10-Q 1 d87122e10-q.txt FORM 10-Q FOR QUARTER ENDED MARCH 31, 2001 1 ================================================================================ SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q --------------- (Mark One) [X] Quarterly report under Section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly period ended March 31, 2001. [ ] 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 000-26153 --------------- HIGH SPEED ACCESS CORP. (Exact name of Registrant as specified in its charter) DELAWARE 61-1324009 (State or other jurisdiction of (I.R.S. Employer Identification Number) incorporation or organization)
10901 WEST TOLLER DRIVE LITTLETON, COLORADO 80127 (Address of principal executive offices, including zip code) 720/922-2500 (Registrant's telephone number, including area code) FORMER NAME, FORMER ADDRESS, AND FORMER YEAR, IF CHANGED SINCE LAST REPORT: NOT APPLICABLE 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 [ ] Number of shares of Common Stock outstanding as of April 30, 2001...58,809,052 2 INDEX
PAGE PART I - FINANCIAL INFORMATION Item 1 - Financial Statements Condensed Consolidated Balance Sheets as of March 31, 2001 (Unaudited) and December 31, 2000 3 Condensed Consolidated Statements of Operations for the three months ended March 31, 2001 and 2000 (Unaudited) 4 Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2001 and 2000 (Unaudited) 5 Notes to Condensed Consolidated Financial Statements (Unaudited) 6 Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations 8 Item 3 - Quantitative and Qualitative Disclosures About Market Risk 25 PART II - OTHER INFORMATION Item 1 - Legal Proceedings 25 Item 2 - Changes in Securities and Use of Proceeds 25 Item 3 - Defaults upon Senior Securities 26 Item 4 - Submission of Matters to a Vote of Security Holders 26 Item 5 - Other Information 26 Item 6 - Exhibits and Reports on Form 8-K 26 Signatures 27
2 3 PART I - FINANCIAL INFORMATION ITEM 1 - FINANCIAL STATEMENTS HIGH SPEED ACCESS CORP. CONDENSED CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AMOUNTS)
MARCH 31, DECEMBER 31, 2001 2000 -------------- ------------- (UNAUDITED) ASSETS Current assets: Cash and cash equivalents $ 84,625 $ 114,847 Short-term investments 7,065 15,698 Accounts receivable, net of allowance for doubtful accounts of $464 and $296, respectively 2,897 2,087 Prepaid expenses and other current assets 3,766 3,818 -------------- ------------- Total current assets 98,353 136,450 Property, equipment and improvements, net 60,095 63,008 Intangible assets, net 3,820 4,197 Deferred distribution agreement costs, net 12,880 11,783 Other non-current assets 5,270 4,269 -------------- ------------- Total assets $ 180,418 $ 219,707 ============== ============= LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 11,865 $ 15,395 Accrued compensation and related expenses 4,468 6,757 Other current liabilities 9,720 9,073 Long-term debt, current portion 2,709 2,633 Capital lease obligations, current portion 8,050 7,790 -------------- ------------- Total current liabilities 36,812 41,648 Long-term debt 1,731 2,313 Capital lease obligations 9,475 11,380 -------------- ------------- Total liabilities 48,018 55,341 -------------- ------------- Commitments and contingencies Stockholders' equity: Convertible preferred stock, $.01 par value (aggregate liquidation preference of $75.0 million), 10,000,000 shares authorized, 75,000 shares issued and outstanding at March 31, 2001 and December 31, 2000 1 1 Common stock, $.01 par value, 400,000,000 shares authorized, 58,684,052 shares issued and outstanding at March 31, 2001 and December 31, 2000 587 587 Class A common stock, 100,000,000 shares authorized, none issued and outstanding - - Additional paid-in capital 738,916 737,215 Deferred compensation (636) (713) Accumulated deficit (606,607) (573,217) Accumulated other comprehensive income 139 493 -------------- ------------- Total stockholders' equity 132,400 164,366 -------------- ------------- Total liabilities and stockholders' equity $ 180,418 $ 219,707 ============== =============
The accompanying notes are an integral part of these condensed consolidated financial statements. 3 4 HIGH SPEED ACCESS CORP. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE MONTHS ENDED MARCH 31, 2001 AND 2000 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) (UNAUDITED)
2001 2000 --------------- --------------- Net revenue $ 7,004 $ 1,994 Costs and expenses: Operating 22,097 15,946 Engineering 7,279 4,912 Sales and marketing 4,634 6,216 General and administrative: Non-cash compensation expense from stock options, warrants and restricted stock 77 24 Amortization of distribution agreement costs 604 225 Other general and administrative expenses 6,471 4,033 --------------- --------------- Total general and administrative 7,152 4,282 --------------- --------------- Total costs and expenses 41,162 31,356 --------------- --------------- Loss from operations (34,158) (29,362) Investment income 1,417 2,125 Interest expense (649) (490) --------------- --------------- Net loss available to common stockholders $ (33,390) $ (27,727) =============== =============== Basic and diluted net loss available to common stockholders per share $ (0.57) $ (0.51) =============== =============== Weighted average shares used in computation of basic and diluted net loss available to common stockholders per share 58,684,052 54,329,031
The accompanying notes are an integral part of these condensed consolidated financial statements. 4 5 HIGH SPEED ACCESS CORP. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE THREE MONTHS ENDED MARCH 31, 2001 AND 2000 (IN THOUSANDS) (UNAUDITED)
2001 2000 ------------- ------------ OPERATING ACTIVITIES Net loss $ (33,390) $ (27,727) Adjustments to reconcile net loss to cash used in operating activities: Depreciation and amortization 9,128 3,603 Non-cash compensation expense from stock options, warrants and restricted stock 77 24 Amortization of distribution agreement costs 604 225 Changes in operating assets and liabilities Accounts receivable (810) (213) Prepaid expenses and other current assets 52 342 Other non-current assets (1,001) (321) Accounts payable (6,657) (1,482) Accrued compensation and related expenses (2,289) (871) Other current liabilities 647 2,214 ------------- ------------ Net cash used in operating activities (33,639) (24,206) ------------- ------------ INVESTING ACTIVITIES Purchases of short-term investments (1,534) (65,883) Sales and maturities of short-term investments 9,813 101,483 Purchases of property, equipment and improvements, net of leases (2,388) (7,912) ------------- ------------ Net cash provided by investing activities 5,891 27,688 ------------- ------------ FINANCING ACTIVITIES Payments on capital lease obligations (1,968) (2,443) Proceeds from long-term debt - 1,213 Payments on long-term debt (506) (414) Proceeds from exercise of stock options - 376 ------------- ------------ Net cash used by financing activities (2,474) (1,268) ------------- ------------ Net change in cash and cash equivalents (30,222) 2,214 Cash and cash equivalents, beginning of period 114,847 53,310 ------------- ------------ Cash and cash equivalents, end of period $ 84,625 $ 55,524 ============= ============ SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING AND FINANCING ACTIVITIES: Equipment acquired under capital leases $ 323 $ 885 Property and equipment purchases payable $ 1,403 $ 6,543 Warrants earned in connection with distribution agreements $ 1,701 $ -
The accompanying notes are an integral part of these condensed consolidated financial statements. 5 6 ITEM 1 - NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE 1 - THE COMPANY AND BASIS OF PRESENTATION THE COMPANY High Speed Access Corp. and its subsidiaries (hereinafter referred to as the Company, we, us, or our) provides high speed Internet access to residential and commercial end users primarily using cable modem technology. The Company focuses primarily on residential end users in exurban areas, although the Company has recently begun providing broadband services in some urban markets. The Company defines exurban markets as cable systems with fewer than 100,000 homes passed. The term "homes passed" refers to the number of homes that potentially can be served by a cable system. The Company enters into long-term exclusive contracts with cable system operators to provide a suite of services on a comprehensive "turnkey" basis, as well as on an unbundled or "Network Services" basis. These services enable a cable system's customers to receive high speed Internet access. In exchange for providing the Company with access to its customers in the turnkey solution, we pay the cable operator a portion of the monthly fees received from an end user that subscribes to our services. In an unbundled or Network Services solution, we deliver fewer services and incur lower costs than a turnkey solution, but also earn a smaller percentage of the subscription revenue or a fixed fee on a per subscriber basis. Under the Network Services solution, our cable partners will typically bill the end user and will remit to us our percentage of the revenue or the fixed fee. Network Services solutions have become a significant part of our business mix, and we anticipate this trend will continue. We intend to offer facilities-based Digital Subscriber Line ("DSL") Internet access services. Additionally, we are expanding our offering of services to include expanded web site hosting and a range of other value-added and ongoing support services, all primarily for small and medium enterprises ("SMEs"). We also intend to continue expanding our suite of core connectivity and related value-added services, both domestically and internationally, as broadband technology proliferates and additional services become viable. The Company also provides, on a limited basis, standard Internet access through traditional dial-up service to residential and SME customers. BASIS OF PRESENTATION The unaudited condensed consolidated financial statements included herein reflect all adjustments, consisting only of normal recurring adjustments, which in the opinion of management are necessary to present fairly the Company's financial position, results of operations and cash flows for the periods presented. Certain information and footnote disclosures normally included in audited financial information prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to the Securities and Exchange Commission's rules and regulations. The results of operations for the period ended March 31, 2001 are not necessarily indicative of the results to be expected for any subsequent quarter or for the entire fiscal year ending December 31, 2001. These financial statements should be read in conjunction with the financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2000. LIQUIDITY The Company has incurred losses from operations and negative cash flows from operating activities since April 3, 1998 ("Inception"), which have been funded primarily through the issuance of equity securities and borrowings. Management expects to experience substantial negative cash flows for at least the next several years. As of March 31, 2001, the Company had $91.7 million of cash, cash equivalents and short-term investments which management believes are sufficient to meet the Company's cash needs in 2001. Management is closely monitoring the level of expenditures and cash commitments. Continued implementation of the Company's business plan will be dependent upon obtaining additional financing by no later than early 2002 to fund operations, to finance investments in equipment and corporate infrastructure needed for the Company's planned expansion, to enhance and expand the range of services the Company offers and to respond to competitive pressures and perceived opportunities, such as investment, acquisition and international expansion activities. Management is evaluating the availability of additional financing. There can be no assurance that additional financing will be available on terms favorable to the Company, or at all. If additional financing is not available on acceptable terms, the Company will be forced to curtail operations, which could have a material adverse effect on the Company. Such curtailment of operations would involve significant amendments to the Company's current business plan including, 6 7 but not limited to some or all of the following: a delay in further deployment of certain services, administrative and operating expense reductions, a reduction in planned capital expenditures, reduction of our sales and marketing efforts, sales of certain assets or sale of the Company. USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported results of operations during the reporting period. These estimates are based on knowledge of current events and anticipated future events. Actual results could differ from those estimates. NOTE 2 - ADOPTION OF ACCOUNTING PRONOUNCEMENT In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivatives and Hedging Activities" ("SFAS 133") as amended by SFAS 138, which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities. SFAS 133 requires that all derivatives be recognized as either assets or liabilities in the balance sheet at their fair value, and sets forth the manner in which gains or losses thereon are to be recognized. The treatment of such gains or losses is dependent upon the type of exposure, if any, the derivative is designated to hedge. The Company adopted SFAS 133 effective January 1, 2001. The adoption did not have a material impact on the Company's financial position, results of operations or cash flows. NOTE 3 - LOSS PER SHARE The Company computes net loss available to common stockholders per share under the provisions of SFAS No. 128, "Earnings per Share," ("SFAS 128"). Under the provisions of SFAS 128, basic net loss available to common stockholders per share is computed by dividing the net loss available to common stockholders for the period by the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share is determined in the same manner as basic earnings per share, except that the number of shares is increased assuming exercise of dilutive stock options and warrants using the treasury stock method and assuming conversion of preferred stock. In addition, income or loss is adjusted for dividends and other transactions relating to preferred stock for which conversion is assumed. The calculation of diluted net loss available to common stockholders per share excludes potential common shares if the effect is dilutive. Basic and diluted net loss available to common stockholders per share for the three months ended March 31, 2001 and 2000, were $0.57 and $0.51 based on weighted average shares outstanding of 58,684,052 and 54,329,031, respectively. Diluted loss available to common stockholders per share equals basic loss available to common stockholders per share because the assumed exercise of the Company's stock options and warrants and the assumed conversion of preferred stock are dilutive. Options and warrants to purchase 10,086,960 shares and 3,864,664 shares of common stock at March 31, 2001 and 2000, respectively, were excluded from the calculation of net loss available to common stockholders per share. There is a potential to issue additional warrants pursuant to the agreements set forth in Note 5. These potential warrants have been excluded from the calculation above because they are not currently measurable and would be dilutive. In the future, the Company also may issue additional stock or warrants to purchase its common stock in connection with its efforts to expand the distribution of its services. Stockholders could face additional dilution from these possible future transactions. NOTE 4 - COMPREHENSIVE LOSS Comprehensive loss, comprised of net loss available to common stockholders and net unrealized holding gains and losses on investments, totaled $33.7 million and $28.2 million for the three months ended March 31, 2001 and 2000, respectively. NOTE 5 - DISTRIBUTION AGREEMENTS As an inducement to certain cable partners to commit systems, the Company issues warrants to purchase its common stock in connection with Network Service agreements and other agreements, collectively referred to as distribution agreements. The Company 7 8 values warrants to purchase its common stock using an accepted options pricing model based on the value of the stock when the warrants and options are earned. The Company recognizes an addition to equity for the fair value of any warrants issued, and recognizes the related expense over the term of the agreement with the respective cable system, generally four to five years, in accordance with Emerging Issues Task Force Issue No. 96-18, "Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring or in Conjunction with Selling, Goods or Services." In May 2000, the Company entered into a second Network Services agreement with Charter Communications, Inc. ("Charter"), a related party. Under this agreement, Charter committed to provide the Company exclusive right to provide Network Services related to the delivery of Internet access to homes passed in certain cable systems. We will provide Network Services, including system monitoring and security as well as call center support. Charter will receive the warrants described in the following paragraph as an incentive to provide the Company additional homes passed, although it is not obligated to do so. Charter can terminate these exclusivity rights, on a system-by-system basis, if the Company fails to meet performance specifications or otherwise breaches the agreement. The agreement has an initial term of five years and may be renewed at Charter's option for additional successive five-year terms. In connection with the second Network Services agreement, the Company and Charter entered into an amended and restated warrant to purchase up to 12,000,000 shares of common stock at an exercise price of $3.23 per share and terminated two warrants that had been issued to Charter in November 1998. The new warrant becomes exercisable at the rate of 1.55 shares for each home passed committed to us by Charter under the Network Services agreement entered into by Charter and us in November 1998. The warrant also becomes exercisable at the rate of .775 shares for each home passed committed to us by Charter under the Network Services agreement entered into in May 2000 up to 5,000,000 homes passed, and at a rate of 1.55 shares for each home passed in excess of 5,000,000. Charter also has the opportunity to earn additional warrants to purchase shares of common stock upon any renewal of the May 2000 agreement. Such a renewal warrant will have an exercise price of $10 per share and will be exercisable to purchase .50 shares for each home passed in the systems for which the May 2000 agreement is renewed. With respect to each home passed, launched or intended to be launched on or before the second anniversary date of the second Network Services agreement, the Company will pay Charter, at Charter's option, a launch fee of $3.00 per home passed committed. As of March 31, 2001, the Company has paid Charter approximately $4.8 million of launch fees related to launched systems or systems to be deployed in the near future. The launch fees paid will be amortized over the remaining term of the agreement. For the three months ended March 31, 2001, the Company recognized $3.5 million of revenue under these distribution agreements. As of March 31, 2001, various cable partners, including Charter, had earned 2,735,406 warrants under distribution agreements of which 508,641 of these warrants were earned at a cost of $1.7 million in the three months ended March 31, 2001. Deferred distribution agreement costs of $12.9 million, net of accumulated amortization of $3.4 million were recorded in conjunction with these warrants at March 31, 2001. Amortization of distribution agreement costs of $0.6 million and $0.2 million were recognized in the statement of operations for the three months ended March 31, 2001 and 2000, respectively. Additional deferred distribution agreement costs may be recorded and amortized in future periods should the cable partners earn the right to purchase additional common shares based on the number of homes passed committed to the Company. At March 31, 2001, there were 15,064,594 additional warrants available to be earned under distribution agreements. NOTE 6 - COMMITMENTS AND CONTINGENCIES The Company is not a party to any material legal proceedings. In the opinion of management, the amount of ultimate liability with respect to any known actions will not materially affect the financial position, results of operations or cash flows of the Company. NOTE 7 - BUSINESS DEVELOPMENTS In April 2001, the Company notified its cable partners that it intends to discontinue turnkey services in the majority of its one-way cable TV markets. The change, which will affect fewer than four percent of the Company's subscribers, may be accomplished by modifying the contractual relationship between the Company and the cable operator from turnkey services to Network Services or by terminating service in these markets. If service is terminated, the Company may incur certain termination fees and asset write-downs. ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Quarterly Report on Form 10-Q contains certain statements of a forward-looking nature relating to future events or the future financial performance of the Company. Such statements are only predictions, involve risks and uncertainties, and actual events or 8 9 results may differ materially from the results discussed in the forward-looking statements. Factors that could cause or contribute to such differences include those discussed under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations - Risk Factors" as well as those discussed in other filings with the Securities and Exchange Commission, including the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2000. OVERVIEW We provide high speed Internet access to residential and commercial customers primarily via cable modems. We focus primarily on residential and commercial end users in exurban areas, although we have begun to provide broadband services in some urban markets. The Company defines exurban markets as cable systems with fewer than 100,000 homes passed. The term "homes passed" refers to the number of homes that potentially can be served by a cable system. We enter into long-term exclusive contracts with cable system operators to provide a suite of services on a comprehensive "turnkey" basis as well as on an unbundled or "Network Services" basis. These services enable a cable system's customers to receive high speed Internet access. In our turnkey solution, we generate revenue primarily from the monthly fees we receive from end users for our cable modem-based Internet access services and for the traditional dial-up services we offer as part of our end user acquisition strategy. In our turnkey solution, we generally bill the end user directly and pay our cable partners a portion of the monthly fee we receive. In these instances, we report our revenues net of the percentage split we pay to our cable partners. For promotional purposes, we often provide new end users with 30 days of free Internet access when they subscribe to our services. As a result, our revenue does not reflect new end users until the end of the promotional period. We also receive revenues from renting cable modems to end users. We also offer services to our cable partners on an unbundled or "Network Services" basis. In a Network Services solution, we deliver fewer services and incur lower costs than in a turnkey solution but will also earn a smaller percentage of the subscription revenue or a fixed fee on a per subscriber basis. Our cable partners typically bill the end user and remit to us our percentage of the revenue or the fixed fee. In May 2000, the Company entered into a second Network Services agreement with Charter in which the Company has agreed to provide unbundled services. Network Services solutions have become a significant part of our business mix and we anticipate this trend will continue. We also provide certain services, primarily engineering services related to design and installation of data network hardware and software necessary to offer Internet service via cable modems, on a fee for service basis. Our revenue from dial-up services, as a percentage of total revenue, has been decreasing and, we expect, will continue to decline over time as our high speed business and other service revenue grows. Moreover, although we expect cable modem rentals to be a significant part of our revenue during the next few years, we expect our cable modem rental income to decline as cable modems become commercially available at lower costs through retail stores and as they become standard features of personal computers. However, we expect this reduction to be partially offset by a reduction in the cost of purchasing and installing cable modems for end users. We provided DSL Internet access on a limited basis through reseller arrangements. We terminated these DSL reseller agreements during the first quarter of 2001, but we intend to offer facilities-based DSL services in the future. DSL revenue was not a significant portion of total revenue during the three months ended March 31, 2001 or during 2000, but we anticipate that our business will become more dependent upon providing facilities-based DSL service to commercial customers in the future. We are also expanding our offering of services to include web site hosting and a range of other value-added and ongoing support services, all primarily for SMEs. We also intend to continue expanding our suite of core connectivity and related value-added services, both domestically and internationally, as broadband technology proliferates and additional services become viable. Our expenses consist of the following: - Operating costs, which consist primarily of salaries and related personnel expenses for customer care, field technical support and network operations center employees and web site design and development personnel; telecommunications expenses, including charges for Internet backbone and telecommunications circuitry; allocated cost of facilities; costs of installing cable modems for our end users; and depreciation and maintenance of equipment. In one-way cable systems, where the end user transmits data back to the cable headend via a standard telephone line, we must support the telephone return path from the local telephone company's central office to the cable headend. Accordingly, we incur greater telecommunications costs in a one-way system than we incur in a two-way system. Consequently, the number of one-way systems in which we provide 9 10 service will affect our operating margins. In April 2001, the Company notified certain cable partners that it intends to discontinue turnkey services in the majority of its one-way cable TV markets. The change, which will affect fewer than four percent of the Company's subscribers, may be accomplished by modifying the contractual relationship between the Company and the cable operator from turnkey services to Network Services or by terminating service in these markets. If service is terminated, the Company may incur certain termination fees and write-down of assets. We may also incur significant fees if we cancel our telecommunications contracts in advance of the expiration of the term of the contract. Many of our operating costs are relatively fixed in the short term. However, as we add new end users we hope to be able to spread these costs over a larger revenue base, and, accordingly, decrease our costs per subscriber and improve our operating margins. - Engineering expenses, which consist primarily of salaries and related costs for the development and support of our information systems; network design and installation of the telecommunications and data network hardware and software; system testing and project management expenses; allocated cost of facilities; and depreciation and maintenance on the equipment used in our engineering processes. - Sales and marketing expenses, which consist primarily of salaries and related personnel expenses, commissions, costs associated with the development and distribution of sales and marketing materials, the preparation of database market analytics, and direct mail and telemarketing expenses. - Non-cash compensation expense from stock options, warrants and restricted stock consists of the fair market value of our stock at the time of grant over the exercise price of the stock options granted to employees and directors amortized over the vesting period and the fair market value of non-distribution agreement warrants and restricted stock issued to employees amortized over the vesting period. - Amortization of distribution agreement costs, which relates to warrants issued to cable and strategic partners in connection with network services and other distribution related agreements, collectively referred to as distribution agreements. We measure the cost of warrants issued to cable and strategic partners based on the fair values of the warrants when earned by those partners. Because the fair value of the warrant is dependent to a large extent on the price of our common stock, the cost of warrants earned in the future may vary significantly. Costs of warrants granted in connection with distribution agreements are amortized over the term of the underlying agreement. - Other general and administrative expenses, which consist primarily of salaries for our executive, administrative, finance and human resource personnel; amortization of goodwill; and fees for professional services. Our operating results have varied on a quarterly basis during our short operating history and may fluctuate significantly in the future due to a variety of factors, many of which are outside our control. In addition, the results of any quarter do not indicate the results to be expected for a full fiscal year. The factors that may contribute to fluctuations in our operations are set forth generally under the caption "Management's Discussion and Analysis of Financial Conditions and Results of Operations - Risk Factors" and particularly in that section under the heading "Our Quarterly Operating Results Are Likely To Fluctuate Significantly And May Be Below Our Expectations And The Expectations Of Analysts And Investors". As a result of such factors, our annual or quarterly results of operations may be below the expectations of public market analysts or investors, in which case the market price of the common stock could be materially and adversely affected. RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED MARCH 31, 2001 COMPARED WITH THE THREE MONTHS ENDED MARCH 31, 2000 REVENUES Net revenue consists of net monthly subscription fees for cable modem-based and traditional dial-up Internet services, cable modem rental income, fees for engineering services provided to cable partners, international infrastructure services, monthly fees for web hosting services and overall strategic consulting. Total net revenue for the three months ended March 31, 2001 and 2000 was $7.0 million and $2.0 million respectively, an increase of $5.0 million. For the quarters ending March 31, 2001 and 2000, revenue by product offering as a percentage of total net revenue was as follows: 10 11
% OF NET REVENUE ------------------ 2001 2000 ------ ------ Cable modem-based subscription fees - Turnkey 33% 48% Cable modem-based subscription fees - Network Services 24% 3% Traditional dial-up service fees 7% 20% Cable modem rental fees 17% 24% Engineering services provided to cable partners 5% 3% International infrastructure services 5% -- Web hosting 4% -- Other revenue 5% 2% ---- ---- 100% 100% ==== ====
COSTS AND EXPENSES OPERATING. Operating costs for the three months ended March 31, 2001 and 2000 were $22.1 million and $15.9 million, respectively, an increase of $6.2 million. The increase in operating costs resulted primarily from an increase in personnel and personnel related costs for additional staff in our customer care department, additional personnel costs associated with the purchase of Digital Chainsaw ("Digital"), an increase in telecommunications expense from the rollout of our service to new markets, our larger subscriber base, additional depreciation of capital equipment from the expansion of our network and the installation of cable modems for additional subscribers. ENGINEERING. Engineering expenses for the three months ended March 31, 2001 and 2000 were $7.3 million and $4.9 million, respectively, an increase of $2.4 million. The increase in engineering expenses resulted from the development and support of information systems, continued network design, system testing and project management for the evaluation of new equipment and possible new product offerings, including the offering of service via DSL, an increase in personnel and personnel-related costs for additional technical staff to support cable modem services and additional depreciation on capital equipment. SALES AND MARKETING. Sales and marketing expenses for the three months ended March 31, 2001 and 2000 were $4.6 million and $6.2 million, respectively, a decrease of $1.6 million. The decrease in sales and marketing expenses resulted primarily from lower direct advertising costs and lower marketing costs aimed at obtaining new cable partners. NON-CASH COMPENSATION EXPENSE FROM STOCK OPTIONS, WARRANTS AND RESTRICTED STOCK. Non-cash compensation expense from stock options, warrants and restricted stock for the three months ended March 31, 2001 and 2000 was $77,000 and $24,000, respectively. These expenses represent the excess of the fair market value of our common stock over the exercise price of the stock options granted to employees and directors amortized over the vesting period, the amortization of common stock purchase warrants issued to contractors and the fair value of restricted stock amortized over the restriction period. AMORTIZATION OF DISTRIBUTION AGREEMENT COSTS. Amortization of distribution agreement costs for the three months ended March 31, 2001 and 2000 was $0.6 million and $0.2 million, respectively, an increase of $0.4 million. The costs consist of the amortization of the value of warrants earned under distribution agreements for commitments of homes passed. The Company had issued 2,735,406 and 198,744 warrants in connection with distribution agreements at March 31, 2001 and 2000, respectively. We expect to incur additional material non-cash charges related to further issuance of common stock purchase warrants to our cable and strategic partners in the future. We will recognize an addition to equity for the fair value of any warrants issued, and will recognize the related expense over the term of the service agreement with the cable or strategic partner to which the warrants relate. The amount of any such charges is not determinable until the related warrants are earned. The use of warrants in these and similar transactions may increase the volatility of our earnings in the future. In May 2000, the Company and Charter entered into an amended and restated warrant to purchase up to 12,000,000 shares of our common stock at an exercise price of $3.23 per share. The restated warrant becomes exercisable at the rate of 1.55 shares for each home passed committed to us by Charter under the Network Services agreement entered into by Charter and us in November 1998. The warrant also becomes exercisable at the rate of .775 shares for each home passed committed to us by Charter under the second Network Services agreement entered into in May 2000 up to 5,000,000 homes passed and at a rate of 1.55 shares for each home passed in excess of 5,000,000. Charter also has the opportunity to earn additional warrants to purchase shares of our common stock upon any renewal of the May 2000 agreement. Such a renewal warrant will have an exercise price of $10 per share and will be exercisable to purchase one-half of a share for each home passed in the systems for which the May 2000 agreement is renewed. OTHER GENERAL AND ADMINISTRATIVE. Other general and administrative expenses for the three months ended March 31, 2001 and 2000 were $6.5 million and $4.0 million, respectively, an increase of $2.5 million. The increase in other general and administrative expenses resulted from severance costs associated with the termination of certain employees, additional personnel and personnel related costs to administer the procurement, accounting and finance functions, as well as additional depreciation on capital equipment 11 12 and amortization of intangible assets associated with the purchase of Digital. NET INVESTMENT INCOME. Net investment income for the three months ended March 31, 2001 and 2000 was $0.8 million and $1.6 million, respectively. The decrease in investment income for the three months ended March 31, 2001, is the result of lower investment balances during the first quarter of 2001. Net investment income represents interest earned on cash, cash equivalents and short-term investments. INCOME TAXES. At December 31, 2000, we accumulated net operating loss carryforwards for federal and state tax purposes of approximately $182.1 million which will expire beginning in 2018. At December 31, 2000, we had net deferred tax assets of $77.6 million relating principally to our accumulated net operating losses. Our ability to realize the value of our deferred tax assets depends on our future earnings, if any, the timing and amount of which are uncertain. We have recorded a valuation allowance for the entire net deferred tax asset as a result of those uncertainties. Accordingly, we did not record any income tax benefit for net losses incurred for the three months ended March 31, 2001 and 2000. LIQUIDITY AND CAPITAL RESOURCES At March 31, 2001, we had cash and cash equivalents of $84.6 million and short-term investments of $7.1 million, compared with $114.8 million of cash and cash equivalents and $15.7 million of short-term investments at December 31, 2000. We had significant negative cash flow from operating activities for the three months ended March 31, 2001. Cash used in operating activities for the three months ended March 31, 2001 was $33.6 million, caused primarily by a net loss of $33.4 million, an increase in current and non-current assets of $1.7 million, a decrease in accounts payable, accrued expenses and other current liabilities of $8.3 million, offset by non-cash expenses of $9.8 million. Cash provided by investing activities for the three months ended March 31, 2001 was $5.9 million, the result of sales and maturities of short-term investments of $9.8 million, offset by purchases of short-term investments of $1.5 million. Also, capital expenditures totaled $2.4 million for the three months ended March 31, 2001. The principal capital expenditures incurred during this period were for the purchase of cable modems and central network hardware and software, reflecting our expansion into new markets, and costs associated with the implementation of our billing and customer care systems. Cash used by financing activities for the three months ended March 31, 2001 was $2.5 million, comprised of net payments on capital lease obligations and long-term debt. We expect to experience substantial negative cash flow from operating activities and negative cash flow from investing activities for at least the next several years due to continued deployment of our services into new markets and the enhancement of our network and operations. Our future cash requirements will depend on a number of factors including: - The mix of services offered by us, including whether we provide our services on a turnkey or Network Services basis; - The pace of the rollout of our service to our cable partners, including the impact of substantial capital expenditures and related operating expenses; - The rate at which we enter into contracts with cable operators for additional systems; - The rate at which end users subscribe to our services; - Changes in revenue splits with our cable partners; - Price competition in the Internet and cable industries; - Capital expenditures and costs related to infrastructure expansion; - The rate at which our cable partners convert their systems from one-way to two-way systems; - End user turnover rates; - Our ability to protect our systems from telecommunications failures, power loss and software-related system failures; - Changes in our operating expenses including, in particular, personnel expenses; - Our ability to offer DSL services through the acquisition of facilities-based DSL assets; - The introduction of new products or services by us or our competitors; and - Economic conditions specific to the Internet and cable industries, as well as general economic and market conditions. INVESTMENT PORTFOLIO. Cash equivalents are highly liquid investments with insignificant interest rate risk and original maturities of 90 days or less and are stated at amounts that approximate fair value based on quoted market prices. Cash equivalents consist principally of investments in interest-bearing money market accounts with financial institutions and highly liquid investment-grade 12 13 debt securities of corporations and the U.S. Government. Short-term investments are classified as available-for-sale and, as a result, are stated at fair value. Short-term investments are principally comprised of highly-liquid debt securities of corporations and the U.S. Government. We record changes in the fair market value of securities held for short-term investment as an equal adjustment to the carrying value of the security and stockholders' equity. LOAN FACILITIES. The Company has $3.9 million outstanding under various loan facilities and $0.5 million outstanding on a note payable to a related party at March 31, 2001. The related party note matured on and was paid on April 1, 2001. The interest rate on draws on the loan facilities ranged from 14.63% to 15.52% as of March 31, 2001. We expect to incur $8.0 million to $12.0 million of capital expenditures in 2001 principally related to cable modems, data centers, and furniture and telephone and computer equipment for customer care facilities. Actual capital expenditures will be significantly affected by the rate at which end users subscribe to our cable modem Internet access services, which requires us to purchase a cable modem for each new end user where we provide turnkey services, as well as the pace of the rollout of our systems, which requires us to purchase headend data network hardware and software. The Company has incurred losses from operations and negative cash flows from operating activities since Inception, which have been funded primarily through the issuance of equity securities and borrowings. Management expects to experience substantial negative cash flows for at least the next several years. As of March 31, 2001, the Company had $91.7 million of cash, cash equivalents and short-term investments which management believes are sufficient to meet the Company's cash needs in 2001. Management is closely monitoring the level of expenditures and cash commitments. Continued implementation of the Company's business plan will be dependent upon obtaining additional financing by no later than early 2002 to fund operations, to finance investments in equipment and corporate infrastructure needed for the Company's planned expansion, to enhance and expand the range of services the Company offers and to respond to competitive pressures and perceived opportunities, such as investment, acquisition and international expansion activities. Management is evaluating the availability of additional financing. Such financing could involve the issuance, or deemed issuance, of additional shares of capital stock at a price below the conversion price of our convertible preferred stock held by Vulcan Ventures, Incorporated ("Vulcan") and Charter, which would result in a downward adjustment of the conversion price. In the event of such an adjustment, the number of shares of common stock issuable upon conversion of the convertible preferred stock would be increased pursuant to the weighted average formula described below under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations - Risk Factors - Our Convertible Preferred Stock Contains Anti-dilution Adjustments and Restrictions On Our Future Activities". There can be no assurance that additional financing will be available on terms favorable to the Company, or at all. If additional financing is not available on acceptable terms, the Company will be forced to curtail operations, which could have a material adverse effect on the Company. Such curtailment of operations would involve significant amendments to the Company's current business plan including, but not limited to some or all of the following: a delay in further deployment of certain services, administrative and operating expense reductions, a reduction in planned capital expenditures, reduction of our sales and marketing efforts, sales of certain assets or sale of the Company. Furthermore, additional equity or debt financing could give rise to any or all of the following: - Additional dilution to our current stockholders; - The issuance of securities with rights, preferences or privileges senior to those of the existing holders of our common stock; and - The issuance of securities with covenants imposing restrictions on our operations. Charter can require any lender with liens on our equipment placed in Charter headends to deliver to Charter a non-disturbance agreement as a condition to such financing. We can offer no assurance that we will be able to obtain additional secured equipment financing for Charter systems subject to such a condition or that a potential lender will be able to negotiate acceptable terms of non-disturbance with Charter. ADOPTION OF ACCOUNTING PRONOUNCEMENT In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivatives and Hedging Activities" ("SFAS 133") as amended by SFAS 138, which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities. SFAS 133 requires that all derivatives be recognized as either assets or liabilities in the balance sheet at their fair value, and sets forth the manner in which gains or losses thereon are to be recognized. The treatment of such gains or losses is dependent upon the type of exposure, if any, the derivative is designated to hedge. The Company adopted SFAS 133 effective January 1, 2001. The adoption did 13 14 not have a material impact on the Company's financial position, results of operations or cash flows. RISK FACTORS You should carefully consider the following factors and other information in this Form 10-Q and other filings we make with the Securities and Exchange Commission before trading in our common stock. If any of the following risks actually occur, our business and financial results could be materially and adversely affected. In that case, the trading price of our common stock could decline and you could lose all or part of your investment. RISKS RELATED TO OUR OPERATIONS WE CANNOT PREDICT OUR SUCCESS BECAUSE OUR BUSINESS MODEL IS UNPROVEN, HAS CHANGED IN THE PAST AND MAY CONTINUE TO CHANGE. Our success depends on continued growth in the use of the Internet and high speed access services. Although Internet usage and popularity have grown rapidly, we cannot be certain that this growth will continue at its present rate, or at all. Critical issues concerning the increased use of the Internet--including security, reliability, cost, ease of access, ease of installation and customer acquisition and quality of service--remain unresolved and are likely to affect the development of the market for our services. Moreover, many industry analysts believe that Internet access providers will become increasingly reliant upon advertising, barter and subscription-based revenues from content due to competitive pressures to provide low cost or even free Internet access. The success of our business ultimately will depend upon the acceptance of our services by end users. We continue to introduce new services, make changes to our product offerings to meet customer demands and to respond to changes in our evolving industry. Although our primary service offering is high bandwidth Internet access, we currently derive a portion of our revenue from standard dial-up Internet access. We cannot predict whether demand for our high speed Internet access services will develop, particularly at the volume or prices we need to become profitable. Even if sufficient demand for our high speed services is generated, we may be unable to deploy our services at the rate required to satisfy demand. Additionally, we believe that Network Services will become an increasingly important part of our business. Under the Network Services arrangements, such as the one we signed with Charter on May 12, 2000, covering a minimum of 5 million homes passed, we will earn less revenue, and absorb less operating expense, per end user, than under a turnkey arrangement. In our Network Services solution, we deliver fewer services and incur lower costs than in a turnkey solution but will also earn a smaller percentage of the subscription revenue or a fixed fee on a per subscriber basis. We are committed to incorporating DSL technology as a key part of our ongoing strategy for the SME market. Our intent is to purchase facilities-based assets to pursue our DSL strategy. There is no assurance that we will be able to successfully identify and purchase DSL assets, let alone enough DSL assets for us to establish a significant footprint. Competition for the purchase of these assets from larger and better-capitalized companies may make it difficult for us to acquire these assets cost-effectively or at all. Even if we purchase DSL assets, there is no assurance that our DSL operations will be successful. Consequently, there is no assurance that we will be successful in implementing our DSL strategy, and it is quite possible that our business will continue to rely on our cable modem service, which may not be well suited for many SMEs and for which market acceptance has been slow. OUR BUSINESS IS DIFFICULT TO EVALUATE BECAUSE WE HAVE A LIMITED OPERATING HISTORY. Our predecessor companies began offering services to cable operators in October 1997. Most of our cable modem deployments occurred within the last eighteen months. Our senior management team and other employees have worked together at our Company for only a short period of time. We have recognized only limited revenues since our Inception. We do not consider any of the markets in which we operate to be mature. Finally, we have recently expanded our business to provide additional product offerings. As a result of our limited operating history, as evidenced by the preceding examples, our business is difficult to evaluate. WE HAVE NOT BEEN PROFITABLE AND EXPECT FUTURE LOSSES. Since our founding, we have not been profitable. We have incurred substantial costs to create and introduce our broadband Internet access services, to operate these services, and to grow our business. We incurred net losses of approximately $254.7 million from 14 15 April 3, 1998 ("Inception") through March 31, 2001. Our limited operating history, the dynamic nature of our industry, changes in our business model and our ambitious growth plans make predicting our operating results, including operating expenses, difficult. We expect to incur substantial losses and experience substantial negative cash flow from operations for at least the next several years as we expand our business. The principal costs of expanding our business will include: - The costs of acquiring DSL facilities-based assets and the associated operating costs; - Direct and indirect selling, marketing and promotional costs; - System operational expenses, including the lease of our Internet backbone, which has a traffic capacity in excess of our current needs; - Costs incurred in connection with staffing levels to meet our growth; - The acquisition and installation of the equipment, software and telecommunications circuits necessary to enable our cable partners to offer our services or to add additional products and services; and - Costs in connection with acquisitions, divestitures, business alliances or changing technologies. If any of these costs or expenses is not accompanied by an increase in revenues, then our business and financial results could be materially and adversely affected. WE WILL NEED ADDITIONAL CAPITAL IN THE FUTURE AND IT MAY NOT BE AVAILABLE ON ACCEPTABLE TERMS. The Company has incurred losses from operations and negative cash flows from operating activities since Inception, which have been funded primarily through the issuance of equity securities and borrowings. Management expects to experience substantial negative cash flows for at least the next several years. As of March 31, 2001, the Company had $91.7 million of cash, cash equivalents and short-term investments which management believes are sufficient to meet the Company's cash needs in 2001. Management is closely monitoring the level of expenditures and cash commitments. Continued implementation of the Company's business plan will be dependent upon obtaining additional financing by no later than early 2002 to fund operations, to finance investments in equipment and corporate infrastructure needed for the Company's planned expansion, to enhance and expand the range of services the Company offers and to respond to competitive pressures and perceived opportunities, such as investment, acquisition and international expansion activities. Management is evaluating the availability of additional financing. Such financing could involve the issuance, or deemed issuance, of additional shares of capital stock at a price below the conversion price of our Series D convertible preferred stock held by Vulcan and Charter, which would result in a downward adjustment of the conversion price. In the event of such an adjustment, the number of shares of common stock issuable upon conversion of the convertible preferred stock would be increased pursuant to the weighted average formula described below under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations - Risk Factors - Our Series D Convertible Preferred Stock Contains Anti-dilution Adjustments and Restrictions on our Future Activities". There can be no assurance that additional financing will be available on terms favorable to the Company, or at all. If additional financing is not available on acceptable terms, the Company will be forced to curtail operations, which could have a material adverse effect on the Company. Such curtailment of operations would involve significant amendments to the Company's current business plan including, but not limited to some or all of the following: a delay in further deployment of certain services, administrative and operating expense reductions, a reduction in planned capital expenditures, reduction of our sales and marketing efforts, sales of certain assets or sale of the Company. Furthermore, additional equity or debt financing could give rise to any or all of the following: - Additional dilution to our current stockholders; - The issuance of securities with rights, preferences or privileges senior to those of the existing holders of our common stock; and - The issuance of securities with covenants imposing restrictions on our operations. Charter can require any lender with liens on our equipment placed in Charter headends to deliver to Charter a non-disturbance agreement as a condition to such financing. We can offer no assurance that we will be able to obtain additional secured equipment financing for Charter systems subject to such a condition or that a potential lender will be able to negotiate acceptable terms of non-disturbance with Charter. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources." OUR ABILITY TO ATTRACT AND RETAIN END USERS DEPENDS ON MANY FACTORS WE CANNOT CONTROL. 15 16 Our ability to increase the number of our end users, and our ability to retain end users, will depend on a number of factors, many of which are beyond our control. These factors include: - Our ability to enter into and retain agreements with cable operators; - The speed at which our cable partners acquire new end users in Network Services systems; - The speed at which we are able to deploy our services, particularly if we cannot obtain on a timely basis, the telecommunications circuitry necessary to connect DSL customers and cable headend equipment to the Internet; - The speed at which our competitors are able to deploy their service offerings; - Our success in marketing our connectivity, web hosting and other advanced services to new and existing end users; - Competition, including new entrants advertising free or lower-priced Internet access and/or alternative access technologies; - Whether our cable partners maintain their cable systems or upgrade their systems from one-way to two-way service; - Whether incumbent local exchange carriers maintain and upgrade their loops to support DSL services; - The quality of the customer and technical support we provide; and - The quality of the content we offer. In addition, our service is currently priced at a premium to many other online services and many end users may not be willing to pay a premium for our service. Because of these factors, our actual revenues or the rate at which we will add new end users may differ from past increases, the forecasts of industry analysts, or a level that meets the expectations of investors. OUR QUARTERLY OPERATING RESULTS ARE LIKELY TO FLUCTUATE SIGNIFICANTLY AND MAY BE BELOW OUR EXPECTATIONS AND THE EXPECTATIONS OF ANALYSTS AND INVESTORS. Our revenues and expenses, and in particular our quarterly revenues, expenses and operating results have varied in the past and may fluctuate significantly in the future due to a variety of factors, many of which are outside of our control. These factors include: - The pace of the rollout of DSL services to end users and our cable modem service to our cable partners, including the impact of substantial capital expenditures and related operating expenses; - Whether and the rate at which we enter into contracts with cable operators for additional systems; - The rate at which new end users subscribe to our services, the rate at which these customers are installed and provisioned for service, and the rate at which we retain these customers, net of customers who disconnect; - Changes in revenue splits with our cable partners; - Price competition in the Internet, telecommunications and cable industries; - The extent to which we provide Network Services, rather than turnkey access; - Capital expenditures and costs related to infrastructure expansion; - The rate at which our cable partners convert their systems from one-way to two-way systems; - Our ability to protect our systems from telecommunications failures, power loss and software-related system failures; - Changes in our operating expenses including, in particular, personnel expenses; - The success of our cost control measures; - The introduction of new products or services by us or our competitors; - Our ability to enter into strategic alliances with content providers; and - Economic conditions specific to the Internet and cable industries, as well as general economic and market conditions. In addition, our operating expenses are based on our expectations of the future demand for our services and are relatively fixed in the short term. We may be unable to adjust spending quickly enough to offset any unexpected demand surge or shortfall in demand. A shortfall in revenues in relation to our expenses could have a material and adverse effect on our business and financial results. The quarter-to-quarter comparisons of our results of operations should not be relied upon as an indication of future performance. It is possible that in some future periods our results of operations may be below our expectations and the expectations of public market analysts and investors. In that event, the price of our common stock is likely to fall. WE MAY NOT BE ABLE TO ESTABLISH OR MAINTAIN ACCEPTABLE RELATIONSHIPS WITH CABLE OPERATORS. 16 17 Our success depends, in part, on our ability to gain access to cable customers. We gain that access through our agreements with cable operators. There can be no assurance that we will be able to establish or maintain relationships with cable operators. Even if we are able to establish and maintain those relationships, there can be no assurance that we will be able to do so on terms favorable to us or in the quantities we need to become profitable. If we fail to form partnerships rapidly with a large number of cable operators, we can be effectively excluded from providing our services in the systems owned by those operators. Not only can other cable-based broadband service providers compete against us for an exclusive contract, the cable operator may decide to offer cable-based Internet services directly without assistance from us or our competitors. Delays in forming relationships and deploying our cable-based services also create windows of time for alternative broadband access providers to enter the market and acquire customers. Furthermore, in order to rapidly deploy our services within a market, we typically begin installation of our equipment and related telecommunications circuits prior to the execution of final documentation. If we are unable to finalize our contractual relationship with a cable operator, if the exclusive relationship between us and our cable partners, or between our cable partners and their cable customers, is impaired, or if we do not become affiliated with a sufficient number of cable operators, our business and financial results could be materially and adversely affected. OUR LARGEST CABLE PARTNER CAN TERMINATE ITS CONTRACT WITH US. Our largest cable partner is Charter. Charter is an affiliate of Vulcan, an affiliate of Microsoft co-founder Paul Allen, who may be deemed to beneficially own 49.0% of our outstanding common stock as of March 31, 2001, assuming 100% conversion of the Company's convertible preferred stock and the exercise of 2,559,351 warrants owned by Charter. We have entered into several agreements with Charter, including several Network Services agreements. The first Network Services agreement was entered into in November 1998 and the second in May 2000. Under both agreements, Charter has committed to provide us the exclusive right to provide network services related to the delivery of Internet access to homes passed in some cable systems. Under the May 2000 agreement, we will provide Network Services, including call center support for cable modem customers as well as network monitoring, troubleshooting and security services. The agreement has an initial term of five years and may be renewed at Charter's option for additional successive five-year terms. In a Network Services solution, we deliver fewer services and incur lower costs than in turnkey solutions, but will also earn a smaller percentage of the subscription revenue based on a fixed fee per subscriber. Under the November 1998 agreement, we have primarily provided turnkey services. Subject to the provisions of the Network Service agreements, Charter can terminate our exclusivity rights, on a system-by-system basis, if we fail to meet performance specifications or otherwise breach our agreement. Moreover, Charter can terminate the November 1998 agreement, for any reason, as long as it purchases the associated cable headend equipment and modems at book value and pays us a termination fee based on the net present value of the revenues we otherwise would earn for the remaining term of the agreement from those end users subscribing to our services as of the date of termination. We may be unable to meet the benchmarks related to its customer penetration rates. Further, Charter may decide to terminate either agreement for any other reason. If Charter were to terminate either agreement, in whole or for any material system, regardless of any termination fee we may receive, we would lose end users and market share, and likely be forced to incur significant unanticipated costs to establish alternative arrangements, which may not be available on competitive terms, or at all. OUR AGREEMENTS WITH VULCAN VENTURES COULD CONSTRAIN OUR ABILITY TO GENERATE REVENUES FROM PROVIDING CONTENT AND FUTURE SERVICES OUR END USERS MAY DEMAND. Under our programming content agreement with Vulcan, Vulcan has the right to require us to carry, on an exclusive basis in all cable systems we serve, content it designates. Vulcan content may include start-up and related web pages, electronic programming guides, other multimedia information and telephony services. We will not share in any revenues Vulcan may earn through the content or telephony services it provides. We must provide all equipment necessary for the delivery of Vulcan content, although Vulcan will reimburse us for any costs we incur in excess of $3,000 per cable headend. Vulcan cannot charge us for any Vulcan content through November 2008; after that date we will be obligated to pay Vulcan for this content at the lowest fee charged to any Internet service provider who subscribes to Vulcan content. Vulcan has the right to prohibit us from providing content or telephony services that compete with Vulcan content at Vulcan's discretion and can require us to remove competing content. Many industry analysts believe that Internet access will become increasingly reliant upon revenues from content due to competitive pressures to provide low cost or even free Internet access. If Vulcan were to require us to remove our content or substitute its telephony services for any we might provide, we could lose a source of additional revenues and might not recover all related costs of providing our content or telephony services. Vulcan's ability to 17 18 prohibit us from providing content and telephony services means that Vulcan's interests are not necessarily aligned with those of our other stockholders. OUR CONVERTIBLE PREFERRED STOCK CONTAINS ANTI-DILUTION ADJUSTMENTS AND RESTRICTIONS ON OUR FUTURE ACTIVITIES. In December 2000, we closed the sale of 75,000 shares of our convertible preferred stock for an aggregate purchase price of $75.0 million. Vulcan purchased 38,000 and Charter purchased 37,000 shares, each at a price of $1,000 per share. Paul Allen controls Vulcan and Charter. The shares of convertible preferred stock initially are convertible at a conversion price of $5.01875 per share into 14,943,960 shares of common stock. The conversion price is subject to an anti-dilution adjustment which would increase the number of shares issuable to Vulcan and Charter upon conversion of the convertible preferred stock if we issue common stock (or are deemed to issue common stock) at below the conversion price. The terms of the convertible preferred stock also place significant restrictions on our activities in the future. Among other things, these constraints will require us to: - Obtain the approval of Vulcan and Charter before declaring a dividend, entering into a merger, acquisition, consolidation, business combination, or other similar transaction, or issuing any debt or equity securities; - Provide Vulcan and Charter with a right of first refusal to purchase shares of stock, common or otherwise, that we may offer in the future; and - Offer and make available to Vulcan, Charter and their affiliates, licensing and business arrangements relating to our technologies, products and services, of any combination thereof, on terms and conditions at least as favorable as those agreed to with any third party at substantially the same level of purchase or other financial commitment. Because the convertible preferred stock has voting rights, its issuance has a dilutive effect on the relative voting power of our common stockholders. You should also be aware that conversion of the convertible preferred stock into shares of common stock will have a dilutive effect on earnings per share of our common stockholders. In addition, you should note that we may issue additional shares of common stock in connection with the payment of dividends or conversion price adjustments on the convertible preferred stock, which may increase the number of shares of common stock issued in connection with the transaction. ONE-WAY CABLE SYSTEMS INCREASE OUR OPERATING COSTS AND MAY NOT PROVIDE THE QUALITY NECESSARY TO ATTRACT CUSTOMERS. Although our service can operate in one-way cable systems where data can be transmitted at high speeds from the cable headend to the end user, the end user in a one-way system can only transmit data back to the cable headend via a standard phone line. Because we must support the telephone return component of the system, we incur higher operating costs in one-way systems. Presently, three-fourths of the systems where we are or will soon operate our services are two-way systems. Over time, we expect most, if not all, of our cable partners to upgrade and or rebuild their plants to provide increased bandwidth and two-way capabilities. We believe faster uploads and the elimination of phone line return costs make our service more valuable and may lead to higher customer penetration rates, which in turn benefits the cable operator through higher revenue. However, upgrading a cable system can be expensive and time-consuming for the cable operator. Delays in upgrading one-way cable plants also makes our services vulnerable to competition from alternative broadband technologies, and may make our cable partners vulnerable to overbuilds by competitors. Moreover, we do not require our cable partners to make these upgrades and they have no legal obligation to do so. Consequently, if our cable partners do not upgrade to two-way capability at the rate we anticipate, our financial results may be negatively affected. In April 2001, the Company notified its cable partners that it intends to discontinue turnkey services in the majority of its one-way cable TV markets. The change, which will affect fewer than four percent of the Company's subscribers, may be accomplished by modifying the contractual relationship between the Company and the cable operator from turnkey services to Network Services or by terminating service in these markets. If service is terminated, the Company may incur certain termination fees and write-down of assets. WE MAY HAVE DIFFICULTY MANAGING OUR GROWTH PLANS. To manage our anticipated growth, we must continue to implement and improve our operational, financial and management information systems; hire, train and retain additional qualified personnel; continue to expand and upgrade core technologies; and effectively manage our relationships with our end users, suppliers and other third parties. Our expansion could place a significant strain on our current services and support operations, sales and administrative personnel, and other resources. While we believe that 18 19 we generally have adequate controls and procedures in place for our current operations, our billing software is not adequate to meet our growth plans. We are in the process of replacing our billing software with an integrated billing and customer care software system that we believe is capable of meeting our planned future needs, but can offer no assurances that we will successfully achieve such replacement, or if we do achieve such replacement, that we will do so within a time frame that will permit us to achieve our growth objectives. We could also experience difficulties meeting demand for our products and services. Additionally, if we are unable to provide training and support for our products, the implementation process will be longer and customer satisfaction may be lower. We may pursue acquisitions in the implementation of our growth plans. If we acquire a company, we could have difficulty integrating its operations, or assimilating and retaining its key personnel. In addition, if the demand for our service exceeds our ability to provide our services on a timely basis, we may lose customers. There can be no assurance that our systems, procedures or controls will be adequate to support our operations or that our management will be capable of exploiting fully the market for our products and services. The failure to manage our growth effectively could have a material adverse effect on our business and financial results. OUR ABILITY TO INCREASE THE CAPACITY AND MAINTAIN THE SPEED OF OUR NETWORK IS UNPROVEN. We may not be able to increase the transmission capacity of our network to meet expected end user levels while maintaining superior performance. While peak downstream data transmission speeds across the cable infrastructure approach 10 Mbps in each 6 megahertz (Mhz) channel, actual downstream data transmission speeds are almost always significantly slower depending on a variety of factors. These factors include our intentional throttling of data traffic flowing through the local network out in order to optimize the use our network capacity and to sell tiered price-service packages, bandwidth capacity constraints between the cable headend and the Internet backbone, the type and location of content, Internet traffic, the number of active end users on a given cable network node, the number of 6 Mhz channels allocated to us by our cable partner, the capabilities of the cable modems used and the service quality of the cable operators' fiber-coax facilities. The actual data delivery speed that an end user realizes also will depend on the end user's hardware, operating system and software configurations. There can be no assurance that we will be able to achieve or maintain a speed of data transmission sufficiently high to enable us to attract and retain our planned number of end users, especially as the number of end users grows. Because end users will share the available capacity on a cable network node, we may underestimate the capacity we need to provide in order to maintain peak transmission speeds. A perceived or actual failure to achieve or maintain sufficiently high speed data transmission could significantly reduce end user demand for our services or increase costs associated with customer complaints and have a material adverse effect on our business and financial results. OUR NETWORK MAY BE VULNERABLE TO SECURITY RISKS. Despite our implementation of industry-standard security measures the networks we operate may be vulnerable to unauthorized access, computer viruses and other disruptive problems. Internet and online service providers in the past have experienced, and in the future may experience, interruptions in service as a result of the accidental or intentional actions of Internet users. Because the cable infrastructure is a shared medium, it is inherently more vulnerable to security risks than dedicated telephony technologies such as digital subscriber lines. Moreover, we have no control over the security measures that our cable partners and end users adopt. Unauthorized access could also potentially jeopardize the security of confidential information stored in the computer systems maintained by us and our end users. These events may result in liability to us or harm to our end users. Eliminating computer viruses and alleviating other security problems may require interruptions, delays or cessation of service to our end users, which could have a material adverse effect on our business and financial results. In addition, the threat of these and other security risks may deter potential end users from purchasing our services, which could have a material adverse effect on our business and financial results. WE MAY BECOME SUBJECT TO RISKS OF INTERNATIONAL OPERATIONS. We are providing services on an international basis to Kabel Nordrhein-Westfalen GMBH & Co., KG and are currently evaluating other international expansion opportunities. As a result of expanding internationally or entering into joint venture arrangements to pursue international business opportunities, we will become subject to the risks of conducting business internationally, including: - Foreign currency fluctuations, which could result in reduced revenues or increased operating expenses; - Inability to locate qualified local partners and suppliers; - The burdens of complying with a variety of foreign laws and trade standards; - Tariffs and trade barriers; - Difficulty in accounts receivable collection; - Potentially longer payment cycles; - Foreign taxes; 19 20 - Unexpected changes in regulatory requirements, including the regulation of Internet access; and - Uncertainty regarding liability for information retrieved and replicated in foreign countries. If we expand internationally, we will also be subject to general geopolitical risks, such as political and economic instability and changes in diplomatic and trade relationships. Our international operations could harm our revenues and ability to achieve profitability. WE HAVE RECENTLY MADE ACQUISITIONS AND EXPECT TO MAKE FUTURE ACQUISITIONS WHERE ADVISABLE AND ACQUISITIONS INVOLVE NUMEROUS RISKS. Our growth is dependent upon market growth, our ability to enhance our existing products and our ability to introduce new products on a timely basis. One of the ways we have addressed, and will continue to address, the need to develop new products is through acquisitions of other companies. In particular, we recently acquired Digital in order to allow us to offer additional services to our customers, including web hosting and web design. Acquisitions involve numerous risks, including the following: - Difficulties in integration of the operations, technologies, and products of the acquired companies; - The risk of diverting management's attention from normal daily operations of the business; - Potential difficulties in completing projects associated with purchased in-process research and development; - Risks of entering markets in which we have no or limited direct prior experience and where competitors in such markets have stronger market positions; and - The potential loss of key employees of the acquired company. Mergers and acquisitions of high-technology companies are inherently risky, and we can give no assurance that our previous or future acquisitions will be successful and will not materially adversely affect our business, operating results or financial condition. We must also maintain our ability to manage any such growth effectively. Failure to manage growth effectively and successfully integrate acquisitions we made could harm our business and operating results. OUR AGREEMENT WITH ROAD RUNNER MAY NOT BENEFIT US. Under our agreement with ServiceCo LLC, the entity that provides Road Runner's cable Internet access and content aggregation services, we may provide our services as a Road Runner subcontractor to cable operators that we and Road Runner jointly designate to receive our services. We can offer no assurances that Road Runner will agree to designate any cable operator systems to receive our services. We may not be able to meet any system deployment schedule proposed by Road Runner. Even if asked to provide services to a Road Runner-contracted system, we may be asked to deploy far fewer turnkey homes than we originally anticipated. In a Network Services solution, we deliver fewer services and incur lower costs than in a turnkey solution, but will also earn a smaller percentage of the subscription revenue. Since the agreement provides that Road Runner will earn a warrant to purchase one share of our common stock per home passed in cable systems designated to receive service regardless of whether we deploy a Network Services or turnkey solution, our stockholders could suffer dilution in exchange for potentially less profitable homes. Consequently, our agreement with Road Runner may be of no material benefit to us. RISKS RELATED TO THE MARKET FOR HIGH SPEED INTERNET ACCESS THE MARKET FOR INTERNET SERVICES IS HIGHLY COMPETITIVE. We face competition for partnerships with cable operators from other cable modem-based providers of Internet access services and for end users from providers of other types of data and Internet services. We believe the major competitive factors in the market for partnerships with cable operators include breadth of service, speed and ease of deployment, revenue sharing arrangements, cash and equity incentives and operating experience. We believe the major competitive factors in the market to provide high speed Internet access to end users include financial, marketing and sales resources, established customer relationships, price, ease of access and use, transmission speed, reliability of service, quantity and quality of content, network security and customer support. We face competition from many competitors with significantly greater financial, sales and marketing resources, larger customer bases, longer operating histories, greater name recognition and more established relationships with advertisers, content and application providers and/or other strategic partners than we have. We expect the level of 20 21 this competition in cable and DSL Internet access markets to increase in intensity in the future. We face competition from both cable modem service providers and from providers of other types of data and Internet services for end users, including DSL companies. Due to this intense competition, there may be a time-limited market opportunity for our cable-based high speed access and our entry into DSL services. There can be no assurance that we will be successful in achieving widespread acceptance of our services before competitors offer services similar to our current offerings, which might preclude or delay purchasing decisions by potential customers. For the reasons discussed below, we may not be able to compete successfully against current or future competitors, and competitive pressures we face could materially and adversely affect our business and financial results. CABLE-BASED INTERNET ACCESS MARKET. Our competitors in the cable-based Internet access market are those companies that have developed their own cable-based services and market those services to cable system operators. In particular, @Home, Road Runner, and Earthlink and their respective cable partners, are deploying high speed Internet access services over cable networks. @Home, through its @Home Solutions product, markets to systems in markets with at least 20,000 homes passed. Other competitors in the cable-based Internet access market are those companies seeking to establish distribution arrangements with cable system operators in exurban markets and/or provide one-way system capability. In addition, other cable system operators have launched their own cable-based Internet services that could limit the market for our services. Many of our competitors and potential competitors in the market for partnerships with cable operators, in particular @Home, have substantially greater financial, sales and marketing resources, larger customer bases, longer operating histories, greater name recognition and more established relationships with cable operators, advertisers and content and application providers than we do. Widespread commercial acceptance of any of these competitors' products could significantly reduce the potential customer base for our services, which could have a material adverse effect on our business and financial results. DSL AND OTHER TECHNOLOGIES. We intend to offer DSL Internet access services primarily through the opportunistic acquisition of facilities-based DSL assets. We believe we will face significant competition from DSL companies and other Internet access providers in our attempts to acquire these DSL assets. To the extent we are successful in acquiring DSL assets and in expanding our DSL service offerings, we will compete directly against DSL companies and telecommunications companies offering DSL services to end users. In addition, long distance inter-exchange carriers, such as AT&T, Sprint and MCI WorldCom, have deployed large-scale Internet access networks and sell Internet access to business and residential customers. The regional Bell operating companies and other local exchange carriers have also entered this field and are providing price competitive services. Many of these carriers are offering diversified packages of telecommunications services, including Internet access, to residential customers, and could bundle these services together, which could put us at a competitive disadvantage. Many of these competitors are offering, or may soon offer, technologies that will compete with our cable-based high speed data service offerings. Such competing technologies include integrated services digital networks, digital subscriber lines and wireless and satellite services. Many of our competitors and potential competitors, particularly regional Bell operating companies, have substantially greater financial, sales and marketing resources than we have, and also may compete favorably in terms of price, ease of access and use, transmission speed and reliability of service. Widespread commercial acceptance of DSL or other competing technologies could significantly reduce the potential customer base for our cable-based services, which could have a material adverse effect on our business and financial results. INTERNET AND ONLINE SERVICE PROVIDERS. We also compete with traditional Internet service providers, which provide basic Internet access to residential and commercial end users and businesses, generally using the existing telephone network. While not presently offering the advantages of broadband access, these services are widely available and inexpensive. Many online service providers, such as America Online, have the advantage of large customer bases, industry experience, longer operating histories, greater name recognition, established relationships with advertisers and content and application providers, and significant financial, marketing and sales resources. Moreover, America Online recently merged with Time Warner, a major content provider and cable system owner/operator, to create AOL Time Warner. One condition placed on this merger involves AOL Time Warner permitting unaffiliated Internet access providers to use AOL Time Warner's cable systems to provide high speed Internet access to their customers. These "open access" arrangements may affect our business in various respects. See "Government Regulation." Previously, AOL announced alliances with SBC Communications and Bell Atlantic to offer AOL's services via digital subscriber line connections to be installed by these regional Bell operating companies. The pace at which AOL and its telephone company partners roll out DSL service could limit our ability to attract and retain end users in areas where our service offerings overlap. PEAKING CONSUMER INTEREST IN INTERNET ACCESS. Although the growth in consumer interest in accessing the Internet has been growing for several years, growth in consumer time spent on the Internet will eventually level off and may decline. This leveling off of demand may be offset over time by the development of additional Internet-based services and functions by existing and new Internet-oriented firms, but there is no assurance that these new services will actually be developed or will achieve customer 21 22 acceptance. A leveling of demand will tend to intensify competition among existing providers of Internet access, including us and traditional dial-up providers of access. OUR CABLE PARTNERS COULD SELL THEIR SYSTEMS OR BE ACQUIRED. In recent years, the cable television industry has undergone substantial consolidation. If one of our cable partners is acquired by a cable operator that already has a relationship with one of our competitors or that does not enter into a contract with us, we could lose the ability to offer our cable modem access services in the systems formerly served by our cable partner, which could have a material and adverse effect on our business and financial results. Many of the cable operators with whom we have contracts operate multiple systems, thus increasing the risk to us if they are acquired. Moreover, it is common in the cable industry for operators to swap systems, which could cause us to lose our contract for a swapped system. Even though many of our contracts obligate our cable partners to pay us a termination fee if they sell their system to another operator who does not assume our contract, the potential termination fee may not be adequate to ensure that the successor operator assumes our contract, or to compensate us fully for the loss of future business in that system. OUR CABLE PARTNERS COULD LOSE THEIR FRANCHISES, AND ARE VULNERABLE TO COMPETITION. Cable television companies operate under franchises granted by local or state authorities that are subject to renewal and renegotiations from time to time. A franchise is generally granted for a fixed term ranging from five to 15 years, although in many cases the franchise is terminable if the franchisee fails to comply with the material provisions of its franchise agreement. No assurance can be given that the cable operators that have contracts with us will be able to retain or renew their franchises. The non-renewal or termination of any of these franchises would result in the termination of our contract with the applicable cable operator. Moreover, cable television operators are sometimes subject to overbuilding by competing operators who offer competing video and Internet access services. Moreover, many direct broadcast satellite ("DBS") operators can compete with cable operators and provide Internet access services to their subscribers. Any such dilution of our cable operator market base can adversely affect our potential market base. OUR MARKET IS CHARACTERIZED BY RAPID TECHNOLOGICAL CHANGE AND OUR SERVICES COULD BECOME OBSOLETE OR FAIL TO GAIN MARKET ACCEPTANCE. The market for our services is characterized by rapid technological advances, evolving industry standards, changes in end user requirements and frequent new service introductions and enhancements. For example, the North American cable industry has adopted a set of interface specifications, known as "DOCSIS," for hardware and software to support cable-based data delivery using cable modems. Our ability to adapt to rapidly changing technology and industry standards, such as DOCSIS, and to develop and introduce new and enhanced products and service offerings will be significant factors in maintaining or improving our competitive position reducing our costs, and our prospects for growth. If our technologies become obsolete or fail to gain widespread consumer acceptance, or if we are unable to meet newly adopted industry standards, then our business and financial results will be materially and adversely affected. We currently anticipate that we will use a significant portion of our working capital to acquire cable modem and DSL equipment. The technology underlying that equipment is continuing to evolve. It is possible that the equipment we acquire could become obsolete prior to the time we would otherwise intend to replace it, which could require us to make unanticipated capital expenditures. Our inability to replace obsolete equipment on a timely basis could have a material adverse effect on our business and financial results. WE DEPEND ON THIRD PARTIES AND OUR BUSINESS IS SUBJECT TO DISRUPTION BY EVENTS OUTSIDE OUR CONTROL. Our success will depend upon the capacity, reliability and security of the infrastructure used to carry data between our end users and the Internet. A significant portion of that infrastructure is owned by third parties. Accordingly, we have no control over its quality and maintenance. For example, we rely on our cable partners to maintain their cable infrastructures. We also rely on other third parties to provide a connection from the cable infrastructure to the Internet and to provide fulfillment services to us. Currently, we have transit agreements with MCI WorldCom and its affiliate, UUNet, and others to support the exchange of traffic between our data servers, the cable infrastructure and the Internet. We also have agreements with various vendors to manage and oversee our customer installation process, including installation, customer education, dispatch service, quality control, recruitment and training. The failure of these third parties to maintain this infrastructure and otherwise fulfill their obligations under these agreements could have a material adverse effect on our business and financial results. 22 23 Our operations also depend on our ability to avoid damages from fires, earthquakes, floods, power losses, telecommunications failures, network software flaws, transmission cable cuts, and similar events. The occurrence of any of these events could interrupt our services. The failure of the Internet backbone, our servers, or any other link in the delivery chain, whether from operational disruption, natural disaster or otherwise, resulting in an interruption in our operations could have a material adverse effect on our business and financial results. WE MAY BE HELD LIABLE FOR DEFAMATORY OR INDECENT CONTENT, AS WELL AS INFORMATION RETRIEVED OR REPLICATED. In part, our business involves supplying information and entertainment to customers over the cable systems of our cable system partners. Accordingly, we face the same types of risks that apply to all businesses that publish or distribute information, such as potential liability for defamation, libel, invasion of privacy and similar claims, as well as copyright or trademark infringement and similar claims. A number of third parties have claimed that they hold patents covering various forms of online transactions or online technologies. In addition, our errors and omissions and liability insurance may not cover potential patent or copyright infringement claims and may not adequately indemnify us for any liability that may be imposed. The law relating to the liability of Internet and online service providers for information carried or disseminated through their networks is unsettled. There are some federal laws regarding the distribution of obscene or indecent material over the Internet under which we are subject to potential liability. These risks are mitigated by two federal laws. One, passed in 1996, immunizes Internet service providers from liability for defamation and similar claims for materials the Internet service provider did not create, but merely distributed. The other, passed in 1998, creates a "safe harbor" from copyright infringement liability for Internet service providers who comply with its requirements, which we intend to do. These laws apply only in the United States; if we expand our operations to other countries, our potential liability under the laws of those countries could be greater. WE MAY BECOME SUBJECT TO BURDENSOME GOVERNMENT REGULATION, "OPEN ACCESS" COMPETITION AND OTHER DSL- AND DBS-BASED COMPETITION. The regulatory climate affecting our business is uncertain at this time, and we may become subject to burdensome governmental regulation in the future. Historically, the Company and its cable partners believed that for regulatory purposes our services would be considered a form of cable service, or an unregulated information service. Some federal courts have reached decisions consistent with these views. However, in June 2000, the federal appeals court for the 9th Circuit concluded that a cable operator's provision of transmission facilities in some instances is a telecommunications service under the Communications Act. This classification could subject our cable partners, and possibly us, to federal and state regulation as "telecommunications carriers." If we or our cable partners were classified as telecommunications common carriers, or otherwise subject to common carrier-like access and non-discrimination requirements in the provision of our Internet over cable service, the Company or its cable partners could be subject to burdensome governmental regulations. In particular, the government might seek to regulate us and our cable partners with respect to the terms, conditions and prices for Internet connection services and interconnections with the public switched telephone network, and require that we make contributions to the universal service support fund. The law in this area thus remains unsettled. In addition, the DSL service we expect to offer and deploy in the future will also likely be regulated as a common carrier telecommunications service, although at present the specific regulatory burdens associated with offering this service are not unduly severe. Accordingly, if we are successful in acquiring DSL assets, we may be required to get a "telecommunications franchise" or a license to operate as a "competitive local exchange carrier" from some states or localities, which might not be available on reasonable terms, or at all. Moreover, some local franchising authorities might claim that our cable partners need a separate franchise to offer our service. This franchise may not be obtainable on reasonable terms, or at all. In addition, some local cable franchising authorities seek to impose "non-discrimination" or "open access" obligations on our cable partners, under which competing ISPs would have access to the high-speed transmission capabilities of our cable partners' networks. AOL and Time Warner agreed to such an "open access" condition, applicable to Time Warner's cable networks, in order to obtain federal antitrust approval for their recent merger. A consortium of dial-up Internet service providers and large telephone companies are encouraging local franchising authorities and the Federal Communications Commission ("FCC") to ban the type of exclusive ISP-cable operator arrangements that we have with our cable partners that make us the exclusive supplier of high speed data on the cable systems where our service is offered. If such arrangements are banned, the Company could face additional competition from other Internet access providers using the cable system to connect to their customers, which could have a material adverse effect on our business and financial results. Both AOL-Time Warner and AT&T have announced plans to open their networks to competing Internet service providers in the coming years, and AT&T and Time Warner Cable have initiated "open-access" trials with selected ISPs in several markets. Other ISPs are petitioning the FCC and various large cable operators for access to cable plants. The Company cannot predict the degree to which such voluntary or involuntary "open access" will affect our business. 23 24 In addition, regulatory decisions that make services based on DSL technology easier for competing telephone companies to deploy over normal telephone lines and less expensive for customers to buy, could negatively affect the Company's cable-based high speed access business. The FCC issued a line-sharing ruling in December 1999 that allows DSL providers to simply lease the data spectrum of the customer's local loop from the incumbent carrier. This obviates the need for the customers to lease a secondary DSL-provisioned loop from the incumbent carrier in order to obtain high speed DSL data service, which in turn could make DSL service a more cost-competitive alternative to our services. In addition, in several decisions issued in 2000, the FCC took steps designed to make it more efficient for DSL providers to locate their equipment in telephone company switching centers. Furthermore, firms controlling digital broadcast spectrum have announced plans to utilize a portion of that spectrum to offer consumers high-bandwidth data delivery via broadcast. Some DBS video companies are also deploying higher-bandwidth data delivery products. The Company cannot predict when or whether these services will be offered, but if offered, they could present material competition to our cable-based high speed access services and could materially and adversely affect our success in the marketplace. In addition to regulatory activity, large Incumbent Local Exchange Carriers ("ILECs") have been pressing Congress to amend the Communications Act to make it easier for those firms to offer high-speed Internet access services to consumers and to participate directly in transmitting information between their customers and the Internet backbone. If such legislation were to pass, ILECs could become even more formidable competitors in the high speed Internet access business. WE DEPEND ON OUR KEY PERSONNEL AND MAY HAVE DIFFICULTY ATTRACTING AND RETAINING THE SKILLED EMPLOYEES WE NEED TO EXECUTE OUR GROWTH PLAN. Our future success depends on the continued service of our key personnel, especially our Chief Executive Officer and Chief Operating Officer. We do not carry key person life insurance on most of our personnel. Given our early stage and plans for rapid expansion, the loss of the services of any of our executive officers or the loss of the services of other key employees could have a material adverse effect on our business and financial results. Our future success also depends on our ability to attract, retain and motivate highly skilled employees, particularly engineering and technical personnel. Competition for employees in our industry is intense. We may not be able to retain our key employees or attract, assimilate or retain other highly qualified employees in the future. From time to time we have experienced, and we expect to continue to experience in the future, difficulty in hiring and retaining highly skilled employees. RISK RELATED TO TRADING IN OUR STOCK BECAUSE OF OUR RELATIONSHIP WITH VULCAN VENTURES, NEW INVESTORS WILL HAVE LITTLE INFLUENCE OVER MANAGEMENT DECISIONS. Vulcan and Charter currently own 36.1% and 12.9%, respectively, of our outstanding stock assuming 100% conversion of the Company's convertible preferred stock and the exercise of 2,559,351 warrants owned by Charter. Charter, also has warrants to purchase up to 12,000,000 shares of our common stock at an exercise price of $3.23 per share. Paul Allen is the controlling stockholder of Charter and Vulcan and as a result Mr. Allen's beneficial ownership of our outstanding stock is 49.0%. Accordingly, Mr. Allen will be able to significantly influence and possibly exercise control over most matters requiring approval by our stockholders, including the election of directors and approval of significant corporate transactions. This concentration of ownership may also have the effect of delaying or preventing a change in control. In addition, conflicts of interest may arise as a consequence of Mr. Allen's control relationship with us, including: - Conflicts between Vulcan, Charter and other affiliates of Mr. Allen and our other stockholders, whose interests may differ with respect to, among other things, our strategic direction or significant corporate transactions; - Conflicts related to corporate opportunities that could be pursued by us, on the one hand, or by Vulcan, Charter or other affiliates of Mr. Allen, on the other hand; or - Conflicts related to existing or new contractual relationships between us, on the one hand, and Mr. Allen and his affiliates, such as Vulcan and Charter, on the other hand. In particular Mr. Allen controls Charter, our largest cable partner. Additionally, Vulcan has the exclusive right to provide or designate the first page our end users see when they log on to our service and, if it provides that first page, will be entitled to all of the related revenues. Moreover, Vulcan can prohibit us from providing content that competes with content it chooses to provide, and can prohibit us from providing telephony service if it chooses to provide those services. INVESTORS MAY SUFFER SUBSTANTIAL DILUTION FROM OTHER TRANSACTIONS. 24 25 As an inducement to cause Charter to commit additional systems to us in connection with Network Services agreements entered into in November 1998 and May 2000, we have granted Charter warrants to purchase up to 12,000,000 shares of our common stock at an exercise price of $3.23 per share. These warrants become exercisable, in respect of turnkey systems at the rate of 1.55 shares for each home passed in excess of 750,000, and Network Services systems at the rate of 0.775 shares for each home passed for up to 5,000,000 homes passed; and at a rate of 1.55 shares for each additional home passed in excess of 5,000,000. To the extent that Charter becomes eligible to exercise all or a significant portion of these warrants, the Company's stockholders will experience substantial dilution. In addition, we have granted Microsoft a warrant to purchase 387,500 shares of our common stock at an exercise price of $16.25, with additional warrants issuable for homes passed above 2,500,000 homes passed committed to us by Comcast. Furthermore, under our agreement with ServiceCo LLC, we are obligated to grant warrants to purchase up to 5,000,000 shares of our common stock at a price of $5 per share if they elect to use our services. The Company has also granted Classic Cable, Inc. and CMA Associates, both cable operators, a warrant to purchase 600,000 and 200,000 shares at an exercise price of $13, respectively, in connection with the distribution of our services. We have issued and may in the future issue additional stock or warrants to purchase our common stock in connection with our efforts to expand the distribution of our services and retain various consulting services. Stockholders could face additional dilution from these possible future transactions. THE FUTURE SALE OF SHARES MAY HURT OUR MARKET PRICE. A substantial number of shares of our common stock are available for resale. If our stockholders sell substantial amounts of our common stock in the public market, the market price of our common stock could fall. These sales also might make it more difficult for us to sell equity securities in the future at times and prices that we deem appropriate. OUR STOCK PRICE IS LIKELY TO BE HIGHLY VOLATILE. The stock market has experienced extreme price and volume fluctuations. In particular, the market prices of the securities of Internet-related companies have been especially volatile. In the past, companies that have experienced volatility in the market price of their stock have been the object of securities class action litigation. If we were the object of securities class action litigation, it could result in substantial costs and a diversion of our management's attention and resources. WE HAVE ANTI-TAKEOVER PROVISIONS. Certain provisions of our certificate of incorporation, our bylaws and Delaware law, in addition to the concentration of ownership by Mr. Paul Allen, could make it difficult for a third party to acquire us, even if doing so might be beneficial to our other stockholders. ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Our exposure to market risk is limited to interest rate sensitivity, which is affected by changes in the general level of U.S. interest rates, and foreign currency exchange rates. Our cash equivalents are invested with high-quality issuers and limit the amount of credit exposure to any one issuer. Due to the short-term nature of our cash equivalents, we believe that we are not subject to any material market risk exposure. Substantially all of our revenues are realized in U.S. dollars and are from customers in the United States. We do not have any foreign currency hedging instruments. PART II - OTHER INFORMATION ITEM 1 - LEGAL PROCEEDINGS We are not a party to any material legal proceedings. ITEM 2 - CHANGES IN SECURITIES AND USE OF PROCEEDS (a) In June 1999, we completed our initial public offering of Common Stock. Concurrent with the initial public offering, we sold Common Stock to Cisco Systems, Com21 and Microsoft under stock purchase agreements. The initial proceeds to the Company after deducting underwriting discounts and commissions of $13,081,250 were $199,768,750. Through March 31, 2001 the gross proceeds 25 26 of the offering have been applied as follows: Direct or Indirect payment to others for: Underwriting discounts and commissions $ 13,081,250 Other offering expenses $ 1,828,854 Working Capital $ 190,267,259
None of these expenses were direct or indirect payments to investors or officers or 10% stockholders of the Company. The remainder of the proceeds is invested in interest-bearing money market accounts with financial institutions and highly-liquid investment-grade debt securities of corporations and the U.S. Government. (b) In December 2000, we issued and sold 38,000 shares and 37,000 shares of senior convertible preferred stock to Vulcan and Charter Communications Ventures, LLC, an affiliate of Charter, respectively. In this private placement, we received aggregate consideration of $38,000,000 and $37,000,000 from Vulcan and Charter, respectively. The preferred stock may convert into common stock of the Company at a conversion price of $5.01875 per share, subject to adjustment for future stock issuances at less than the conversion price and other customary adjustments. The initial proceeds to the Company were $75.0 million. Through March 31, 2001 the proceeds have been applied to offering expenses of $1.0 million only. None of these expenses were direct or indirect payments to investors or officers or 10% stockholders of the Company. The remainder of the proceeds is invested in interest-bearing money market accounts with financial institutions and highly-liquid investment-grade debt securities of corporations and the U.S. Government. This issuance of preferred stock was made in reliance on the exemption from registration provided by section 4(2) of the Securities Act and Rule 506 promulgated thereunder. ITEM 3 - DEFAULTS UPON SENIOR SECURITIES None. ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. ITEM 5 - OTHER INFORMATION None. ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits None. (b) Reports on Form 8-K None. 26 27 SIGNATURES 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 thereunto duly authorized. High Speed Access Corp. Date: May 15, 2001 By /s/ Daniel J. O'Brien ---------------------------- -------------------------- Daniel J. O'Brien President, Chief Executive Officer and Director Date: May 15, 2001 By /s/ George Willett ---------------------------- -------------------------- George Willett Chief Financial Officer
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