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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------
FORM 10-Q
(XXXX ONE)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE QUARTER ENDED SEPTEMBER 30, 2001
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER: 000-26873
DIGEX, INCORPORATED
(Exact name of registrant as specified in its charter)
DELAWARE 00-0000000
(State or other jurisdiction (I.R.S. Employer
of Identification Number)
incorporation or organization)
00000 XXXXXXXX XXXX
XXXXXX, XX 00000
(Address of principal executive offices)
(000) 000-0000
Telephone Number
Indicate by check xxxx whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days:
Yes /X/ No / /
As of October 31, 2001, there were 24,788,466 and 39,350,000 shares of the
Registrant's Class A and Class B Common Stock outstanding, respectively.
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DIGEX, INCORPORATED
INDEX
PAGE
NO.
--------
PART I. FINANCIAL INFORMATION
ITEM 1. Financial Statements (Unaudited):
Consolidated Statements of Operations--
Three and nine months ended September 30, 2001 and 2000... 3
Consolidated Balance Sheets--
September 30, 2001 and December 31, 2000.................. 4
Consolidated Statements of Cash Flows--
Nine months ended September 30, 2001 and 2000............. 5
Notes to Consolidated Financial Statements.................. 6
ITEM 2. Management's Discussion and Analysis of Financial Condition
and
Results of Operations..................................... 13
ITEM 3. Quantitative and Qualitative Disclosures about Market
Risk...................................................... 21
PART II. OTHER INFORMATION
ITEM 1. Legal Proceedings........................................... 22
ITEM 2. Changes in Securities and Use of Proceeds................... 22
ITEM 3. Defaults Upon Senior Securities............................. 22
ITEM 4. Submission of Matters to a Vote of Security Holders......... 22
ITEM 5. Other Information........................................... 22
ITEM 6. Exhibits and Reports on Form 8-K............................ 22
SIGNATURES........................................................... 24
2
PART 1: FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
DIGEX, INCORPORATED
CONSOLIDATED STATEMENTS OF OPERATIONS
UNAUDITED (AMOUNTS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------- -------------------------
2001 2000 2001 2000
----------- ----------- ----------- -----------
Revenue:
Revenue................................. $ 43,130 $ 43,979 $ 144,869 $ 110,143
Revenue from WorldCom................... 9,194 -- 14,298 --
----------- ----------- ----------- -----------
Total revenue............................. 52,324 43,979 159,167 110,143
Costs and expenses:
Cost of operations...................... 2,710 4,237 12,241 17,275
Cost of services........................ 28,792 20,193 79,792 46,737
Selling, general and administrative..... 35,964 37,474 109,750 98,243
Deferred compensation................... 683 1,087 2,489 3,077
Depreciation and amortization........... 34,035 21,883 95,071 52,435
----------- ----------- ----------- -----------
Total costs and expenses.................. 102,184 84,874 299,343 217,767
----------- ----------- ----------- -----------
Loss from operations...................... (49,860) (40,895) (140,176) (107,624)
Other income (expense):
Interest expense........................ (1,670) (523) (3,115) (1,395)
Interest income and other............... 353 130 572 7,531
----------- ----------- ----------- -----------
Loss before cumulative effect of change in
accounting principle.................... (51,177) (41,288) (142,719) (101,488)
Cumulative effect of change in accounting
principle............................... -- -- -- (166)
----------- ----------- ----------- -----------
Net loss.................................. (51,177) (41,288) (142,719) (101,654)
Accretion of preferred stock discount..... (1,006) -- (3,019) --
----------- ----------- ----------- -----------
Net loss available to common
stockholders............................ $ (52,183) $ (41,288) $ (145,738) $ (101,654)
=========== =========== =========== ===========
LOSS PER COMMON SHARE--BASIC AND DILUTED:
Loss before cumulative effect of change in
accounting principle.................... $ (0.81) $ (0.65) $ (2.28) $ (1.60)
Cumulative effect of change in accounting
principle............................... -- -- -- (0.01)
----------- ----------- ----------- -----------
Net loss per common share................. $ (0.81) $ (0.65) $ (2.28) $ (1.61)
=========== =========== =========== ===========
Shares used in computing basic and diluted
net loss per share...................... 64,138,466 63,616,765 64,055,814 63,248,403
=========== =========== =========== ===========
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
3
DIGEX, INCORPORATED
CONSOLIDATED BALANCE SHEETS
(AMOUNTS IN THOUSANDS, EXCEPT SHARE INFORMATION)
SEPTEMBER 30, DECEMBER 31,
2001 2000
------------- ------------
(UNAUDITED)
ASSETS
Current assets:
Cash and cash equivalents................................. $ 6,522 $ 83,434
Restricted investments.................................... 3,178 2,000
Accounts receivable, net of allowance of $6,033 in 2001
and $4,741 in 2000, respectively........................ 28,285 36,201
Due from Intermedia....................................... -- 40
Due from WorldCom......................................... 15,135 6,000
Deferred costs............................................ 7,678 8,627
Prepaid expenses and other current assets................. 6,499 7,452
--------- ---------
Total current assets.................................. 67,297 143,754
Property and equipment, net................................. 354,307 348,975
Intangible assets, net...................................... 20,228 23,222
Other assets................................................ 3,324 5,100
--------- ---------
Total assets.......................................... $ 445,156 $ 521,051
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses..................... $ 61,794 $ 59,455
Current portion of deferred revenue....................... 7,935 7,734
Current portion of notes payable.......................... 4,346 2,772
Current portion of capital lease obligations.............. 5,945 1,871
Due to Intermedia......................................... 6,207 --
Note payable to Intermedia................................ 12,000 --
--------- ---------
Total current liabilities............................. 98,227 71,832
Deferred revenue............................................ 2,559 4,025
Notes payable............................................... 3,194 1,435
Notes payable to Intermedia................................. 28,000 --
Capital lease obligations................................... 30,776 27,131
--------- ---------
Total liabilities..................................... 162,756 104,423
--------- ---------
Redeemable preferred stock, $.01 par value; 5,000,000 shares
authorized; 100,000 shares designated as Series A
Convertible; 100,000 Series A Convertible shares issued
and outstanding (aggregate liquidation preference of
$100,000)................................................. 79,069 71,572
Stockholders' equity:
Class A common stock, $.01 par value; 100,000,000 shares
authorized; 24,788,466 and 24,546,543 shares issued and
outstanding in 2001 and 2000, respectively.............. 248 245
Class B common stock, $.01 par value; 50,000,000 shares
authorized; 39,350,000 issued and outstanding in 2001
and 2000, respectively.................................. 394 394
Additional capital........................................ 546,427 550,465
Accumulated deficit....................................... (338,588) (195,869)
Deferred compensation..................................... (4,966) (10,141)
Accumulated other comprehensive loss...................... (184) (38)
--------- ---------
Total stockholders' equity............................ 203,331 345,056
--------- ---------
Total liabilities and stockholders'equity............. $ 445,156 $ 521,051
========= =========
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
4
DIGEX, INCORPORATED
CONSOLIDATED STATEMENTS OF CASH FLOWS
UNAUDITED (AMOUNTS IN THOUSANDS)
NINE MONTHS ENDED
SEPTEMBER 30,
-----------------------
2001 2000
---------- ----------
OPERATING ACTIVITIES:
Net loss.................................................. $ (142,719) $ (101,654)
Cumulative effect of change in accounting principle....... -- 166
---------- ----------
Loss before cumulative effect of change in accounting
principle............................................... (142,719) (101,488)
Adjustments to reconcile net loss to cash used in
operating activities:
Depreciation and amortization........................... 95,071 52,435
Provision for doubtful accounts......................... 12,415 4,739
Amortization of deferred compensation................... 2,489 3,113
Loss on sale/ disposals of telecommunications
equipment............................................. 958 732
Accretion of interest on note payable and capital lease
obligations........................................... 84 395
Changes in operating assets and liabilities:
Accounts receivable..................................... (4,499) (14,070)
Due from WorldCom....................................... (9,135) (6,000)
Deferred costs.......................................... 949 (11,490)
Prepaid expenses and other current assets............... 953 (7,576)
Other assets............................................ 1,362 (646)
Accounts payable and accrued expenses................... 2,339 16,374
Deferred revenue........................................ (1,265) 11,480
Due to (from) Intermedia................................ 6,247 3,438
---------- ----------
Net cash used in operating activities..................... (34,751) (48,564)
INVESTING ACTIVITIES:
Purchases of property and equipment....................... (83,121) (156,707)
Proceeds from sale of telecommunication assets............ 233 --
Purchase of restricted investments........................ (1,178) (2,000)
---------- ----------
Net cash used in investing activities..................... (84,066) (158,707)
FINANCING ACTIVITIES:
Proceeds from subsequent public offering, net of costs.... -- 171,645
Proceeds from issuance of preferred stock................. -- 85,000
Proceeds from issuances of notes payable.................. 43,300 --
Proceeds from exercises of common stock options........... 2,084 5,244
Principal payments on note payable and capital lease
obligations............................................. (3,333) (664)
---------- ----------
Net cash provided by financing activities................. 42,051 261,225
Effect of exchange rate on cash and cash equivalents........ (146) --
Net (decrease) increase in cash and cash equivalents........ (76,912) 53,954
Cash and cash equivalents at beginning of the period........ 83,434 88,778
---------- ----------
Cash and cash equivalents at end of period.................. $ 6,522 $ 142,732
========== ==========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Assets acquired through capital leases.................... $ 11,041 $ 12,857
Interest paid............................................. 2,420 1,315
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
5
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. BASIS OF PRESENTATION
The accompanying consolidated financial statements have been prepared by
Digex, Incorporated, without audit, pursuant to the rules and regulations of the
Securities and Exchange Commission (the "SEC"). Certain information and footnote
disclosures normally included in financial statements prepared in accordance
with generally accepted accounting principles ("GAAP") have been omitted
pursuant to such rules and regulations. The unaudited consolidated financial
statements should be read in conjunction with the consolidated financial
statements, notes thereto and other information included in the Form 10-K of
Digex for the year ended December 31, 2000.
The accompanying unaudited consolidated financial statements include the
accounts of Digex and its wholly-owned subsidiaries. All significant
intercompany accounts and transactions have been eliminated in consolidation.
Certain prior period amounts have been reclassified to conform to the current
period presentation.
The accompanying unaudited consolidated financial statements reflect, in the
opinion of management, all adjustments, which are of a normal and recurring
nature, necessary for a fair presentation of the financial condition and results
of operations and cash flows for the periods presented. The preparation of
financial statements in accordance with GAAP requires management to make
estimates and assumptions. Such estimates and assumptions affect the reported
amounts of assets and liabilities, as well as the disclosure of contingent
assets and liabilities at the date of the financial statements and the reported
amounts of revenue and expenses during the reporting period. Actual results
could differ from those estimates. The results of operations for the interim
periods are not necessarily indicative of the results for the entire year.
CHANGE IN ACCOUNTING PRINCIPLE
Effective January 1, 2000, Digex changed its method of accounting for
revenue recognition in accordance with Staff Accounting Bulletin No. 101 ("SAB
101"), REVENUE RECOGNITION IN FINANCIAL STATEMENTS. Historically, Digex has
recognized installation revenue, in accordance with industry practice, upon
completion of the managed Web hosting solution. The direct costs associated with
the installation were expensed as incurred. Under the new accounting method
adopted retroactive to January 1, 2000, Digex now recognizes installation
revenue and related direct incremental costs of performing the installation over
the contract term (generally 24 months). Accordingly, the consolidated statement
of operations for the third quarter of 2000 has been restated to reflect the
accounting change.
For the quarter ended September 30, 2001, Digex recognized revenue of
$2.1 million that had been deferred as of December 31, 2000. With the adoption
of SAB 101, there was no impact to Digex's business operations or cash flows.
There was also no material impact to Digex's consolidated financial statements.
IMPAIRMENT OF LONG-LIVED ASSETS
In accordance with Statement of Financial Accounting Standards ("SFAS")
No. 121, ACCOUNTING FOR THE IMPAIRMENT OF LONG-LIVED ASSETS AND FOR LONG-LIVED
ASSETS TO BE DISPOSED OF, Digex reviews its long-lived assets for impairment
when events or changes in circumstances indicate the carrying value of such
assets may not be recoverable. The review consists of a comparison of the
carrying value of the assets with the assets' expected future undiscounted cash
flows without interest costs. Estimates of expected future cash flows represent
management's best estimate based on reasonable and supportable assumptions
6
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS --(CONTINUED)
(UNAUDITED)
and projections. If the expected future cash flow exceeds the carrying value of
the asset, no impairment indicator is considered present. If the carrying value
exceeds the future cash flow, an impairment indicator is considered present.
Such impairment would be measured and recognized using a discounted cash flow
method.
Digex has performed an undiscounted cash flow analysis related to its
long-lived assets. The result of that analysis indicates that no impairment to
the carrying value of these assets has occurred as of September 30, 2001.
Management will continue to evaluate overall industry and company specific
circumstances and conditions as necessary.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 2000, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 138, ACCOUNTING FOR CERTAIN DERIVATIVE INSTRUMENTS AND CERTAIN HEDGING
ACTIVITIES, an amendment of SFAS No. 133, which is effective for fiscal years
beginning after June 15, 2000. With the adoption of SFAS No. 133, as amended,
effective January 1, 2001, there is no impact on Digex's consolidated financial
statements as it has not entered into any derivative contracts.
In June 2001, the FASB issued SFAS No. 141, BUSINESS COMBINATIONS, which
requires the purchase method of accounting for business combinations initiated
after June 30, 2001 and eliminates the pooling-of-interests method. Currently,
Digex does not believe that the adoption of SFAS No. 141 will have any impact on
its consolidated financial statements.
Also in June 2001, the FASB issued SFAS No. 142, GOODWILL AND OTHER
INTANGIBLE ASSETS, which is effective for fiscal years beginning after
December 15, 2001. Under the new rules, goodwill and intangible assets deemed to
have indefinite lives will no longer be amortized but will be subject to annual
impairment tests. In addition, the statement includes provisions for the
reclassification of certain existing recognized intangibles as goodwill,
reassessment of the useful lives of existing recognized intangibles,
reclassification of certain intangibles out of previously reported goodwill and
the identification of reporting units for purposes of assessing potential future
impairments of goodwill. Goodwill and other intangibles, acquired prior to
July 1, 2001, may be amortized until the adoption of the statement.
Digex will adopt the provisions of SFAS No. 142 beginning in 2002. At that
time, Digex will cease amortization of amounts assigned to goodwill and acquired
workforce. Amortization of goodwill and acquired workforce was approximately
$0.5 million and $1.6 million for the three and nine months ended September 30,
2001. Digex is currently assessing but has not yet determined the impact, if
any, of applying the impairment test guidance under SFAS No. 142.
2. INTERMEDIA--WORLDCOM MERGER
On July 1, 2001, pursuant to the terms of the agreement and plan of merger,
dated September 1, 2000, and the amendments thereto, a wholly-owned subsidiary
of WorldCom, Inc. was merged with and into
Intermedia Communications Inc. with
Intermedia continuing as the surviving corporation and as a subsidiary of
WorldCom (the "Intermedia--WorldCom Merger"). As a result of the Intermedia--
WorldCom Merger, WorldCom now owns all of the capital stock of Intermedia, other
than the 13 1/2% series B preferred stock, and approximately 90% of the voting
securities of Intermedia. Therefore, WorldCom has acquired an indirect
controlling interest of Digex through Intermedia as Intermedia continues to own
approximately 61.4% of Digex's equity interests and controls 94.1% of Digex's
voting interests, calculated based on total common stock outstanding, as of
July 1, 2001.
7
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS --(CONTINUED)
(UNAUDITED)
3. COMPREHENSIVE LOSS
The following table reflects the calculation of comprehensive losses (in
thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------- -----------------------
2001 2000 2001 2000
--------- --------- ---------- ----------
Net loss available to common stockholders....... $ (52,183) $ (41,288) $ (145,738) $ (101,654)
--------- --------- ---------- ----------
Other comprehensive loss:
Foreign currency translation adjustments...... 60 -- (146) --
--------- --------- ---------- ----------
Comprehensive loss applicable to
common stockholders........................... $ (52,123) $ (41,288) $ (145,884) $ (101,654)
========= ========= ========== ==========
4. SERIES A CONVERTIBLE PREFERRED STOCK
In January 2000, Digex sold 100,000 shares of its non-voting preferred
stock, designated as Series A Convertible Preferred Stock, with detachable
warrants to purchase 1,065,000 shares of its Class A common stock, for an
aggregate of $100.0 million, of which $15.0 million was in the form of equipment
purchase credits. The warrants can be exercised at any time on or before
January 12, 2003 at an initial price of $57.00 per share, subject to certain
adjustments. The proceeds from the offering were allocated between the preferred
stock and the warrants based upon their relative fair values.
In the event of liquidation, each share of preferred stock is entitled to a
liquidation preference of $1,000 per share before any amount may be paid to
common stockholders. The holders of the preferred stock are also not entitled to
receive dividends. Digex may not issue any stock with the same or senior
preferences or priorities to this series without the consent of the majority of
its preferred stockholders.
Each share of preferred stock is convertible into shares of Class A common
stock at a conversion price of $68.40 per share, subject to certain adjustments,
for a total of approximately 1,462,000 shares of Class A common stock. Unless
earlier converted, on January 12, 2005, each share of preferred stock will
automatically convert into the number of shares of Class A common stock equal to
$1,000 divided by the average of the closing prices of the Class A common stock
for the twenty consecutive trading days prior to January 12, 2005.
Subject to the legal availability of funds, the preferred stock is
redeemable in cash at the option of the holders after January 12, 2004 or upon a
change of control of Digex at a price of $1,000 per share if the redemption is
then permitted under those indentures of Digex and Intermedia which existed on
January 10, 2000. If the restrictions under these agreements terminate at an
earlier date, the holders may require Digex to redeem the preferred stock before
entering into an agreement which would restrict its ability to redeem the
preferred stock. Digex is not required to make sinking fund payments with
respect to the preferred stock.
Since the redemption features are not solely within its control, Digex has
restated its consolidated balance sheet as of December 31, 2000 to report
redeemable equity outside of stockholders' equity. The result of which was to
reduce stockholders' equity in the amount of $71.6 million (the aggregate fair
value of the outstanding preferred stock at issuance, net of $16.1 million
allocated to the warrants and $12.3 million of available equipment purchase
credits. Of the $15.0 million of equipment purchase credits,
8
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS --(CONTINUED)
(UNAUDITED)
approximately $4.5 million was used for equipment purchases in 2001.) Previously
filed reports on Form 10-Q and Form 10-K, since January 12, 2000, will be
amended for the restatement.
Digex is accreting the preferred stock discount of $16.1 million to the
mandatory conversion date in January 2005. The effect of the accretion is to
increase net loss available to common stockholders by approximately
$1.0 million (or $0.01 per share) and $3.0 million (or $0.05 per share) for the
three and nine months ended September 30, 2001, respectively. To date, Digex
believes that a redemption event is not probable due to the covenants contained
in the indentures of Digex and Intermedia restricting redemption and the
requirement of legal availability of funds, which would prohibit redemption of
the securities. Digex also believes that the accretion will not have an impact
on its business operations or cash flows.
5. COMMITMENTS
In January 2001, Digex received proceeds from a $3.0 million loan from the
State of Maryland Department of Business and Economic Development under the
Sunny Day Fund initiative. The loan is subject to multiple maturity dates, and
is guaranteed by Intermedia. Interest on the unpaid principal balances accrues
at 5% per annum. The principal amounts and any accrued interest will be deferred
each year through December 31, 2008 if Digex meets certain annual conditions
regarding the hiring of permanent, full time employees and the expenditures for
the development of a Web hosting facility in Prince George's County, Maryland.
At December 31, 2008, the principal amounts and any accrued interest outstanding
may convert to a grant upon the achievement of certain requirements by Digex.
In April 2001, Digex received proceeds from a $300,000 loan from Prince
George's County Economic Development Corporation. The loan matures on April 6,
2006 and is guaranteed by Intermedia. Interest on the unpaid principal balances
accrues at 5% per annum. Interest and principal are payable monthly, beginning
May 6, 2001.
In the first and second quarters of 2001, Digex entered into master lease
and financing agreements with two vendors for lines of credit to facilitate the
leasing of computer hardware and software. The terms of the associated schedules
range from 12 months for financing a maintenance contract to 36 months for
leasing computer equipment. Digex will have an option to purchase the equipment
at the end of the initial lease term. Interest and principal are payable monthly
with interest rates ranging from 7.2% to 12.3% per annum. As of September 30,
2001, Digex had acquired $10.9 million of computer equipment and maintenance
services under these leasing and financing arrangements.
6. CONTINGENCIES
On April 6, 2001, a final settlement of the consolidated derivative and
class action suits was approved by the Delaware Court of Chancery in Wilmington,
Delaware. On May 7, 2001, the appeals period for appealing the Chancery Court's
approval of the settlement expired with no appeals having been filed.
Pursuant to the settlement, WorldCom made a payment of WorldCom common stock
having a total value of $165.0 million for distribution to Digex common stock
holders following the closing of the Intermedia--WorldCom Merger in July 2001.
One half of the settlement fund net of plaintiffs' attorneys fees was
distributed to record holders of Digex common stock as of September 1, 2000. The
balance of the settlement fund net of attorneys' fees was paid to record holders
of Digex stock as of June 29, 2001. Neither Intermedia nor its affiliates was
entitled to any distribution from the settlement fund. The merger agreement
between Intermedia and WorldCom was amended, among other things, to change the
consideration to be paid to Intermedia shareholders in connection with the
merger. The fees and expenses of all
9
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS --(CONTINUED)
(UNAUDITED)
plaintiffs and all counsel representing all plaintiffs in the action were paid
out of the settlement fund. In connection with the settlement, WorldCom has
agreed to reimburse Digex for certain fees and expenses incurred by Digex
associated with the merger and the consolidated lawsuit in an amount not to
exceed $15.0 million. A further provision of the settlement makes Section 203 of
the Delaware General Corporation Law inapplicable to future transactions between
WorldCom and Digex.
For every one share of WorldCom Group common stock paid into the settlement
fund, 1/25th of a share of MCI Group common stock was also paid into such fund.
The value of the WorldCom Group common stock and the MCI Group common stock was
based upon the average trading price of 10 trading days randomly selected from a
20-day trading period from May 31, 2001 through June 27, 2001. Based on a
randomly selected average trading price of $16.672 per share, WorldCom deposited
9,896,833 shares of WorldCom Group common stock and 395,873 shares of MCI Group
common stock into the settlement fund on July 2, 2001. Approximately 7.5% of the
shares deposited into the settlement fund was distributed to the legal counsel
for the plaintiffs in the litigation, approximately 46.25% of the settlement
fund was distributed to the holders of record of Digex Class A common stock as
of September 1, 2000 (based on an exchange rate of 0.18838 shares of WorldCom
Group common stock and 0.00754 shares of MCI Group common stock for each share
of Digex Class A common stock), and the remaining 46.25% was distributed to
holders of record of Digex Class A common stock as of June 29, 2001 (based on an
exchange rate of 0.18465 shares of WorldCom Group common stock and 0.00739
shares of MCI Group common stock for each share of Digex Class A common stock).
On July 9, 2001, Digex received $12.5 million from WorldCom for the
reimbursement of certain merger-related fees and expenses associated with the
litigation. Digex does not expect to incur any future liability from the outcome
of this litigation. Digex also does not believe that there are any pending or
threatened legal proceedings that, if adversely determined, would have a
material adverse effect on Digex's results of operations, cash flows, or
financial position.
7. RELATED PARTY AGREEMENTS
WORLDCOM
In connection with the Intermedia--WorldCom Merger, Digex and certain
subsidiaries of WorldCom have entered into four commercial agreements, including
a sales channel agreement, funding agreement, facilities agreement, and network
agreement. Except for the funding agreement, all agreements expire on
December 31, 2003 and permit either party to request for a 12-month extension
from the initial term, provided that written notice be given to the other party
by December 31, 2002 for the initial extension. The principal terms of the
agreements are as follows:
SALES CHANNEL AGREEMENT. Effective January 1, 2001, WorldCom will
purchase the Digex portfolio of managed Web hosting products for resale to
WorldCom customers. If Digex satisfies certain service level and data center
capacity commitments, WorldCom agrees to purchase a minimum of
$50.0 million of Digex's services during 2001 and up to a total of
$500.0 million during the period from 2001 through 2003. WorldCom agreed to
compensate Digex, on a quarterly basis, for the full amount of operating
losses before depreciation and amortization incurred in servicing WorldCom
customers under the sales channel agreement, during 2001. However, in 2001
and thereafter, to the extent that Digex generates operating income before
depreciation and amortization in servicing WorldCom under the sales channel
agreement, Digex has agreed to share such operating income with WorldCom.
WorldCom's participation in operating results is recognized as adjustments
to revenue recognized under the sales channel agreement.
10
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS --(CONTINUED)
(UNAUDITED)
During the three and nine month period ended September 30, 2001, Digex
recognized revenue from WorldCom of $9.2 million and $14.3 million,
respectively. Accounts receivable from WorldCom, under the sales channel
agreement, on September 30, 2001 represented approximately $14.7 million and
is included in due from WorldCom on the consolidated balance sheet.
FUNDING AGREEMENT. On July 31, 2001, Digex entered into a note purchase
agreement with WorldCom whereby WorldCom has agreed to provide funding for
the Digex business plans for 2001 and 2002 as approved by the Digex and
WorldCom boards of directors. To date, the Digex and WorldCom boards of
directors have approved the Digex 2001 business plan. The preparation of the
Digex business plan for 2002 is currently underway and is expected to be
submitted to the WorldCom board of directors for approval no later than
December 1, 2001. Subject to the terms and conditions of the agreement,
Digex will issue and WorldCom will purchase (or cause an affiliate to
purchase) a series of senior notes up to an aggregate principal amount
sufficient to satisfy Digex's net cash requirements under the approved
business plan. Interest on the unpaid principal balance is payable monthly
at a rate equal to LIBOR plus 300 basis points. Repayment of principal is
due on December 31, 2002 and may be extended to December 31, 2006 upon the
election of Digex by written notice. Any changes to its business plans that
require increased funding would require the WorldCom board of directors'
approval before WorldCom would be obligated to fund any such increase.
In the third quarter of 2001, Digex issued and WorldCom caused
Intermedia to purchase a series of senior notes totaling $28.0 million to
satisfy Digex's net cash requirements under its approved 2001 business plan.
The principal remains outstanding at September 30, 2001. Through
September 30, 2001, variable interest on the unpaid principal balance was
paid monthly at an average interest rate of 6.53% per annum.
FACILITIES AGREEMENT. Effective January 1, 2001, managed Web hosting
facilities for Digex were built and may continue to be built in several
WorldCom data centers in the United States and around the world. Digex will
lease space from WorldCom at these data centers based on customer demand.
The charges for the data center space and connections from the space to a
WorldCom Internet Protocol network hub amounted to $1.0 million for the
three and nine months ended September 30, 2001, respectively.
NETWORK AGREEMENT. This agreement, effective January 1, 2001, provides
terms for Digex to purchase bandwidth and connectivity from WorldCom in the
United States to support its managed Web hosting activities. The charges for
the dedicated Internet connections and WorldCom network services amounted to
$1.4 million and $4.4 million for the three and nine months ended
September 30, 2001, respectively.
WorldCom also provides certain operational services to Digex under vendor
contracts in the ordinary course of business, such as telephone and other
circuit related services. The following table reflects charges related to
services provided by WorldCom in the ordinary course of business to Digex (in
thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------- -------------------
2001 2000 2001 2000
-------- -------- -------- --------
Other circuit related expense................. $ 2,679 $ 1,172 $ 5,069 $ 2,141
Telephone expense............................. 693 17 2,018 189
------- ------- ------- -------
$ 3,372 $ 1,189 $ 7,087 $ 2,330
======= ======= ======= =======
11
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS --(CONTINUED)
(UNAUDITED)
INTERMEDIA
On April 30, 1999, Digex entered into a general and administrative services
agreement with Intermedia which expired on April 1, 2001. Under the terms of
this agreement, as amended to date, Intermedia provided Digex with treasury
services in the first quarter of 2001. The charge for these services was minimal
for the three months ended March 31, 2001.
Under the terms of the network services agreements with Intermedia, which
expired in July 2001, Intermedia provided Digex with east and west coast
Internet transit and Internet access. Subsequent to the expiration date, Digex
continued with Intermedia's network services at the current monthly rate under
the expired network agreement. Additionally, Intermedia granted a $1.0 million
credit for services provided during the first half of 2001 to Digex in the third
quarter of 2001. The charges for the Internet transit and access services
amounted to $0.2 million and $0.7 million for the three and nine months ended
September 30, 2001, respectively.
In the second quarter of 2001, Digex received proceeds from a $12.0 million
loan from Intermedia. The loan is governed by the terms under the revolving
credit agreement dated as of December 22, 1999, and amendments to date, among
Intermedia, Bank of America N.A., the Bank of New York and Toronto Dominion
(
Texas), Inc. Repayment was due on demand at the earlier of: (1) the
consummation of the Intermedia--WorldCom Merger; (2) July 3, 2001; (3) the
cancellation or termination of the credit facility; or (4) following default
which would accelerate the amounts due. Through June 30, 2001, variable interest
on the unpaid principal balance was paid monthly at an average LIBOR rate of
approximately 4.50% per annum. On June 26, 2001, Digex borrowed an additional
$6.0 million from Intermedia as an intercompany loan. Currently, Digex is in
discussions with WorldCom and Intermedia to refinance both loans from Intermedia
as an $18.0 million long term borrowing. Digex expects to document this
refinancing in the fourth quarter of 2001.
8. SUBSEQUENT EVENTS
During the fourth quarter of 2001, WorldCom caused Intermedia to purchase a
series of senior notes totaling $25.0 million from Digex under the note purchase
agreement. Through November 1, 2001, variable interest on the unpaid principal
balance was paid monthly at an average interest rate of 5.60% per annum.
Repayment of principal is due on December 31, 2002, unless otherwise extended at
the election of Digex.
12
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion should be read in conjunction with the unaudited
consolidated financial statements and related notes herein, and with the
Management's Discussion and Analysis of Financial Condition and Results of
Operations and audited consolidated financial statements and related notes
included in Digex's Form 10-K, as filed with the SEC on April 2, 2001.
OVERVIEW
We are a leading provider of managed Web and application hosting services to
businesses operating mission-critical, multi-functional Web sites. We provide
the computer hardware, software, network technology, and systems management
necessary to provide our customers comprehensive, managed Web hosting and
application hosting solutions. We also offer related value-added services such
as firewall management, stress testing and consulting services, including
capacity and migration planning and database optimization. We currently provide
such services to a diversified customer base consisting of over 600 customers.
As of September 30, 2001, we managed approximately 3,768 Windows- and UNIX-based
servers in our state-of-the-art data centers which are strategically positioned
on the east and west coasts of the United States, in Europe and Asia. We believe
our singular focus on delivering mission-critical Web and application hosting
solutions has been the major contributor to our growth.
In March 2001, as part of the settlement of shareholder litigation, we
entered into certain commercial agreements with WorldCom. Through the sales
channel agreement, WorldCom has commenced reselling our portfolio of managed Web
hosting products. If we satisfy certain service level commitments, WorldCom
agrees to purchase up to a total of $500.0 million during the period from 2001
through 2003. We share costs and profits generated from the WorldCom sales
channel with WorldCom. In November 2000, WorldCom announced the immediate U.S.
availability of an expanded global Web hosting product suite to include high-end
managed hosting services through arrangements with us. We also utilize
WorldCom's sales force to enhance our global presence.
Through our facilities agreement with WorldCom, we have built managed Web
hosting facilities in several existing WorldCom data centers in the United
States and around the world. We will lease space from WorldCom at these data
centers based on customer demand. These hosting facilities were patterned after
our facilities in the U.S. Our first data center completed through this
agreement is located in Ashburn, Virginia and became operational in the first
quarter of 2001. In the second quarter of 2001, we operationalized data centers
built in WorldCom facilities in New Jersey, France, Germany, and Japan. We may
continue to build additional Web hosting facilities in other WorldCom data
centers in the future.
Our network agreement with WorldCom provides us with terms to purchase
bandwidth and connectivity from WorldCom in the United States to support our
managed Web and application hosting activities. Through the arrangement, we were
able to connect our Internet data centers to the WorldCom global IP network that
runs through North America, South America, Europe, Asia, and Australia with over
2,500 points of presence. In the second quarter of 2001, we fully transitioned
to the WorldCom global IP network as our primary network.
REVENUE. Our revenues consist primarily of monthly fees from our managed
Web and application hosting services. Contracts for these services are typically
between one and three years in length. In addition to Web and application
hosting, we also offer enterprise services and consulting services and believe
that we will begin to derive increasing amounts of revenues from the sale of
these services in the future.
COSTS AND EXPENSES. Costs and expenses include:
- cost of operations;
- cost of services;
- selling, general and administrative expenses;
13
- deferred compensation; and
- depreciation and amortization expense.
Cost of operations consist primarily of the costs for our network
connectivity and firewall services. We expect our network connectivity
requirements to grow in conjunction with the growth of our overall business and
pricing arrangements we negotiated with our providers, including the expansion
of our business abroad through our wholly-owned subsidiaries, and accordingly
expect these costs to increase in the future.
Cost of services consist primarily of facilities administration expenses
including rent, maintenance and utilities to support our data centers and
salaries and related benefits for our technical operations. We expect our cost
of services to increase in dollar amount but to decline as a percentage of
revenue due to economies of scale and expected improvements in technology and
productivity.
Selling, general and administrative expenses consist primarily of salaries
and benefits for our marketing, sales and support personnel, advertising costs,
consultants' fees, provision for doubtful accounts, research and development
costs and other miscellaneous expenses. We expect selling, general and
administrative expenses to increase in dollar amount and to decline as a
percentage of revenue over time.
Deferred compensation expense relates to stock options that were granted by
Digex to certain employees at exercise prices below market value.
Depreciation and amortization expense consists primarily of depreciation of
our data centers, servers and related equipment and amortization of our
intangible assets. We expect these expenses to increase due to our plans to
invest significant capital to continue to expand our data center capacity.
PLAN OF OPERATION
We plan to expand our Web and application hosting business by focusing on
large companies which are looking to develop a presence on the Internet by both
providing e-commerce business solutions to their customers and outsourcing the
management of their Web sites and Web-enabled business applications. In the
fourth quarter of 1999, we opened our state-of-the-art data centers on the east
and west coasts of the United States. Our first international data center,
located in London, became operational in July 2000. Since December 31, 2000, we
have operationalized data centers built in WorldCom facilities in Virginia, New
Jersey, Japan, France, and Germany. We believe that the new data centers in the
United States and those we continue to develop internationally will place us in
a stronger competitive position to successfully provide outsourced solutions of
scalable managed Web and application hosting solutions. We also offer
value-added services, such as firewall management, stress testing, and
consulting services, including capacity and migration planning and database
optimization, and believe that we will derive increasing amounts of revenue from
these services in the future.
Our commercial agreements with WorldCom allow us to purchase bandwidth and
connectivity from WorldCom in the United States and around the world to support
our managed Web and application hosting activities. Through the arrangements, we
were able to connect our Internet data centers in the U.S. to the WorldCom
global IP network that runs through North America, South America, Europe, Asia,
and Australia with over 2,500 points of presence. In the second quarter of 2001,
we have fully transitioned to the WorldCom global IP network as our primary
network.
14
RESULTS OF OPERATIONS
The following table presents certain information derived from our
consolidated statements of operations for the three and nine months ended
September 30, 2001 and 2000, expressed as a percentage of revenue.
THREE MONTHS NINE MONTHS
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------- -------------------------
2001 2000 2001 2000
-------- -------- -------- --------
Revenues............................................ 100.0% 100.0% 100.0% 100.0%
Costs and expenses:
Cost of operations................................ 5.2 9.6 7.7 15.7
Cost of services.................................. 55.0 45.9 50.1 42.4
Selling, general and administrative............... 68.7 85.2 69.0 89.2
Deferred compensation............................. 1.3 2.5 1.6 2.8
Depreciation and amortization..................... 65.1 49.8 59.7 47.6
----- ----- ----- -----
Total costs and expenses............................ 195.3 193.0 188.1 197.7
----- ----- ----- -----
Loss from operations................................ (95.3) (93.0) (88.1) (97.7)
Other income (expense):
Interest expense.................................. (3.2) (1.2) (2.0) (1.3)
Interest income and other......................... 0.7 0.3 0.4 6.8
----- ----- ----- -----
Loss before cumulative effect of change
in accounting principle........................... (97.8) (93.9) (89.7) (92.2)
Cumulative effect of change in accounting
principle......................................... -- -- -- (0.2)
----- ----- ----- -----
Net loss............................................ (97.8)% (93.9)% (89.7)% (92.4)%
===== ===== ===== =====
THREE MONTHS ENDED SEPTEMBER 30, 2001 COMPARED TO THREE MONTHS ENDED
SEPTEMBER 30, 2000
REVENUE
Total revenue increased 19.0% to $52.3 million for the third quarter of 2001
compared to $44.0 million for the same period in 2000. The increase in revenue
was due to sales to new customers, additional services to existing customers,
and revenue recognized through our sales channel agreement with WorldCom, net of
customers' modifications to site configurations in the third quarter of 2001
compared to the same period in 2000. Digex recognized revenue of $9.2 million
under the sales channel agreement with WorldCom in addition to revenue from
managed Web and application hosting services via our normal channels of
distribution.
COST OF OPERATIONS
Cost of operations decreased 36.0% to $2.7 million for the third quarter of
2001 compared to $4.2 million for the same period in 2000. The decrease was
primarily due to improved operating efficiencies and lower costs attributed to
our network agreement with WorldCom in the third quarter of 2001. Additionally,
in the third quarter of 2001, we recorded a $1.0 million credit for network
services provided to us by Intermedia during the first half of 2001. As a
percentage of revenue, cost of operations decreased to 5.2% for the quarter
ended September 30, 2001 compared to 9.6% for the same period in 2000 as a
result of improved network utilization.
COST OF SERVICES
Cost of services increased 42.6% to $28.8 million for the third quarter of
2001 compared to $20.2 million for the same period in 2000. The increase was
primarily related to the increased level of operations, the expansion of our new
data centers including costs related to the hiring of additional personnel in
customer service, engineering, and facilities administration supporting server
growth, and accruals for changes in employee benefits. As a percentage of
revenue, total cost of services increased to 55.0% for the quarter ended
September 30, 2001 compared to 45.9% for the same period in 2000.
15
SELLING, GENERAL AND ADMINISTRATIVE
Selling, general and administrative expenses decreased 4.0% to
$36.0 million for the third quarter of 2001 compared to $37.5 million for the
same period in 2000. The slight decrease in selling, general and administrative
expenses for 2001 is primarily attributed to a large decrease in marketing and
advertising expenses coupled with costs associated with an increased employee
base, an increased provision for doubtful accounts receivable, research and
development costs, and accruals for changes in employee benefits. As a
percentage of revenue, total selling, general and administrative expenses
decreased to 68.7% for the quarter ended September 30, 2001 compared to 85.2%
for the same period in 2000 primarily because our revenue grew while a portion
of the selling, general and administrative cost remained fixed.
DEFERRED COMPENSATION
Deferred compensation expense decreased 37.2% to $0.7 million for the third
quarter of 2001 compared to $1.1 million for the same period in 2000. The
decrease was primarily due to forfeitures in stock options held by certain
employees terminated since September 30, 2000. During the twelve months ended
September 30, 2001, approximately $3.9 million of unearned compensation was
forfeited. Since September 30, 2000, we recorded approximately $0.9 million of
deferred compensation, a separate component of stockholders' equity, to be
expensed over the four-year vesting period of the options.
DEPRECIATION AND AMORTIZATION
Depreciation and amortization expenses increased 55.5% to $34.0 million for
the third quarter of 2001 compared to $21.9 million for the same period in 2000.
The increase was principally due to additional servers and other facilities and
equipment placed in service since September 30, 2000. We entered into capital
leases for equipment in the second and third quarters of 2001, which also
contributed to the increase in expense. We have electronics, computer hardware,
and computer software with useful lives ranging from three to five years. We
expect increases in depreciation charges through 2001 due to future increased
server installations based on customer demand.
INTEREST EXPENSE
Interest expense increased 219.3% to $1.7 million for the third quarter of
2001 compared to $0.5 million for the same period in 2000. The increase resulted
from the capital lease for our new corporate headquarters facility, capital
leases for equipment and vehicles, and from issuances of $43.3 million of notes
payable primarily to Intermedia since September 30, 2000.
INTEREST INCOME AND OTHER
Interest income and other decreased 171.5% to $0.4 million for the third
quarter of 2001 compared to $0.1 million for the same period in 2000. The
decrease resulted principally from declining cash balances and falling interest
rates during the period.
EBITDA BEFORE CERTAIN CHARGES
EBITDA before certain charges, as defined below, decreased 15.5% to $(15.1)
million in the quarter ended September 30, 2001 compared to $(17.9) million for
the same period in 2000. The change is primarily attributable to increased
revenue and a slower growth rate in costs due to operational efficiencies. Costs
associated with the administration and maintenance of our expanded data centers
and increased selling, general and administrative costs will continue to
represent a large portion of expenses. In addition, we expect to continue to
experience growth in marketing and selling expenses as new customers are
acquired.
16
EBITDA BEFORE CERTAIN CHARGES CONSISTS OF EARNINGS (LOSS) BEFORE INTEREST
EXPENSE, INTEREST INCOME AND OTHER, MERGER-RELATED EXPENSES, FOREIGN EXCHANGE
GAINS (LOSSES), INCOME TAX BENEFIT, DEFERRED COMPENSATION, AND DEPRECIATION AND
AMORTIZATION. EBITDA BEFORE CERTAIN CHARGES DOES NOT REPRESENT FUNDS AVAILABLE
FOR MANAGEMENT'S DISCRETIONARY USE AND IS NOT INTENDED TO REPRESENT CASH FLOW
FROM OPERATIONS. EBITDA BEFORE CERTAIN CHARGES SHOULD ALSO NOT BE CONSTRUED AS A
SUBSTITUTE FOR OPERATING INCOME OR A BETTER MEASURE OF LIQUIDITY THAN CASH FLOW
FROM OPERATING ACTIVITIES, WHICH ARE DETERMINED IN ACCORDANCE WITH GENERALLY
ACCEPTED ACCOUNTING PRINCIPLES. THIS CAPTION EXCLUDES COMPONENTS THAT ARE
SIGNIFICANT IN UNDERSTANDING AND ASSESSING OUR RESULTS OF OPERATIONS AND CASH
FLOWS. IN ADDITION, EBITDA BEFORE CERTAIN CHARGES IS NOT A TERM DEFINED BY
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES AND AS A RESULT OUR MEASURE OF EBITDA
BEFORE CERTAIN CHARGES MIGHT NOT BE COMPARABLE TO SIMILARLY TITLED MEASURES USED
BY OTHER COMPANIES. HOWEVER, WE BELIEVE THAT EBITDA BEFORE CERTAIN CHARGES IS
RELEVANT AND USEFUL INFORMATION WHICH IS OFTEN REPORTED AND WIDELY USED BY
ANALYSTS, INVESTORS AND OTHER INTERESTED PARTIES IN THE WEB AND APPLICATION
HOSTING INDUSTRY. ACCORDINGLY, WE ARE DISCLOSING THIS INFORMATION TO PERMIT A
MORE COMPREHENSIVE ANALYSIS OF OUR OPERATING PERFORMANCE, AS AN ADDITIONAL
MEANINGFUL MEASURE OF PERFORMANCE AND LIQUIDITY, AND TO PROVIDE ADDITIONAL
INFORMATION WITH RESPECT TO OUR ABILITY TO MEET FUTURE DEBT SERVICE, CAPITAL
EXPENDITURE AND WORKING CAPITAL REQUIREMENTS. SEE THE CONSOLIDATED FINANCIAL
STATEMENTS AND NOTES THERETO CONTAINED ELSEWHERE IN THIS REPORT FOR MORE
DETAILED INFORMATION.
NINE MONTHS ENDED SEPTEMBER 30, 2001 COMPARED TO NINE MONTHS ENDED
SEPTEMBER 30, 2000
REVENUE
Total revenue increased 44.5% to $159.2 million for the nine months ended
September 30, 2001 compared to $110.1 million for the same period in 2000. The
increase in revenue was due to sales to new customers, additional services to
existing customers, and revenue recognized through our sales channel agreement
with WorldCom, net of customers' modifications to site configurations during the
nine months ended September 30, 2001 compared to the same period in 2000. Digex
also recognized revenue of $14.3 million under the sales channel agreement with
WorldCom in addition to revenue from managed Web and application hosting
services via our normal channels of distribution in 2001. In the second quarter
of 2000, Digex recognized $5.0 million of one-time equipment sales revenue to a
customer in addition to revenue from managed Web and application hosting
services.
COST OF OPERATIONS
Cost of operations decreased 29.1% to $12.2 million for the nine months
ended September 30, 2001 compared to $17.3 million for the same period in 2000.
The decrease was primarily due to improved operating efficiencies and lower
costs attributed to our amended network agreement with Intermedia in the second
quarter of 2001 and our network agreement with WorldCom in 2001. Additionally,
in the third quarter of 2001, we recorded a $1.0 million credit for network
services provided to us by Intermedia during the first half of 2001. As a
percentage of revenue, cost of operations decreased to 7.7% for the nine months
ended September 30, 2001 compared to 12.8% for the same period in 2000
(excluding third party equipment sales and costs in the second quarter of 2000)
as a result of improved network utilization. Expenses directly attributed to the
sale of third party equipment in the second quarter of 2000 is included in the
cost of operations.
COST OF SERVICES
Cost of services increased 70.7% to $79.8 million for the nine months ended
September 30, 2001 compared to $46.7 million for the same period in 2000. The
increase was primarily related to the increased level of operations, the
expansion of our new data centers including costs related to the hiring of
additional personnel in customer service, engineering, and facilities
administration supporting server growth, and accruals for changes in employee
benefits. As a percentage of revenue, total cost of services increased to 50.1%
for the nine months ended September 30, 2001 compared to 42.4% for the same
period in 2000.
17
SELLING, GENERAL AND ADMINISTRATIVE
Selling, general and administrative expenses increased 11.7% to
$109.8 million for the nine months ended September 30, 2001 compared to
$98.2 million for the same period in 2000. Increases in selling, general and
administrative expenses for 2001 include the costs associated with an increased
employee base, advertising campaigns, an increased provision for doubtful
accounts receivable, research and development costs, the addition of key
executive management to support the growth of the business, and accruals for
changes in employee benefits. As a percentage of revenue, total selling, general
and administrative expenses decreased to 69.0% for the nine months ended
September 30, 2001 compared to 89.2% for the same period in 2000 primarily
because our revenue grew while a portion of the selling, general and
administrative cost remained fixed.
DEFERRED COMPENSATION
Deferred compensation expense decreased 19.1% to $2.5 million for the nine
months ended September 30, 2001 compared to $3.1 million for the same period in
2000. The decrease was primarily due to forfeitures in stock options held by
certain employees terminated since September 30, 2000. During the twelve months
ended September 30, 2001, approximately $3.9 million of unearned compensation
was forfeited. Since September 30, 2000, we recorded approximately $0.9 million
of deferred compensation, a separate component of stockholders' equity, to be
expensed over the four-year vesting period of the options.
DEPRECIATION AND AMORTIZATION
Depreciation and amortization expenses increased 81.3% to $95.1 million for
the nine months ended September 30, 2001 compared to $52.4 million for the same
period in 2000. The increase was principally due to additional servers and other
facilities and equipment placed in service since September 30, 2000. We entered
into a capital lease for our corporate headquarters facility in the third
quarter of 2000; capital leases for vehicles in the fourth quarter of 2000 and
in 2001; and capital leases for equipment in the second and third quarters of
2001, which have also contributed to the increase in expense. We have
electronics, computer hardware, and computer software with useful lives ranging
from three to five years. We expect increases in depreciation charges through
2001 due to future increased server installations based on customer demand.
INTEREST EXPENSE
Interest expense increased 123.3% to $3.1 million for the nine months ended
September 30, 2001 compared to $1.4 million for the same period in 2000. The
increase resulted from the capital lease for our new corporate headquarters
facility, capital leases for equipment and vehicles, and from issuances of
$43.3 million of notes payable primarily to Intermedia since September 30, 2000.
INTEREST INCOME AND OTHER
Interest income and other decreased 92.4% to $0.6 million for the nine
months ended September 30, 2001 compared to $7.5 million for the same period in
2000. The decrease resulted principally from declining cash balances and falling
interest rates during the period.
EBITDA BEFORE CERTAIN CHARGES
EBITDA before certain charges, as defined below, decreased 18.2% to $(42.6)
million in the nine months ended September 30, 2001 compared to $(52.1) million
for the same period in 2000. The change is primarily attributable to increased
revenue and a slower growth rate in costs due to operational efficiencies. Costs
associated with the administration and maintenance of our expanded data centers
and increased selling, general and administrative costs will continue to
represent a large portion of expenses. In addition,
18
we expect to continue to experience growth in marketing and selling expenses as
new customers are acquired.
EBITDA BEFORE CERTAIN CHARGES CONSISTS OF EARNINGS (LOSS) BEFORE INTEREST
EXPENSE, INTEREST INCOME AND OTHER, MERGER-RELATED EXPENSES, FOREIGN EXCHANGE
GAINS (LOSSES), INCOME TAX BENEFIT, DEFERRED COMPENSATION, AND DEPRECIATION AND
AMORTIZATION. EBITDA BEFORE CERTAIN CHARGES DOES NOT REPRESENT FUNDS AVAILABLE
FOR MANAGEMENT'S DISCRETIONARY USE AND IS NOT INTENDED TO REPRESENT CASH FLOW
FROM OPERATIONS. EBITDA BEFORE CERTAIN CHARGES SHOULD ALSO NOT BE CONSTRUED AS A
SUBSTITUTE FOR OPERATING INCOME OR A BETTER MEASURE OF LIQUIDITY THAN CASH FLOW
FROM OPERATING ACTIVITIES, WHICH ARE DETERMINED IN ACCORDANCE WITH GENERALLY
ACCEPTED ACCOUNTING PRINCIPLES. THIS CAPTION EXCLUDES COMPONENTS THAT ARE
SIGNIFICANT IN UNDERSTANDING AND ASSESSING OUR RESULTS OF OPERATIONS AND CASH
FLOWS. IN ADDITION, EBITDA BEFORE CERTAIN CHARGES IS NOT A TERM DEFINED BY
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES AND AS A RESULT OUR MEASURE OF EBITDA
BEFORE CERTAIN CHARGES MIGHT NOT BE COMPARABLE TO SIMILARLY TITLED MEASURES USED
BY OTHER COMPANIES. HOWEVER, WE BELIEVE THAT EBITDA BEFORE CERTAIN CHARGES IS
RELEVANT AND USEFUL INFORMATION WHICH IS OFTEN REPORTED AND WIDELY USED BY
ANALYSTS, INVESTORS AND OTHER INTERESTED PARTIES IN THE WEB AND APPLICATION
HOSTING INDUSTRY. ACCORDINGLY, WE ARE DISCLOSING THIS INFORMATION TO PERMIT A
MORE COMPREHENSIVE ANALYSIS OF OUR OPERATING PERFORMANCE, AS AN ADDITIONAL
MEANINGFUL MEASURE OF PERFORMANCE AND LIQUIDITY, AND TO PROVIDE ADDITIONAL
INFORMATION WITH RESPECT TO OUR ABILITY TO MEET FUTURE DEBT SERVICE, CAPITAL
EXPENDITURE AND WORKING CAPITAL REQUIREMENTS. SEE THE CONSOLIDATED FINANCIAL
STATEMENTS AND NOTES THERETO CONTAINED ELSEWHERE IN THIS REPORT FOR MORE
DETAILED INFORMATION.
LIQUIDITY AND CAPITAL RESOURCES
Net cash used in operating activities was $34.8 million and $48.6 million
during the nine months ended September 30, 2001 and 2000, respectively. Net cash
used for operating activities in each of these periods was primarily the result
of operating losses and changes in working capital.
Net cash used for investing activities during the nine months ended
September 30, 2001 and 2000 was $84.1 million and $158.7 million, respectively.
Net cash used for investing activities in each of these periods was primarily
the result of capital expenditures for data center infrastructure, which
includes servers purchased for customer use, as well as leasehold improvements,
furniture and fixtures, computers, and other equipment. Although we have plans
to invest in equipment required to support our customer base, we have no
material commitments for such items at this time.
On July 1, 2001, pursuant to the terms of the merger agreement, dated
September 1, 2000, and the amendments thereto, a wholly-owned subsidiary of
WorldCom was merged with and into Intermedia with Intermedia continuing as the
surviving corporation and as a subsidiary of WorldCom. As a result of the
merger, WorldCom beneficially owns a majority of our capital stock and has
voting control of us.
On July 31, 2001, we entered into a note purchase agreement with WorldCom
whereby WorldCom has agreed to provide funding for the Digex business plans for
2001 and 2002 as approved by the Digex and WorldCom boards of directors. To
date, the Digex and WorldCom board of directors have approved the Digex 2001
business plan. The preparation of the Digex business plan for 2002 is currently
underway and is expected to be submitted to the WorldCom board of directors for
approval no later than December 1, 2001. Subject to the terms and conditions of
the agreement, we will issue and WorldCom will purchase (or cause an affiliate
to purchase) a series of senior notes up to an aggregate principal amount
sufficient to satisfy our net cash requirements under the approved business
plan. Interest on the unpaid principal balance is payable monthly at a rate
equal to LIBOR plus 300 basis points. Repayment of principal is due on
December 31, 2002 and may be extended to December 31, 2006 upon our election by
written notice. Any changes to our business plans that require increased funding
would require the WorldCom board of directors' approval before WorldCom would be
obligated to fund any such increase.
In the third quarter of 2001, Digex issued and WorldCom caused Intermedia to
purchase a series of senior notes totaling $28.0 million to satisfy our net cash
requirements under our approved 2001 business
19
plan. The principal remains outstanding at September 30, 2001. Through
September 30, 2001, variable interest on the unpaid principal balance was paid
monthly at an average interest rate of 6.53% per annum.
We issued a promissory note, governed by the terms of the revolving credit
facility agreement dated December 22, 1999, as amended to date, to Intermedia
for the $12.0 million borrowing in the second quarter of 2001. Repayment was due
on demand at the earlier of: (1) the consummation of the Intermedia--WorldCom
Merger; (2) July 3, 2001; (3) the cancellation or termination of the credit
facility; and (4) following default which would accelerate the amounts due.
Through June 30, 2001, variable interest on the unpaid principal balance was
paid monthly at an average LIBOR rate of approximately 4.50% per annum. On
June 26, 2001, we borrowed an additional $6.0 million from Intermedia as an
intercompany loan. Currently, we are in discussions with WorldCom and Intermedia
to refinance both loans from Intermedia as an $18.0 million long term borrowing.
We expect to document this refinancing in the fourth quarter of 2001.
Following the completion of the Intermedia--WorldCom Merger in July 2001,
WorldCom repaid the total amount outstanding under the credit facility and
terminated Intermedia's revolving credit facility as of August 1, 2001.
In January 2001, we received proceeds from a $3.0 million loan from the
State of Maryland Department of Business and Economic Development under the
Sunny Day Fund initiative. The loan is subject to multiple maturity dates, and
is guaranteed by Intermedia. Interest on the unpaid principal balances accrues
at 5% per annum. The principal amounts and any accrued interest will be deferred
each year through December 31, 2008 if we meet certain annual conditions
regarding the hiring of permanent, full time employees and the expenditures for
the development of a Web hosting facility in Prince George's County, Maryland.
At December 31, 2008, the principal amounts and any accrued interest outstanding
may convert to a grant upon the achievement of certain requirements by us.
In April 2001, we received proceeds from a $300,000 loan from Prince
George's County Economic Development Corporation. The loan matures on April 6,
2006, and is guaranteed by Intermedia. Interest on the unpaid principal balances
accrues at 5% per annum. Interest and principal are payable monthly, beginning
May 6, 2001.
We will use the proceeds from these loans to finance a portion of the cost
of acquiring equipment and construction at our headquarter facilities in Laurel,
Maryland. Subject to the terms of the loan agreements and the approval by the
State of Maryland and/or Prince George's County, on or after January 1, 2005, we
may be eligible for an additional loan of $1.0 million under the Sunny Day Fund
initiative from the State of Maryland and/or $100,000 from Prince George's
County to finance a portion of the cost of acquiring equipment and constructing
facilities within Prince George's County, Maryland.
In the first and second quarters of 2001, we entered into master lease and
financing agreements with two vendors for lines of credit to facilitate the
leasing of computer hardware and software. The terms of the associated schedules
range from 12 months for financing a maintenance contract to 36 months for
leasing computer equipment. We will have an option to purchase the equipment at
the end of the initial lease term. Interest and principal are payable monthly
with interest rates ranging from 7.2% to 12.3% per annum. As of September 30,
2001, we acquired $10.9 million of computer equipment and maintenance services
under these leasing and financing arrangements.
We expect to continue experiencing negative cash flow from operating and
investing activities due to our plans for expansion and the growth of our
business. We anticipate we will have significant cash requirements for several
years as we fill our existing data center capacity, expand into WorldCom data
centers, increase servers under management, acquire additional office space to
support our expanding operations and invest in our marketing organization. In
addition, we expect to invest in the purchase of property and equipment and for
research and development, including funding the expenses associated with our
research and development alliance with Microsoft and a subsidiary of Compaq. We
expect our capital
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expenditures to increase due to the growth of servers under management and our
continuing data center expansion in the United States and abroad. If necessary,
we intend to pursue additional equipment lease financing from our vendors or
third parties to facilitate the acquisition of computer hardware and related
software in the future. We will also use the proceeds of $3.3 million in loans
from the State of Maryland and Prince George's County to finance a portion of
the cost of acquiring equipment and construction at our headquarter facilities
in Laurel, Maryland. With our existing cash resources and financing available
from Intermedia and WorldCom, we believe we have sufficient capital to sustain
our current operations and capital expenditure plans into early 2002. Once the
Digex business plan for 2002 is approved by the Digex and WorldCom boards of
directors, we expect to have adequate funding for our 2002 operations and
capital expenditure requirements as well. Because the note purchase agreement
provides us with access to readily available cash, we plan to maintain minimal
cash balances and borrow only when required to sustain our operations.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 2000, the FASB issued SFAS No. 138, ACCOUNTING FOR CERTAIN
DERIVATIVE INSTRUMENTS AND CERTAIN HEDGING ACTIVITIES, an amendment of SFAS
No. 133, which is effective for fiscal years beginning after June 15, 2000. With
the adoption of SFAS No. 133, as amended, effective January 1, 2001, there is no
effect on our consolidated financial statements as we have not entered into any
derivative contracts.
In June 2001, the FASB issued SFAS No. 141, BUSINESS COMBINATIONS, which
requires the purchase method of accounting for business combinations initiated
after June 30, 2001 and eliminates the pooling-of-interests method. Currently,
we do not believe that the adoption of SFAS No. 141 will have any impact on our
consolidated financial statements.
Also in June 2001, the FASB issued SFAS No. 142, GOODWILL AND OTHER
INTANGIBLE ASSETS, effective for fiscal years beginning after December 15, 2001.
Under the new rules, goodwill and intangible assets deemed to have indefinite
lives will no longer be amortized but will be subject to annual impairment
tests. In addition, the statement includes provisions for the reclassification
of certain existing recognized intangibles as goodwill, reassessment of the
useful lives of existing recognized intangibles, reclassification of certain
intangibles out of previously reported goodwill and the identification of
reporting units for purposes of assessing potential future impairments of
goodwill. Goodwill and other intangibles, acquired prior to July 1, 2001, may be
amortized until the adoption of the statement.
We will adopt the provisions of SFAS No. 142 beginning in 2002. At that
time, we will cease amortization of amounts assigned to goodwill and acquired
workforce. Amortization of goodwill and acquired workforce was approximately
$0.5 million and $1.6 million for the three and nine months ended September 30,
2001. We are currently assessing but has not yet determined the impact, if any,
of applying the impairment test guidance under SFAS No. 142.
INFORMATION REGARDING FORWARD-LOOKING STATEMENTS
The information set forth above in "Management's Discussion and Analysis of
Financial Conditions and Results of Operations" includes forward-looking
statements that involve numerous risks and uncertainties. Forward-looking
statements can be identified by the use of forward-looking terminology such as
"estimates," "projects," "anticipates," "expects," "intends," "believes," or the
negative thereof or other variations thereon or comparable terminology or by
discussions of strategy that involve risks and uncertainties. This report
includes forward-looking statements, which could differ from actual results. See
"Risk Factors" in our Form 10-K for the year ended December 31, 2000 as filed
with the SEC on April 2, 2001.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
No changes.
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PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
None.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
RECENT SALES OF UNREGISTERED SECURITIES
None.
USE OF PROCEEDS FROM A SALE OF REGISTERED SECURITIES
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
NUMBER EXHIBIT
------ -------
3.1 -- Certificate of Incorporation of Digex, as amended.
Incorporated herein by reference from Digex's Form 10-Q
(File No. 000-26873) filed with the SEC on September 13,
1999.
3.2 -- By-laws of Digex. Incorporated herein by reference from
Digex's Form 10-Q (File No. 000-26873) filed with the SEC
on May 12, 2000.
3.3 -- Certificate of Designation for the Series A Preferred Stock.
Incorporated herein by reference from Digex's registration
statement on Form S-1 (File No. 333-94879) filed with the
SEC on January 18, 2000.
3.4 -- Proposed Amendment to the Certificate of Incorporation.
Incorporated herein by reference from Digex's Form 8-K (File
No. 000-26873) filed with the SEC on February 15, 2001.
10.1 -- Promissory Note, dated May 29, 2001, between Digex and
Intermedia. Incorporated herein by reference from Digex's
Form 10-Q (File No. 000-26873) filed with the SEC on
May 12, 2000.
10.2 -- Note Purchase Agreement, dated July 31, 2001, between Digex
and WorldCom.
10.3 -- Employment letter, dated April 10, 2001, between Digex and
Xxxxxx X. Xxxxx. (1)
------------------------
(1) Management contract or compensatory plan or arrangement.
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(b) REPORTS ON FORM 8-K
The following reports on Form 8-K of Digex were filed during the third
quarter of 2001:
Digex filed a Current Report on Form 8-K, dated July 13, 2001, reporting
under Item 1 the change in control of Intermedia (and Digex, indirectly)
following the consummation of the Intermedia--WorldCom Merger on July 1,
2001 and the appointment of four members to the board of directors effective
July 1, 2001. Digex also reported under Item 7 the filing of the press
release as an exhibit to the Form 8-K.
Digex filed a Current Report on Form 8-K, dated August 2, 2001,
reporting under Item 1 the appointment of four additional members to the
board of directors and under Item 5 the issuance of a press release
discussing Digex's second quarter 2001 results. Digex also reported under
Item 7 the filing of the press release as an exhibit to the Form 8-K.
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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.
DIGEX, INCORPORATED
(Registrant)
By: /s/ XXXXXXX X. XXXXX
-----------------------------------------
Xxxxxxx X. Xxxxx
CHIEF FINANCIAL OFFICER
By: /s/ T. XXXXX XXXXXXXXX
-----------------------------------------
T. Xxxxx Xxxxxxxxx
VICE PRESIDENT AND CONTROLLER
Dated: November 14, 2001
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