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INTERNAP NETWORK SERVICES CORP - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULT OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) Forward-Looking Statements This Quarterly Report on Form 10-Q contains "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include, among others, statements regarding industry trends, our future financial position and performance, business strategy, revenues and expenses in future periods, projected levels of growth and other matters that do not relate strictly to historical facts. These statements are often identified by words such as "may," "will," "seeks," "anticipates," "believes," "vision," "estimates," "expects," "projects," "forecasts," "plans," "intends," "continue," "could" or "should," statements regarding our vision or similar expressions or variations. These statements are based on the beliefs and expectations of our management team based on information currently available. Such forward-looking statements are not guarantees of future performance and are subject to risks and uncertainties that could cause actual results to differ materially from those contemplated by forward-looking statements. Important factors currently known to our management that could cause or contribute to such differences include, but are not limited to, those referenced in our Annual Report on Form 10-K for the year ended December 31, 2013 under Item 1A "Risk Factors." We undertake no obligation to update any forward-looking statements as a result of new information, future events or otherwise. As used herein, except as otherwise indicated by context, references to "we," "us" or "our" refer to Internap Network Services Corporation and our subsidiaries. Overview We strive to help people build and manage the world's best performing Internet infrastructure. Today, our infrastructure services power many of the applications that shape the way we live, work and play. Our hybrid Internet infrastructure services blend virtual and bare-metal cloud, hosting and colocation services across a global network of data centers, optimized from the application to the end user and backed by our customer support. We believe many of the world's most innovative companies rely on us to make their applications faster and more scalable. Operating Segments Data Center Services Our data center services segment includes colocation, hosting and cloud services. Colocation involves providing physical space within data centers and associated services such as power, interconnection, environmental controls, monitoring and security while allowing our customers to deploy and manage their servers, storage and other equipment in our secure data centers. Hosting and cloud services involve the provision and maintenance of hardware, operating system software, management and monitoring software, data center infrastructure and interconnection, while allowing our customers to own and manage their software applications and content. We sell our data center services at 52 data centers across North America, Europe and the Asia-Pacific region. We refer to 17 of these facilities as "company-controlled," meaning we control the data centers' operations, staffing and infrastructure and have negotiated long-term leases for the facilities. For company-controlled facilities, in most cases we design the data center infrastructure, procure the capital equipment, deploy the infrastructure and are responsible for the operation and maintenance of the facility. We refer to the remaining 35 data centers as "partner" sites. In these locations, a third-party designs and deploys the infrastructure and provides for the operation and maintenance of the facility. Within the data center services segment, we identify between "core" and "partner colocation" revenues. Core revenues are from our company-controlled colocation, hosting and cloud services and include all revenue from iWeb Technologies Inc., formerly known as iWeb Group Inc., ("iWeb"), which we acquired in November 2013. Partner colocation revenues are from our third-party colocation sites. IP Services Our Internet Protocol ("IP") services segment includes our patented Performance IP™ service, content delivery network ("CDN") services and IP routing hardware and software platform. By intelligently routing traffic with redundant, high-speed connections over multiple, major Internet backbones, our IP services provide high-performance and highly-reliable delivery of content, applications and communications to end users globally. We deliver our IP services through 89 IP service points around the world. Our patented and patent-pending network route optimization technologies address inherent weaknesses of the Internet, allowing businesses to take advantage of the convenience, flexibility and reach of the Internet to connect to customers, suppliers and partners, and to adopt new IT delivery models, in a scalable, reliable and predictable manner. 9 Our CDN services enable our customers to quickly and securely stream and distribute rich media and content, such as video, audio software and applications, to audiences across the globe through strategically located points of presence. Providing capacity-on-demand to handle large events and unanticipated traffic spikes, we deliver scalable high-quality content distribution and audience-analytic tools. Recent Accounting Pronouncements Recent accounting pronouncements are summarized in note 9 to the accompanying consolidated financial statements. Currently, we do not expect any recent accounting pronouncements that we have not yet adopted to have a material impact on our consolidated financial statements. Results of Operations As of September 30, 2014, we had approximately 12,000 customers. Our customer base is not concentrated in any particular industry and, for the three and nine months ended September 30, 2014, no single customer accounted for 10% or more of our revenues. Three Months Ended September 30, 2014 and 2013 The following table sets forth selected consolidated statements of operations and comprehensive loss data during the periods presented, including comparative information between the periods (dollars in thousands): Three Months Ended Increase (decrease) from September 30, 2013 to 2014 2014 2013 Amount Percent Revenues: Data center services: Core $ 49,941 $ 32,857 $ 17,084 52 % Partner colocation 11,699 12,631 (932 ) (7 ) Total data center services 61,640 45,488 16,152 36 IP services 23,027 24,084 (1,057 ) (4 ) Total revenues 84,667 69,572 15,095 22 Operating costs and expenses: Direct costs of network, sales and services, exclusive of depreciation and amortization, shown below: Data center services 27,716 23,171 4,545 20 IP services 9,432 9,624 (192 ) (2 ) Direct costs of customer support 9,114 7,528 1,586 21 Direct costs of amortization of acquired technologies 1,524 1,273 251 20 Sales and marketing 8,858 8,048 810 10 General and administrative 11,611 8,740 2,871 33 Depreciation and amortization 19,391 12,264 7,127 58 Loss on disposal of property and equipment, net - 4 (4 ) - Exit activities, restructuring and impairments 56 274 (218 ) (80 ) Total operating costs and expenses 87,702 70,926 16,776 24 Loss from operations $ (3,035 ) $ (1,354 ) $ (1,681 ) 124 Interest expense $ 6,699 $ 2,429 $ 4,270 176 Data Center Services Revenues for data center services increased $16.2 million, or 36%, to $61.6 million for the three months ended September 30, 2014, compared to $45.5 million for the same period in 2013. The increase was primarily due to growth in our core revenues, of which $11.9 million is attributable to iWeb. Direct costs of data center services, exclusive of depreciation and amortization, increased $4.5 million, or 20%, to $27.7 million for the three months ended September 30, 2014, compared to $23.2 million for the same period in 2013. The increase in direct costs was primarily due to revenue growth and $2.2 million of costs attributable to iWeb. Direct costs of data center services, exclusive of depreciation and amortization, have substantial fixed cost components, primarily rent for operating leases, but also significant demand-based pricing variables, such as utilities attributable to seasonal costs and customers' changing power requirements. Direct costs of data center services as a percentage of revenues vary with the mix of usage between company-controlled data centers and partner sites, and the utilization of total available space. Since we recognize some of the initial operating costs of company-controlled data centers in advance of revenues or in advance of sites being fully utilized, these sites are less profitable in the early years of operation compared to partner sites and we expect them to be more profitable as occupancy increases. Conversely, costs in partner sites are more demand-based and therefore are more closely associated with the level of utilization. 10 We continue to focus on increasing revenues from company-controlled facilities as compared to partner sites. We also expect direct costs of data center services as a percentage of corresponding revenues to decrease as our new and recently-expanded company-controlled data centers continue to contribute to revenue and become more fully occupied. This is evidenced by the improvement in direct costs of data center services as a percentage of corresponding revenues of 45% during the three months ended September 30, 2014, compared to 51% during the same period in 2013. IP Services Revenues for IP services decreased $1.1 million, or 4%, to $23.0 million for the three months ended September 30, 2014, compared to $24.1 million for the same period in 2013. The decrease continues to be driven by a decline in IP pricing for new and renewing customers and the loss of legacy contracts, partially offset by an increase in overall traffic. IP traffic increased approximately 8% for the three months ended September 30, 2014, compared to the same period in 2013, calculated based on an average over the number of months in the respective periods. Direct costs of IP services, exclusive of depreciation and amortization, decreased $0.2 million, or 2%, to $9.4 million for the three months ended September 30, 2014, compared to $9.6 million for the same period in 2013. This decrease was primarily due to renegotiation of vendor contracts and cost reduction efforts. There have been ongoing industry-wide pricing declines over the last several years and this trend continued during the three months ended September 30, 2014 and 2013. Technological improvements and excess capacity have been the primary drivers for lower pricing of IP services. The increase in IP traffic resulted from both new and existing customers using more applications and the nature of applications consuming greater amounts of bandwidth. Other Operating Costs and Expenses Compensation. Total compensation and benefits, including stock-based compensation, were $19.1 million and $17.2 million for the three months ended September 30, 2014 and 2013, respectively. The increase was primarily due to $2.1 million of expenses attributable to iWeb, a $0.8 million increase in bonus accrual related to annual salary increases and expected achievement levels under our variable compensation plan, partially offset by a $0.7 million decrease in cash-based compensation and payroll costs due to decreased headcount and a $0.6 million decrease in commissions. Stock-based compensation, net of amount capitalized, increased to $1.8 million during the three months ended September 30, 2014 from $1.7 million during the same period in 2013. The increase was primarily due to stock-based compensation granted to certain iWeb employees after the acquisition. The following table summarizes the amount of stock-based compensation, net of estimated forfeitures, included in the accompanying consolidated statements of operations and comprehensive loss (in thousands): Three Months Ended September 30, 2014 2013 Direct costs of customer support $ 353 $ 331 Sales and marketing 248 359 General and administrative 1,177 1,019 $ 1,778 $ 1,709 Direct Costs of Customer Support. Direct costs of customer support increased 21% to $9.1 million during the three months ended September 30, 2014 from $7.5 million during the same period in 2013. The increase was primarily due to $1.7 million of expenses attributable to iWeb. Sales and Marketing. Sales and marketing costs increased 10% to $8.9 million during the three months ended September 30, 2014 from $8.0 million during the same period in 2013. The increase was primarily due to $1.7 million of expenses attributable to iWeb, partially offset by a $0.6 million decrease in commissions. General and Administrative. General and administrative costs increased 33% to $11.6 million during the three months ended September 30, 2014 from $8.7 million during the same period in 2013. The increase was primarily due to $2.0 million of expenses attributable to iWeb and a $0.8 million increase in bonus accrual. Depreciation and Amortization. Depreciation and amortization increased 58% to $19.4 million during the three months ended September 30, 2014 from $12.3 million during the same period in 2013. The increase was primarily due to the effects of expanding our company-controlled data centers, private network access point infrastructure and capitalized software, including $3.0 million of expenses related to iWeb. 11 Interest Expense. Interest expense increased to $6.7 million during the three months ended September 30, 2014 from $2.4 million during the same period in 2013. The increase in interest expense was primarily due to increased borrowings and interest rate under our credit agreement. Nine Months Ended September 30, 2014 and 2013 The following table sets forth selected consolidated statements of operations and comprehensive loss data during the periods presented, including comparative information between the periods (dollars in thousands): Nine Months Ended Increase (decrease) from September 30, 2013 to 2014 2014 2013 Amount Percent Revenues: Data center services: Core $ 145,679 $ 96,608 $ 49,071 51 % Partner colocation 35,639 38,853 (3,214 ) (8 )Total data center services 181,318 135,461 45,857 34 IP services 69,378 73,794 (4,416 ) (6 ) Total revenues 250,696 209,255 41,441 20 Operating costs and expenses: Direct costs of network, sales and services, exclusive of depreciation and amortization, shown below: Data center services 80,170 68,461 11,709 17 IP services 29,300 29,858 (558 ) (2 )Direct costs of customer support 27,594 22,052 5,542 25 Direct costs of amortization of acquired technologies 4,535 3,643 892 24 Sales and marketing 28,938 23,609 5,329 23 General and administrative 34,439 27,979 6,460 23 Depreciation and amortization 54,773 34,075 20,698 61 Loss on disposal of property and equipment, net 32 4 28 - Exit activities, restructuring and impairments 3,001 1,206 1,795 149 Total operating costs and expenses 262,782 210,887 51,895 25 Loss from operations $ (12,086 ) $ (1,632 ) $ (10,454 ) 640 Interest expense $ 19,996 $ 7,324 $ 12,672 173 Benefit for income taxes $ 982 $ 98 $ 884 902 Data Center Services Revenues for data center services increased $45.9 million, or 34%, to $181.3 million for the nine months ended September 30, 2014, compared to $135.5 million for the same period in 2013. The increase was primarily due to growth in our core revenues, of which $34.8 million is attributable to iWeb and $2.7 million to the renegotiation of customer contracts. Direct costs of data center services, exclusive of depreciation and amortization, increased $11.7 million, or 17%, to $80.2 million for the nine months ended September 30, 2014, compared to $68.5 million for the same period in 2013. The increase in direct costs was primarily due to revenue growth, $6.5 million of direct costs attributable to iWeb and $0.9 million of costs related to the renegotiation of customer contracts. Direct costs of data center services as a percentage of corresponding revenues was 44% during the nine months ended September 30, 2014, compared to 51% during the same period in 2013. IP Services Revenues for IP services decreased $4.4 million, or 6%, to $69.4 million for the nine months ended September 30, 2014, compared to $73.8 million for the same period in 2013. The decrease continues to be driven by a decline in IP pricing for new and renewing customers and the loss of legacy contracts, partially offset by an increase in overall traffic. IP traffic increased approximately 14% for the nine months ended September 30, 2014, compared to the same period in 2013, calculated based on an average over the number of months in the respective periods. Direct costs of IP services, exclusive of depreciation and amortization, decreased $0.6 million, or 2%, to $29.3 million for the nine months ended September 30, 2014, compared to $29.9 million for the same period in 2013. This decrease was primarily due to renegotiation of vendor contracts and cost reduction efforts. 12 Other Operating Costs and Expenses Compensation. Total compensation and benefits, including stock-based compensation, were $61.8 million and $51.7 million for the nine months ended September 30, 2014 and 2013, respectively. The increase was primarily due to a $1.3 million increase in bonus accrual related to annual salary increases and expected achievement levels under our variable compensation plan and $9.2 million of expenses attributable to iWeb, partially offset by $0.7 million decrease in stock-based compensation. Stock-based compensation, net of amount capitalized, increased to $5.7 million during the nine months ended September 30, 2014 from $5.1 million during the same period in 2013. The increase was primarily due to $1.3 million of stock-based compensation granted to certain iWeb employees after the acquisition, partially offset by forfeitures upon employment terminations. The following table summarizes the amount of stock-based compensation, net of estimated forfeitures, included in the accompanying consolidated statements of operations and comprehensive loss (in thousands): Nine Months Ended September 30, 2014 2013 Direct costs of customer support $ 970 $ 882 Sales and marketing 788 960 General and administrative 3,917 3,243 $ 5,675 $ 5,085 Direct Costs of Customer Support. Direct costs of customer support increased 25% to $27.6 million during the nine months ended September 30, 2014 from $22.1 million during the same period in 2013. The increase was primarily due to $5.4 million of expenses attributable to iWeb. Direct Costs of Amortization of Acquired Technologies. Direct costs of amortization of acquired technologies increased 24% to $4.5 million during the nine months ended September 30, 2014 from $3.6 million during the same period in 2013. The increase was primarily due to amortization of technologies acquired in the iWeb acquisition. Sales and Marketing. Sales and marketing costs increased 23% to $28.9 million during the nine months ended September 30, 2014 from $23.6 million during the same period in 2013. The increase was primarily due to $5.5 million of expenses attributable to iWeb, and a $0.5 million increase in agent fees, partially offset by a $0.7 million decrease in cash-based compensation and payroll taxes. General and Administrative. General and administrative costs increased 23% to $34.4 million during the nine months ended September 30, 2014 from $28.0 million during the same period in 2013. The increase was primarily due to $6.4 million of expenses attributable to iWeb, a $1.3 million increase in bonus accrual and a $0.9 million increase in cash-based compensation and payroll costs, partially offset by a $0.6 million decrease in bad debt expense, a $0.6 million decrease in taxes and licenses and a $0.4 million decrease in outside professional services. Depreciation and Amortization. Depreciation and amortization increased 61% to $54.8 million during the nine months ended September 30, 2014 from $34.1 million during the same period in 2013. The increase was primarily due to the effects of expanding our company-controlled data centers, private network access point infrastructure and capitalized software, including $9.5 million of expenses related to iWeb. Exit Activities, Restructuring and Impairments. Exit activities, restructuring and impairments increased to $3.0 million during the nine months ended September 30, 2014 from $1.2 million during the same period in 2013. The expense was primarily due to $1.3 million of initial exit activity charges related to ceasing use of a portion of data center space, $1.1 million of subsequent plan adjustments and a $0.4 million impairment charge for certain leasehold improvements in the nine months ended September 30, 2014. Interest Expense. Interest expense increased to $20.0 million during the nine months ended September 30, 2014 from $7.3 million during the same period in 2013. The increase in interest expense was primarily due to increased borrowings and interest rate under our credit agreement. Benefit for Income Taxes. The benefit for income taxes increased to $1.0 million during the nine months ended September 30, 2014 from $0.1 million during the same period in 2013. Our effective tax rates for the nine months ended September 30, 2014 and 2013 were 3.0% and 1%, respectively. The majority of fluctuation in the effective income tax rate was primarily due to the recognition of income tax benefit from the reversal of uncertain tax positions in 2013 and from the operations of iWeb in 2014. Non-GAAP Financial Measure We report our consolidated financial statements in accordance with accounting principles generally accepted in the United States of America ("GAAP"). We present the non-GAAP performance measure of adjusted EBITDA to assist us in explaining underlying performance trends in our business, which we believe will enhance investors' ability to analyze trends in our business and evaluate our performance relative to other companies. We define adjusted EBTIDA as (loss) income from operations plus depreciation and amortization, loss (gain) on disposal of property and equipment, exit activities, restructuring and impairments, stock-based compensation and acquisition costs. 13 As a non-GAAP financial measure, adjusted EBITDA should not be considered in isolation of, or as a substitute for, net loss or other GAAP measures as an indicator of operating performance. In addition, adjusted EBITDA should not be considered as an alternative to income from operations or net loss as a measure of operating performance. Our calculation of adjusted EBITDA may differ from others in our industry and is not necessarily comparable with similar titles used by other companies. The following table reconciles adjusted EBITDA to loss from operations as presented in our consolidated statements of operations and comprehensive loss: Three Months Ended September 30, 2014 2013 Loss from operations $ (3,035 ) $ (1,354 ) Depreciation and amortization, including amortization of acquired technologies 20,915 13,537 Loss on disposal of property and equipment, net - 4 Exit activities, restructuring and impairments 56 274 Stock-based compensation 1,778 1,709 Adjusted EBITDA $ 19,714 $ 14,170 Liquidity and Capital Resources Liquidity We monitor and review our performance and operations in light of global economic conditions, which could impact the ability of our customers to meet their obligations to us, which could delay collection of accounts receivable and increase our provision for doubtful accounts. We expect to meet our cash requirements for the next 12 months through a combination of net cash provided by operating activities, existing cash on hand and utilizing additional borrowings under our credit agreement described below in "Capital Resources-Credit Agreement." Our capital requirements depend on a number of factors, including the continued market acceptance of our services and the ability to expand and retain our customer base. If our cash requirements vary materially from what we expect or if we fail to generate sufficient cash flows from selling our services, we may require additional financing sooner than anticipated. We can offer no assurance that we will be able to obtain additional financing on commercially favorable terms, or at all, and provisions in our credit agreement limit our ability to incur additional indebtedness. Our anticipated uses of cash include capital expenditures, working capital needs and required payments on our credit agreement and other commitments. We have a history of quarterly and annual period net losses. During the three and nine months ended September 30, 2014, we had a net loss of $9.3 million and $31.2 million, respectively. As of September 30, 2014, our accumulated deficit was $1.1 billion. We continue to analyze our business to control our costs, principally through making process enhancements and renegotiating network contracts for more favorable pricing and terms. We may not be able to sustain or increase profitability on a quarterly basis, and our failure to do so may adversely affect our business, including our ability to raise additional funds. Capital Resources Credit Agreement. We have a $350.0 million credit agreement, which provides for a $300.0 million term loan and a $50.0 million revolving credit facility. As of September 30, 2014, the term loan had an outstanding principal amount of $297.8 million, which we repay in $750,000 quarterly installments on the last day of each fiscal quarter with the remaining unpaid balance due November 26, 2019. As of September 30, 2014, the revolving credit facility, expiring in November 2018, had an outstanding balance of $5.0 million and we issued $6.6 million letters of credit, resulting in $38.4 million in borrowing capacity. As of September 30, 2014, the interest rate on the term loan was 6% and the revolving credit facility was 4.7%. The credit agreement includes customary representations, warranties, negative and affirmative covenants, including certain financial covenants relating to maximum total leverage ratio, minimum consolidated interest coverage ratio and limitation on capital expenditures. As of September 30, 2014, we were in compliance with these covenants. Capital Leases. During the three months ended September 30, 2014, we completed sale-leaseback transactions with third-parties for a total of $2.6 million of cash proceeds. As a result of these transactions, we recorded capital lease obligations of $1.5 million. During the three months ended March 31, 2014, we exercised a renewal option of an existing operating lease for company-controlled data center properties in Montreal. The lease extension, for accounting purposes, triggered a new lease which expires in 2032, with the new terms resulting in capital lease treatment. We recorded property of $6.0 million, net of the deferred rent balance on the previous operating lease, and a capital lease obligation of $7.4 million. 14 We summarize our new capital lease obligations in note 5 to the accompanying consolidated financial statements. Our present value of minimum lease payments on all remaining capital lease obligations at September 30, 2014 was $60.2million. Cash Flows Operating Activities Net cash provided by operating activities during the nine months ended September 30, 2014 was $36.2 million. We generated cash from operations of $36.2 million as a result of adjustments for non-cash items from our net loss, while changes in operating assets and liabilities generated cash from operations of less than $0.1 million. We expect to use cash flows from operating activities to fund a portion of our capital expenditures and other requirements and to meet our other commitments and obligations, including outstanding debt. Investing Activities Net cash used in investing activities during the nine months ended September 30, 2014 was $50.6 million, primarily due to capital expenditures related to the continued expansion and upgrade of our company-controlled data centers and network infrastructure, partially offset by $2.6 million of proceeds from sale-leaseback transactions. Financing Activities Net cash provided by financing activities during the nine months ended September 30, 2014 was $5.1 million, primarily due to $5.0 million of proceeds from the revolving credit facility and a return of deposit collateral of $6.5 million, partially offset by principal payments of $6.5 million on the credit agreement and capital lease obligations. |