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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED MAY 31, 2003
COMMISSION FILE NUMBER: 0-17932
INTERLAND, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
MINNESOTA 41-1404301
(STATE OR OTHER JURISDICTION (I.R.S. EMPLOYER
OF INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
303 PEACHTREE CENTER AVENUE, SUITE 500, ATLANTA, GA 30303
(ADDRESS, INCLUDING ZIP CODE, OF PRINCIPAL EXECUTIVE OFFICES)
(404) 720-8301
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
COMMON STOCK, PAR VALUE $.01 PER SHARE
REGISTERED ON THE NASDAQ NATIONAL MARKET
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, and (2) has been subject to such filing requirements
for the past 90 days. Yes [X] No [_]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [X] No [_]
The number of outstanding shares of the registrant's Common Stock on June 30,
2003 was 162,374,054.
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PART I - FINANCIAL INFORMATION
Item 1 Financial Statements
Consolidated Statements of Operations............................... 2
Consolidated Balance Sheets ........................................ 3
Consolidated Statements of Cash Flows .............................. 4
Notes to Consolidated Financial Statements ......................... 5
Item 2 Management's Discussion and Analysis of Financial Condition and
Results of Operations............................................. 16
Item 3 Qualitative and Quantitative Disclosures about Market Risk.......... 34
Item 4 Controls and Procedures............................................. 35
PART II - OTHER INFORMATION
Item 1 Legal Proceedings................................................... 39
Item 2 Changes in Securities and Use of Proceeds........................... 40
Item 6 Exhibits and Reports on Form 8-K.................................... 41
1
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
Interland, Inc.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands except per share amounts)
(Unaudited)
For the three months ended For the nine months ended
-------------------------- -------------------------
May 31, May 31, May 31, May 31,
2003 2002 2003 2002
--------- --------- --------- ---------
Revenues $ 25,898 $ 24,719 $ 79,295 $ 73,886
Operating costs and expenses:
Network operating costs 8,065 7,544 27,235 26,075
Sales and marketing 5,727 5,330 15,600 21,881
Technical support 3,998 4,689 11,519 12,617
General and administrative 12,004 7,932 32,260 28,257
Bad debt expense 1,975 2,612 5,791 5,616
Depreciation and amortization 22,194 9,923 47,590 25,293
Restructuring costs 2,204 (668) 5,644 (986)
Merger and integration costs -- 766 527 7,855
Goodwill impairment 89,928 -- 89,928 --
Intangible asset impairment 13,868 -- 13,868 --
Other expense (income), net 1,558 117 1,627 745
--------- --------- --------- ---------
Total operating costs and expenses 161,521 38,245 251,589 127,353
--------- --------- --------- ---------
Operating loss (135,623) (13,526) (172,294) (53,467)
Interest income (expense), net (74) (25) 77 293
--------- --------- --------- ---------
Loss from continuing operations before taxes (135,697) (13,551) (172,217) (53,174)
Income tax benefit (expense) (629) 64,242 (629) 64,242
--------- --------- --------- ---------
Net income (loss) from continuing operations (136,326) 50,691 (172,846) 11,068
Loss on disposal of discontinued operations, net of tax (167) (4,562) (482) (4,562)
--------- --------- --------- ---------
Net income (loss) $(136,493) $ 46,129 $(173,328) $ 6,506
========= ========= ========= =========
Basic net income (loss) per share:
Continuing operations $ (0.94) $ 0.37 $ (1.22) $ 0.08
Discontinued operations -- (0.03) -- (0.03)
--------- --------- --------- ---------
$ (0.94) $ 0.34 $ (1.22) $ 0.05
========= ========= ========= =========
Diluted net income (loss) per share:
Continuing operations $ (0.94) $ 0.36 $ (1.22) $ 0.08
Discontinued operations -- (0.03) -- (0.03)
--------- --------- --------- ---------
$ (0.94) $ 0.33 $ (1.22) $ 0.05
========= ========= ========= =========
Number of shares used in per share calculation:
Basic 144,905 136,366 142,171 137,187
Diluted 144,905 139,293 142,171 139,080
The accompanying notes are an integral part of these consolidated financial
statements.
2
INTERLAND, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands)
AS OF
------------------- ---------
MAY 31, AUGUST 31,
2003 2002
--------- ---------
(UNAUDITED) (AUDITED)
Assets
Cash and cash equivalents $ 46,005 $ 62,693
Short term investments 19,500 43,388
Receivables, net 6,835 9,139
Income taxes recoverable 612 2,019
Other current assets 3,086 3,292
Restricted investments 333 6,894
--------- ---------
Total current assets 76,371 127,425
--------- ---------
Restricted investments 19,702 27,409
Property plant and equipment, net 35,366 59,058
Goodwill 47,562 120,011
Intangibles, net 22,605 53,250
Investments held to maturity -- 7,512
Other assets 425 613
--------- ---------
Total assets $ 202,031 $ 395,278
========= =========
Liabilities and shareholders' equity
Accounts payable $ 5,271 $ 3,918
Accrued expenses 26,706 30,364
Current portion of long-term debt and capital lease obligations 10,602 19,157
Deferred revenue 12,347 19,629
--------- ---------
Total current liabilities 54,926 73,068
--------- ---------
Long-term debt and capital lease obligations 3,256 12,009
Deferred revenue, long-term 475 1,195
Other liabilities 10,849 11,276
--------- ---------
Total liabilities 69,506 97,548
========= =========
Shareholders' equity
Common stock, $.01 par value, authorized 210 million shares,
issued and outstanding 149.5 million and 141.3 million shares, respectively 1,496 1,413
Additional capital 300,699 296,949
Warrants 4,990 1,690
Deferred compensation (1,238) (2,228)
Note receivable from shareholder (2,735) (2,735)
Retained earnings/(accumulated deficit) (170,687) 2,641
--------- ---------
Total shareholders' equity 132,525 297,730
--------- ---------
--------- ---------
Total liabilities and shareholders' equity $ 202,031 $ 395,278
========= =========
The accompanying notes are an integral part of these consolidated financial
statements.
3
INTERLAND, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(UNAUDITED)
NINE MONTHS ENDED
-----------------------------
MAY 31, MAY 31,
2003 2002
--------- ---------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss) $(173,328) $ 6,506
Adjustments to reconcile net income (loss) to net cash provided by (used in)
operating activities from continuing operations:
Loss from discontinued operations 482 4,562
Loss on sale of assets 1,578 --
Depreciation and amortization 47,590 25,293
Provision for doubtful accounts 5,791 5,615
Goodwill and intangible asset impairment 103,796 --
Other non-cash adjustments 1,997 4,019
Changes in operating assets and liabilities
net of effect of acquisitions:
Receivables, net (3,624) (10,363)
Income tax recoverable 778 18,585
Other current assets 477 (336)
Accounts payable, accrued expenses and deferred revenue (12,422) (16,168)
--------- ---------
Cash provided by (used) in operating activities of continuing operations (26,885) 37,713
--------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES
Expenditures for property, plant, and equipment (10,024) (8,991)
Purchases of held-to-maturity investment securities (30,300) (69,042)
Proceeds from held-to-maturity investment securities 61,700 77,598
Net change in restricted investments 14,293 (6,385)
Acquisitions, net of cash acquired (4,590) (32,505)
Notes issued to related party -- (2,735)
--------- ---------
Cash provided by (used in) investing activities of continuing operations 31,079 (42,060)
--------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES
Repayments of debt and capital lease obligations (18,250) (12,740)
Proceeds from issuance of common stock 433 626
Purchase and retirement of stock (985) (7,278)
Other (17) --
--------- ---------
Cash used in financing activities of continuing operations (18,819) (19,392)
--------- ---------
Net cash used in continuing operations (14,625) (23,739)
Net cash used in discontinued operations (2,063) (10,258)
--------- ---------
Net decrease in cash and cash equivalents (16,688) (33,997)
Cash and cash equivalents at beginning of period 62,693 142,675
--------- ---------
Cash and cash equivalents at end of period $ 46,005 $ 108,678
========= =========
The accompanying notes are an integral part of these consolidated financial
statements.
4
INTERLAND, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. GENERAL
BUSINESS -- Interland, Inc. (known as Micron Electronics, Inc. prior to August
6, 2001), together with its subsidiaries (collectively the "Company"), is a
leading Web hosting and online services Company dedicated to helping small- and
medium-sized businesses ("SMB") achieve success by providing the knowledge,
services and tools to build, manage and promote businesses online. Interland
offers a wide selection of online services, including standardized Web hosting,
e-commerce, application hosting, and Web site development, marketing and
optimization tools. Historically, the Company provided a variety of computer
products and related services through its PC Systems, SpecTek, and Web hosting
business segments. The Company disposed of its PC Systems and SpecTek business
segments during the third quarter of fiscal 2001. The Company's Web hosting
business remains as the Company's sole continuing operation. Prior to its
disposal, the PC Systems business consisted of developing, marketing,
manufacturing, selling and supporting a wide range of desktop and notebook
systems and network servers under the micronpc.com brand name and selling,
reselling, and supporting a variety of additional peripherals, software and
services. Prior to its disposal, the SpecTek business consisted of processing
and marketing various grades of memory products in either component or module
form for specific applications.
HISTORY OF OPERATING LOSSES -- The Company's Web hosting business has incurred
net losses and losses from operations for all but one quarter from inception
through the first nine-months of fiscal 2003. The Company's future success is
dependent upon its ability to achieve positive cash flow prior to the depletion
of cash resources and its ability to raise funds, if needed. Nonetheless, the
Company's current financial forecast supports management's expectation that the
Company will have adequate cash resources to fund operations throughout fiscal
2004.
2. SIGNIFICANT ACCOUNTING POLICIES
INTERIM UNAUDITED FINANCIAL INFORMATION -- The accompanying unaudited
consolidated financial statements as of May 31, 2003 and for the three and
nine-month periods ended May 31, 2003 and 2002, have been prepared in accordance
with generally accepted accounting principles for interim financial information.
In management's opinion, these statements include all adjustments necessary for
a fair presentation of the results of the interim periods shown. All adjustments
are of a normal recurring nature unless otherwise disclosed. Operating results
for the three and nine-month periods ended May 31, 2003 are not necessarily
indicative of the results that may be expected for the full year.
Effective with the Company's filing of Form 10-Q for the quarterly period ended
February 28, 2003, the Company has revised the presentation of its consolidated
statements of operations for all periods presented to conform to presentations
used by others in the Web hosting industry. As the Company has migrated from a
manufacturing entity to a Web hosting company, it believes its revised
presentation reflects more appropriately its results of operation and allows for
more comparability to its peers. The revised presentation removes the gross
margin sub-total and instead classifies all operating expenses and costs in
their respective line item. Additionally, depreciation and amortization expense,
previously presented as components of network operating costs, general and
administrative costs, sales and marketing costs and technical support costs is
now presented separately. These reclassifications, none of which affect net
loss, have been made to all periods presented to present the financial
statements on a consistent basis.
BASIS OF PRESENTATION -- This report on Form 10-Q ("10-Q") for the third quarter
ended May 31, 2003 should be read in conjunction with the Company's Annual
Report on Form 10-K ("10-K") for the fiscal year ended August 31, 2002. The
financial statements include the accounts of Interland, Inc. and its wholly
owned subsidiaries. All significant intercompany balances and transactions have
been eliminated.
USE OF ESTIMATES -- The preparation of financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the amounts reported in the financial statements.
The amounts that the Company will ultimately incur or recover could differ
materially from its current estimates. The underlying estimates and facts
supporting these estimates could change in 2003 and thereafter.
5
INTERLAND, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
REVENUE RECOGNITION -- Revenues are primarily generated from shared and
dedicated hosting, managed services, e-commerce services, applications hosting
and domain name registrations. Revenues are recognized as the services are
provided. Hosting contracts generally are for service periods ranging from one
to twenty-four months and typically require up-front fees. These fees, including
set-up fees for hosting services, are deferred and recognized ratably over the
customers' expected service period. Deferred revenues represent the liability
for advance billings to customers for services not yet provided. The comparative
deferred revenue balances for the period ended August 31, 2002 versus May 31,
2003 reflect a decrease primarily due to the continued conversion of customer
accounts from term contracts to month-to-month contracts thereby reducing the
timeframe related to services yet to be provided.
BASIC AND DILUTED INCOME (LOSS) PER SHARE -- Basic income (loss) per share is
computed using the weighted average number of common shares outstanding. Diluted
income (loss) per share is computed using the weighted average number of common
shares outstanding and potential common shares outstanding when their effect is
dilutive. Potential common shares result from the assumed exercise of
outstanding stock options and warrants. Because the Company reported income from
continuing operations during the third quarter of fiscal 2002, the effect of
potential common shares is included in the calculation of per share amounts.
In addition to net income (loss) per share, the Company has also reported per
share amounts on the separate income statement components required by Accounting
Principles Board ("APB") Opinion No. 30, "Reporting the Results of Operations -
Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary,
Unusual and Infrequently Occurring Events and Transactions."
COMPREHENSIVE INCOME -- The Company reports comprehensive income in accordance
with Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting
Comprehensive Income." This statement requires the disclosure of accumulated
other comprehensive income or loss (excluding net income or loss) as a separate
component of shareholders' equity. For all periods presented, comprehensive
income is the same as net income.
INCOME TAXES -- The Company accounts for income taxes under the provisions of
SFAS No. 109, "Accounting for Income Taxes." SFAS 109 requires recognition of
deferred tax liabilities and assets for the expected future tax consequences of
events that have been included in the financial statements or tax returns. Under
this method, deferred tax liabilities and assets are determined based on the
difference between the financial statement and tax basis of assets and
liabilities using enacted tax rates in effect for the year in which the
difference is expected to reverse.
STOCK-BASED EMPLOYEE COMPENSATION -- The Company accounts for stock-based
compensation issued to employees using the intrinsic value method as prescribed
by Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock
Issued to Employees and has adopted the disclosure requirements of SFAS No. 123
and SFAS 148.
If the Company had elected to adopt the optional recognition provisions of SFAS
No. 148, which uses the fair value based method for stock-based compensation,
and amortized the fair value of the options to compensation expense on a
straight-line basis over the vesting period of the options, the Company would
have recorded $1.0 million and $2.7 million of compensation expense during the
three and nine-month periods ending May 31, 2003 and $1.6 million and $3.2
million of compensation expense during the three and nine-month periods ending
May 31, 2002. The following table illustrates the effect on net income or loss
and earnings or loss per share if the company had applied the fair value
recognition provisions of SFAS 148 to stock-based employee compensation:
6
INTERLAND, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
THREE-MONTH PERIOD ENDING NINE-MONTH PERIOD ENDING
-------------------------------------------------------------------
5/31/03 5/31/02 5/31/03 5/31/02
----------- ----------- ----------- -----------
Net income (loss) as reported $ (136,493) $ 46,129 $ (173,328) $ 6,506
Add: Stock-based employee compensation
expense included in reported net income,
net of related tax effects 175 166 300 499
Deduct: Total stock-based employee compensation
expense determined under fair value method-
based methods for all awards, net of tax effects (961) (1,616) (2,708) (3,233)
----------- ----------- ----------- -----------
Proforma net income (loss) $ (137,279) $ 44,679 $ (175,736) $ 3,772
=========== =========== =========== ===========
Earnings (loss) per share:
Basic - as reported $ (0.94) $ 0.34 $ (1.22) $ 0.05
=========== =========== =========== ===========
Basic - pro forma $ (0.95) $ 0.33 $ (1.24) $ 0.03
=========== =========== =========== ===========
Diluted - as reported $ (0.94) $ 0.33 $ (1.22) $ 0.05
=========== =========== =========== ===========
Diluted - pro forma $ (0.95) $ 0.32 $ (1.24) $ 0.03
=========== =========== =========== ===========
RECENTLY ISSUED ACCOUNTING STANDARDS -- The FASB issued FIN No. 45 for all
financial statements of interim or annual reports ending after December 15,
2002. This Interpretation elaborates on the disclosures to be made by a
guarantor in its interim and annual financial statements about its obligations
under certain guarantees that it has issued. It also clarifies that a guarantor
is required to recognize, at the inception of a guarantee, a liability for the
fair value of the obligation undertaken in issuing the guarantee. This
Interpretation does not prescribe a specific approach for subsequently measuring
the guarantor's recognized liability over the term of the related guarantee.
This Interpretation also incorporates, without change, the guidance in FASB
Interpretation No. 34, Disclosure of Indirect Guarantees of Indebtedness of
Others, which is being superseded. The provisions of this interpretation have no
material impact on the Company.
3. RESTRUCTURING AND FACILITY EXIT COSTS
During the fourth quarter of 2001, the Company approved and implemented a
restructuring program in connection with its acquisition of Interland-Georgia.
This finalized restructuring plan, for which all payments are expected to be
completed by December 31, 2003, provides for the consolidation of the Company's
operations and elimination of duplicative facilities obtained as a result of
previous business acquisitions. In accordance with EITF No. 94-3, "Liability
Recognition for Certain Employee Termination Benefits and Other Costs to Exit
and Activity," the restructuring costs, excluding asset impairments, were
recognized as liabilities at the time management committed to the plan.
Management determined that these costs provided no future economic benefit, they
were incremental to other costs incurred by the Company prior to the
restructuring, or were contractual obligations that existed prior to the date
the plan was approved and were either continued after the exit plan was
completed with no economic benefit to the Company or were non-cancelable without
a penalty; and they were incurred as a direct result of the plan to exit the
identified activities. The asset impairments were accounted for in accordance
with SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to be Disposed Of." Accordingly, during 2001, the Company
recorded a charge of approximately $110.3 million related to employee
termination benefits, facility closure costs, asset disposals and other exit
costs which the Company has recorded in operating expenses.
7
INTERLAND, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
During the second quarter of 2003, the Company approved and initiated a program
to exit certain facilities and consolidate those operations into other existing
facilities. This restructuring plan is part of management's continued plan to
streamline the Company's operations and to reduce the long-term operating costs.
In accordance with SFAS No. 146, "Accounting for Costs Associated with Exit or
Disposal Activities," costs associated with these activities have been
recognized and measured at their fair value in the period in which the
liabilities are incurred. One-time termination benefits for employees required
to render services until they are terminated in order to receive termination
benefits are being recognized ratably over the future service period. The plan
provided for the closure of three data center facilities, a reduction of those
related workforces of approximately 171 employees, and the termination of
bandwidth and data connectivity contracts in place at these and other
facilities. Management plans to exit all three data centers by July 2003.
Through the nine-months ended May 31, 2003, the Company has incurred $5.6
million in restructuring charges as follows: $1.8 million in lease termination
costs, $1.1 million in bandwidth termination costs, $1.3 million in employee
termination benefits, and $1.4 in fixed asset related charges. The Company does
not expect to incur additional restructuring expenses in fiscal 2003.
The following table shows a reconciliation of the beginning and ending liability
balances from August 31, 2002 through May 31, 2003, related to all restructuring
activities recorded by the Company under both of the restructuring programs
described in the above two paragraphs. The current period costs recorded are
classified in the following table as "Plan charges," including a $1.0 million
charge to property, plant and equipment that represents the write down of the
remaining book value of fixed assets originally written down to their estimated
salvage value. These accrued restructuring charges are reflected in the
consolidated balance sheet in "Accrued expenses":
PROPERTY BANDWDITH EMPLOYEE
LEASE PLANT AND TERMINATION TERMINATION
ABANDONMENT EQUIPMENT COSTS BENEFITS TOTAL
----------- --------- ----------- ----------- -------
(IN THOUSANDS)
BALANCE AT AUGUST 31, 2002 $ 7,634 $ -- $ 1,179 $ -- $ 8,813
Plan charges 2,043 1,367 1,658 1,265 6,333
Cash Paid (2,692) (240) (549) (955) (4,436)
Other Adjustments (216) -- (527) -- (743)
Non-cash write Downs -- (871) -- -- (871)
------- ------- ------- ------- -------
BALANCE AT MAY 31, 2003 $ 6,769 $ 256 $ 1,761 $ 310 $ 9,096
======= ======= ======= ======= =======
During the nine-month period ended May 31, 2003, the Company settled certain
data connectivity contracts obligations for amounts less than original
estimates. In connection with the settlements, the bandwidth termination costs
accrual was reduced by $0.5 million and is reflected in the above table in
"Other adjustments." In addition, one of the Company's lease abandonment
liabilities was reduced by $0.2 million in connection with the reduction of the
Company's obligation due to a sublease arrangement for the facility.
For the quarter and nine-months ending May 31, 2002, the Company recorded $(0.7)
million and $(1.0) million to "Restructuring costs." In connection with the sale
of the consumer dial-up accounts to SolutionPro, Inc., the Company assigned and
transferred certain data connectivity contracts to SolutionPro, which released
the Company from future termination penalties that had previously been accrued
during the restructuring program. Accordingly, the Company reversed the accrual
for these termination penalties.
4. MERGER AND INTEGRATION COSTS
During the nine-months ended May 31, 2003, the Company recorded $0.5 million to
merger and integration costs for severance and relocation expenses.
8
INTERLAND, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
During the quarter and nine-month period ended May 31, 2002, the Company
recorded $0.8 million and $7.9 million for financial advisory services, legal,
accounting, relocation, employee stay bonuses and other non-capitalizable
expenses directly related to merger and integration with Interland-Georgia.
5. ACQUISITIONS
Effective August 1, 2002, the Company acquired iNNERHOST, Inc. for an aggregate
purchase price of $17.7 million, consisting of approximately $5.2 million in
cash and up to 9,701,822 shares of Interland common stock . In addition, the
purchase agreement stipulated that the purchase consideration was subject to
adjustment based on the following provisions:
- An earn-out provision that specified that the realization of
the full purchase price by the shareholders of iNNERHOST would
be contingent upon the iNNERHOST revenues for the three-month
period following the date of acquisition being at least 95% of
the historical monthly revenues. iNNERHOST revenues for the
subject three-month period were in fact in compliance with
this requirement and thus no modification to the purchase
price and related consideration was necessary.
- A price protection provision that specified that a pro-rata
payback of shares to Interland if the average closing price
for the five business days preceding the effective date of the
registration statement covering shares issued in this
acquisition is greater than $3.70 but less than $5.00 per
share by the amount of the closing price over $2.50 per share.
The agreement also provides additional payment of shares to
the iNNERHOST shareholders on a pro-rata basis if the average
closing price of five business days preceding the effective
date of the registration statement covering shares issued in
this acquisition is less than $2.50 per share but greater than
$1.00 per share by the amount of the closing price below $2.50
per share.
During April 2003, the Company completed the registration process and issued an
additional 5,530,284 shares of Interland common stock in accordance with the
price protection provision bringing the total number of shares issued to
9,701,822 (including contingent shares described above). The acquisition of
iNNERHOST was accounted for in accordance with SFAS No. 141,"Business
Combinations." The contingently issued shares of the Company's stock did not
affect the aggregate recorded cost of the acquisition.
In connection with the acquisition, 0.5 million shares of stock and $0.3 million
were placed into escrow for one year to satisfy unidentified claims that
occurred prior to the acquisition date. Management believes that the value of
the escrow account is sufficient to cover all known claims that have a likely
probability of an unfavorable outcome. The results of iNNERHOST's operations
have been included in the consolidated financial statements since August 1,
2002, the effective date of acquisition. The aggregate purchase price was $17.7
million, including direct acquisition costs of $0.2 million.
During the second quarter ended February 28, 2003, the iNNERHOST purchase price
allocation was completed and amounts were allocated to identifiable intangible
assets and goodwill. The following table summarizes the purchase price
allocation based on the fair values of the assets acquired and liabilities
assumed at the date of acquisition:
9
INTERLAND, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
FAIR VALUE
--------------
(In Thousands)
Current assets $ 2,235
Property and equipment 6,995
Trade names and trademarks 200
Customer relationships 3,400
Other assets 512
Goodwill 9,384
Current liabilities (4,301)
Long-term liabilities (676)
--------
Net assets acquired $ 17,749
========
On January 3, 2003, the Company acquired Trellix Corporation, a privately held
developer of software-based Web site solutions. Founded in 1995, Trellix is a
provider of private-label Web site publishing solutions, integrated business
services, and low-cost hosting technology. The primary reason for the
acquisition is that Trellix offers a suite of site-building tools and services
that enable users to create professional Web sites. Trellix's product line
offers an expansion of the existing Interland product line. Trellix's financial
results are included in Interland's financial results beginning in January 2003.
Initially, the estimated aggregate purchase price was approximately $12.2
million, however, based on Trellix's financial position on the date of close and
a contractual working capital adjustment contained in the merger agreement, the
actual aggregate purchase price was approximately $11.7 million consisting of
$3.2 million in cash, three million shares of Interland stock, and six million
warrants to purchase shares of Interland stock at a price of $5.00 per warrant.
The Company is disputing an amount of $0.5 million with the Trellix Stockholders
related to Trellix's working capital position at the time of close. This amount
has not been included in the $11.7 million Trellix purchase price and if
ultimately paid by Interland, the purchase price would increase to $12.2
million. The fair value of the warrants at the date of acquisition was $0.55
each using the Black-Scholes pricing model. The acquisition of Trellix accounted
for the majority of the significant change in shareholders' equity by increasing
the balance of additional capital by $4.9 million and warrants by $3.3 million.
The following table summarizes the purchase price allocation based on the fair
values of the assets acquired and liabilities assumed at the date of
acquisition:
FAIR VALUE
--------------
(IN THOUSANDS)
Current assets $ 700
Property and equipment 603
Trade names and trademarks 140
Technology 5,900
Goodwill 8,096
Current liabilities (3,763)
--------
Net assets acquired $ 11,676
========
6. ACQUIRED INTANGIBLES AND GOODWILL
In June 2001, the Financial Accounting Standards Board issued SFAS No. 141,
"Business Combinations" ("SFAS 141") and SFAS No. 142, "Goodwill and Other
Intangible Assets" ("SFAS 142"). SFAS 141 requires that the purchase method of
10
INTERLAND, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
accounting be used for all business combinations initiated after June 30, 2001.
SFAS 141 also specifies the criteria applicable to intangible assets acquired in
a purchase method business combination to be recognized and reported apart from
goodwill. SFAS 142 requires that goodwill and intangible assets with indefinite
useful lives no longer be amortized, but instead be tested for impairment, at
least annually. SFAS 142 also requires that intangible assets with definite
useful lives be amortized over their respective estimated useful lives to their
estimated residual values, and be reviewed for impairment.
The Company adopted SFAS 141 and 142 effective September 1, 2001. Upon adoption
of SFAS 142, the Company no longer amortizes goodwill.
In accordance with the requirements of SFAS 142, the Company tests for
impairment on an annual basis and between annual tests if an event occurs or
circumstances change that would more likely than not reduce the fair value of
goodwill below its carrying amount. Interland performed an initial impairment
assessment upon adoption at September 1, 2001, and determined that a transition
charge was not required. During the third quarter of 2003, the Company completed
the annual impairment test which entailed comparing the aggregate market value
of the company's outstanding securities plus its liabilities to the aggregate
carrying value of the Company's assets, including goodwill and other indefinite
life intangible assets. The Company's market price of its stock has experienced
significant volatility over the last fiscal year and closed as of May 31, 2003,
with a market value significantly less than the value at the beginning of the
fiscal year. Management retained valuation specialists to assist in the
valuation of its tangible and identifiable intangible assets for purposes of
determining the implied fair value of goodwill at May 31, 2003. Upon completion
of the annual assessment, Interland recorded a non-cash impairment charge of
$89.9 million to reduce the carrying value of goodwill to its estimated fair
value of $47.6 million.
The following table discloses changes in the carrying amount of goodwill from
August 31, 2002 through May 31, 2003:
FOR THE NINE MONTHS ENDED
MAY 31, 2003
-------------------------
Balance at the beginning of the year $ 120,011
Goodwill acquired 17,479
Impairment write-down (89,928)
Other adjustment --
---------
Balance at the end of the first nine months $ 47,562
=========
Given the Company's aggressive acquisition strategy over the last two years,
significant customer related intangible asset balances have accumulated through
May 31, 2003. The Company has continued to monitor the performance of these
acquired customer related intangible assets and during the third quarter, the
Company determined that revenues, operating profits and cash flows from its
Interliant, AT&T and Burlee customer account acquisitions, as well as customer
relationship intangible assets from its CommuniTech, iNNERHOST and Dialtone
acquisitions were materially less than previously estimated, primarily related
to customer and Company initiated terminations. As such, the Company determined
that these identifiable intangible assets needed to be tested for
recoverability. Management used the expected present value of future cash flows
to determine the fair value of these identifiable intangible assets and
determined that the carrying amount of these assets was higher than their fair
values. Upon completion of the assessment, Interland recorded a non-cash
impairment charge of $13.9 million to reduce the carrying value of identifiable
intangible assets to estimated fair values.
The following table summarizes intangible assets by asset class and related
accumulated amortization as required by SFAS 142:
11
INTERLAND, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
AS OF MAY 31, 2003 AS OF AUGUST 31, 2002
-------------------------- ------------------------------
GROSS GROSS
CARRYING ACCUMULATED CARRYING ACCUMULATED
AMOUNT AMORTIZATION AMOUNT AMORTIZATION
-------- ------------ --------- ------------
(IN THOUSANDS)
Amortizable intangible assets:
Core technology $18,380 $ 7,398 $12,480 $ 2,683
Customer account acquisitions 16,333 12,167 25,424 5,298
Customer relationships 6,229 3,342 6,300 917
Trademarks 5,740 1,551 5,400 831
Other 1,162 781 13,998 623
------- ------- ------- -------
Total $47,844 $25,239 $63,602 $10,352
======= ======= ======= =======
Aggregate amortization expense:
For the nine months ended May 31, 2003 $14,887
Estimated amortization expense:
For the year ended August 31, 2003 $17,553
For the year ended August 31, 2004 $ 8,835
For the year ended August 31, 2005 $ 6,417
For the year ended August 31, 2006 $ 2,807
For the year ended August 31, 2007 $ 1,880
At August 31, 2002, included in "Other" was $12.8 million related to the
acquisition of iNNERHOST. Upon completion of the purchase price allocation for
iNNERHOST, this balance was allocated to the appropriate intangible asset
categories and goodwill.
Core technology is amortized over a weighted average of four years, customer
account acquisitions and customer relationships are amortized over a weighted
average of three years, trademarks are amortized over a weighted average of
seven years, and all other intangible assets are amortized over a weighted
average of three years. The weighted average amortization period for all
intangible assets as a group is four years. None of the goodwill balance is
deductible for tax purposes.
7. PURCHASE BUSINESS COMBINATION LIABILITIES
In connection with the acquisitions of Interland-Georgia in fiscal 2001,
iNNERHOST in fiscal 2002, and Trellix Corporation in January 2003, the Company
accrued certain liabilities representing estimated costs of exiting certain
facilities, termination of bandwidth contracts and involuntary termination of
employees in accordance with EITF No. 95-3, "Recognition of Liabilities in
Connection with a Purchase Business Combination." These amounts are included in
"Accrued expenses" on the balance sheet and are not included in the
restructuring reserves discussed in Note 3. The following table shows the
changes in the accrual from August 31, 2002:
12
INTERLAND, INC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
EMPLOYEE
LEASE TERMINATION
ABANDONMENT BENEFITS TOTAL
----------- ----------- -------
(IN THOUSANDS)
BALANCE AT AUGUST 31, 2002 $ 7,574 $ 252 $ 7,826
Liabilities accrued -- 675 675
Cash paid (6,563) (623) (7,186)
------- ------- -------
BALANCE AT MAY 31, 2003 $ 1,011 $ 304 $ 1,315
======= ======= =======
In accordance with EITF 95-3, the additional $0.7 million of liabilities accrued
during the nine-month period ended May 31, 2003 represent termination benefits
for Trellix employees who were involuntarily terminated and for former iNNERHOST
founders who had contracts entitling them to termination benefits under
contractual obligations that existed prior to the acquisition date.
8. CONTINGENCIES
Interland is defending an employee class action lawsuit filed in the U.S.
District Court for Idaho. In this case, five individual plaintiffs claim that
when they were employees of Micron Electronics Inc. ("MEI") between 1999 and
April 2001, they and other similarly situated employees did not receive overtime
pay to which they were entitled under the Fair Labor Standards Act. Interland
disputes these claims and believes the plaintiffs are not entitled to any
material additional wages. The court conditionally certified a class of not more
than eight hundred former employees, and notices of the litigation are being
sent to these persons to give them the opportunity to "opt in" to the
litigation. The parties are continuing to conduct discovery. At this early stage
of the litigation, Interland is unable to estimate its total expenses, possible
loss or range of loss that may ultimately be connected with the matter. This
potential liability remains with Interland even though it sold the PC Systems
business.
In February of 2003, the Company filed a lawsuit in Cobb County, Georgia against
Mr. Gabriel Murphy, one of the former principals of Communitech, which was
acquired by Interland in February 2002. The Company's lawsuit claims, among
other things, that Mr. Murphy breached certain covenants under his employee
agreement, and also demands payment from Mr. Murphy under his delinquent $2.7
million promissory note. These notes are collateralized by 2,735,257 shares of
the Company's common stock, and the receivable balance is shown on the balance
sheet as a reduction in equity.
Messrs. Heitman and Murphy filed a lawsuit against Interland, its CEO, Mr. Joel
Kocher, and Interland's subsidiary CommuniTech.Net, Inc., in Jackson County,
Missouri claiming, among other things, that Interland acted unreasonably in
failing to have the S-3 registration statement declared effective by the SEC on
a timely basis and claiming that Interland and/or Mr. Kocher made inaccurate
disclosures in connection with Interland's acquisition of Communitech. The
complaint asks for compensatory and punitive damages in an unspecified amount.
Interland believes that these claims are without merit and will not have a
material adverse effect on Interland, and intends to vigorously defend the
claims.
On March 14, 2003, Halo Management, LLC, filed a suit against Interland in the
U.S. District Court for the Northern District of California. The suit alleges
that Interland's use of "blueHALO" (U.S. Patent and Trademark Office Serial No.
78/135,621) to describe its proprietary web hosting architecture infringes on
the plaintiff's registered trademark Halo (U.S. Patent and Trademark Office
Serial No. 75/870,390; Registration No. 2,586,017). The suit requests an
injunction against Interland's use of its blueHALO mark and money damages.
Interland is investigating the matter but believes it will have meritorious
defenses and plans to vigorously defend the matter.
Periodically, the Company is made aware that technology it used in its
discontinued operations may have infringed on intellectual property rights held
by others. The Company has evaluated all such claims and, if necessary and
appropriate, sought to obtain licenses for the use of such technology. If the
Company or its suppliers were unable to obtain licenses
13
INTERLAND, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
necessary to use intellectual property in its discontinued operation's products
or processes, it may be forced to defend legal actions taken against it relating
to allegedly protected technology. The Company evaluates all such claims and has
accrued a liability and charged discontinued operations for the estimated costs
of settlement or adjudication of claims for alleged infringement as of the
respective dates of the balance sheets included in this report. As of May 31,
2003, the Company had an aggregate amount of $0.5 million accrued for such
matters.
In accordance with SFAS No. 5 "Accounting for Contingencies" the Company
believes it has adequately reserved for the contingencies arising from the above
legal matters where an outcome was deemed to be probable and the loss amount
could be reasonably estimated. As such, the Company does not believe that the
anticipated outcome of the aforementioned proceedings will have a materially
adverse impact on its results of operations, its financial condition or its cash
flows.
The Company is also a defendant in a number of other lawsuits which the Company
regards as minor and unlikely to result in any material payment; nonetheless,
the outcome of litigation may not be assured, and the Company's cash balances
could be materially affected by an adverse judgment.
9. COMMON STOCK AND RELATED MATTERS
In March 2003, the board of directors authorized a stock repurchase program to
acquire outstanding common stock. Under the program, up to $10.0 million of
common stock could be reacquired over the next year. During the third quarter,
the Company purchased approximately 852,000 shares of common stock at an
aggregate cost of approximately $1.0 million.
The Company was notified by NASDAQ on May 22, 2003 that it had regained
compliance with Marketplace Rule 4450(a)(5) since, by that time, the closing bid
of the Company's common stock had been at $1.00 per share or greater for at
least ten consecutive trading days.
10. SUBSEQUENT EVENTS
On June 13, 2003, the Company completed the previously announced acquisition of
Hostcentric, Inc. for $25.8 million in cash and stock. In return for all
outstanding shares of Hostcentric, Hostcentric shareholders received $3.0
million in cash and approximately 13.5 million shares of Interland stock. The
number of shares to be issued was fixed as of the agreement's execution date.
The results of Hostcentric's operations are not included in the consolidated
financial statements given that the acquisition was completed subsequent to the
end of the third quarter. Formed in 2000, Hostcentric is a privately held
provider of a broad range of Web hosting services to small business and
enterprise customers. The purchase price allocation for the acquisition of
Hostcentric is still being finalized.
In June 2003, the Company announced that its board of directors had approved a
1-for-10 reverse stock split expected to go into effect by the end of the fourth
quarter. In July, the Board set the record date and the effective date for the
reverse stock split as August 1, 2003 and August 2, 2003. The following table
discloses historical earning per share on a pre-split basis and pro forma
earning per share on a post split basis:
14
INTERLAND, INC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
HISTORICAL EARNINGS PER SHARE (PRE-SPLIT BASIS)
------------------------------------------------------------
UNAUDITED FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
-------------------------- -------------------------
MAY 31, MAY 31, MAY 31, MAY 31,
2003 2002 2003 2002
---------- ---------- -------- --------
BASIC NET INCOME (LOSS) PER SHARE:
Continuing operations $(0.94) $ 0.37 $(1.22) $ 0.08
Discontinued operations -- (0.03) -- (0.03)
------ ------ ------ --------
$(0.94) $ 0.34 $(1.22) $ 0.05
DILUTED NET INCOME (LOSS) PER SHARE:
Continuing operations $(0.94) $ 0.36 $(1.22) $ 0.08
Discontinued operations -- (0.03) -- (0.03)
------ ------ ------ --------
$(0.94) $ 0.33 $(1.22) $ 0.05
PRO FORMA EARNINGS PER SHARE (POST-SPLIT BASIS)
------------------------------------------------------------
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
-------------------------- --------------------------
BASIC NET INCOME (LOSS) PER SHARE:
Continuing operations $(9.41) $ 3.72 $(12.16) $ 0.80
Discontinued operations (0.01) (0.33) (0.03) (0.33)
------ ------ ------- ------
$(9.42) $ 3.39 $(12.19) $ 0.47
DILUTED NET INCOME (LOSS) PER SHARE:
Continuing operations $(9.41) $ 3.64 $(12.16) $ 0.80
Discontinued operations (0.01) (0.33) (0.03) (0.33)
------ ------ ------- ------
$(9.42) $ 3.31 $(12.19) $ 0.47
15
INTERLAND, INC.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
STATEMENTS CONTAINED IN THIS FORM 10-Q THAT ARE NOT PURELY HISTORICAL ARE
FORWARD-LOOKING STATEMENTS AND ARE BEING PROVIDED IN RELIANCE UPON THE "SAFE
HARBOR" PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995.
WORDS SUCH AS "ANTICIPATES," "EXPECTS," "INTENDS," "PLANS," "BELIEVES," "SEEKS,"
"ESTIMATES," AND SIMILAR EXPRESSIONS IDENTIFY FORWARD-LOOKING STATEMENTS. THESE
FORWARD-LOOKING STATEMENTS INCLUDE BUT ARE NOT LIMITED TO STATEMENTS REGARDING
INTERLAND'S EXPECTATIONS OF THE COMPANY'S FUTURE LIQUIDITY NEEDS, ITS
EXPECTATIONS REGARDING ITS FUTURE OPERATING RESULTS INCLUDING ITS PLANNED
INCREASE IN ITS REVENUE LEVELS AND THE ACTIONS THE COMPANY EXPECTS TO TAKE IN
ORDER TO MAINTAIN ITS EXISTING CUSTOMERS AND EXPAND ITS OPERATIONS AND CUSTOMER
BASE. ALL FORWARD-LOOKING STATEMENTS ARE MADE AS OF THE DATE HEREOF AND ARE
BASED ON CURRENT MANAGEMENT EXPECTATIONS AND INFORMATION AVAILABLE TO IT AS OF
SUCH DATE. THE COMPANY ASSUMES NO OBLIGATION TO UPDATE ANY FORWARD-LOOKING
STATEMENT. IT IS IMPORTANT TO NOTE THAT ACTUAL RESULTS COULD DIFFER MATERIALLY
FROM HISTORICAL RESULTS OR THOSE CONTEMPLATED IN THE FORWARD-LOOKING STATEMENTS.
FORWARD-LOOKING STATEMENTS INVOLVE A NUMBER OF RISKS AND UNCERTAINTIES, AND
INCLUDE RISKS ASSOCIATED WITH OUR TARGET MARKETS AND RISKS PERTAINING TO OUR
ABILITY TO SUCCESSFULLY INTEGRATE THE OPERATIONS AND PERSONNEL OF THE RECENT
ACQUISITIONS. FACTORS THAT COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM
EXPECTED RESULTS ARE IDENTIFIED IN "RISK FACTORS" IN THE COMPANY'S ANNUAL REPORT
ON FORM 10-K FOR THE YEAR ENDED AUGUST 31, 2002 AND IN THE COMPANY'S OTHER
FILINGS WITH THE SECURITIES AND EXCHANGE COMMISSION. ALL QUARTERLY REFERENCES
ARE TO THE COMPANY'S FISCAL PERIODS ENDED MAY 31, 2003, OR MAY 31, 2002, UNLESS
OTHERWISE INDICATED. ALL ANNUAL REFERENCES ARE ALSO ON A FISCAL AUGUST 31ST
YEAR-END BASIS, UNLESS OTHERWISE INDICATED. ALL TABULAR DOLLAR AMOUNTS ARE
STATED IN THOUSANDS.
OVERVIEW
Interland is a leader in delivering standardized business-class Web hosting
solutions to small- and medium-sized businesses. Interland offers a broad range
of products and services, including shared and dedicated hosting services,
electronic commerce and other application hosting services. Prior to its
transformation in fiscal 2001, the Company also provided a variety of computer
products and related services through PC Systems, a computer manufacturing
business, SpecTek, a memory products business. During fiscal 2001, the Company
discontinued its PC Systems and SpecTek businesses. Following the disposition of
these business segments, the Company's ongoing operations became exclusively
those of a Web hosting company that also provides Web site development solutions
to small businesses.
The current Web hosting business was formed through twelve company or account
acquisitions from 1999 through May 31, 2003. On August 2, 1999, the Company
acquired 100% of the outstanding stock of NetLimited, Inc. d.b.a. "HostPro", a
Web and applications hosting provider. On September 2, 1999, the Company
acquired the property and equipment of Micron Internet Services, formerly a
division of Micron Technology, a provider of dedicated, nationwide dial-up and
broadband Internet access, virtual private network solutions and e-commerce
services. On December 14, 1999, the Company acquired LightRealm, Inc.,
("LightRealm"), a Kirkland, Washington-based Web and applications hosting and
Internet access-company serving small- and medium-sized businesses. On March 16,
2000, the Company acquired Worldwide Internet Publishing Corporation,
("Worldwide Internet"), a Boca Raton, Florida-based Web hosting company that
also served small- and medium-sized businesses. On August 6, 2001, the Company
acquired Interland, Inc. ("Interland-Georgia"), an Atlanta, Georgia-based
provider of a broad range of Web hosting, applications hosting and other related
Web-based business solutions, specifically designed to meet the needs of small-
and medium-sized businesses. In connection with the acquisition of
Interland-Georgia, Micron Electronics, Inc., ("MEI"), changed its name to
Interland, Inc. and its trading symbol to "INLD."
In October 2001, January 2002, and May 2002 respectively, the Company acquired
the small business-focused shared and dedicated Web hosting customer accounts of
Interliant, Inc., ("Interliant"), AT&T Corp., ("AT&T"), and Burlee Networks LLC,
("Burlee").
On February 8, 2002, the Company acquired CommuniTech.Net, Inc.,
("CommuniTech.Net"), a Kansas City, Missouri- based Web hosting company. On May
3, 2002, the Company acquired Dialtone, Inc., ("Dialtone"), a Fort Lauderdale,
Florida-based leading dedicated Web hosting company.
As of August 1, 2002, the Company acquired iNNERHOST,Inc., ("iNNERHOST"), a
Miami, Florida-based Web hosting company serving small- and medium-sized
businesses.
16
INTERLAND, INC.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
On January 3, 2003, the Company acquired Trellix Corporation ("Trellix"), a
privately held developer of software-based Web site solutions. Founded in 1995,
Trellix is a provider of private-label Web site publishing solutions, integrated
business services, and low-cost hosting technology. Trellix offers a suite of
site building tools and services that enable users to create professional Web
sites.
On December 19, 2002, the Company entered into a merger agreement to acquire
Hostcentric, Inc. for $25.8 million in cash and stock. Formed in 2000,
Hostcentric is a privately held provider of a broad range of Web hosting
services to small business and enterprise customers. In return for all
outstanding shares of Hostcentric, Hostcentric shareholders received $3 million
in cash and approximately 13.5 million shares of Interland stock. The
transaction closed on June 13, 2003.
Interland's business is rapidly evolving as a result of the acquisitions
detailed above. The Company also has a limited operating history as a Web
hosting company. The Company's rapid annual hosting revenue growth primarily has
been the result of its acquisitions. In order to reduce expenses, the Company
exited redundant facilities, reduced the associated work force and terminated
contracts related to unused Internet connectivity or "bandwidth." As a result,
the Company does not believe its historical financial results are indicative of
expected future results. Going forward, the Company does not anticipate further
acquisitions as a means of growing revenue, but rather to pursue organic growth
strategies, including execution of plans to offer combined website design,
website hosting, and marketing consultation to small- and medium-sized
businesses, sometimes referred to as a "mass-market" or "mainstream market"
strategy. Furthermore, the Company expects to realize substantial cost
efficiencies in the fourth quarter of fiscal 2003 and beyond as a result of the
integration of previously acquired companies. Management expects that these
efforts will result in quarterly operating cost savings of $7.0 million,
effective with the fourth quarter of fiscal 2003, as compared with the first
quarter of fiscal 2003. These reductions are expected to continue to benefit the
Company in the future.
DISCONTINUED OPERATIONS
PC SYSTEMS
In fiscal 2001, the Company discontinued the operations of its PC Systems
business segment, which was accounted for as discontinued operations in
accordance with Accounting Principles Board Opinion (APB) No. 30, "Reporting the
Results of Operations -- Reporting the Effects of Disposal of a Segment of a
Business, and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions." On May 31, 2001, the Company sold its PC Systems business to GTG
PC Holdings, LLC, ("GTG PC"), an affiliate of the Gores Technology Group. Under
the terms of the agreement, GTG PC received assets, which included $76.5 million
in cash, and assumed specified liabilities of the PC Systems business. The
Company retained all liabilities of the PC Systems business not assumed by GTG
PC, including, for example, liabilities for taxes arising prior to the closing
of the transaction, employee termination and related expenses and any contingent
liabilities arising prior to the closing date.
Through May 31, 2003, or for the applicable statute of limitations with respect
to taxes and government contracts, the Company is obligated to indemnify the
purchaser and affiliated entities for any breaches of the representations and
warranties contained in the agreement. In addition, the Company is obligated for
an indefinite period of time to indemnify the purchaser and affiliated entities
for any breaches in covenants. The agreement provides that the maximum aggregate
liability of the Company for indemnification under the agreement is $10.0
million. To date, the Company has not made any indemnification payments in
regards to these matters. Furthermore, the Company believes that it is unlikely
that any material claims will be made, and therefore has not recorded any
liability for this indemnification.
For the quarter and nine-months ending May 31, 2003, the Company recorded
expenses of $167,000 and $482,000, respectively, primarily related to legal
expenses for its discontinued operations.
RESULTS OF CONTINUING OPERATIONS
Effective with the filing of the Company's Form 10-Q for the fiscal quarter
ending February 28, 2003 the Company revised the presentation of its
consolidated statements of operations for all periods presented to conform to
presentations used by others in the industry. The revised presentation removes
the gross margin sub-total and instead classifies all operating
17
INTERLAND, INC.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
expenses and costs in their respective line item. Additionally, depreciation and
amortization have been removed as components of network operating costs, general
and administrative costs, sales and marketing costs and technical support costs
and are instead presented on a separate line item. These reclassifications, none
of which affect net loss, have been made to all periods to present the financial
statements on a consistent basis.
The Company's consolidated financial information presents the net effect of
discontinued operations separate from the results of the Company's continuing
operations. Historical financial information has been reclassified to
consistently present the discontinued operations, and the discussion and
analysis that follow generally focuses on continuing operations. The following
table sets forth, for the periods indicated, certain data derived from the
Company's consolidated statements of operations as a percentage of revenues:
FOR THE QUARTER ENDED FOR THE NINE MONTHS ENDED
----------------------- -------------------------
MAY 31, MAY 31, MAY 31, MAY 31,
2003 2002 2003 2002
-------- ------- ------- -------
Revenues 100.0% 100.0% 100.0% 100.0%
Operating costs and expenses:
Network operating costs 31.1% 30.5% 34.3% 35.3%
Sales and marketing 22.1% 21.6% 19.7% 29.6%
Technical support 15.4% 19.0% 14.5% 17.1%
General and administrative 46.4% 32.1% 40.7% 38.2%
Bad debt expense 7.6% 10.6% 7.3% 7.6%
Depreciation and amortization 85.7% 40.1% 60.0% 34.2%
Restructuring costs 8.5% -2.7% 7.1% -1.3%
Merger and integration costs 3.1% 0.7% 10.6%
Goodwill Impairment 347.2% -- 113.4% --
Intangible asset impairment 53.5% -- 17.5% --
Other expense (income), net 6.0% 0.5% 2.1% 1.0%
------ ----- ------ -----
Total operating costs and expenses 623.7% 154.7% 317.3% 172.4%
------ ----- ------ -----
Operating loss -523.7% -54.8% -217.3% -72.4%
Interest income (expense), net -0.3% -0.1% 0.1% 0.4%
------ ----- ------ -----
Loss from continuing operations before taxes -524.0% -54.9% -217.2% -72.0%
Income tax benefit (expense) -2.4% 259.9% -0.8% 86.9%
------ ----- ------ -----
Net income (loss) from continuing operations -526.4% 205.0% -218.0% 14.9%
====== ===== ====== =====
The loss from continuing operations increased $187.0 million, or 368.9% for the
quarter ended May 31, 2003, and increased $183.9 million, or 1,661.7%,
respectively, for the nine-months ended May 31, 2003 when compared to the same
periods of the prior fiscal year. The basic loss per share increased $1.31 per
share, or 354.1% for the quarter ended May 31, 2003, and increased $1.30 per
share, or 1,625.0%, respectively, for the nine-months ended May 31, 2003 when
compared to the same periods of the prior fiscal year. The diluted loss per
share increased $1.30 per share, or 361.1% for the quarter ended May 31, 2003,
and increased $1.30 per share, or 1,625.0%, respectively, for the nine-months
ended May 31, 2003 when compared to the same periods of the prior fiscal year.
18
INTERLAND, INC.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
COMPARISON OF THE QUARTERS ENDED MAY 31, 2003 AND 2002
REVENUES
FOR THE QUARTER ENDED FOR THE NINE MONTHS ENDED
----------------------- --------------------------
MAY 31, MAY 31, MAY 31, MAY 31,
2003 2002 2003 2002
------- ------- ------- -------
Hosting revenue $24,927 $24,269 $77,096 $72,451
Other revenue 971 450 2,199 1,435
------- ------- ------- -------
Total revenue $25,898 $24,719 $79,295 $73,886
======= ======= ======= =======
Total revenues increased $1.2 million, or 4.8%, and $5.4 million, or 7.3%,
respectively, for the quarter and for the nine-months ended May 31, 2003 when
compared to the same periods of the prior fiscal year. Hosting revenues
increased 2.7% to $24.9 million and 6.4% to $77.1 million, respectively, for the
quarter and for the nine-months ended May 31, 2003 when compared to the same
periods of the prior fiscal year. Hosting revenues are comprised of shared,
dedicated, and application hosting services and domain name registrations. The
growth in hosting revenues, which is primarily attributable to acquisitions,
continues to be offset by account cancellations. These cancellations may occur
as a result of: a) customer action; b) termination by the Company for
non-payment; or c) termination by the Company as a result of a decision to no
longer provide a particular service. The Company has not, during its period of
acquisition and integration, focused on organic growth, and has reduced its
spending on marketing and advertising from the spending levels of the first
quarter of fiscal 2002. Consequently, the Company has, aside from acquisitions,
yet to achieve overall growth in revenue. As previously discussed in the
Overview section, the Company does not expect to make further revenue-oriented
acquisitions now that it has acquired Trellix and Hostcentric, which the Company
does expect will provide additional revenue. Although the Company intends to
increase the net revenue of its Web hosting business, it will focus on the
mainstream market as the primary source of future growth.
Other revenues increased $0.5 million, or 115.8%, and $0.8 million, or 53.2%,
respectively, for the quarter and for the nine- months ended May 31, 2003 when
compared to the same periods of the prior fiscal year. Other revenues are
primarily comprised of consulting, co-location, and web-based business solution
services. The increases are due to the inclusion of Trellix revenues, which
consist of Web-based business solution services.
As of May 31, 2003, the Company had approximately 171,000 paid shared hosting
customer accounts and managed approximately 7,000 dedicated servers, many of
which host multiple web sites, compared to approximately 221,000 paid shared
hosting customer accounts and approximately 6,600 dedicated servers at May 31,
2002. The decrease in shared hosting customer accounts is primarily due to
account churn, integration breakage and the deactivation of non-paying accounts
during the last three quarters. The increase in dedicated servers is primarily
attributable to the Company's acquisitions completed during fiscal 2002 and
improved sales performance. Additionally, the Company acquired approximately
62,000 hosting accounts from Trellix, although these accounts each contribute
substantially less revenue per account than the Company's other hosting
accounts. The Company has experienced average revenues per unit ("ARPU")
increases for both shared hosting and dedicated hosting services during the
three and nine-months ended May 31, 2003, as compared to the same periods of the
prior fiscal year. These increases are most directly related to the customer
accounts obtained thru recent acquisitions.
OPERATING COSTS AND EXPENSES
NETWORK OPERATING COSTS
Network operating costs increased 6.9% to $8.1 million and 4.4% to $27.2
million, respectively, for the quarter and for the nine-months ended May 31,
2003 from $7.5 million and $26.1 million in the same periods of the prior year.
As a percentage of revenues, the Company's network operating expenses were 31.1%
and 34.3%, respectively, for the quarter and for the nine-months ended May 31,
2003 as compared to 30.5% and 35.3% in the same periods of the prior fiscal
year. The increase in
19
INTERLAND, INC.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
network operating expense in the third quarter of fiscal 2003 was primarily
related to expenses incurred in a $0.4 million buyout of a domain registration
agreement, and $0.6 million of costs to secure maintenance agreements in support
of network software and hardware infrastructure, partially offset by $0.5
million of reduced data connectivity costs in regard to the execution of more
favorable bandwidth contracts. As a result of completing the Company's
restructuring, integration, and transition plans with an in-year cost of
approximately $16.1 million, management expects to realize approximately $25.0
million of annualized operating cost savings effective with the fourth quarter
of fiscal 2003.
SALES AND MARKETING
Sales and marketing expenses increased 7.4% to $5.7 million and decreased 28.7%
to $15.6 million, respectively, for the quarter and for the nine-months ended
May 31, 2003 from $5.3 million and $21.9 million in the same periods of the
prior year. The Company's sales and marketing expenses as a percentage of
revenues were 22.1% and 19.7%, respectively, for the quarter and for the
nine-months ended May 31, 2003 as compared to 21.6% and 29.6% in the same
periods of the prior fiscal year. The increase in sales and marketing expenses
in the third quarter of fiscal 2003 is primarily due to an increase in marketing
expenditures of $0.3 million targeted at the mainstream market initiative. The
$6.3 million decrease in sales and marketing expenses for the nine-month period
ended May 31, 2003 as compared to the same period of the prior fiscal year is
primarily due to greater use of on-line advertising. Management expects the
trend of reduced advertising expenses to continue into fiscal 2004.
TECHNICAL SUPPORT
Technical support expenses decreased 14.7% to $4.0 million and 8.7% to $11.5
million, respectively, for the quarter and for the nine-months ended May 31,
2003 from $4.7 million and $12.6 million in the same periods of the prior year.
The Company's technical support expenses as a percentage of revenues were 15.4%
and 14.5%, respectively, for the quarter and for the nine-months ended May 31,
2003 compared to 19.0% and 17.1% in the same periods of the prior fiscal year.
The decrease in technical support expenses in the third quarter from the same
quarter of the prior fiscal year was primarily attributable to a $0.4 million
reduction in e-mail product third party support expenses and a $0.3 million
reduction in professional fees pertaining to process reengineering and
improvement initiatives undertaken in the prior fiscal year.
GENERAL AND ADMINISTRATIVE
General and administrative expenses increased 51.3% to $12.0 million and
increased 14.2% to $32.3 million, respectively, for the quarter and for the
nine-months ended May 31, 2003 from $7.9 million and $28.3 million in the same
periods of the prior year. As a percentage of revenues, the Company's general
and administrative expenses were 46.4% and 40.7%, respectively, for the quarter
and for the nine-months ended May 31, 2003 as compared to 32.1% and 38.2% in the
same periods of the prior fiscal year. The primary factors causing the increase
in general and administrative expenses in the third quarter of fiscal 2003 were
$1.2 million of additional salary and benefit costs associated with the acquired
workforces of Dialtone Internet, iNNERHOST and Trellix, $0.9 million of
litigation expenses arising from the integration of recent acquisitions and
related security registration costs, $0.4 million in staffing relocation costs
necessary to complete consolidation initiatives, $0.5 million of spending to
terminate uneconomical facility leases, and $0.2 million of incremental
management travel related expenses associated with investor relations and
acquisition related activities.
BAD DEBT EXPENSE
Bad debt expense decreased 24.4% to $2.0 million and increased 3.1% to $5.8
million, respectively, for the quarter and for the nine-months ended May 31,
2003 from $2.6 million and $5.6 million in the same periods of the prior year.
As a percentage of revenues the Company's bad debt expense was 7.6% and 7.3%,
respectively, for the quarter and the nine-months ended May 31, 2003 as compared
to 10.6% and 7.6% in the same periods of the prior fiscal year. The decrease in
bad debt expense for the third quarter of fiscal 2003 versus the same quarter of
fiscal 2002 is due to more stringent collection and termination policies, which
decreased Days Sales Outstanding to 24.5 days at May 31, 2003 from 59.6 days at
May 31, 2002. The increase in bad debt expense during the nine-month period of
fiscal 2003 as compared to the same period of fiscal 2002 was a direct
consequence of the write-off and deactivation of non-paying accounts and the
institution of more stringent credit policies particularly as applied to
acquired customer accounts of Interland-Georgia, CommuniTech.Net, Dialtone
Internet, and iNNERHOST.
20
INTERLAND, INC.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
DEPRECIATION AND AMORTIZATION
Depreciation and amortization expenses increased 123.7% to $22.2 million and
88.2% to $47.6 million, respectively, for the quarter and for the nine-months
ended May 31, 2003 from $9.9 million and $25.3 million in the same periods of
the prior year. The Company's depreciation and amortization expenses as a
percentage of revenues were 85.7% and 60.0%, respectively, for the quarter and
for the nine-months ended May 31, 2003 as compared to 40.1% and 34.2% in the
same periods of the prior fiscal year. The third quarter increase in fiscal 2003
depreciation expense is partially due to the accelerated depreciation of assets
associated with closed data centers as follows: $1.8 million for the Los Angeles
data center, $0.8 million for the Kansas City data center, and $4.2 million for
the Seattle data center. Also contributing to the increased expense level is
$2.3 million of additional intangible asset amortization charges associated with
fully utilized core technology. The remaining increase is due to $3.2 million of
additional depreciation expense for acquired entities.
RESTRUCTURING COSTS
Restructuring costs increased 429.9% to $2.2 million and 672.4% to $5.6 million,
respectively, for the quarter and for the nine-months ended May 31, 2003 from
$(0.7) million and $(1.0) million in the same periods of the prior year. During
the third quarter of fiscal 2003, the Company's restructuring costs were
associated with the closure and consolidation of data centers and were comprised
of $1.0 million for employee-related severance, $0.5 million for facility lease
termination charges, and $0.7 million for the termination of bandwidth
connectivity contracts. During the third quarter of fiscal 2002, the Company
settled a disputed tenant improvement allowance with the landlord of an exited
facility, which gave rise to a $0.7 million expense reduction. Also during the
nine month period ended May 31, 2002, the Company assigned and transferred
certain data connectivity contracts to SolutionPro, Inc., which released the
Company from previously accrued expenses and resulted in an additional $0.3
million expense reduction.
MERGER AND INTEGRATION COSTS
During the Company's fiscal third quarter, no merger and integration costs were
incurred. During the nine months ended May 31, 2003, $0.5 million of expenses
were incurred for employee severance and relocation payments. During the quarter
and nine-month period ended May 31, 2002, the Company recorded $0.8 million and
$7.9 million for financial advisory services, legal, accounting, relocation,
employee stay bonuses and other non-capitalizable expenses directly related to
merger and integration of the business following the Interland-Georgia
acquisition and other acquisitions occurring in fiscal 2002.
GOODWILL IMPAIRMENT
In accordance with the requirements of SFAS 142, the Company completed its
annual goodwill impairment test which entailed comparing the aggregate market
value of the company's outstanding securities plus its liabilities to the
aggregate carrying value of the Company's assets, including goodwill and other
indefinite life intangible assets. The Company's market price of its stock has
experienced significant volatility over the last fiscal year and closed as of
May 31, 2003, with a market value significantly less that the value at the
beginning of the fiscal year. Management retained valuation specialists to
assist in the valuation of its tangible and identifiable intangible assets for
purposes of determining the implied fair value of goodwill at May 31, 2003. Upon
completion of the annual assessment, Interland recorded a non-cash impairment
charge of $89.9 million to reduce the carrying value of goodwill to its
estimated fair value of $47.6 million.
OTHER EXPENSE (INCOME), NET
During the three month period ended May 31, 2003, the Company recognized $1.6
million of other expenses associated with a loss recognition related to the
disposal of long-lived assets in accordance with SFAS No. 144.
IDENTIFIABLE INTANGIBLE ASSET IMPAIRMENT
Given the Company's aggressive acquisition strategy over the last two years,
significant customer related intangible asset balances have accumulated through
May 31, 2003. The Company has continued to monitor the performance of these
acquired customer related intangible assets and during the third quarter, the
Company determined that revenues, operating profits and
21
INTERLAND, INC.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
cash flows from its Interliant, AT&T and Burlee customer account acquisitions,
as well as customer relationship intangible assets from its CommuniTech,
iNNERHOST and Dialtone acquisitions were materially less than previously
estimated, primarily related to customer and Company initiated terminations. As
such, the Company determined that these identifiable intangible assets needed to
be tested for recoverability. Management used the expected present value of
future cash flows to determine the fair value of these identifiable intangible
assets and determined that the carrying amount of these assets was higher than
their fair values. Upon completion of the assessment, Interland recorded a
non-cash impairment charge of $13.9 million to reduce the carrying value of
identifiable intangible assets to estimated fair values.
INTEREST INCOME (EXPENSE), NET
Interest income (expense), net increased 196.0% to $(74) thousand and decreased
73.7% to $77 thousand respectively, for the quarter and for the nine-months
ended May 31, 2003 from $(25) thousand and $0.3 million for the same periods of
the prior year. Interest income (expense), net consists of interest income
earned on the Company's combined cash and cash equivalents, short-term
investments, and restricted investments of $85.5 million, less interest expense
on debt (primarily capital leases) of $13.8 million. The reduction in interest
income (expense), net is primarily due to the lower levels of cash and liquid
investments that were available for investment, lower interest rates during the
third quarter of fiscal 2003 versus the same period in fiscal 2002, and interest
expense incurred in the early payoff of an outstanding line of credit.
INCOME TAX EXPENSE
Income tax expense of $0.6 million was recorded in the third quarter of fiscal
2003. This expense resulted from an adjustment to the income tax receivable
asset.
NET CASH USED IN OPERATING ACTIVITIES AND EARNINGS FROM CONTINUING OPERATIONS
BEFORE INTEREST, TAXES, DEPRECIATION AND AMORTIZATION (EBITDA)
EBITDA is defined as net income less (i) provision for income taxes, (ii)
interest income or expense, and (iii) depreciation and amortization. EBITDA is
not an indicator of financial performance under generally accepted accounting
principles and may not be comparable to similarly captioned information reported
by other companies. In addition, it does not replace net income (loss),
operating income (loss), or cash flows from operating activities as indicators
of operating performance. The effect of taxes and interest on Interland's net
loss is not significant, but depreciation and amortization, primarily as a
result of acquisitions, is significant. The Company believes that measuring the
performance of the business without regard to non-cash depreciation and
amortization can make trends in operating results more readily apparent, and
when considered with other information, assist investors and other users of the
Company's financial statements who wish to evaluate the Company's ability to
generate future cash flows.
For the third quarter ending May 31, 2003, the Company's EBITDA decreased $109.8
million or 3,048.1% to a loss of $113.4 million as compared to a loss of $3.6
million for the third quarter of fiscal 2002. The decrease in third quarter
EBITDA is primarily the result of the following: $89.9 million for goodwill
impairment, $13.9 million for identifiable intangible asset impairment, and the
$1.6 million loss recognized on the disposal of long lived assets. For the
nine-months ending May 31, 2003, the Company's EBITDA decreased $96.5 million or
342.6% to a loss of $124.7 million as compared to a loss of $28.2 million for
the nine-months ended May 31, 2002. The decrease in year-to-date EBITDA is
primarily due to the same factors affecting the third quarter results and
partially offsetting reductions of a $6.3 million decrease in sales and
marketing costs and a $7.3 million decrease in merger and integration costs.
The following table reflects the calculation of EBITDA from continuing
operations and a reconciliation to net cash provided by (used in) operating
activities:
22
INTERLAND, INC.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
QUARTER ENDED NINE MONTHS ENDED
----------------------- -----------------------
MAY 31, MAY 31, MAY 31, MAY 31,
2003 2002 2003 2002
--------- --------- --------- ---------
Net income (loss) $(136,493) $ 46,129 $(173,328) $ 6,506
--------- --------- --------- ---------
Depreciation and amortization 22,194 9,923 47,590 25,293
Interest expense (income) 74 25 (77) (293)
Income tax expense (benefit) 629 (64,242) 629 (64,242)
Discontinued operations 167 4,562 482 4,562
--------- --------- --------- ---------
EBITDA from continuing operations $(113,429) $ (3,603) $(124,704) $ (28,174)
========= ========= ========= =========
Interest (expense) / income (74) (25) 77 293
Provision for bad debts 1,975 2,612 5,791 5,615
Other non-cash adjustments 106,273 2,544 107,371 4,019
Income tax (expense) benefit (629) 64,242 (629) 64,242
Changes in assets and liabilities:
Income tax recoverable -- -- 778 18,585
Receivables, net (2,086) (1,162) (3,624) (10,363)
Other current assets 820 (205) 477 (336)
Accounts payable, accrued expenses, and deferred revenue (4,185) (10,277) (12,422) (16,168)
--------- --------- --------- ---------
Net cash provided by (used) in operating activities $ (11,335) $ 54,126 $ (26,885) $ 37,713
========= ========= ========= =========
LIQUIDITY AND CAPITAL RESOURCES
As of May 31, 2003, the Company had $46.0 million in cash and cash equivalents
as noted on the Company's consolidated balance sheet and statement of cash
flows. In addition, the Company had $19.5 million in short-term investments and
$20.0 million in short and long-term restricted investments representing a total
of $85.5 million of restricted and unrestricted cash and investments. This
represents a decrease of $62.4 million compared to August 31, 2002.
On a comparative basis cash used in operating activities of continuing
operations increased $64.6 million or 171.3% to $26.9 million for the
nine-months ended May 31, 2003 versus the $37.7 million of cash provided by
operating activities for the same period in the last fiscal year. The primary
reason for the cash provided by operating activities during the nine-months
ended May 31, 2002, is the receipt of approximately $85.0 million of income tax
refunds offset by $56.1 million of cash required to fund operations during that
period. During the nine-months ended May 31, 2003, the Company utilized $17.7
million of cash expenditures for integration and restructuring activities and
$5.4 million to pay off a credit line. Cash provided by investing activities
increased $73.1 million or 173.9% to $31.1 million for the nine-months ended May
31, 2003 versus $42.1 million of cash used in investing activities for the same
period in the last fiscal year. The increase in cash generated from investing
activities is primarily related to changes in the Company's acquisition and
investment philosophy. Recent acquisitions have been financed principally by
stock issuance. The Company's current fiscal year investment strategy has
favored more liquid investment facilities. Cash used in financing activities
decreased $0.6 million or 3.0% to $18.8 million for the nine-month period ended
May 31, 2003 versus the $19.4 million of cash used in financing activities for
the same period of last fiscal year. The decrease in cash used in financing
activities is primarily due to a significantly lower volume of repurchases
during the past three fiscal quarters. Cash used in discontinued operations
decreased $8.2 million or 79.9% to $2.1 million for the nine-months ended May
31, 2003 versus the $10.3 million of cash used to fund discontinued operations
during the same period of the last fiscal year. The primary reason for the
decrease in cash used in discontinued operations is the continued winding down
of the computer products and services businesses.
On July 20, 2001, the Company entered into a financing arrangement with US Bank
under which the Company executed a $5.4 million credit agreement. This agreement
had a stated interest rate of prime less 100 basis points or 3.25%. During the
quarter ended February 28, 2003, this credit agreement was paid in full. The
payoff of this loan released $6.7 million of collateralized cash that was
pledged under this agreement.
In July 2001, the Company entered into a financing arrangement with U.S. Bancorp
Oliver-Allen Technology Leasing for a sale and leaseback of up to $14.6 million
for certain equipment, primarily computer hardware. The stated interest rate on
the facility is 5.75%. In January 2002, the Company repurchased certain of the
leased assets from U.S. Bancorp Oliver-Allen Technology Leasing at a total cost
of $2.9 million. In connection with the repurchase, approximately $3.3 million
of cash and equivalents became unrestricted. As of May 31, 2003, the principal
balance on the facility was $4.9 million. As of May 31,
23
INTERLAND, INC.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
2003, the Company has pledged $8.2 million as collateral for this agreement. The
restrictions prevent the Company from utilizing the related cash and cash
equivalents until all of its obligations under the lease are satisfied.
Prior to the acquisition of iNNERHOST, Inc., iNNERHOST executed a $1.3 million
note to finance the construction of a data center. The note bears an interest
rate of 10.0%. In connection with the acquisition of iNNERHOST the Company
assumed this obligation, which had an outstanding balance of $0.7 million at May
31, 2003. Also prior to acquisition, iNNERHOST executed several term loans to
finance equipment purchases. The Company has assumed these debts, which have an
interest rate of 12.0% and an outstanding balance of $0.1 million at May 31,
2003.
The Company anticipates making capital expenditures of approximately $14.1
million during fiscal 2003, generally for server equipment and related software,
integration and restructuring activities, and other expenditures related to new
customer growth. During the first nine-months of fiscal 2003, the Company
expended $10.0 million on capital equipment purchases.
The Company also expects to use approximately $0.8 million for legal expenses
and remaining contractual obligations related to discontinued operations.
On January 3, 2003, the Company acquired Trellix Corporation, a privately held
developer of software-based Web site solutions. The Company is expected to spend
approximately $3.0 million for the full integration of Trellix and for the
related mainstream-market deployment during fiscal 2003. In connection with the
acquisition, the Company also assumed $0.2 million in capital lease obligations
as well as a $2.5 million working capital deficit.
As of June 13, 2003, the Company acquired Hostcentric, Inc., a privately held
provider of a broad range of Web hosting services to small business and
enterprise customers. The aggregate purchase price was approximately $25.8
million, consisting of $3.0 million in cash and 13.5 million shares of Interland
stock. Additionally, in connection with the acquisition, the Company expects to
assume $1.8 million in debt and capital lease obligations, most of which will
mature within one year after the acquisition.
The Company implemented an integration and transition program designed to reduce
future operating expenses. These expenditures, estimated to total approximately
$24.0 million during fiscal 2003 ($7.0 million for capital expenditures and
$16.5 million for operating expenses), are aimed at streamlining the Company's
infrastructure, completing the integration of acquisitions, upgrading internal
systems, divesting acquired data centers, and consolidating operations. A total
of $22.3 million has been spent for the nine-months ending May 31, 2003, $16.2
million for operations and $6.1 million in capital expenditures.
The Company believes it has adequate cash and liquid resources to fund
operations and planned capital expenditures through fiscal 2004. The Company's
continued future success is dependent upon its ability to achieve and sustain
positive cash flow prior to the depletion of cash resources and to raise funds,
thereafter, if needed.
REVERSE STOCK SPLIT
The Company announced that its board of directors had approved a 1-for-10
reverse stock split expected to go into effect during the fourth quarter.
Management believes that reducing the share count from its current level of
163.2 million shares is appropriate for a company its size, and will permit
meaningful changes in net income to be reflected in meaningful changes in
Earnings Per Share. An anticipated higher price for each share is expected to
permit certain institutional investors, prohibited by their governing rules from
purchasing stocks at prices below a stated threshold to invest in the Company's
stock, and will also reduce transaction costs for those wishing to purchase
significant dollar amounts of the Company's stock.
24
INTERLAND, INC.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
STOCK REPURCHASE PROGRAM
In March 2003, the Board of Directors authorized a stock repurchase program to
acquire outstanding common stock. Under the program, up to $10.0 million of
common stock could be reacquired over the next year. Since its announcement of
the authorization of a share purchase program by its Board of Directors, the
Company utilized $1.0 million to buy back shares of its outstanding stock.
RECENTLY ISSUED ACCOUNTING STANDARDS
The FASB issued FIN No. 45 for all financial statements of interim or annual
reports ending after December 15, 2002. This Interpretation elaborates on the
disclosures to be made by a guarantor in its interim and annual financial
statements about its obligations under certain guarantees that it has issued. It
also clarifies that a guarantor is required to recognize, at the inception of a
guarantee, a liability for the fair value of the obligation undertaken in
issuing the guarantee. This Interpretation does not prescribe a specific
approach for subsequently measuring the guarantor's recognized liability over
the term of the related guarantee. This Interpretation also incorporates,
without change, the guidance in FASB Interpretation No. 34, Disclosure of
Indirect Guarantees of Indebtedness of Others, which is being superseded. The
provisions of this interpretation have no material impact on the Company.
RISK FACTORS
You should carefully consider the following factors and all other information
contained in this Form 10-Q and the Company's recently filed Form 10-K for the
fiscal year ended August 31, 2002 before you make any investment decisions with
respect to the Company's securities. The risks and uncertainties described below
are not the only risks the Company faces.
INTERLAND HAS INCURRED LOSSES SINCE INCEPTION AND COULD INCUR LOSSES IN THE
FUTURE.
Interland has incurred net losses and losses from operations for all but one of
each quarterly period from its inception through the third quarter of fiscal
2003. A number of factors could increase its operating expenses, such as:
- Adapting network infrastructure and administrative resources
to accommodate additional customers and future growth;
- Developing products, distribution, marketing, and management
for the mainstream market;
- Unanticipated liabilities from the sale of GTG PC; and
- Integrating recently acquired businesses.
To the extent that increases in expenses are not offset by increases in
revenues, operating losses could increase.
BECAUSE INTERLAND'S HISTORICAL FINANCIAL INFORMATION IS NOT REPRESENTATIVE OF
ITS FUTURE RESULTS, INVESTORS AND ANALYSTS WILL HAVE DIFFICULTY ANALYZING
INTERLAND'S FUTURE EARNINGS POTENTIAL.
Because the Company has grown through acquisition, and because its past
operating results reflect the costs of integrating these acquisitions, as well
as costs that are not expected to continue, investors and their advisors will
find it challenging to predict future operating expenses. Because the Company
will be primarily seeking to drive growth from the mainstream market, which is a
new market for the Company, investors and their advisors will find it
challenging to predict future revenues.
25
INTERLAND, INC.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
INTERLAND HAS A LIMITED OPERATING HISTORY AND ITS BUSINESS MODEL IS STILL
EVOLVING, WHICH MAKES IT DIFFICULT TO EVALUATE ITS PROSPECTS.
Interland's limited operating history makes evaluating its business operations
and prospects difficult. Its range of service offerings has changed since
inception and its business model is still developing. Interland has changed from
being primarily a seller of personal computers and related accessories to being
primarily a Web hosting company, and has announced it intends to pursue the
mainstream market. Because some of its services are new, the market for them is
uncertain. As a result, the revenues and income potential of its business, as
well as the potential benefits of its acquisitions, may be difficult to
evaluate.
QUARTERLY AND ANNUAL OPERATING RESULTS MAY FLUCTUATE, WHICH COULD CAUSE
INTERLAND'S STOCK PRICE TO BE VOLATILE.
Past operating results have fluctuated on a quarterly and an annual basis.
Quarterly and annual operating results may continue to fluctuate due to a wide
variety of factors. Because of these fluctuations, comparing operating results
from period to period is not necessarily meaningful, and you should not rely
upon such comparisons as an indicator of future performance. Factors that may
cause its operating results to fluctuate include, but are not limited to:
- Demand for and market acceptance of its services;
- Introduction of new services or enhancements by Interland or
its competitors;
- Technical difficulties or system downtime affecting the
Internet generally or its hosting operations specifically;
- Customer retention;
- Increased competition and consolidation within the Web hosting
and applications hosting markets;
- Changes in its pricing policies and the pricing policies of
its competitors; and
- Gains or losses of key strategic relationships.
Interland cannot provide any assurances that it will succeed in its plans to
increase the size of its customer base, the amount of services it offers, or its
revenues during the next fiscal year and beyond. In addition, relatively large
portions of its expenses are fixed in the short term, and therefore its results
of operations are particularly sensitive to fluctuations in revenues. Also, if
it cannot continue using third-party products in its service offerings, its
service development costs could increase significantly.
INTERLAND'S STOCK PRICE MAY BE VOLATILE WHICH COULD CAUSE AN INVESTMENT IN ITS
COMMON STOCK TO DECREASE SIGNIFICANTLY.
The market price of its common stock has experienced a significant decline. The
price has been and is likely to continue to be highly volatile. The following
are examples of developments that would likely reduce the market price of
Interland stock:
- Its failure to benefit from the expected synergies from its
recent mergers and acquisitions;
- Variations in operating results and analyst earnings
estimates;
- The volatility of stock within the sectors within which it
conducts business;
- General decline in economic conditions;
- Reductions in the volume of trading in its common stock and;
- The Company's inability to reduce the rate of account
cancellations, or to increase the rate of adding new accounts,
or both.
26
INTERLAND, INC.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
During the 52 weeks ended June 30, 2003, the high and low closing price for
Interland common stock on NASDAQ was $3.28 and $0.65, respectively.
INTERLAND OPERATES IN A NEW AND EVOLVING MARKET WITH UNCERTAIN PROSPECTS FOR
GROWTH AND MAY NOT BE ABLE TO SUSTAIN GROWTH IN ITS CUSTOMER BASE.
The market for Web hosting and applications hosting services for small- and
medium-sized businesses, and especially the mainstream market, has only recently
begun to develop and is evolving rapidly. Interland's future growth, if any,
will depend upon the willingness of small- and medium-sized businesses to
purchase Web and applications services, Interland's ability to increase or at
least maintain its average revenues-per customer, and its ability to retain
customers. For the three-months ended May 31, 2003, Interland's average monthly
revenue per customer account was $29.60 for shared hosting services and $440.60
for dedicated hosting services, and its average monthly customer turnover was
4.0% for shared hosting services and 6.1% for dedicated hosting services. The
corresponding average monthly revenue per customer for the three-months ended
May 31, 2002 was $25.31 for shared hosting services and $398.13 for dedicated
hosting services, and the associated average monthly customer turnover rates
were 3.9% for shared hosting services and 7.1% for dedicated hosting services.
The market for Interland's services may not develop further, consumers may not
widely adopt its services and significant numbers of businesses or organizations
may not use the Internet for commerce and communication. If this market fails to
develop further or develops more slowly than expected, or if Interland's
services do not achieve broader market acceptance, Interland will not be able to
grow its customer base. In addition, Interland must be able to differentiate its
company from its competition through its service offerings and brand
recognition. These activities may be more expensive than Interland anticipates,
and Interland may not succeed in differentiating itself from its competitors,
achieving market acceptance of its services, or selling additional services to
its existing customer base.
INTERLAND'S ABILITY TO SIGNIFICANTLY ORGANICALLY GROW REVENUE IS DEPENDENT ON
SUCCESSFUL PENETRATION OF THE MAINSTREAM MARKET OF SMALL- AND MEDIUM- SIZED
BUSINESSES LACKING AN EFFECTIVE WEB PRESENCE.
The mainstream market of small- and medium-sized businesses lacking an effective
Web presence has only been evaluated with limited market research and trials;
furthermore, the Company is dependent upon the successful broader market
introduction of the Company's software-based Web site development product
offerings. Delays in seizing this market initiative and/or in the related
product introduction will limit the Company's future revenue growth to modest
levels.
BECAUSE INTERLAND'S TARGET MARKETS ARE VOLATILE, THE COMPANY MAY FACE A LOSS OF
CUSTOMERS OR A HIGH LEVEL OF NON-COLLECTIBLE ACCOUNTS.
The Company intends to continue to concentrate on serving the small- and
medium-sized business market. This market contains many businesses that may not
be successful, and consequently present a substantially greater risk for
non-collectible accounts receivable and for non-renewal. Moreover, a significant
portion of this target market is highly sensitive to price, and may be lost to a
competitor with a lower pricing structure. Because few businesses in this target
market employ trained technologists, they tend to generate a high number of
customer service and technical support calls. The expense of responding to these
calls is considerable, and the expense is likely to increase in direct
proportion to revenue, potentially limiting the scalability of the business.
Additionally, if the customer becomes dissatisfied with the Company's response
to such calls, cancellation, non-payment, or non-renewal becomes more likely.
Interland's strategy for minimizing the negative aspects of its target market
include:
- Continued expenditure on sales and marketing to replace
failing customers;
- Capitalizing on planned efficiencies to become a profitable
provider at the lowest sustainable price;
- Automating customer care and technical support to reduce the
cost per call, and to minimize the time spent by Company
personnel; and,
- Intensive training and supervision of customer care and
technical support personnel to maximize customer satisfaction.
27
INTERLAND, INC.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The Company can give no assurance, however, that any of these measures will be
successful, and the Company's failure to manage these risks could decrease
revenues and profitability.
INTERLAND COULD INCUR LIABILITIES IN THE FUTURE RELATING TO ITS PC SYSTEMS
BUSINESS, WHICH COULD CAUSE ADDITIONAL OPERATING LOSSES.
Interland could incur liabilities from the sale of the PC Systems business to
GTG PC. According to the terms of its agreement with GTG PC, it retained
liabilities relating to the operation of the PC systems business prior to the
closing of the transaction including liabilities for taxes, contingent
liabilities and liabilities for accounts payable accrued prior to the closing.
It also agreed to indemnify GTG PC and its affiliates for any breach of our
representations and warranties contained in the agreement for a period of two
years, or for the applicable statute of limitations for matters related to
taxes. Its indemnification obligation is capped at $10.0 million. Except for
claims for fraud or injunctive relief, this indemnity is the exclusive remedy
for any breach of its representations, warranties and covenants contained in the
agreement with GTG PC. Accordingly, it could be required in the future to make
payments to GTG PC and its affiliates in accordance with the agreement, which
could adversely affect its future results of operations and cash flows. To date
it has not had to satisfy any such claims.
BECAUSE INTERLAND FACES INTENSE COMPETITION, IT MAY NOT BE ABLE TO OPERATE
PROFITABLY IN ITS MARKETS.
The Web hosting and applications hosting markets are highly competitive and are
becoming more so, which could hinder Interland's ability to successfully market
its products and services. The Company may not have the resources, expertise or
other competitive factors to compete successfully in the future. Because there
are few substantial barriers to entry, the Company expects that it will face
additional competition from existing competitors and new market entrants in the
future. Many of Interland's competitors have greater name recognition and more
established relationships in the industry and greater resources. As a result,
these competitors may be able to:
- Develop and expand their network infrastructures and service
offerings more rapidly;
- Adapt to new or emerging technologies and changes in customer
requirements more quickly;
- Take advantage of acquisition and other opportunities more
readily; and
- Devote greater resources to the marketing and sale of their
services and adopt more aggressive pricing policies than the
Company can.
Current and potential competitors in the market include Web hosting service
providers, applications hosting providers, Internet service providers,
telecommunications companies, large information technology firms that provide a
wide array of information technology services, and computer hardware suppliers.
These competitors may operate in one or more of these areas and include
companies such as NTT/Verio, and Affinity Interrnet.
IMPAIRMENT OF INTERLAND'S INTELLECTUAL PROPERTY RIGHTS COULD NEGATIVELY AFFECT
ITS BUSINESS OR COULD ALLOW COMPETITORS TO MINIMIZE ANY ADVANTAGE THAT
INTERLAND'S PROPRIETARY TECHNOLOGY MAY GIVE IT.
The Company currently has no patented technology that would preclude or inhibit
competitors from entering the Web hosting market that it serves. While it is the
Company's practice to enter into agreements with all employees and with some of
its customers and suppliers to prohibit or restrict the disclosure of
proprietary information, the Company cannot be sure that these contractual
arrangements or the other steps it takes to protect its proprietary rights will
prove sufficient to prevent illegal use of its proprietary rights or to deter
independent, third-party development of similar proprietary assets.
Effective copyright, trademark, trade secret and patent protection may not be
available in every country in which its products and services are offered. It
currently is, and in the future may be, involved in legal disputes relating to
the validity or alleged infringement of its intellectual property rights or
those of a third party. Intellectual property litigation is typically extremely
costly and can be disruptive to business operations by diverting the attention
and energies of management and key technical personnel. In addition, any adverse
decisions could subject it to significant liabilities, require it to seek
licenses from others,
28
INTERLAND, INC.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
prevent it from using, licensing or selling certain of its products and
services, or cause severe disruptions to operations or the markets in which it
competes which could decrease profitability.
Periodically, it is made aware of claims, or potential claims, that technology
it used in its discontinued operations may have infringed on intellectual
property rights held by others. It has accrued a liability and charged
operations for the estimated costs of settlement or adjudication of several
asserted and unasserted claims for alleged infringement relating to its
discontinued operations prior to the balance sheet date. Resolution of these
claims could be costly and decrease profitability.
UNFAVORABLE RESULTS OF EXISTING LITIGATION MAY CAUSE INTERLAND TO HAVE
ADDITIONAL EXPENSES OR OPERATING LOSSES.
Interland is defending an employee class action lawsuit filed in the U.S.
District Court for Idaho. In this case, five individual plaintiffs claim that
when they were employees of Micron Electronics Inc. ("MEI") between 1999 and
April 2001, they and other similarly situated employees did not receive overtime
pay to which they were entitled under the Fair Labor Standards Act. Interland
disputes these claims and believes the plaintiffs are not entitled to any
material additional wages. The court conditionally certified a class of not more
than eight hundred former employees, and notices of the litigation are being
sent to these persons to give them the opportunity to "opt in" to the
litigation. The parties are continuing to conduct discovery. At this early stage
of the litigation, Interland is unable to estimate its total expenses, possible
loss or range of loss that may ultimately be connected with the matter. This
potential liability remains with Interland even though it sold the PC Systems
business.
In February of 2003, the Company filed a lawsuit in Cobb County, Georgia against
Mr. Gabriel Murphy, one of the former principals of Communitech, which was
acquired by Interland in February 2002. The Company's lawsuit claims, among
other things, that Mr. Murphy breached certain covenants under his employee
agreement, and also demands payment from Mr. Murphy under his delinquent $2.7
million promissory note. These notes are collateralized by 2,735,257 shares of
the Company's common stock, and the receivable balance is shown on the balance
sheet as a reduction in equity.
Messrs. Heitman and Murphy filed a lawsuit against Interland, its CEO, Mr. Joel
Kocher, and Interland's subsidiary Communitech.net, Inc., in Jackson County,
Missouri claiming, among other things, that Interland acted unreasonably in
failing to have the S-3 registration statement declared effective by the SEC on
a timely basis and claiming that Interland and/or Mr. Kocher made inaccurate
disclosures in connection with Interland's acquisition of Communitech. The
complaint asks for compensatory and punitive damages in an unspecified amount.
Interland believes that these claims are without merit and will not have a
material adverse effect on Interland, and intends to vigorously defend the
claims.
On March 14, 2003, Halo Management, LLC, filed a suit against Interland in the
U.S. District Court for the Northern District of California. The suit alleges
that Interland's use of "blueHALO" (U.S. Patent and Trademark Office Serial No.
78/135,621) to describe its proprietary web hosting architecture infringes on
the plaintiff's registered trademark Halo (U.S. Patent and Trademark Office
Serial No. 75/870,390; Registration No. 2,586,017). The suit requests an
injunction against Interland's use of its blueHALO mark and money damages.
Interland is investigating the matter but believes it will have meritorious
defenses and plans to vigorously defend the matter.
Periodically, the Company is made aware that technology it used in its
discontinued operations may have infringed on intellectual property rights held
by others. The Company has evaluated all such claims and, if necessary and
appropriate, sought to obtain licenses for the use of such technology. If the
Company or its suppliers were unable to obtain licenses necessary to use
intellectual property in its discontinued operation's products or processes, it
may be forced to defend legal actions taken against it relating to allegedly
protected technology. The Company evaluates all such claims and has accrued a
liability and charged discontinued operations for the estimated costs of
settlement or adjudication of claims for alleged infringement as of the
respective dates of the balance sheets included in this report. As of May 31,
2003, the Company had an aggregate amount of $0.5 million accrued for such
matters.
In accordance with SFAS No. 5 "Accounting for Contingencies" the Company
believes it has adequately reserved for the contingencies arising from the above
legal matters where an outcome was deemed to be probable and the loss amount
could be reasonably estimated. As such, the Company does not believe that the
anticipated outcome of the aforementioned proceedings will have a materially
adverse impact on its results of operations, its financial condition or its cash
flows.
29
INTERLAND, INC.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The Company is also a defendant in a number of other lawsuits which the Company
regards as minor and unlikely to result in any material payment; nonetheless,
the outcome of litigation may not be assured, and the Company's cash balances
could be materially affected by an adverse judgment.
IF INTERLAND IS UNABLE TO ATTRACT AND RETAIN KEY PERSONNEL, IT MAY NOT BE ABLE
TO COMPETE EFFECTIVELY IN ITS MARKET.
The future success of Interland will depend, in part, on its ability to attract
and retain key management, technical, and sales and marketing personnel. The
Company attempts to enhance its management and technical expertise by recruiting
qualified individuals who possess desired skills and experience in certain
targeted areas. The Company experiences strong competition for such personnel in
the Web hosting industry. The Company's inability to retain employees and
attract and retain sufficient additional employees, information technology,
engineering, and technical support resources could adversely affect its ability
to remain competitive in its markets. The Company may face the loss of key
personnel, which could limit the ability of the Company to develop and market
its products and services.
INTERLAND DEPENDS ON ITS RESELLER SALES CHANNEL TO MARKET AND SELL MANY OF ITS
SERVICES. INTERLAND DOES NOT CONTROL ITS RESELLERS, AND IF IT FAILS TO DEVELOP
OR MAINTAIN GOOD RELATIONS WITH RESELLERS, IT MAY NOT ACHIEVE THE GROWTH IN
CUSTOMERS AND REVENUES THAT IT EXPECTS.
An element of the strategy for the Company's growth is to further develop the
use of third parties that resell its services. Many of these resellers are Web
development or Web consulting companies that also sell Interland's Web hosting
services, but that generally do not have established customer bases to which
they can market these services. The Company is not currently dependent on any
one reseller to generate a significant level of business, but it has benefited
from business generated by the reseller channel. Although Interland attempts to
provide its resellers with incentives such as price discounts on its services
that the resellers seek to resell at a profit, the failure of its services to be
commercially accepted in some markets, whether as a result of a reseller's
performance or otherwise, could cause its current resellers to discontinue their
relationships with the Company.
INTERLAND IS VULNERABLE TO SYSTEM FAILURES, WHICH COULD HARM ITS REPUTATION,
CAUSE ITS CUSTOMERS TO SEEK REIMBURSEMENT FOR SERVICES, AND CAUSE ITS CUSTOMERS
TO SEEK ANOTHER PROVIDER FOR SERVICES.
The Company must be able to operate the systems that manage its network around
the clock without interruption. Its operations will depend upon its ability to
protect its network infrastructure, equipment and customer files against damage
from human error, fire, earthquakes, hurricanes, floods, power loss,
telecommunications failures, sabotage, intentional acts of vandalism and similar
events. Although the Company has attempted to build redundancy into its
networks, its networks are currently subject to various points of failure. For
example, a problem with one of its routers (devices that move information from
one computer network to another) or switches could cause an interruption in the
services the Company provides to a portion of its customers. In the past, the
Company has experienced periodic interruptions in service. In the past, the
Company has also experienced, and in the future it may experience, delays or
interruptions in service as a result of the accidental or intentional actions of
Internet users, current and former employees, or others. In addition, failure of
any of its telecommunications providers to provide the data communications
capacity that the Company requires, as a result of human error, a natural
disaster or other operational disruption, could result in interruptions in
services. Any future interruptions could:
- Cause customers or end users to seek damages for losses
incurred;
- Require the Company to replace existing equipment or add
redundant facilities;
- Damage the Company's reputation for reliable service;
- Cause existing customers to cancel their contracts; or
- Make it more difficult for the Company to attract new
customers.
30
INTERLAND, INC.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
INTERLAND'S DATA CENTERS AND NETWORKS VULNERABILITY TO SECURITY BREACHES COULD
CAUSE DISRUPTIONS IN ITS SERVICE, LIABILITY TO THIRD PARTIES, OR LOSS OF
CUSTOMERS.
A significant barrier to electronic commerce and communications is the need for
secure transmission of confidential information over public networks. Some of
the Company's services rely on security technology licensed from third parties
that provides the encryption and authentication necessary to effect the secure
transmission of confidential information. Despite the design and implementation
of a variety of network security measures by the Company, unauthorized access,
computer viruses, accidental or intentional actions and other disruptions could
occur. In addition, inappropriate use of the network by third parties could also
potentially jeopardize the security of confidential information, such as credit
card and bank account numbers stored in the Company's computer systems. These
security problems could result in the Company's liability and could also cause
the loss of existing customers and potential customers.
Although the Company continues to implement industry-standard security measures,
third parties may be able to overcome any measures that it implements. The costs
required to eliminate computer viruses and alleviate other security problems
could be prohibitively expensive and the efforts to address such problems could
result in interruptions, delays or cessation of service to customers, and harm
the Company's reputation and growth. Concerns over the security of Internet
transactions and the privacy of users may also inhibit the growth of the
Internet, especially as a means of conducting commercial transactions.
DISRUPTION OF INTERLAND'S SERVICES CAUSED BY UNKNOWN SOFTWARE OR HARDWARE
DEFECTS COULD HARM ITS BUSINESS AND REPUTATION.
The Company's service offerings depend on complex software and hardware,
including proprietary software tools and software licensed from third parties.
Complex software and hardware may contain defects, particularly when first
introduced or when new versions are released. The Company may not discover
software or hardware defects that affect its new or current services or
enhancements until after they are deployed. Although Interland has not
experienced any material software or hardware defects to date, it is possible
that defects may exist or occur in the future. These defects could cause service
interruptions, which could damage its reputation or increase its service costs,
cause it to lose revenue, delay market acceptance or divert its development
resources.
PROVIDING SERVICES TO CUSTOMERS WITH CRITICAL WEB SITES AND WEB-BASED
APPLICATIONS COULD POTENTIALLY EXPOSE INTERLAND TO LAWSUITS FOR CUSTOMERS' LOST
PROFITS OR OTHER DAMAGES.
Because the Company's Web hosting and applications hosting services are critical
to many of its customers' businesses, any significant interruption in those
services could result in lost profits or other indirect or consequential damages
to its customers as well as negative publicity and additional expenditures for
it to correct the problem. Although the standard terms and conditions of the
Company's customer contracts disclaim liability for any such damages, a customer
could still bring a lawsuit against it claiming lost profits or other
consequential damages as the result of a service interruption or other Web site
or application problems that the customer may ascribe to it. A court might not
enforce any limitations on its liability, and the outcome of any lawsuit would
depend on the specific facts of the case and legal and policy considerations
even if the Company believes it would have meritorious defenses to any such
claims. In such cases, it could be liable for substantial damage awards. Such
damage awards might exceed its liability insurance by unknown but significant
amounts, which would seriously harm its business.
INTERLAND COULD FACE LIABILITY FOR INFORMATION DISTRIBUTED THROUGH ITS NETWORK.
The law relating to the liability of online services companies for information
carried on or distributed through their networks is currently unsettled. Online
services companies could be subject to claims under both United States and
foreign law for defamation, negligence, copyright or trademark infringement,
violation of securities laws or other theories based on the nature and content
of the materials distributed through their networks. Several private lawsuits
seeking to impose such liability upon other entities are currently pending
against other companies. In addition, organizations and individuals have sent
unsolicited commercial e-mails from servers hosted by service providers to
massive numbers of people, typically to advertise products or services. This
practice, known as "spamming," can lead to complaints against service providers
that enable such activities, particularly where recipients view the materials
received as offensive. The Company may, in the future, receive letters from
recipients of information transmitted by its customers objecting to such
transmission. Although the Company prohibits its
31
INTERLAND, INC.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
customers by contract from spamming, it cannot provide assurances that its
customers will not engage in this practice, which could subject it to claims for
damages. In addition, the Company may become subject to proposed legislation
that would impose liability for or prohibit the transmission over the Internet
of some types of information. Other countries may also enact legislation or take
action that could impose liability on the Company or cause it not to be able to
operate in those countries. The imposition upon the Company and other online
services of potential liability for information carried on or distributed
through its systems could require it to implement measures to reduce its
exposure to this liability, which may require it to expend substantial
resources, or to discontinue service offerings. The increased attention focused
upon liability issues as a result of these lawsuits and legislative proposals
also could affect the growth of Internet use.
INTERLAND'S BUSINESS OPERATES IN AN UNCERTAIN LEGAL ENVIRONMENT WHERE FUTURE
GOVERNMENT REGULATION AND LAWSUITS COULD RESTRICT INTERLAND'S BUSINESS OR CAUSE
UNEXPECTED LOSSES.
Due to the increasing popularity and use of the Internet, laws and regulations
with respect to the Internet may be adopted at federal, state and local levels,
covering issues such as user privacy, freedom of expression, pricing,
characteristics and quality of products and services, taxation, advertising,
intellectual property rights, information security and the convergence of
traditional telecommunications services with Internet communications. The
Company cannot fully predict the nature of future legislation and the manner in
which government authorities may interpret and enforce. As a result, Interland
and its customers could be subject to potential liability under future
legislation, which in turn could have a material adverse effect on the Company's
business. For example, if legislation were adopted in the U.S. or
internationally that makes transacting business over the Internet less favorable
or otherwise curtails the growth of the Internet; the Company's business would
suffer. The adoption of any such laws or regulations might decrease the growth
of the Internet which in turn could decrease the demand for the Company's
services, or increase the cost of doing business, or in some other manner harm
its business. In addition, applicability to the Internet of existing laws
governing issues such as property ownership, copyright and other intellectual
property issues, taxation, libel, obscenity and personal privacy is uncertain.
These laws generally pre-date the advent of the Internet and related
technologies and, as a result, do not consider or address the unique issues of
the Internet and related technologies. Changes to laws intended to address these
issues could create uncertainty in the marketplace that could reduce demand for
the Company's services or increase the cost of doing business as a result of
costs of litigation or increased service delivery costs.
RESOLVING WEAKNESSES IN DISCLOSURE AND INTERNAL CONTROLS COULD REQUIRE MORE TIME
THAN ANTICIPATED, DISTRACT MANAGEMENT'S ATTENTION FROM INTERLAND'S DAY TO DAY
OPERATIONS, OR ALLOW ONGOING COST INEFFICIENCIES.
Interland disclosed in its Form 10-K for the fiscal year ending August 31, 2002
that it had some material weaknesses in its internal and disclosure controls and
procedures. In Part II - Item 4 of this Form 10-Q for the quarter ending
May 31, 2003, Interland reported significant progress in several areas. In
addition management believes that its use of alternative mitigating disclosure
and reporting processes have been sufficient to provide it with a good faith
belief that there are no material inaccuracies or omissions from its recent Form
10-K or Form 10-Q. However, management recognizes that further improvements in
its disclosure controls and procedures and internal controls and procedures are
appropriate. The implementation of these remaining improvements will be time
consuming and expensive. In this regard management is unable to estimate the
financial impact of:
- - A delay in the implementation of remaining necessary internal and
disclosure control improvements;
- - The effects of management's distraction caused by the implementation of
the procedural improvements; and,
- - The ongoing cost inefficiencies caused by the weaknesses in internal
controls pending completion of the requisite improvements.
Furthermore, uncertainty over these factors and the delay in implementation may
cause additional volatility in Interland's stock price.
SUBSTANTIAL FUTURE SALES OF SHARES BY SHAREHOLDERS COULD NEGATIVELY AFFECT ITS
STOCK PRICE.
If its shareholders sell substantial amounts of its common stock in the public
market, the market price of its common stock could decline. Micron Technology
Foundation beneficially owned approximately 43% of its outstanding common stock
at the
32
INTERLAND, INC.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
time of the Interland-Georgia transaction. On February 8, 2002, Micron
Technology Foundation sold approximately 52.8 million shares. The parties who
purchased the shares held by the Foundation have the right to require the
Company to register their shares for sale pursuant to an existing registration
rights agreement, and most are among the selling shareholders in a separate Form
S-3 Registration (File No. 333-96647). As of February 6, 2003, the shares
purchased from the Foundation are now also eligible for resale on the public
markets without registration, subject to volume limitations and holding period
requirements imposed by Rule 144 of the Securities Act. In addition, the
Company's shares distributed to the iNNERHOST shareholders became available for
sale after May 6, 2003.
33
INTERLAND, INC.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Substantially all of the Company's liquid investments and a majority of its debt
are at fixed interest rates, and therefore the fair value of these instruments
is affected by changes in market interest rates. As of May 31, 2003,
approximately 84.4% of the Company's liquid investments mature within three
months and 100% mature within one year. As of May 31, 2003, management believes
the reported amounts of liquid investments and debt to be reasonable
approximations of their fair values. Generally, the fair market value of fixed
interest rate investment securities will increase as interest rates fall and
decrease as interest rates rise. The Company does not use derivative financial
instruments in its investment portfolio. The portfolio has been primarily
comprised of commercial paper rated A1/P1, bank certificates rated AA or better,
and corporate medium-term notes rated AA or better. At May 31, 2003, the
Company's investment portfolio included fixed rate securities with an estimated
fair value of $57.7 million. The interest rate changes affect the fair market
values but do not impact earnings or cash flows. The fair market value of
long-term fixed interest rate debt is also subject to interest rate risk.
Generally, the fair market of fixed interest rate debt will increase as interest
rates fall and decrease as interest rates rise. The estimated fair value of the
Company's long-term debt at May 31, 2003 was $3.3 million.
34
INTERLAND, INC.
ITEM 4. CONTROLS AND PROCEDURES
The Company's chief executive officer, chief financial officer, and chief
accounting officer evaluated the effectiveness of the Company's disclosure
controls and procedures (as defined in the Securities Exchange Act of 1934 Rules
13(a) - 14(c), and 15(d), which became effective August 29, 2002) within the 90
days preceding the filing of this quarterly report, in connection with the
preparation of its quarterly report on Form 10-Q for the three months ending May
31, 2003. Based on this review, the chief executive officer, chief financial
officer, and chief accounting officer concluded that Interland's disclosure
controls and procedures continue to require further improvement.
INTERNAL CONTROLS
The Company's internal and disclosure controls and procedures are necessarily
interdependent. During the course of the fiscal 2002 year-end close and
subsequent audit, the Company's management and its auditors identified several
matters related to internal controls that needed to be addressed. Several of
these matters were classified by the auditors as material weaknesses or
reportable conditions in accordance with the standards of the American Institute
of Certified Public Accountants. The Company's chief executive officer, chief
financial officer, chief accounting officer, and Audit Committee are aware of
these conditions and of the Company's responses. The following factors
contributed to the control conditions:
- Rapid growth of the Company;
- Twelve recent company and account acquisitions;
- Significant rate of turnover of key personnel; and,
- Legacy systems developed internally for much smaller
enterprises.
Since September 1, 2002, the Company has reevaluated its staffing levels,
reorganized the finance and accounting organization and hired ten additional
experienced accounting personnel, including a Chief Financial Officer, AVP and
Corporate Controller, and a Director of Revenue and Receivables Assurance.
Discussed below are the material weaknesses and reportable conditions identified
by management and its independent auditors, and the Company's corrective actions
through July 14, 2003.
MATERIAL WEAKNESSES
Accounts were not being appropriately analyzed and adjusted in a timely manner.
The auditors recommended that management institute a thorough close out process,
including a detailed review of the financial statements, comparing budget to
actual and current period to prior period to determine any unusual items. They
also recommended that the Company prepare an accounting policy and procedures
manual for all significant transactions to include procedures for revenue
recognition, business and account acquisitions, accounts receivable allowance,
and accruals.
In response, in November 2002, the Company revised and improved its month end
close process and created a checklist containing detailed close procedures. The
Company now performs monthly account reconciliations on all balance sheet
accounts across all subsidiaries. Also, beginning in November 2002, on a
monthly basis the functional manager or director one level above the preparer
reviews all balance sheet account reconciliations. The accounting team is
preparing an accounting policy and procedures manual to include procedures for
all significant policies, business practices, routine and non-routine
procedures performed by each functional area, which it will finalize in the
fourth quarter of fiscal 2003. Finally, under procedures adopted in November
2002, the Company's financial accounting and reporting department prepares a
monthly reporting package that includes management's discussion and analysis of
results of operations, financial statements, cash and investments reporting,
month-to-month variances and departmental results of operations.
35
INTERLAND, INC.
ITEM 4. CONTROLS AND PROCEDURES
The Company was not appropriately calculating deferred revenue on its hosting
contracts. Interland-Georgia, the company acquired in August 2001, had a policy
since inception of taking all revenue in the month of billing for month-to-month
bills ("monthly" customers) and utilized a half-month convention in the first
month for customers with a contract two months or longer ("term" customers). The
calculation of deferred revenue was very manual and was calculated on large
amortization spreadsheets.
The acquiring company used different methods, depending on location, to
calculate deferred revenue, but in all cases, attempted to match the revenue
recognition over the contract period. This was done either through the
utilization of half-month convention or verification that the billings
predominately occurred on the first of the month, therefore allowing a full
month of revenue since contracts are billed in advance.
During fiscal 2002, as the Company transitioned its billing to the
Interland-Georgia facility, the Interland-Georgia approach of no deferrals on
month-to-month service contracts was adopted. Also, during the third quarter,
the Company mechanized its deferred revenue calculation. This new process took
the active customer file and calculated the deferred revenue balance based on
the customer contract terms. The logic underlying the calculation, however,
calculated deferred revenue based on the "next whole month," in effect removing
the half-month convention for term customers and recognizing this as revenue.
As a result of this error, the Company restated its quarterly reports for the
first three quarters of fiscal year 2002 and now correctly calculates deferred
revenue for all hosting contracts on a consistent basis.
The Company did not have an efficient system for monitoring accounts receivable.
The Company's internally developed billing systems (MAARS/OASIS) require
significant manual intervention. In the third quarter of fiscal 2002, management
learned that the accounts receivable aging report generated from MAARS was
improperly excluding certain customer credits, therefore overstating accounts
receivable.
The aforementioned excluded credits have since been recorded and the faulty
accounts receivable aging program has been replaced.
Balances that were not collected in the over 90 days categories were written
off. Accounts receivable balances are now written off at 61 days. The Company
generally no longer recognizes revenue from customers with invoices more than 30
days past due until the invoice is paid. The Company also maintains a balance in
the allowance for doubtful accounts to cover specific percentages of the
accounts receivable aging categories: 7.4% of the 0-60 day balance, and 100% of
all balances more than 60 days old. In February 2003, the Company instituted a
new credit policy generally denying service to customers with balances greater
than 30 days past due.
The Company has continued to redesign the billing system to provide additional
functionality and reporting capabilities through a transaction log and, while it
may not be the most robust system, the enhancements to the system and
modifications to business processes have mitigated the weaknesses previously
identified.
The Company invested significant time and money working with IBM's Business
Process Consulting Group to evaluate all of its customer account management
practices. Included in this process was the selection of a new billing system
that will have a General Ledger interface. The new billing system will be fully
implemented by December 2003. Until the new system is fully implemented, the
accounting department will continue to perform extensive monthly analytical
reviews of billings as an additional control procedure to mitigate the
weaknesses in the current system.
REPORTABLE CONDITIONS
Restructuring and purchase accounting accruals (bandwidth and lease
terminations) had not been reviewed for adequacy prior to year-end. As a result,
several large adjustments were recorded after the close of the general
36
INTERLAND, INC.
ITEM 4. CONTROLS AND PROCEDURES
ledger. The Company's auditors recommended that these accruals be reviewed and
adjusted quarterly based on the best information available to management at that
time with changes in the estimates appropriately supported.
In connection with the modifications made within the accounting department and
significant improvements to the monthly close process mentioned above, beginning
in November 2002, all balance sheet accruals, prepaids, and deferrals including
restructuring and business combination accruals are being monitored, reconciled
and adjusted on a monthly basis. Additionally, the monthly account
reconciliations for accrued restructuring and business combination accruals
include details of all activity, and ending balances are reviewed and adjusted
at each review date.
The Company did not have effective controls in place to ascertain that the
Company's stock option plan administrator properly recorded stock option grants.
The auditors recommended timely review by Human Resources to ensure that data
supplied to the administrator is appropriately recorded.
Interland converted to a new stock plan administrator effective November 2002.
The Human Resources department has audited the underlying data to ensure
conversion of accurate information. Identified discrepancies were corrected.
Human Resources has implemented a review process using edit/change reports from
its administrator.
Management also identified the following additional weakness, which did not
constitute a material weakness or reportable condition under AICPA standards:
The Company's accounting procedures as pertaining to opening balance sheet
amounts and liabilities of acquired entities need strengthening and could result
in the subsequent recognition of additional liabilities not previously disclosed
by the seller. In response to this issue, prior to the closing of the Trellix
and Hostcentric acquisitions, the Company's qualified accounting and financial
personnel completed a thorough review of the seller's books and records.
DISCLOSURE CONTROLS
In January 2003, the Company instituted monthly meetings to review each
significant department's activities. Each department was assigned an analyst to
assist line management in analyzing financial performance and forecasting.
Additionally, the department tracks non-financial metrics such as headcount and
bandwidth costs. Monthly reports are presented to the Chief Financial Officer,
the Corporate Controller, and the Chief Financial Analyst at a monthly Financial
Review meeting, and a similar report is presented to the Chief Financial Officer
and the Chief Executive Officer at an Operations Review meeting. The department
heads each meet at least monthly with the Chief Executive Officer. Management
believes that this process helps to inform senior management of material
developments that affect the business, and aids in providing adequate
disclosure.
Management has moved expeditiously, committing considerable resources to address
the internal control deficiencies it has identified to date. However, not all of
the salutary procedures and actions deemed desirable by management have been
able to be fully executed to date. It will take some additional time to realize
all of the benefits of the Company's initiatives.
Interland is committed to ongoing periodic reviews of its controls and their
effectiveness. Controls are improving and management has no reason to believe
that the financial statements included in this report are not fairly stated in
all material respects. However, new problems could be identified in the future.
Management expects to continue to improve controls with each passing quarter.
Management expects to have the internal and disclosure controls discussed herein
in effect by August 31, 2003, except for the new billing system, which will be
implemented by December 31, 2003.
Management believes that its practices and procedures, albeit not as mature or
as formal as management intends them to be in the future, are adequate under the
circumstances, and that there are no material inaccuracies or omissions in this
Form 10-Q.
In addition to the responses outlined above, the following actions have been or
are being taken to strengthen disclosure and internal controls:
37
INTERLAND, INC.
ITEM 4. CONTROLS AND PROCEDURES
- Maintenance of specific documentation files to support
financial statement and footnote disclosures are now in
effect;
- Conduct and document quarterly reviews as to the effectiveness
of our internal and disclosure controls. Now in effect;
- Circulating for review the Company's public filings to key
members of the senior management team representing each
functional area. These individuals have been charged with
ensuring that the filings include all required disclosures.
These procedures were in effect for the quarter ended February
28, 2003.
- Create an internal questionnaire and disclosure certification
document to be completed by each senior vice president and
designed to ensure that all material and required disclosures
are disclosed in our public filings. These procedures are in
the process of being formalized and will be fully in effect
for the fourth quarter and fiscal year ended August 31, 2003.
38
INTERLAND, INC.
PART II. - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Interland is defending an employee class action lawsuit filed in the U.S.
District Court for Idaho. In this case, five individual plaintiffs claim that
when they were employees of Micron Electronics Inc. ("MEI") between 1999 and
April 2001, they and other similarly situated employees did not receive overtime
pay to which they were entitled under the Fair Labor Standards Act. Interland
disputes these claims and believes the plaintiffs are not entitled to any
material additional wages. The court conditionally certified a class of not more
than eight hundred former employees, and notices of the litigation are being
sent to these persons to give them the opportunity to "opt in" to the
litigation. The parties are continuing to conduct discovery. At this early stage
of the litigation, Interland is unable to estimate its total expenses, possible
loss or range of loss that may ultimately be connected with the matter. This
potential liability remains with Interland even though it sold the PC Systems
business.
In February of 2003, the Company filed a lawsuit in Cobb County, Georgia against
Mr. Gabriel Murphy, one of the former principals of Communitech, which was
acquired by Interland in February 2002. The Company's lawsuit claims, among
other things, that Mr. Murphy breached certain covenants under his employee
agreement, and also demands payment from Mr. Murphy under his delinquent $2.7
million promissory note. These notes are collateralized by 2,735,257 shares of
the Company's common stock, and the receivable balance is shown on the balance
sheet as a reduction in equity.
Messrs. Heitman and Murphy filed a lawsuit against Interland, its CEO, Mr. Joel
Kocher, and Interland's subsidiary CommuniTech.Net, Inc., in Jackson County,
Missouri claiming, among other things, that Interland acted unreasonably in
failing to have the S-3 registration statement declared effective by the SEC on
a timely basis and claiming that Interland and/or Mr. Kocher made inaccurate
disclosures in connection with Interland's acquisition of Communitech. The
complaint asks for compensatory and punitive damages in an unspecified amount.
Interland believes that these claims are without merit and will not have a
material adverse effect on Interland, and intends to vigorously defend the
claims.
On March 14, 2003, Halo Management, LLC, filed a suit against Interland in the
U.S. District Court for the Northern District of California. The suit alleges
that Interland's use of "blueHALO" (U.S. Patent and Trademark Office Serial No.
78/135,621) to describe its proprietary web hosting architecture infringes on
the plaintiff's registered trademark Halo (U.S. Patent and Trademark Office
Serial No. 75/870,390; Registration No. 2,586,017). The suit requests an
injunction against Interland's use of its blueHALO mark and money damages.
Interland is investigating the matter but believes it will have meritorious
defenses and plans to vigorously defend the matter.
Periodically, the Company is made aware that technology it used in its
discontinued operations may have infringed on intellectual property rights held
by others. The Company has evaluated all such claims and, if necessary and
appropriate, sought to obtain licenses for the use of such technology. If the
Company or its suppliers were unable to obtain licenses necessary to use
intellectual property in its discontinued operation's products or processes, it
may be forced to defend legal actions taken against it relating to allegedly
protected technology. The Company evaluates all such claims and has accrued a
liability and charged discontinued operations for the estimated costs of
settlement or adjudication of claims for alleged infringement as of the
respective dates of the balance sheets included in this report. As of May 31,
2003, the Company had an aggregate amount of $0.5 million accrued for such
matters.
In accordance with SFAS No. 5 "Accounting for Contingencies" the Company
believes it has adequately reserved for the contingencies arising from the above
legal matters where an outcome was deemed to be probable and the loss amount
could be reasonably estimated. As such, the Company does not believe that the
anticipated outcome of the aforementioned proceedings will have a materially
adverse impact on its results of operations, its financial condition or its cash
flows.
The Company is also a defendant in a number of other lawsuits which the Company
regards as minor and unlikely to result in any material payment; nonetheless,
the outcome of litigation may not be assured, and the Company's cash balances
could be materially affected by an adverse judgment.
39
INTERLAND, INC.
PART II. - OTHER INFORMATION
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
Effective August 1, 2002, the Company acquired iNNERHOST, Inc. for an aggregate
purchase price of $17.7 million, consisting of approximately $5.2 million in
cash and shares of Interland common stock. During April 2003, the Company issued
an additional 5,530,284 shares of Interland common stock in accordance with a
price protection provision included in the purchase agreement. The acquisition
of iNNERHOST was accounted for in accordance with SFAS No. 141, "Business
Combinations," and accordingly, the contingently issued shares of the Company's
stock did not affect the aggregate cost of the acquisition. The Company relied
on Section 4(2) of the Securities Act of 1933 and Regulation D promulgated
thereunder on the basis that the transaction did not involve any public
offering. There were a limited number of purchasers, all of whom were accredited
investors who owned shares of iNNERHOST, and acquired the shares for investment.
None of the investors were solicited by means of a general solicitation, and all
were considered sophisticated.
In January 2003, Mr. Kocher was awarded a stock grant of 91,451 shares with a
market value of $113,400. The grant was in recognition of Mr. Kocher's voluntary
election to forego his 2001 bonus that, if paid, would have equaled $113,400,
determined by dividing $113,400 by $1.24, the market closing price per share on
the day preceding the stock grant. Exemption from the registration provisions of
the Securities Act for this was claimed under Section 4(2) of the Securities Act
and the rules and regulations promulgated thereunder on the basis that such
transaction did not involve any public offering, the purchaser was sophisticated
with access to the kind of information registration would provide and that such
purchaser acquired such securities without a view towards distribution thereof.
In addition, exemption from the registration provisions of the Securities Act
for the transaction was claimed under Section 3(b) of the Securities Act on the
basis that such securities were issued pursuant to a written compensatory
benefit plan or pursuant to a written contract relating to compensation and not
for capital raising purposes.
40
INTERLAND, INC.
PART II. - OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(A) Exhibits:
Exhibit Description
------- -----------
2.1(1) Agreement and Plan of Merger dated as of December 19, 2002 by
and among Interland, Inc., Bobcat Acquisition Corporation,
Hostcentric, Inc., and William Bunting, Steve Harter, and
Dominique Bellanger as Stockholders Representatives
(incorporated by reference to the Registrant's Current Report
on Form 8-K filed on 12/20/02).
2.10(1) Merger Agreement and Plan of Reorganization, dated as of
December 11, 2002, among Trellix Corporation, Interland, Inc.
and Cheetah Acquisition Corporation (incorporated by reference
to the Registrant's registration Statement on Form S-3 filed
on 1/22/03).
3.01 Unofficial Restated Articles of Incorporation of Registrant
(as amended through April 24, 2002) (incorporated by reference
to the Registrant's Quarterly Report on Form 10-Q for the
quarter ended 5/31/02).Unofficial Restated Bylaws of the
Registrant (as amended through April 24, 2002) (incorporated
by reference to the Registrant's Quarterly Report on Form 10-Q
for the quarter ended 5/31/02).
10.1 Escrow Agreement dated as of June 13, 2003, by and among
Interland, Inc., William B. Bunting, Steve Harter, and
Dominique Bellanger, and Suntrust Bank, a Georgia banking
corporation (the "Escrow Agent")
99.1 Certification of Chief Executive Officer under Section 906 of
the Sarbanes-Oxley Act of 2002.
99.2 Certification of Chief Financial Officer under Section 906 of
the Sarbanes-Oxley Act of 2002.
(1) Schedules and exhibits have been omitted from this exhibit. A
list of omitted schedules and exhibits is set forth at the end of the exhibit.
Copies will be provided to the Commission upon request.
(B) Reports on Form 8-K.
On January 13 2003, the Company filed a Form 8-K with a press release
regarding its financial targets for the fourth quarter of the fiscal year ended
August 31, 2003.
On March 24, 2003, the Company filed a Form 8-K/A to amend its Form 8-K
of January 13, 2003 to disclose certain non-GAAP information pursuant to Item 9
of Form 8-K, instead of Item 5 of Form 8-K as disclosed in Interland's Form 8-K
filed January 13, 2003.
On March 27, 2003, the Company filed a Form 8-K regarding its financial
results for the second quarter.
41
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Interland, Inc.
------------------------------------------------
(Registrant)
Dated: July 15, 2003 /s / Allen L. Shulman
------------------------------------------------
Allen L. Shulman
Senior Vice President, Chief Financial Officer,
and General Counsel
(Principal Financial Officer)
42
CERTIFICATIONS
I, Joel J. Kocher, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Interland, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly report
is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officer and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: July 15, 2003
/s/ Joel J. Kocher
-------------------------------------------
Joel J. Kocher
Chairman of the Board, President and
Chief Executive Officer
43
I, Allen L. Shulman, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Interland, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly report
is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officer and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: July 15, 2003
/s/ Allen L. Shulman
-------------------------------------
Allen L. Shulman
Senior Vice President, Chief Financial
Officer, and General Counsel
44