customers' financial condition and generally do not require collateral or
other security against trade receivables. Our customer base includes a
significant number of dot.com businesses that face increased risk of loss of
funding depending on the availability of private and or public funding. We make
estimates of the uncollectability of our accounts receivables and maintain an
allowance for doubtful accounts for potential credit losses. We specifically
analyze accounts receivable and consider historical bad debts, customer and
industry concentrations, customer credit-worthiness, current economic trends and
changes in our customer payment patterns when evaluating the adequacy of the
allowance for doubtful accounts. We specifically reserve for 100% of the balance
of customer accounts deemed uncollectible. For all other customer accounts, we
reserve for 50% of the balance over 120 days old and 3% of all other customer
balances. This method historically approximated actual write off experience.
Changes in economic conditions or the financial viability of our customers may
result in additional provisions for doubtful accounts in excess of our current
estimate.
Page 19 of 30
Impairment of Long-lived Assets. We review our long-lived assets,
primarily property and equipment, for impairment whenever events or changes in
circumstances indicate that the carrying amount of these assets may not be
recoverable. Recoverability is measured by a comparison of the carrying amount
of an asset to future undiscounted cash flows expected to be generated by the
asset. If such assets were considered to be impaired, the impairment to be
recognized would be measured by the amount by which the carrying value of the
assets exceed their fair value. Fair value is determined based on discounted
cash flows or appraised values, depending on the nature of the asset. Assets to
be disposed of are valued at the lower of the carrying amount or their fair
value less disposal costs. Property and equipment is primarily comprised of
leasehold improvements, computer and office equipment, and software licenses.
During the fourth quarter of fiscal 2001, due to significant industry and
economic trends affecting both the Company's current and future operations as
well as a significant decline in the Company's stock price, the Company
completed an impairment review of its property and equipment. This review
included a comparison of the carrying amount of such assets to the estimated
future undiscounted net cash flows expected to be generated by those assets at
an enterprise level. As a result of this review, the Company determined that
there was no impairment in the property and equipment. The preparation of future
cash flows requires significant judgments and estimates with respect to future
revenues related to the respective asset and the future cash outlays related to
those revenues. Actual revenues and related cash flows or changes in anticipated
revenues and related cash flows could result in a change in this assessment and
result in an impairment charge. In addition, we are currently evaluating our
business model and the manner in which we provide services. As of result of this
evaluation, we may decide to restructure how we deliver our services which could
result in, but not be limited to, an impairment of our data center assets and/or
a change in the estimated useful life of certain assets. The preparation of
discounted cash flows also requires the selection of an appropriate discount
rate. The use of different assumptions would increase or decrease estimated
discounted cash flows and could increase or decrease the related impairment
charge.
During fiscal 2002, in connection with restructuring of certain of our
operating leases, we entered into equipment purchase agreements and lease
modifications resulting in both the direct buyout of customer equipment and a
change in lease classification from operating to capital. In connection with
these agreements, we obtained appraisals from third parties providing the fair
market values of the related equipment purchased or leased under capital leases
and recorded impairment charges totaling approximately $29 million, which
represents the excess consideration paid (including cash and the present value
of future minimum lease payments discounted at our estimated incremental
borrowing rate of 12%) over the fair value of the assets acquired or leased
We performed an evaluation of our customer dedicated equipment
inventory during the second quarter of fiscal 2002 and identified $3.4 million
of excess and idle equipment which is held for sale. The carrying value of this
equipment approximated its fair value less costs to sell as most of the
equipment was included in the lease restructuring agreements and were recorded
at their fair value based on appraisal. Our plan is to sell this excess
equipment at its fair value. Should we not realize the fair value of the
equipment upon sale or not be able to sell the equipment, we may incur
additional impairment charges. We also recorded an impairment charge of $1.9
million for obsolete equipment and equipment no longer on hand.
Related Party Transactions
We are currently a 77.33% owned subsidiary of CMGI. CMGI has provided
us with funding since our inception through the issuance of common stock,
preferred stock and convertible debt.
We sell our products and services to companies in which CMGI has an
investment interest or a significant ownership interest. Total revenue realized
from services to related parties was $3.9 million and $9.7 million for the three
and six-month periods ended January 31, 2002 compared to $10.7 million and $21.7
million for the three and six-month periods ended January 31, 2001. These
related parties typically receive a 10% discount for services provided by the
Company. The related cost of revenue is consistent with the costs incurred on
similar transactions with unrelated parties. Subsequent to January 31, 2002, we
entered into an agreement with Engage, a related party, whereby Engage's
contract with us was cancelled. Pursuant to the settlement, we will receive cash
payments of $3.6 million during the third and fourth quarter of fiscal 2002 and
will recognize estimated de-installation revenue of $2.3 million in our third
quarter ended April 30, 2002.
CMGI has provided us with accounting, systems and related services at
amounts that approximated the fair value of services received in each of the
periods presented in these financial statements. We also purchase certain
employee benefits (including 401(k) plan participation by employees of the
Company) and insurance (including property and casualty insurance) through CMGI.
CMGI also has provided us with Internet marketing and business development
services. Amounts due to CMGI as of January 31, 2002 totaled $3.1 million.
Page 20 of 30
We also provide administrative services to CMGI and related entities as they
relate to lease schedules for equipment ordered by NaviSite prior to October 22,
1999. These lease schedules include equipment leased for both NaviSite and CMGI,
however, the majority of the equipment is used by NaviSite. As part of this
agreement, CMGI provides administrative services for leases that include
equipment for both NaviSite and CMGI under which CMGI or a related entity is the
majority equipment user. The administrative services include the payment of the
lessor's monthly lease charges. In both cases, the entity providing the
administrative services charges the other for the actual lease fees, however in
all of these cases, CMGI bears all liability for the payment and NaviSite is not
financially obligated under the leases.
INFLATION
We believe that our revenue and results from operations have not been
significantly impacted by inflation.
Additional Risk Factors That May Affect Future Results:
The risks and uncertainties described below are not the only risks we
face. Additional risks and uncertainties not presently known to us or that are
currently deemed immaterial may also impair our business operations. If any of
the following risks actually occur, our financial condition and operating
results could be materially adversely affected.
WE HAVE A HISTORY OF OPERATING LOSSES AND EXPECT FUTURE LOSSES. We cannot assure
you that we will ever achieve profitability on a quarterly or annual basis or,
if we achieve profitability, that it will be sustainable. We were organized in
1996 by CMGI to support the networks and host the Web sites of CMGI and a number
of CMGI affiliates. It was not until the fall of 1997 that we began providing
Web site hosting and Internet application management services to companies
unaffiliated with CMGI. Since our inception in 1996, we have experienced
operating losses and negative cash flows for each quarterly and annual period.
As of January 31, 2002, we had an accumulated deficit of $286.8 million. We
anticipate increased expenses as we continue to improve our infrastructure,
introduce new services, enhance our application management expertise, expand our
sales and marketing efforts, and pursue additional industry relationships. As a
result, we expect to incur operating losses for at least the next fiscal year.
FLUCTUATIONS IN OUR QUARTERLY OPERATING RESULTS MAY NEGATIVELY IMPACT OUR STOCK
PRICE. Our quarterly operating results may fluctuate significantly in the future
as a result of a variety of factors, many of which are outside our control.
These factors include: reduction of market demand and or acceptance for our Web
site and Internet application hosting and management services; oversupply of
data center space in the industry; our ability to develop, market and introduce
new services on a timely basis; downward price adjustments by our competitors;
changes in the mix of services provided by our competitors; technical
difficulties or system downtime affecting the Internet generally or our hosting
operations specifically; our ability to meet any increased technological demands
of our customers; the amount and timing of costs related to our marketing
efforts and service introductions; and economic conditions specific to the
Internet application service provider industry. Our operating results for any
particular quarter may fall short of our expectations or those of investors or
securities analysts. In this event, the market price of our common stock would
be likely to fall.
CMGI IS CURRENTLY A MAJORITY STOCKHOLDER, AND CFS IS A POTENTIAL MAJORITY
STOCKHOLDER, AND BOTH MAY HAVE INTERESTS THAT CONFLICT WITH THE INTERESTS OF OUR
OTHER STOCKHOLDERS. As of January 31, 2002, CMGI beneficially owned
approximately 84.22% of our outstanding common stock. Accordingly, CMGI has the
power, acting alone, to elect a majority of our board of directors and has the
ability to determine the outcome of any corporate actions requiring stockholder
approval, regardless of how our other stockholders may vote. Under Delaware law,
CMGI may exercise its voting power by written consent, without convening a
meeting of the stockholders, meaning that CMGI could affect a sale or merger of
our company without prior notice to, or the consent of, our other stockholders.
CMGI's interests could conflict with the interests of our other stockholders.
The possible need of CMGI to maintain control of us in order to avoid becoming a
registered investment company could influence future decisions by CMGI as to the
disposition of any or all of its ownership position in our company. CMGI would
be subject to numerous regulatory requirements with which it would have
difficulty complying if it were required to register as an investment company.
As a result, CMGI may be motivated to maintain at least a majority ownership
position in us, even if our other stockholders might consider a sale of control
of our company to be in their best interests. As long as it is a majority
stockholder, CMGI has contractual rights to purchase shares in any of our future
financing sufficient to maintain its majority ownership position. CMGI's
ownership may have the effect of delaying, deferring or preventing a change in
control of our company or
Page 21 of 30
discouraging a potential acquirer from attempting to obtain control of us, which
in turn could adversely affect the market price of our common stock. On November
8, 2001, in conjunction with the restructuring of certain of our lease
obligations, we issued convertible notes which, upon conversion, would give CFS
a controlling interest in NaviSite. Should CFS elect to convert its $55 million
in convertible notes into our common stock and CMGI elect not to convert, CFS
would own approximately 211,897,436 shares of our common stock, which, based on
our capitalization as of November 8, 2001, would be approximately 71% of our
then outstanding shares of common stock. In the event both CFS and CMGI elect to
convert their notes into our common stock, CFS would own approximately 63% of
our common stock and CMGI would own approximately 28% of our common stock.
Accordingly, if CFS converts these notes to shares of our common stock, CFS
would have the power, acting alone, to elect a majority of our board of
directors and would have the ability to determine the outcome of any corporate
actions requiring stockholder approval regardless of how our other stockholders
may vote. If CFS becomes a majority stockholder, it may have interests that
conflict with the interests of our other stockholders, as described above for
CMGI.
A SIGNIFICANT PORTION OF OUR REVENUE CURRENTLY IS GENERATED BY SERVICES PROVIDED
TO CMGI AND COMPANIES AFFILIATED WITH CMGI, AND THE LOSS OF THIS REVENUE WOULD
SUBSTANTIALLY IMPAIR THE GROWTH OF OUR BUSINESS. We anticipate that we will
continue to receive a significant portion of our revenue in the future from CMGI
and CMGI affiliates. CMGI and CMGI affiliates accounted for approximately 27.8%
of our revenue in the six months ended January 31, 2002 and approximately 35.4%
of our revenue for the fiscal year ended July 31, 2001. We cannot assure you
that revenues generated by CMGI and CMGI affiliates will continue or that we
will be able to secure business from unaffiliated customers to replace this
revenue in the future. The loss of revenue from CMGI and CMGI affiliates, or our
inability to replace this operating revenue, would substantially impair the
growth of our business. The number of CMGI and CMGI affiliated customers
decreased 68.2% to seven at January 31, 2002 from 22 as of January 31, 2001.
OUR ABILITY TO GROW OUR BUSINESS WOULD BE SUBSTANTIALLY IMPAIRED IF WE WERE
UNABLE TO OBTAIN, ON COMMERCIALLY REASONABLE TERMS, CERTAIN EQUIPMENT THAT IS
CURRENTLY PROVIDED UNDER LEASES. Certain of the equipment that we use or provide
to our customers for their use in connection with our services is provided under
lease. We or our customers will have to obtain this equipment for new leases and
renewal of existing leases directly, on a stand alone basis. Our business would
be substantially impaired if we were unable to obtain or continue these leases
on commercially reasonable terms.
OUR DECISION TO DISCONTINUE OUR PRACTICE, ON A PROSPECTIVE BASIS, OF OBTAINING
EQUIPMENT UNDER LEASES AND SUBSEQUENTLY RENTING THE EQUIPEMENT TO OUR CUSTOMERS
MAY HAVE A MATERIAL ADVERSE EFFECT ON OUR FUTURE RESULTS AND BUSINESS
OPERATIONS. New customers and current customers seeking to renew their
agreements will have to obtain equipment directly from equipment vendors. We may
not be successful in attracting new customers who would prefer to obtain
equipment from us. Current customers may not renew their agreements and seek a
hosting provider who would also rent equipment directly to them to satisfy their
equipment needs. If we are unable to keep our current customers and attract new
customers, our future results and business operations could be materially
harmed.
OUR COMMON STOCK MAY BE DELISTED FROM NASDAQ. On February 14, 2002, we received
a deficiency notice from Nasdaq indicating that our common stock had not
maintained a minimum market value of publicly held shares of $15,000,000 and had
failed to maintain a minimum bid price per share of $3.00 over the previous 30
consecutive trading days and that we have until May 15, 2002 to regain
compliance with Nasdaq's listing requirements. Nasdaq informed us that if we
fail to demonstrate compliance with Nasdaq's listing requirements on or before
May 15, 2002, Nasdaq will provide us with written notification that it has
determined that we do not meet the standards for continued listing, and our
securities will be delisted from Nasdaq. If we are unable to regain compliance
with Nasdaq's requirements, our common stock could be delisted from trading on
Nasdaq. If our common stock were delisted from Nasdaq, among other things, this
could result in a number of negative implications, including reduced liquidity
in our common stock as a result of the loss of market efficiencies associated
with Nasdaq and the loss of federal preemption of state securities laws as well
as the potential loss of confidence by suppliers, customers and employees, the
loss of analyst coverage and institutional investor interest, fewer business
development opportunities and greater difficulty in obtaining financing.
IF THE MARKET FOR INTERNET COMMERCE AND COMMUNICATION DOES NOT CONTINUE, OR IT
CONTINUES TO DECREASE, THERE MAY BE INSUFFICIENT DEMAND FOR OUR SERVICES, AND AS
A RESULT, OUR BUSINESS STRATEGY MAY NOT BE SUCCESSFUL. The increased use of the
Internet for retrieving, sharing and transferring information among businesses
and consumers has developed only recently, and the market for the purchase of
products and services over the Internet is new and emerging. If acceptance and
growth of the Internet as a medium for commerce and communication does not
continue, our business strategy may not be successful because there may not be a
continuing market demand for our Web site and Internet application hosting and
management services. Our growth could be substantially impaired if the market
for Internet application services fails to continue to develop or if we cannot
continue to achieve broad market acceptance. The market for Internet application
services has recently developed and is evolving.
OUR ABILITY TO SUCCESSFULLY MARKET OUR SERVICES COULD BE SUBSTANTIALLY IMPAIRED
IF WE ARE UNABLE TO DEPLOY NEW INTERNET APPLICATIONS OR IF NEW INTERNET
APPLICATIONS DEPLOYED BY US PROVE TO BE UNRELIABLE, DEFECTIVE OR INCOMPATIBLE.
We cannot assure you that we will not experience difficulties that could delay
or prevent the successful development, introduction or marketing of Internet
application services in the future. If any newly introduced Internet
applications suffer from reliability, quality or compatibility problems, market
acceptance of our services could be greatly hindered and our ability to attract
new customers could be adversely affected. We cannot assure you that new
applications deployed by us will be free from any reliability, quality or
compatibility problems. If we incur increased costs or are unable, for technical
or other reasons, to host and manage new Internet applications or enhancements
of existing applications, our ability to successfully market our services could
be substantially impaired.
THE MARKET WE SERVE IS HIGHLY COMPETITIVE, WE MAY LACK THE FINANCIAL AND OTHER
RESOURCES, EXPERTISE OR CAPABILITY NEEDED TO CAPTURE INCREASED MARKET SHARE OR
MAINTAIN MARKET SHARE. We compete in the Internet application service market.
This market is rapidly evolving, highly competitive and
Page 22 of 30
likely to be characterized by over capacity and industry consolidation. We
believe that participants in this market must grow rapidly and achieve a
significant presence to compete effectively. Our business is not as developed as
that of many of our competitors. Many of our competitors have substantially
greater financial, technical and market resources, greater name recognition and
more established relationships in the industry. We may lack the financial and
other resources, expertise or capability needed to capture increased market
share in this environment in the future.
ANY INTERRUPTIONS IN, OR DEGRADATION OF, OUR PRIVATE TRANSIT INTERNET
CONNECTIONS COULD RESULT IN THE LOSS OF CUSTOMERS OR HINDER OUR ABILITY TO
ATTRACT NEW CUSTOMERS. Our customers rely on our ability to move their digital
content as efficiently as possible to the people accessing their Web sites and
Internet applications. We utilize our direct private transit Internet
connections to major backbone providers as a means of avoiding congestion and
resulting performance degradation at public Internet exchange points. We rely on
these telecommunications network suppliers to maintain the operational integrity
of their backbones so that our private transit Internet connections operate
effectively.
INCREASED COSTS ASSOCIATED WITH OUR PRIVATE TRANSIT INTERNET CONNECTIONS COULD
RESULT IN THE LOSS OF CUSTOMERS OR SIGNIFICANT INCREASES IN OPERATING COSTS. Our
private transit Internet connections are already more costly than alternative
arrangements commonly utilized to move Internet traffic. If providers increase
the pricing associated with utilizing their bandwidth, we may be required to
identify alternative methods to distribute our customers' digital content. We
cannot assure you that our customers will continue to be willing to pay the
higher costs associated with direct private transit or that we could effectively
move to another network approach. If we were unable to access alternative
networks to distribute our customers' digital content on a cost- effective basis
or to pass any additional costs on to our customers, our operating costs would
increase significantly.
IF WE ARE UNABLE TO MAINTAIN EXISTING AND DEVELOP ADDITIONAL RELATIONSHIPS WITH
INTERNET APPLICATION SOFTWARE VENDORS, THE SALE, MARKETING AND PROVISION OF OUR
INTERNET APPLICATION SERVICES MAY BE UNSUCCESSFUL. We believe that to penetrate
the market for Web site and Internet application hosting and management services
we must maintain existing and develop additional relationships with
industry-leading Internet application software vendors and other third parties.
We license or lease select software applications from Internet application
software vendors. The loss of our ability to continually obtain and utilize any
of these applications could materially impair our ability to provide services to
our customers or require us to obtain substitute software applications of lower
quality or performance standards or at greater cost. In addition, because we
generally license applications on a non-exclusive basis, our competitors may
license and utilize the same software applications. In fact, many of the
companies with which we have strategic relationships currently have, or could
enter into, similar license agreements with our competitors or prospective
competitors. We cannot assure you that software applications will continue to be
available to us from Internet application software vendors on commercially
reasonable terms. If we are unable to identify and license software applications
which meet our targeted criteria for new application introductions, we may have
to discontinue or delay introduction of services relating to these applications.
WE PURCHASE FROM A LIMITED NUMBER OF SUPPLIERS KEY COMPONENTS OF OUR
INFRASTRUCTURE, INCLUDING NETWORKING EQUIPMENT. We cannot assure you that we
will have the necessary hardware or parts on hand or that our suppliers will be
able to provide them in a timely manner in the event of equipment failure. Our
dependency to obtain and continue to maintain the necessary hardware or parts on
a timely basis could result in sustained equipment failure and a loss of revenue
due to customer loss or claims for service credits under our service level
guarantees.
Our inability to scale our infrastructure or manage our customer growth and the
related expansion of our operations could result in decreased revenue and
continued operating losses. In order to service our customer base, we will need
to continue to improve and expand our network infrastructure. Our ability to
continue to meet the needs of a substantial number of customers while
maintaining superior performance is largely unproven. If our network
infrastructure is not scalable, we may not be able to provide our services to
additional customers, which would result in decreased revenue.
OUR CUSTOMER BASE INCLUDES A SIGNIFICANT NUMBER OF DOT.COM BUSINESSES THAT FACE
INCREASED RISK OF LOSS OF FUNDING DEPENDING UPON THE AVAILABILITY OF PRIVATE
AND/OR PUBLIC FUNDING. Many of our customers are small start-up Internet based
businesses that have traditionally been initially funded by venture capital
firms and then through public securities offerings. If the market for technology
and Internet based businesses is not supported by the private investors who have
funded these customers, we face the risk that these customers may cease, curtail
or limit Web site operations hosted by us. We have experienced and may continue
to experience a loss of revenue associated with these customers and will then
have to increase sales to other businesses using the Internet in order to
preserve and grow our revenue.
YOU MAY EXPERIENCE DILUTION BECAUSE OF OUR RECENT FINANCING ARRANGEMENTS WITH
CFS AND CMGI. The financing arrangement, as of October 29, 2001, with CFS and
CMGI includes terms that allow CFS and CMGI at their discretion, to convert the
debt obligation of $65 million into our common stock at a conversion price of
$0.26 per share, subject to our stockholder approval. This conversion would
increase the number of shares of our common stock issued by approximately 250
million shares. In addition, we may pay a portion of interest due to CFS and all
interest due to CMGI with our common shares. Moreover, if additional funds are
raised through the issuance of additional equity or convertible debt securities,
your percentage of ownership in us
Page 23 of 30
will be reduced and you may experience additional dilution. In certain
circumstances, if we issue equity or convertible debt securities at values below
those provided to CFS, we must issue CFS additional shares of our common stock
which will further dilute existing stockholders.
FUNDING MAY NOT BE AVAILABLE TO US ON FAVORABLE TERMS, IF AT ALL. We may need to
raise additional funds from time to time and we cannot assure you that
additional financing will be available on terms favorable to us, if at all. In
addition, pursuant to our financing arrangements with CFS as of October 29,
2001, we may need to obtain approval from CFS for incremental funding, and we
may not obtain this approval for CFS.
OUR NETWORK INFRASTRUCTURE COULD FAIL, WHICH WOULD IMPAIR OUR ABILITY TO PROVIDE
GUARANTEED LEVELS OF SERVICE AND COULD RESULT IN SIGNIFICANT OPERATING LOSSES.
To provide our customers with guaranteed levels of service, we must operate our
network infrastructure 24 hours a day, seven days a week without interruption.
In order to operate in this manner, we must protect our network infrastructure,
equipment and customer files against damage from human error, natural disasters,
unexpected equipment failure, power loss or telecommunications failures,
sabotage or other intentional acts of vandalism. Even if we take precautions,
the occurrence of a natural disaster, equipment failure or other unanticipated
problem at one or more of our data centers could result in interruptions in the
services we provide to our customers. We cannot assure you that our disaster
recovery plan will address all, or even most, of the problems we may encounter
in the event of such a disaster.
We have experienced service interruptions in the past, and any future service
interruptions could: require us to spend substantial amounts of money to replace
equipment or facilities; entitle customers to claim service credits under our
service level guarantees; cause customers to seek damages for losses incurred;
or make it more difficult for us to attract new customers, retain current
customers or enter into additional strategic relationships. Any of these
occurrences could result in significant operating losses.
THE MISAPPROPRIATION OF OUR PROPRIETARY RIGHTS COULD RESULT IN THE LOSS OF OUR
COMPETITIVE ADVANTAGE IN THE MARKET. We rely on a combination of trademark,
service mark, copyright and trade secret laws and contractual restrictions to
establish and protect our proprietary rights. We do not own any patents that
would prevent or inhibit competitors from using our technology or entering our
market. We cannot assure you that the contractual arrangements or other steps
taken by us to protect our proprietary rights will prove sufficient to prevent
misappropriation of our proprietary rights or to deter independent, third-party
development of similar proprietary assets. In addition, we provide our services
in other countries where the laws may not afford adequate protection for our
proprietary rights.
THIRD-PARTY INFRINGEMENT CLAIMS AGAINST OUR TECHNOLOGY SUPPLIERS, CUSTOMERS OR
US COULD RESULT IN DISRUPTIONS IN SERVICE, THE LOSS OF CUSTOMERS OR COSTLY AND
TIME-CONSUMING LITIGATION. We license or lease most technologies used in the
Internet application services that we offer. Our technology suppliers may become
subject to third-party infringement or other claims and assertions, which could
result in their inability or unwillingness to continue to license their
technology to us. We expect that we and our customers increasingly will be
subject to third-party infringement claims as the number of Web sites and third-
party service providers for Web-based businesses grows. In addition, we have
received notices alleging that our service marks infringe the trademark rights
of third parties. We cannot assure you that third parties will not assert claims
against us in the future or that these claims will not be successful. Any
infringement claim as to our technologies or services, regardless of its merit,
could result in delays in service, installation or upgrades, the loss of
customers or costly and time-consuming litigation, or require us to enter into
royalty or licensing agreements.
THE LOSS OF KEY OFFICERS, KEY MANAGEMENT AND OTHER PERSONNEL COULD IMPAIR OUR
ABILITY TO SUCCESSFULLY EXECUTE OUR BUSINESS STRATEGY, BECAUSE WE SUBSTANTIALLY
RELY ON THEIR EXPERIENCE AND MANAGEMENT SKILLS, OR COULD JEOPARDIZE OUR ABILITY
TO CONTINUE TO PROVIDE SERVICE TO OUR CUSTOMERS. We believe that the continued
service of key personnel, including Tricia Gilligan, our President and Chief
Executive Officer, is a key component of the future success of our business.
None of our key officers or personnel is currently a party to an employment
agreement with us. This means that any officer or employee can terminate his or
her relationship with us at any time. In addition, we do not carry life
insurance for any of our key personnel to insure our business in the event of
their death. In addition, the loss of key members of our sales and marketing
teams or key technical service personnel could jeopardize our positive relations
with our customers. Any loss of key technical personnel would jeopardize the
stability of our infrastructure and our ability to provide the guaranteed
service levels our customers expect. On July 31, 2001, we initiated a reduction
in force eliminating 126 full-and part-time employees, representing
approximately 25 percent of our total staff. We also announced the departure of
7 of 13 vice presidents, in the areas of sales, human resources, international,
strategic planning, managed services, marketing and technology planning, as well
as our general counsel. In addition, since July 31, 2001, Joel B. Rosen, our
then Chief Executive Officer, and Kenneth W. Hale, our then Chief Financial
Officer, have left our company. We cannot assure you that future reductions or
departures will not occur.
IF WE FAIL TO ATTRACT OR RETAIN SKILLED PERSONNEL, OUR ABILITY TO PROVIDE WEB
SITE AND INTERNET APPLICATION MANAGEMENT AND TECHNICAL SUPPORT MAY BE LIMITED,
AND AS A RESULT, WE MAY BE UNABLE TO ATTRACT CUSTOMERS. Our business requires
individuals with significant levels of Internet
Page 24 of 30
application expertise, in particular to win consumer confidence in outsourcing
the hosting and management of mission-critical applications. Qualified technical
personnel are likely to remain a limited resource for the foreseeable future. We
may not be able to retain or hire the necessary personnel to implement our
business strategy or may need to provide higher compensation to such personnel
than we currently anticipate.
ANY FUTURE ACQUISITIONS WE MAKE OF COMPANIES OR TECHNOLOGIES MAY RESULT IN
DISRUPTIONS TO OUR BUSINESS OR DISTRACTIONS OF OUR MANAGEMENT DUE TO
DIFFICULTIES IN ASSIMILATING ACQUIRED PERSONNEL AND OPERATIONS. Our business
strategy contemplates future acquisitions of complementary technologies. If we
do pursue additional acquisitions, our risks may increase because our ongoing
business may be disrupted and management's attention and resources may be
diverted from other business concerns. In addition, through acquisitions, we may
enter into markets or market segments in which we have limited prior experience.
ONCE WE COMPLETE AN ACQUISITION, WE WILL FACE ADDITIONAL RISKS. These risks
include: difficulty assimilating acquired operations, technologies and
personnel; inability to retain management and other key personnel of the
acquired business; and changes in management or other key personnel that may
harm relationships with the acquired business's customers and employees. We
cannot assure you that any acquisitions will be successfully identified and
completed or that, if one or more acquisitions are completed, the acquired
business, assets or technologies will generate sufficient revenue to offset the
associated costs or other adverse effects.
ANY FUTURE DIVESTITURES WE MAKE OF COMPANIES OR TECHNOLOGIES MAY RESULT IN
DISRUPTIONS TO OUR BUSINESS OR DISTRACTIONS OF OUR MANAGEMENT DUE TO
DIFFICULTIES DISASSIMILATING PERSONNEL, TECHNOLOGIES OR OPERATIONS. Our business
strategy may include divestiture of certain technologies. If we do pursue
divestitures, our risks may increase because our ongoing business may be
disrupted and management's attention and resources may be diverted from other
business concerns.
THE EMERGENCE AND GROWTH OF A MARKET FOR OUR INTERNET APPLICATION SERVICES WILL
BE IMPAIRED IF THIRD PARTIES DO NOT CONTINUE TO DEVELOP AND IMPROVE THE INTERNET
INFRASTRUCTURE. The recent growth in the use of the Internet has caused frequent
periods of performance degradation, requiring the upgrade of routers and
switches, telecommunications links and other components forming the
infrastructure of the Internet-by-Internet service providers and other
organizations with links to the Internet. Any perceived degradation in the
performance of the Internet as a means to transact business and communicate
could undermine the benefits and market acceptance of our Web site and Internet
application hosting and management services. Our services are ultimately limited
by, and dependent upon, the speed and reliability of hardware, communications
services and networks operated by third parties. Consequently, the market for
our Internet application services will be impaired if improvements are not made
to the entire Internet infrastructure to alleviate overloading and congestion.
WE COULD BE SUBJECT TO INCREASED OPERATING COSTS, AS WELL AS CLAIMS, LITIGATION
OR OTHER POTENTIAL LIABILITY, IN CONNECTION WITH RISKS ASSOCIATED WITH INTERNET
SECURITY AND THE SECURITY OF OUR SYSTEMS. A significant barrier to the growth of
e-commerce and communications over the Internet has been the need for secure
transmission of confidential information. Several of our Internet application
services utilize encryption and authentication technology licensed from third
parties to provide the protections necessary to ensure secure transmission of
confidential information. We also rely on security systems designed by third
parties and the personnel in our network operations centers to secure those data
centers. Any unauthorized access, computer viruses, accidental or intentional
actions and other disruptions could result in increased operating costs. For
example, we may incur additional significant costs to protect against these
interruptions and the threat of security breaches or to alleviate problems
caused by such interruptions or breaches, and we expect to expend additional
financial resources in the future to equip our data centers with enhanced
security measures. If a third party were able to misappropriate a consumer's
personal or proprietary information, including credit card information, during
the use of an application solution provided by us, we could be subject to
claims, litigation or other potential liability.
WE MAY BECOME SUBJECT TO BURDENSOME GOVERNMENT REGULATION AND LEGAL
UNCERTAINTIES THAT COULD SUBSTANTIALLY IMPAIR OUR BUSINESS OR EXPOSE US TO
UNANTICIPATED LIABILITIES. It is likely that laws and regulations directly
applicable to the Internet or to Internet application service providers may be
adopted. These laws may cover a variety of issues, including user privacy and
the pricing, characteristics and quality of products and services. The adoption
or modification of laws or regulations relating to commerce over the Internet
could substantially impair the growth of our business or expose us to
unanticipated liabilities. Moreover, the applicability of existing laws to the
Internet and Internet application service providers is uncertain. These existing
laws could expose us to substantial liability if they are found to be applicable
to our business. For example, we provide services over the Internet in many
states in the United States and elsewhere and facilitate the activities of our
customers in such jurisdictions. As a result, we may be required to qualify to
do business, be subject to taxation or be subject to other laws and regulations
in these jurisdictions, even if we do not have a physical presence, employees or
property there.
WE MAY BE SUBJECT TO LEGAL CLAIMS IN CONNECTION WITH THE INFORMATION
DISSEMINATED THROUGH OUR NETWORK, WHICH COULD HAVE THE EFFECT OF DIVERTING
MANAGEMENT'S ATTENTION AND REQUIRE US TO EXPEND SIGNIFICANT FINANCIAL RESOURCES.
We may face potential direct and indirect liability for claims of defamation,
negligence, copyright, patent or trademark infringement, violation of securities
laws and other claims based on the nature and content of the materials
disseminated through our network. For example, lawsuits may be brought against
us claiming that content distributed by some of our current or future customers
may be regulated or banned. In these and other instances, we may be required to
engage in protracted and expensive litigation that could have the effect of
diverting management's attention and require us to expend significant financial
resources. Our general liability insurance may not necessarily cover any of
Page 25 of 30
these claims or may not be adequate to protect us against all liability that may
be imposed.
In addition, on a limited number of occasions in the past, businesses,
organizations and individuals have sent unsolicited commercial e-mails from
servers hosted at our facilities to a number of people, typically to advertise
products or services. This practice, known as spamming, can lead to complaints
against service providers that enable such activities, particularly where
recipients view the materials received as offensive. We have in the past
received, and may in the future receive, letters from recipients of information
transmitted by our customers objecting to such transmission. Although we
prohibit our customers by contract from spamming, we cannot assure you that our
customers will not engage in this practice, which could subject us to claims for
damages.
THE MARKET PRICE OF OUR COMMON STOCK MAY EXPERIENCE EXTREME PRICE AND VOLUME
FLUCTUATIONS. The market price of our common stock may fluctuate substantially
due to a variety of factors, including: any actual or anticipated fluctuations
in our financial condition and operating results; public announcements
concerning us or our competitors, or the Internet industry; the introduction or
market acceptance of new service offerings by us or our competitors; changes in
industry research analysts' earnings estimates; changes in accounting
principles; sales of our common stock by existing stockholders; and the loss of
any of our key personnel.
In addition, the stock market has experienced extreme price and volume
fluctuations. The market prices of the securities of technology and Internet-
related companies have been especially volatile. This volatility often has been
unrelated to the operating performance of particular companies. In the past,
securities class action litigation often has been brought against companies that
experience volatility in the market price of their securities. Whether or not
meritorious, litigation brought against us could result in substantial costs and
a diversion of management's attention and resources.
IF OUR POTENTIAL CONTEMPLATED CHANGE TO OUR BUSINESS STRATEGY WHEREBY THE
FACILITY COMPONENT OF OUR SERVICE DELIVERY WOULD BE OUTSOURCED TO DATA CENTERS
OWNED BY THIRD PARTIES RATHER THAN NAVISITE IS NOT SUCCESSFUL, OUR BUSINESS
COULD BE MATERIALLY ADVERSELY AFFECTED. We are currently evaluating our business
model whereby we would provide integrated managed hosting services in data
centers owned by third parties in addition to our own data centers. We believe
that this approach could augment our existing management expertise, software and
operating processes with third-party infrastructure and geographic reach. The
evaluation is in the preliminary stages, and the outcome is uncertain at this
point in time, however, in the event we pursue such a strategy, this new
business strategy may not be successful due to failures of such third-party data
center providers. We would rely on these providers to supply critical components
of our business, and we may not have direct control over the facility or any of
these components. We may not be able to attract new customers or renew current
customers as such customers may require us to own the facility being utilized.
If the third-party data center providers are inadequate or if our present or
potential customers prefer that we own the data centers, our business could be
materially adversely affected.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Our exposure to market risk primarily relates to interest rates related
to our cash and cash equivalents and our fixed rate long term debt. As of
January 31, 2002, we had approximately $31.7 million in cash and cash
equivalents primarily invested in money market accounts which bear interest at
market rates. As of January 31, 2002, we had approximately $65.1 million
of fixed rate convertible debt with CMGI and CFS. Interest rate changes
affect the fair value of this fixed rate debt but do not impact earnings or cash
flows. The Company estimates that a one percentage point decrease or increase in
interest rates would increase or decrease the fair value of the debt by
$2.2 million or $2.1 million, respectively.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings.
Not applicable.
Item 2. Changes in Securities and Use of Proceeds
(c) Recent Sales of Unregistered Securities
On November 8, 2001, in connection with an agreement dated October 29,
2001 among NaviSite, CMGI, Inc. (CMGI) and Compaq Financial Services Corporation
(CFS), a wholly-owned subsidiary of Compaq Computer Corporation, we purchased
certain equipment previously leased by NaviSite from CFS under operating lease
agreements expiring through 2003 in exchange for a note payable in the face
amount of approximately $35 million. Additionally, we received $20 million and
$10 million in cash from CFS and CMGI, respectively, in exchange for six-year
convertible notes payable in the face amounts of $20 million and $10 million to
CFS and CMGI, respectively, making the total notes payable issued by NaviSite to
CFS and CMGI approximately $55 million and $10 million, respectively. The notes
require payment of interest only, at 12% per annum, for the first three years
from the date of issuance and then repayment of principal and interest, on a
straight-line basis, over the next three years until maturity on the sixth
anniversary of the date of issuance. At NaviSite's option, we may make interest
payments (i) 100% in shares of NaviSite common stock, in the case of amounts
owed to CMGI, through December 2007 and (ii) approximately 16.67% in shares of
NaviSite common stock, in the case of amounts owed to CFS, through December
2003. The convertible notes payable are secured by substantially all of the
assets of NaviSite and cannot be prepaid.
The principal balances may be converted into NaviSite common stock at
the option of the holders at any time prior to or at maturity at a conversion
rate of $0.26 per share. CMGI also converted its $80 million in aggregate
principal outstanding under its existing notes payable, plus the accrued
interest thereon, into approximately 14,724,481 shares of NaviSite common stock.
CMGI also converted approximately $16.2 million in other amounts due by NaviSite
to CMGI into approximately 9,905,419 shares of NaviSite common stock.
Holders of the convertible notes payable are entitled to both demand
and "piggyback" registration rights, and CFS is entitled to anti-dilution
protection under certain circumstances. The agreement with CFS also contains
certain restrictive covenants, including but not limited to limitations on the
issuance of additional debt, the sale of equity securities to affiliates and
certain acquisitions and dispositions of assets.
On January 10, 2002, NaviSite paid $173,940 in accrued interest owed to
CMGI under a convertible note by issuing to CMGI 523,915 shares of NaviSite
common stock. Also on January 10, 2002, NaviSite paid $159,190 in accrued
interest owed to CFS under a convertible note by issuing to CFS 479,489 shares
of NaviSite common stock.
The convertible notes and the shares of NaviSite common stock issued as
interest payments under the convertible notes were issued in reliance upon the
exemptions from registration under Section 4(2) of the Securities Act and
Regulation D promulgated thereunder, relative to sales by an issuer not
involving a public offering. No underwriters were involved in the sale of these
securities.
Page 26 of 30
Item 3. Defaults Upon Senior Securities.
Not applicable.
Item 4. Submission of Matters to a Vote of Security Holders.
At the Company's Annual Meeting of Stockholders held on December 19, 2001, the
Company's stockholders approved the following:
Total Vote For Each Total Vote Withheld From
Director Each Director
-------- -------------
(1) To elect two members of the board of directors
of NaviSite to serve for one-year terms.
Nominees:
--------
George A. McMillan 83,313,510 153,181
David S. Wetherell 83,102,488 364,203
BROKER
FOR AGAINST ABSTAIN NON-VOTE
--- ------- ------- --------
(2) To approve the issuance of
NaviSite's common stock upon conversion
of NaviSite's debt obligations held by
Compaq Financial Services Corporation
and CMGI, Inc ......................... 69,176,686 245,575 33,257 14,011,173
(3) To approve an amendment to
NaviSite's Amended and Restated
Certificate of Incorporation increasing
the authorized number of shares of
NaviSite's common stock from
Page 27 of 30
BROKER
FOR AGAINST ABSTAIN NON-VOTE
--- ------- ------- --------
150,000,000 to 395,000,000, in order that
NaviSite will have a sufficient number of
shares in the event the debt obligations held
by Compaq Financial Services Corporation
and CMGI, Inc. are converted in full 69,139,343 285,501 30,674 14,011,173
(4) To authorize the board of directors,
in its discretion, to amend NaviSite's
Amended and Restated Certificate of
Incorporation to effect a 1-for-5
reverse stock split of NaviSite's issued
and outstanding shares of common stock
without further approval or
authorization of NaviSite's stockholders 82,945,399 449,067 72,225 0
(5) To authorize the board of directors,
in its discretion, to amend NaviSite's
Amended and Restated Certificate of
Incorporation to effect a 1-for-10
reverse stock split of NaviSite's issued
and outstanding shares of common stock
without further approval or
authorization of NaviSite's stockholders 82,787,415 656,644 22,632 0
(6) To authorize the board of directors,
in its discretion, to amend NaviSite's
Amended and Restated Certificate of
Incorporation to effect a 1-for-15
reverse stock split of NaviSite's issued
and outstanding shares of Common Stock
without further approval or
authorization of NaviSite's stockholders 82,747,436 699,033 20,222 0
(7) To ratify the appointment by the
board of directors of KPMG LLP as the
independent auditors of NaviSite for the
fiscal year ending July 31, 2002 ....... 83,335,938 85,119 45,634 0
Item 5. Other Information.
Not applicable.
Item 6. Exhibits and Reports on Form 8-K.
(a) Exhibits
Page 28 of 30
Exhibit
Number Exhibit
------- -------
10.1 Form of Executive Retention Agreement by and between the Registrant
and each of Anthony Amato and Robert Poon, dated March 5, 2002.
(b) Reports on Form 8-K
None.
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended,
the Registrant has duly caused this report to be signed on its behalf by the
undersigned hereunto duly authorized.
NAVISITE, INC.
Date: March 18, 2002 By /s/ Kevin Lo
--------------------------
Kevin Lo
Chief Financial Officer
(Principal Financial
Officer)
Page 29 of 30
Exhibit Index
Exhibit No. Exhibit
----------- -------
10.1 Form of Executive Retention Agreement by and between the
Registrant and each of Anthony Amato and Robert Poon, dated
March 5, 2002.