Description
Filed with the SEC from May 19 to May 25:
Internap Network Services (INAP)
Gamco Investors (GBL) declared ownership of 3,119,618 shares (5.97%), noting it paid a total of $23 million, or $7.37 each.
BUSINESS OVERVIEW
Overview
Internap provides high-performance IT infrastructure services that enable our customers to focus on their core business, improve service levels and lower the cost of IT operations. Our colocation, connectivity and managed hosting solutions are differentiated by superior performance, availability and support.
Data center services are comprised of colocation and managed hosting. Colocation allows our customers to deploy and manage their servers, storage and other equipment in our secure data centers. Our managed hosting services increase our customers’ operating flexibility while eliminating the need to provision and manage their own data centers, servers, storage and operating systems.
We sell our colocation and/or managed hosting services at 37 data centers across North America, Europe and the Asia-Pacific region. We refer to nine of these facilities as “company-controlled,” meaning we control the data centers’ operations and infrastructure and have directly negotiated long-term leases with the properties’ lessors. We refer to the remaining 28 data centers as “partner” sites. In these locations, we typically do not control operations and infrastructure, and lease terms are shorter than those in company-controlled properties. Our company-controlled facilities feature our enhanced IP connectivity, are designed and operated to be fully-secure and provide best-in-class power and environmental reliability.
During 2010, we opened a new company-controlled data center in Santa Clara, California and expanded one of our company-controlled data centers in Seattle, Washington. These data centers utilize green data center practices to minimize energy consumption and environmental impact. We also expanded our company-controlled data centers in Houston, Texas and Boston, Massachusetts. These new and expanded data centers collectively added 30,000 net sellable square feet to our company-controlled data center footprint.
IP services include our patented Performance IP™ service, our XIP™ Acceleration-as-a-Service solution, our content delivery network (“CDN”) and flow control platform (“FCP”) products. 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. Our IP services are sold through 76 Internet Protocol (“IP”) service points around the world, which include 20 CDN points of presence (“POPs”) and one additional standalone CDN POP. Our service level agreements (“SLAs”) guarantee performance across multiple networks covering a broader segment of the Internet in the United States, excluding local connections, than providers of conventional Internet connectivity which typically only guarantee performance on their own network.
We currently have approximately 2,700 customers across 28 metropolitan markets, serving a variety of industries, such as entertainment and media, including gaming; financial services; business services; software, including software-as-a-service (“SaaS”); hosting and information technology infrastructure; and telecommunications. For the year ended December 31, 2010, revenues generated and long-lived assets located outside the United States (“U.S.”) were each less than 10% of our total revenues and assets.
We were incorporated as a Washington corporation in 1996 and reincorporated in Delaware in 2001. Our principal executive offices are located at 250 Williams Street, Atlanta, Georgia 30303, and our telephone number is (404) 302-9700. Our common stock trades on the NASDAQ Global Market under the symbol “INAP.” Our website address is www.internap.com .
Industry Background
The Need to Reduce IT Costs While Improving Performance and Capabilities
Businesses need to focus on their core competencies, while using the latest technologies to effectively manage their data. Rapid shifts in technology and the associated costs of training employees, as well as costs to maintain or upgrade equipment and facilities to support more complex applications, have led companies to increasingly outsource their IT infrastructure. Because IT outsourcing providers specialize and can purchase and deploy capabilities at scale, they can provide IT Infrastructure services as a more cost effective solution to lower IT costs for these companies.
The Growing Demand for Secure and Reliable Data Center and Managed Hosting Environments
Businesses and organizations continue to move more data, applications and operations online, creating a demand for secure and reliable data center environments. Many companies do not have the capital or the time to manage ongoing data center operations for their business. As a result, we provide companies secure, offsite environments for their equipment or an outsourced hosting service for their applications and business-critical websites. Our data centers improve a company’s ability to directly connect to network service providers (“NSPs”), which avoids local loops and mitigates online risk.
The Problem of Inefficient Routing of Data Traffic on the Internet
An individual internet service provider (“ISP”) only controls the routing of data within its network and its routing practices tend to compound the inefficiencies of the Internet. When an ISP receives a packet that is not destined for one of its own customers, it must route that packet to another ISP to complete the delivery of the packet over the Internet. An ISP will often route the data from private connections, or peered data, to the nearest point of traffic exchange, in an effort to get the packet off its network and onto a competitor’s network as quickly as possible to reduce capacity and management burdens on its own transport network. Once the origination traffic leaves the network of an ISP, SLAs with that ISP typically do not apply since that carrier cannot control the service quality on the network of another ISP. Consequently, to complete a communication, data ordinarily passes through multiple networks and peering points without consideration for congestion or other factors that inhibit performance. For customers of conventional Internet connectivity providers, this transfer can result in lost data, slower and more erratic transmission speeds and an overall lower quality of service, especially where the ISP is not familiar with the performance of the destination network. The quality of service can be further degraded by basic routing protocols that make assumptions about the “best” path or network to route traffic to, without consideration of the performance of that network. Equally important, customers have no control over the transmission arrangements and have no single point of contact that they can hold accountable for degradation in service levels, such as poor data transmission performance or service failures. As a result, it is virtually impossible for a single ISP to offer a high quality of service across disparate networks.
The Importance of the Internet for Business-Critical Internet-Based Applications
The Internet is the communications platform for an ever-increasing number of business-critical Web- and Internet-based applications, such as those relating to electronic commerce, Voice over IP (“VoIP”), supply chain management, customer relationship management, project coordination, streaming media, video conferencing and collaboration. Businesses are redesigning their information technology operations models to take advantage of new, more cost-effective application delivery models, such as SaaS, hosting and cloud computing. These new delivery models rely on the Internet as the primary means of communicating with customers and users. This results in enhanced expectations of performance, availability and transparent delivery for the business application to work as expected. Businesses often are unable to benefit from the full potential of the Internet. The emergence of technologies and applications that rely on network quality and require consistent, high-speed data transfer are often hindered by inconsistent performance.
The Growing Demand for Delivery of Rich Media Content over the Internet
The proliferation of Internet-connected devices and broadband Internet connections coupled with increased consumption of media over the Internet including personalized media content have created a demand for delivery of rich media content. Increasingly, as the volume and quality of dynamic content progresses, viewers spend more time using the Internet and expect superior performance regardless of the type of website they visit. Companies that need to deliver rich media content can utilize basic Internet connectivity or a CDN. But due to its inherent weaknesses, delivery of rich media content over the Internet is not reliable. To overcome this problem, companies can either invest substantial capital to build the infrastructure to bypass the public Internet or utilize a third party’s CDN.
Segments
We operate in two business segments: data center services and IP services. The data center services segment includes physical space for hosting customers’ network and other equipment, managed hosting and services such as redundant power and network connectivity, environmental controls and security. The IP services segment includes our IP transit activities and high performance Internet connectivity, CDN services and flow control platform (“FCP”) products.
Data Center Services
Our data center services segment includes colocation services, which involve physical space for hosting customers’ IT infrastructure network and other equipment as well as associated services such as redundant power and network connectivity, environmental controls and security. The segment also includes managed hosting services whereby our customers own and manage the software applications and content, while we provide and maintain the hardware, operating system, colocation and bandwidth.
Our data center services enable us to have a more flexible product offering and bundle these services with our high performance IP connectivity and CDN services, along with hosting customers’ infrastructure, data or applications. Our data center services provide a single source for network infrastructure, IP connectivity and security, all of which are designed to maximize solution performance while providing a more stable, dependable infrastructure, and are backed by SLAs and our team of dedicated support professionals.
We use a combination of company-controlled data centers and partner sites. We offer a comprehensive solution at 37 data centers, consisting of nine company-controlled data centers and 28 partner sites. We charge monthly fees for data center services based on the amount of square footage and power that our customers use. We also have relationships with various data center providers to extend our P-NAP model into markets with high demand.
We believe the demand for data center services continues to outpace industry-wide supply. To address this demand, we increased our capital expenditures, which allowed us to open a new company-controlled data center in Santa Clara and expand three of our company-controlled data centers in Seattle, Houston and Boston. These expansions increased the footprint of our company-controlled data centers by 30,000 net sellable square feet.
As a service provider, in today’s global economy, we must demonstrate that we have adequate controls and safeguards in place to protect our customers’ infrastructure in our data centers. To do this, we utilize a third-party service auditor (an independent accounting firm) to perform an examination in accordance with Statement on Auditing Standards No. 70 (commonly referred to as a “SAS 70” Audit) and issue a Type II report which includes a description of our controls, along with detailed testing of the design and operation of these controls. We have SAS 70 Audits performed at our company-controlled data centers every six months. Additionally, the underlying providers for several of our partner sites also have SAS 70 Audits performed and we have obtained and reviewed these reports to our satisfaction.
IP Services
IP services represent our IP transit activities and include our patented Performance IP service, XIP Acceleration-as-a-Service solution,, CDN services, FCP products and a new public cloud storage service in its beta stage. Our intelligent routing technology facilitates traffic over multiple carriers’ networks, as opposed to just one carrier’s network, to ensure highly-reliable performance over the Internet. We believe that our unique managed multi-network approach provides better performance, control and reliability as compared to conventional Internet connectivity alternatives.
Our patented and patent-pending network route optimization technologies address the 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 information technology delivery models, in a reliable and predictable manner. Our services and products take into account the unique performance requirements of each business application to ensure performance as designed, without unnecessary cost. Our fees for IP services are based on a fixed fee, usage or a combination of both.
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 data POPs. Providing capacity-on-demand to handle large events and unanticipated traffic spikes, we deliver scalable high-quality content distribution and the analytic tools to allow our customers to refine their marketing programs.
Our FCP products are a premise-based intelligent routing hardware product for customers who run their own multiple network architectures, known as multi-homing. We offer FCP as either a one-time hardware purchase or as a monthly subscription service. Sales of FCP also generate annual maintenance fees and professional service fees for installation.
Data Centers, Network Access Points and Points of Presence
We provide services through our network access points across North America, Europe and the Asia-Pacific region. Our P-NAPs and data centers feature multiple direct high-speed connections to major NSPs. We provide access to the Internet for our CDN customers through our CDN POPs. As of December 31, 2010, we provided services worldwide through 76 IP service points, which includes 21 CDN POPs and 37 data centers. We directly operate nine of these data center sites and have operating agreements with third parties for the remaining locations. We have P-NAPs, CDN POPs and/or data centers in the following markets, some of which have multiple sites:
(1)
Through our joint venture in Internap Japan Co., Ltd. with NTT-ME Corporation and Nippon Telegraph and Telephone Corporation.
Financial Information about Geographic Areas
For each of the three years ended December 31, 2010, we derived less than 10% of our total revenues from operations outside the United States.
Sales and Marketing
Our sales and marketing objective is to achieve market penetration and increase brand recognition among business customers in key industries that use the Internet for strategic and business-critical operations. We employ a direct sales team with extensive and relevant sales experience in our target markets. Our sales offices are located in key cities across North America, as well as an office in the United Kingdom.
To support our sales efforts and promote the Internap brand, we conduct comprehensive marketing programs. Our marketing strategies include advertising, online marketing, social media, participation at trade shows, email marketing programs, facility open houses, an active public relations and analyst relations program and continuing customer communications.
Research and Development
Research and development costs, which include product development costs, are included in general and administrative cost and are expensed as incurred. These costs primarily consist of compensation and consulting fees related to our development and enhancement of IP routing technology, progressive download and streaming technology for our CDN, acceleration and cloud technologies and network engineering costs associated with changes to the functionality of our proprietary services and network architecture. Research and development costs were $1.9 million, $3.8 million and $5.0 million during the years ended December 31, 2010, 2009 and 2008, respectively. These costs do not include $0.9 million, $0.9 million and $1.4 million of internal-use software costs capitalized during the years ended December 31, 2010, 2009 and 2008, respectively.
Customers
As of December 31, 2010, we had approximately 2,700 customers. We provide services to customers in a variety of industries, such as entertainment and media, including gaming; financial services; business services; software, including SaaS; hosting and information technology infrastructure; and telecommunications. Our customer base, however, is not concentrated in any particular industry. In each of the past three years, no single customer accounted for 10% or more of our net revenues.
Competition
The market for our services is intensely competitive and is characterized by technological change, the introduction of new products and services and price erosion. We believe that the principal factors of competition for service providers in our target markets include speed and reliability of connectivity, quality of facilities, level of customer service and technical support, price and brand recognition. We believe that we compete favorably on the basis of these factors.
Our current and potential competition primarily consists of:
â—Ź Colocation and hosting providers, including Equinix, Inc.; Terremark Worldwide, Inc.; NaviSite, Inc.; Rackspace, Inc.; Quality Technology Services and Savvis, Inc;
â—Ź NSPs that provide connectivity services, including AT&T Inc.; Sprint Nextel Corporation; Verizon Communications Inc.; Level 3 Communications, Inc.; Global Crossing Limited and Verio, an NTT Communications Company;
â—Ź Providers of specific applications or services, such as content delivery, security or storage such as Akamai Technologies, Inc.; Limelight Networks, Inc.; CD Networks Co., Ltd.; Mirror Image Internet, Inc.; Symantec Corporation; Network Appliance, Inc. and Virtela Communications, Inc.; and
â—Ź Software-based, Internet infrastructure companies focused on IP route control and wide area network optimization products such as Riverbed Technology, Inc.; F5 Networks, Inc. and Radware Ltd.
Competition has resulted, and will likely continue to result, in price pressure on us. Many of our competitors have longer operating histories and presence in key markets, greater name recognition, larger customer bases and significantly greater financial, sales and marketing, distribution, engineering, technical and other resources than we have. As a result, these competitors may be able to introduce emerging technologies on a broader scale and adapt to changes in customer requirements, potentially at lower costs, or to devote greater resources to the promotion and sale of their services and products. In all of our markets, we also may face competition from newly established competitors, suppliers of services or products based on new or emerging technologies and customers that choose to develop their own network services or products. We also may encounter further consolidation in the markets in which we compete, such as the recent announcements of the acquisitions of Terremark Worldwide, Inc. and NaviSite, Inc. Increased competition could result in pricing pressures, decreased gross margins and loss of market share, which may materially and adversely affect our business, consolidated financial condition, results of operations and cash flows.
Intellectual Property
Our success and ability to compete depend in part on our ability to develop and maintain the proprietary aspects of our IT infrastructure services and operate without infringing on the proprietary rights of others. We rely on a combination of patent, trademark, trade secret and contractual restrictions to protect the proprietary aspects of our technology. As of December 31, 2010, we had 21 patents (16 issued in the United States and 5 issued internationally) that extend to various dates between 2017 and 2027, and 12 registered trademarks in the United States. Although we believe the protection afforded by our patents, trademarks and trade secrets has value, the rapidly changing technology in our industry and uncertainties in the legal process make our future success dependent primarily on the innovative skills, technological expertise and management abilities of our employees rather than on the protection afforded by patent, trademark and trade secret laws. We seek to limit disclosure of our intellectual property by requiring employees and consultants with access to our proprietary information to execute confidentiality agreements with us.
Employees
As of December 31, 2010, we had 416 employees. None of our employees are represented by a labor union, and we have not experienced any work stoppages to date. We consider the relationships with our employees to be good. Competition for technical personnel in the industries in which we compete is intense. We believe that our future success depends in part on our continued ability to hire, assimilate and retain qualified personnel. We can offer no assurances that we will be successful in recruiting and retaining qualified employees in the future.
CEO BACKGROUND
EXECUTIVE OFFICERS
In addition to Mr. Cooney, our Chief Executive Officer and President, whose biographical information appears under “Proposal 1—Election of Directors,” set forth below are the names, ages and biographical information for each of our current executive officers.
Name
Age
Position
J. Eric Cooney
45
Chief Executive Officer and President
George E. Kilguss III
50
Chief Financial Officer
Steven A. Orchard
39
Senior Vice President, Operations and Support
Randal R. Thompson
43
Senior Vice President, Global Sales
MANAGEMENT DISCUSSION FROM LATEST 10K
The following discussion should be read in conjunction with the accompanying consolidated financial statements and notes provided under Part II, Item 8 of this Annual Report Form 10-K. Certain prior year disclosures within the following discussion have been reclassified to conform to the current year presentation.
Financial Highlights and Outlook
Data center services revenue grew $8.0 million during 2010, although this growth was offset by an $10.5 million reduction due to our proactive churn program. We completed the proactive churn of customer contracts in partner sites on schedule at the end of 2010. We expect our data center revenue to grow in future periods as we have expanded the number and size of the data center sites that we operate and expect to add additional space as part of our continuing data center growth initiative. Our anticipated growth in data center revenues and direct costs of data center services will largely follow our expansion of data center space, and we believe the demand for data center services continues to outpace industry-wide supply.
We continue to experience pricing pressure for our IP services, which has contributed to our decrease in IP services revenue year-over-year. We historically priced our IP services at a premium compared to the services offered by conventional Internet connectivity service providers. However, due to competitive forces, we have been required to lower pricing of our IP services, although this decrease in pricing has been offset by an increase in demand for our IP services. As our IP traffic continues to grow, we expect to obtain lower bandwidth rates and more opportunities to proactively manage network costs, such as utilization and traffic optimization among NSPs. We expect that we will continue to experience pricing pressure as well as gains in IP traffic for these reasons.
In November 2010, we entered into a new $80.0 million credit agreement, which replaced our prior $35.0 million credit facility. We summarize the credit agreement in “—Liquidity and Capital Resources—Capital Resources—Credit Agreement” and in note 10 to the accompanying consolidated financial statements.
Subsequent Events
Approval of Annual Performance Bonuses and Increases in Base Salary
On February 22, 2011, our compensation committee, in the case of named executive officers other than our Chief Executive Officer, and our board of directors, in the case of our Chief Executive Officer, approved bonuses under our 2010 Short-Term Incentive Plan, which we previously filed as Exhibit 10.35 to our Annual Report on Form 10-K for the fiscal year ended December 31, 2009. These bonuses were awarded based upon achievement of individual and corporate objectives. We will pay the bonuses in cash on or before March 15, 2011.
In addition, our compensation committee approved an increase in the base salary of certain executive officers effective April 1, 2011, as follows: Mr. Kilguss, from $290,000 to $300,000; Mr. Thompson from $230,000 to $235,000 and Mr. Orchard from $195,000 to $210,000.
Approval of 2011 Long-Term Incentive Grants
On February 22, 2011, our compensation committee, in the case of named executive officers other than our Chief Executive Officer, and our board of directors, in the case of our Chief Executive Officer, approved long-term incentive grants based on the individual’s role in our company and individual performance. The grants will be made on February 25, 2011. Of each award, 80% of the total grant will be in the form of stock options and 20% will be in the form of time-based restricted common stock, except that 100% of the grant to our Chief Executive Officer will be in the form of stock options. The stock options vest 25% after one year and in equal monthly increments for three years thereafter. The time-based restricted common stock vests in four equal annual installments on the anniversary of the grant date. The options have a 10-year term and will have an exercise price equal to the fair market value of our common stock on February 25, 2011, the grant date. The following grants were approved::
On February 22, 2011, our compensation committee approved the 2011 Short Term Incentive Plan. Under the plan, all full time exempt and eligible non-exempt employees (including named executive officers) may be eligible for the award of a cash bonus after our 2011 fiscal year end. The cash bonus of each participant (other than our Chief Executive Officer and Chief Financial Officer) will be based on achievement of corporate and personal objectives, with a target award level expressed as a percentage of salary. The cash bonus of our Chief Executive Officer and Chief Financial Officer will be based on achievement of corporate objectives only, with a target award level expressed as a percentage of salary. The corporate objectives are based on revenue and earnings before interest, taxes, depreciation and amortization (“EBITDA”). The personal objectives are individualized for each participant.
On February 24, 2011, we entered into a lease for expansion of company-controlled data center space in Dallas, Texas. The lease has a term of approximately 11 years and expands our company-controlled data center footprint by 55,000 net sellable square feet.
Critical Accounting Policies and Estimates
This discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which we have prepared in accordance with accounting principles generally accepted in the U.S. (“GAAP”). The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expense and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those summarized below. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances; the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ materially from these estimates.
In addition to our significant accounting policies summarized in note 2 to our accompanying consolidated financial statements, we believe the following policies are the most sensitive to judgments and estimates in the preparation of our consolidated financial statements.
Revenue Recognition
We generate revenues primarily from the sale of data center services and IP services. We recognize revenue each month provided that we have entered into a written contract and delivered the service to the customer, the fee for the service is fixed or determinable and collection is reasonably assured. Our revenues typically consist of monthly recurring revenues from contracts with terms of one year or more. Data center contracts usually have fixed charges for space occupied, power utilized and cable or fiber connections. IP service contracts usually have fixed minimum commitments based on a certain level of bandwidth usage with additional charges for any usage over a specified limit. If a customer’s usage exceeds the monthly minimum commitment, we recognize revenue for such excess in the period of usage.
We record a reserve amount for SLAs and other sales adjustments, which reduces gross revenues and accounts receivable. We identify adjustments for SLAs within the billing period and reduce revenues accordingly. We base the amount for sales adjustments upon specific customer information, including customer disputes, credit adjustments not yet processed through the billing system and historical activity. If the financial condition of our customer deteriorates or if we become aware of new information impacting a customer’s credit risk, we may make additional adjustments.
We routinely review the collectability of our accounts receivable and payment status of our customers. If we determine that collection of revenue is uncertain, we do not recognize revenue until collection is reasonably assured. Additionally, we maintain an allowance for doubtful accounts resulting from the inability of our customers to make required payments on accounts receivable. We base the allowance for doubtful accounts upon general customer information, which primarily includes our historical cash collection experience and the aging of our accounts receivable. We assess the payment status of customers by reference to the terms under which we provide services or goods, with any payments not made on or before their due date considered past-due. Once we have exhausted all collection efforts, we write the uncollectible balance off against the allowance for doubtful accounts. We routinely perform credit checks for new and existing customers and require deposits or prepayments for customers that we perceive as being a credit risk.
Goodwill and Other Intangible Assets
We assess goodwill for impairment at a reporting unit level on an annual basis. Our assessment of goodwill for impairment includes comparing the fair value of our reporting units to the carrying value. We estimate fair value using a combination of discounted cash flow models and market approaches. If the fair value of a reporting unit exceeds its carrying value, goodwill is not impaired and no further testing is necessary. If the carrying value of a reporting unit exceeds its fair value, we perform a second test to measure the amount of impairment to goodwill, if any. To measure the amount of any impairment, we determine the implied fair value of goodwill in the same manner as if we were acquiring the affected reporting unit in a business combination. Specifically, we allocate the fair value of the affected reporting unit to all of the assets and liabilities of that unit, including any unrecognized intangible assets, in a hypothetical calculation that would yield the implied fair value of goodwill. If the implied fair value of goodwill is less than the goodwill recorded on our consolidated balance sheet, we record an impairment charge for the difference.
We base the impairment analysis of goodwill on estimated fair values. The assumptions, inputs and judgments used in performing the valuation analysis are inherently subjective and reflect estimates based on known facts and circumstances at the time we perform the valuation. These estimates and assumptions primarily include, but are not limited to, discount rates; terminal growth rates; projected revenues and costs; projected EBITDA for expected cash flows; market comparables and capital expenditures forecasts. The use of different assumptions, inputs and judgments, or changes in circumstances, could materially affect the results of the valuation. Due to the inherent uncertainty involved in making these estimates, actual results could differ from our estimates and could result in additional non-cash impairment charges in the future.
We perform our annual goodwill impairment test as of August 1 absent any impairment indicators or other changes that may cause more frequent analysis. We did not identify impairment as a result of our annual August 1, 2010 impairment test and none of our reporting units were at risk of failing step one. In addition, we assess on a quarterly basis whether any events have occurred or circumstances have changed that would indicate an impairment could exist. We considered the likelihood of triggering events that might cause us to re-assess goodwill on an interim basis and concluded that none had occurred subsequent to August 1, 2010.
Other intangible assets, including developed technologies and patents, have finite lives and we record these assets at cost less accumulated amortization. We calculate amortization on a straight-line basis over the estimated economic useful life of the assets, which are three to eight years for developed technologies and 15 years for patents. We assess other intangible assets and long-lived assets on a quarterly basis whenever any events have occurred or circumstances have changed that would indicate impairment could exist. Our assessment is based on estimated future cash flows directly associated with the asset or asset group. If we determine that the carrying value is not recoverable, we may record an impairment charge, reduce the estimated remaining useful life or both. We concluded that no impairment indicators existed to cause us to re-assess our other intangible and long-lived assets during the year ended December 31, 2010.
Restructuring
When circumstances warrant, we may elect to exit certain business activities or change the manner in which we conduct ongoing operations. If we make such a change, we will estimate the costs to exit a business or restructure ongoing operations. The components of the estimates may include estimates and assumptions regarding the timing and costs of future events and activities that represent our best expectations based on known facts and circumstances at the time of estimation. If circumstances warrant, we will adjust our previous estimates to reflect what we then believe to be a more accurate representation of expected future costs. Because our estimates and assumptions regarding restructuring charges include probabilities of future events, such as our ability to find a sublease tenant within a reasonable period of time or the rate at which a sublease tenant will pay for the available space, such estimates are inherently vulnerable to changes due to unforeseen circumstances that could materially and adversely affect our results of operations. If the amount of time that we expect it to take to find sublease tenants in all of the vacant space already in restructuring were to increase by three months and assuming no other changes to the properties in restructuring, we would record an additional $0.3 million in restructuring charges in the consolidated statement of operations during the period in which the change in estimate occurred. We monitor market conditions at each period end reporting date and will continue to assess our key assumptions and estimates used in the calculation of our restructuring accrual.
Income Taxes
We record a valuation allowance to reduce our deferred tax assets to their estimated realizable value. Historically, we have recorded a valuation allowance equal to our net deferred tax assets, which consist primarily of net operating loss carryforwards. Although we consider the potential for future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, if we determine we would be able to realize our deferred tax assets in the future in excess of our net recorded amount, an adjustment to reduce the valuation allowance would increase net income in the period we made such determination. We may recognize deferred tax assets in future periods if and when we estimate them to be realizable, such as establishing our expected continuing profitability or that of certain of our foreign subsidiaries.
Based on an analysis of our historic and projected future U.S. pre-tax income, we do not have sufficient positive evidence to expect a release of our valuation allowance against our U.S. deferred tax assets currently or within the next 12 months. Accordingly, we continue to maintain the full valuation allowance in the U.S. and all foreign jurisdictions, other than the United Kingdom (“U.K.”).
Stock-Based Compensation
We measure stock-based compensation cost at the grant date based on the calculated fair value of the award. We recognize the expense over the employee’s requisite service period, generally the vesting period of the award. We estimate the fair value of stock options at the grant date using the Black-Scholes option pricing model with weighted average assumptions for the activity under our stock plans. Option pricing model input assumptions, such as expected term, expected volatility and risk-free interest rate, impact the fair value estimate. Further, the forfeiture rate impacts the amount of aggregate compensation. These assumptions are subjective and generally require significant analysis and judgment to develop.
The expected term represents the weighted average period of time that we expect granted options to be outstanding, considering the vesting schedules and our historical exercise patterns. Because our options are not publicly traded, we assume volatility based on the historical volatility of our stock. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant for periods corresponding to the expected option term. We have also used historical data to estimate option exercises, employee termination and stock option forfeiture rates. Changes in any of these assumptions could materially impact our results of operations in the period the change is made. A 10% increase in stock-based compensation would result in additional expense of $0.5 million.
Capitalized Software Costs
We capitalize software development costs incurred during the application development stage. We amortize capitalized software once the software is ready for its intended use and we compute it based on the straight-line method over the economic life of the software product. Judgment is required in determining which software projects are capitalized and the resulting economic life.
Recent Accounting Pronouncements
Recent accounting pronouncements are summarized in note 2 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
Revenues
We generate revenues primarily from the sale of data center services and IP services.
Direct Costs of Network, Sales and Services
Direct costs of network, sales and services are comprised primarily of:
â—Ź
costs for connecting to and accessing NSPs and competitive local exchange providers;
â—Ź
facility and occupancy costs, including power and utilities, for hosting and operating our and our customers’ network equipment;
â—Ź
costs of FCP products and subscriptions sold;
â—Ź
costs incurred for providing additional third party services to our customers; and
â—Ź
royalties and costs of license fees for operating systems software.
If a network access point is not colocated with the respective ISP, we may incur additional local loop charges on a recurring basis. Connectivity costs vary depending on customer demands and pricing variables while network access point facility costs are generally fixed. Direct costs of network, sales and services do not include compensation, depreciation or amortization.
Direct Costs of Customer Support
Direct costs of customer support consist primarily of compensation and other personnel costs for employees engaged in connecting customers to our network, installing customer equipment into network access point facilities and servicing customers through our network operations centers. In addition, direct costs of customer support include facilities costs associated with the network operations centers, including costs related to servicing our data center customers.
Direct Costs of Amortization of Acquired Technologies
Direct costs of amortization of acquired technologies are for technologies acquired through business combinations that are an integral part of the services and products we sell. We amortize the cost of the acquired technologies over original lives of three to eight years. The carrying value of acquired technologies at December 31, 2010 was $14.6 million and the weighted average remaining life was approximately four years. These direct costs in the years ended December 31, 2009 and 2008 also included impairment of the CDN advertising technology we obtained in the VitalStream acquisition.
Sales and Marketing
Sales and marketing costs consist of compensation, commissions and other costs for personnel engaged in marketing, sales and field service support functions, as well as advertising, online marketing, tradeshows, direct response programs, facility open houses, management of our external website and other promotional costs.
General and Administrative
General and administrative costs consist primarily of compensation and other expense for executive, finance, product development, human resources and administrative personnel, professional fees and other general corporate costs. General and administrative costs also include consultant fees and non-capitalized prototype costs related to the design, development and testing of our proprietary technology, enhancement of our network management software and development of internal systems. We capitalize costs associated with internal-use software when the software enters the application development stage until the software is ready for its intended use. We expense all other product development costs as incurred.
Summary of Results of Operations
Following is a summary of our results of operations and financial condition, which is followed by more in-depth discussion and analysis.
During the year ended December 31, 2010, total revenue was $244.2 million, representing a decrease of nearly 5% compared to the same period in 2009. Data center services revenue was 53% of total revenues during the year ended December 31, 2010, compared to 51% during the same period in 2009. IP services revenues was 47% of total revenue during the year ended December 31, 2010, compared to 49% during the same period in 2009. We reported a net loss during the year ended December 31, 2010 of $3.6 million.
At December 31, 2010, we had $59.6 million in cash and cash equivalents and $40.0 million in total debt and capital leases. We have continued to improve our net cash position from net cash flows provided by operating activities. The outstanding balance on our Term Loan (as defined below in “—Liquidity and Capital Resources—Capital Resources—Credit Agreement”) was $19.4 million, net of $0.4 million discount, at December 31, 2010, with $4.1 million of letters of credit issued and $55.9 million of available credit. Days sales outstanding were 26 days at December 31, 2010.
Segment profit is segment revenues less direct costs of network, sales and services, exclusive of depreciation and amortization and does not include direct costs of customer support, direct costs of amortization of acquired technologies or any other depreciation or amortization associated with direct costs. Segment profit is a supplemental financial measure that is not prepared in accordance with GAAP. We view direct costs of network, sales and services as generally less-controllable, external costs and we regularly monitor the margin of revenues in excess of these direct costs. Similarly, we view the costs of customer support to also be an important component of costs of revenues but believe that the costs of customer support are more within our control and to some degree discretionary as we can adjust those costs by managing personnel needs. We also have excluded depreciation and amortization from segment profit because they are based on estimated useful lives of tangible and intangible assets. Further, we base depreciation and amortization on historical costs incurred to build out our deployed network and the historical costs of these assets may not be indicative of current or future capital expenditures. Although we believe, for the foregoing reasons, that our presentation of segment profit non-GAAP financial measures provides useful supplemental information to investors regarding our results of operations, our non-GAAP financial measures should only be considered in addition to, and not as a substitute for, or superior to, any measure of financial performance prepared in accordance with GAAP.
Years Ended December 31, 2010 and 2009
Data Center Services
Revenues for data center services decreased $2.5 million, or 2%, to $128.2 million for the year ended December 31, 2010, compared to $130.7 million for the same period in 2009. The decrease in revenue in the year ended December 31, 2010 was primarily due to our proactive churn program in the amount of $10.5 million, which was partially offset by underlying revenue growth of $8.0 million.
Direct costs of data center services, exclusive of depreciation and amortization, decreased $12.2 million, or 13%, to $82.8 million for the year ended December 31, 2010, compared to $95.0 million for the same period in 2009. The decrease was also the result of our efforts in 2010 to proactively churn certain less profitable customer contracts in partner sites, partially offset by an increase in facilities costs resulting from our expansion of company-controlled data centers.
Direct costs of data center services, exclusive of depreciation and amortization, have substantial fixed cost components, primarily for rent, but also significant demand-based pricing variables, such as utilities. 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, as well as the utilization of total available space. While we recognize some of the initial operating costs of company-controlled data centers in advance of revenues, these sites are more profitable at certain levels of utilization than are partner sites. Conversely, costs in partner sites are more demand-based and therefore are more closely associated with the recognition of revenues. We seek to optimize the most profitable mix of available data center space operated by us and our partners.
We will 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 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 65% during the year ended December 31, 2010, compared to 73% during the same period in 2009.
We believe the demand for data center services continues to outpace industry-wide supply. To address this demand, during 2010 we increased capital expenditures to expand company-controlled data centers. During the year ended December 31, 2010, we opened a new company-controlled data center in Santa Clara and expanded three of our company-controlled data centers in Seattle, Houston and Boston. These expansions increased the footprint of our company-controlled data centers by 30,000 net sellable square feet, an increase of 28% compared to the net sellable square footage of company-controlled data centers as of December 31, 2009. Our expansion of company-controlled data centers has contributed to total lower overall utilization of net sellable square feet as of December 31, 2010 compared to the same period in 2009. At December 31, 2010, we had approximately 199,000 net sellable square feet of data center space with a utilization rate of 68%, compared to approximately 202,000 net sellable square feet of data center space with a utilization rate of 77% at December 31, 2009. We expect our recent company-controlled data center expansions will continue to increase our share of occupied square footage in company-controlled data centers. At December 31, 2010, 68% of our total net sellable square feet were in company-controlled data centers versus partner sites, as compared to 53% of our total net sellable square feet at December 31, 2009.
IP Services
Revenues for IP services decreased $9.6 million, or 8%, to $116.0 million for the year ended December 31, 2010, compared to $125.6 million for the same period in 2009. The decrease was driven by a decline in IP pricing for new and renewing customers and the loss of legacy contracts at higher effective prices, partially offset by an increase in overall traffic. IP traffic increased approximately 32% for the year ended December 31, 2010, compared to the year ended December 31, 2009, calculated based on an average over the sum of the months in the respective periods.
IP services revenues also included FCP product sales of $1.4 million and $0.9 million and FCP-related services and subscription revenue of $1.1 million and $0.9 million during the years ended December 31, 2010 and 2009, respectively.
Direct costs of IP services, exclusive of depreciation and amortization, decreased $3.4 million, or 7%, to $44.7 million for the year ended December 31, 2010, compared to $48.1 million for the same period in 2009. This decrease was due to lower connectivity costs, which vary based upon customer traffic volume and other demand-based pricing variables. In addition, costs for IP services are subject to ongoing negotiations for pricing and minimum commitments. As our IP traffic continues to grow, we expect to obtain lower bandwidth rates and more opportunities to proactively manage network costs, such as utilization and traffic optimization among NSPs.
There have been ongoing industry-wide pricing declines over the last several years and this trend continued during the years ended December 31, 2010 and 2009. Technological improvements and excess capacity have been the primary drivers for lower pricing of IP services as well as the more recent entrance of a large number of specialty service providers such as CDN vendors. We also continue to experience increasing traffic volume in our traditional IP services. The increase in IP traffic resulted from both new and existing customers using more applications, as well as the nature of applications consuming greater amounts of bandwidth. We believe we remain well-positioned to benefit from an increasing reliance on the Internet as the medium for business applications, media distribution, communication and entertainment.
Other Operating Costs and Expenses
Other than direct costs of network, sales and services, compensation has the most pervasive impact on operating costs and expenses. We discuss compensation on an aggregate basis below followed by discussion of functional costs and expenses.
Compensation. Total compensation and benefits, including stock-based compensation, were $56.2 million and $59.3 million during the years ended December 31, 2010 and 2009, respectively.
Cash-based compensation and benefits decreased $2.1 million to $51.6 million during the year ended December 31, 2010 from $53.7 million during the same period in 2009. The decrease was primarily due to (a) a $0.7 million decrease in cash-based compensation related to reduced employee headcount, (b) a $1.3 million decrease due to capitalized payroll costs related to software development in 2010, (c) a $0.8 million decrease in severance incurred in 2009 and $0.9 million related to the transition of our former president and chief executive officer incurred in 2009, (d) a benefit of $0.4 million related to the reversal of a bonus accrual for the year ended December 31, 2009 offset by (w) a $0.4 million increase in the 2010 bonus accrual, (x) a $1.1 million in merit pay increases, (y) a $0.3 million increase in insurance costs and (z) a $1.7 million increase in commissions related to incentives for customer retention.
Additionally, we did not record a Georgia Headquarters Tax Credit, (“HQC”) in 2009 compared to a $1.6 million credit recorded in 2010, which included credits for three years. The HQC is sponsored by the state of Georgia to incentivize companies to relocate corporate headquarters to and increase employment in Georgia. We record the HQC when approved by the Georgia Department of Revenue and are required to apply the credit against our state payroll liability.
Stock-based compensation decreased $1.0 million to $4.6 million during the year ended December 31, 2010 from $5.6 million during the same period in 2009. The decrease was primarily due to a reduction of stock-based compensation expense of $0.8 million related to the transition of our former president and chief executive officer incurred during the year ended December 31, 2009.
Direct Costs of Customer Support . Direct costs of customer support increased 10% to $19.9 million during the year ended December 31, 2010 from $18.0 million during the same period in 2009. The increase was primarily due to a $2.1 million increase in cash-based compensation and employee benefits related to increased headcount given our expansion of company-controlled data centers and the resulting expansion of our customer support function, of which $1.1 million resulted from a transfer of employees from the sales and marketing support function to the customer support function as described below in “—Sales and Marketing,” partially offset by $0.3 million related to executive severance incurred in 2009 and the 2010 HQC benefit of $0.5 million.
Direct Costs of Amortization of Acquired Technologies . Direct costs of amortization of acquired technologies were $3.8 million and $8.3 million during the years ended December 31, 2010 and 2009, respectively. The decrease was due to impairment charges that occurred during the year ended December 31, 2009. In conjunction with consolidating our business segments in 2009, we performed an analysis of the potential impairment and re-assessed the remaining asset lives of other identifiable intangible assets. The analysis and re-assessment of other identifiable intangible assets resulted in an impairment charge of $4.1 million in acquired CDN advertising technology during 2009 due to a strategic change in market focus.
Sales and Marketing . Sales and marketing costs during the year ended December 31, 2010 increased 4% to $29.2 million from $28.1 million during the same period in 2009. The increase was primarily due to a (a) $1.9 million increase in commissions paid to employees related to incentives for customer retention and commissions paid to agents, (b) a $0.7 million increase in marketing and (c) a $0.3 million increase in professional services related to recruiting, partially offset by (x) a $0.4 million decrease in non-essential sales facilities cost, (y) a $0.4 million decrease in stock-based compensation and (z) a $1.3 million decrease in cash-based compensation as the result of reduced employee headcount in this function, of which $1.1 million resulted from a transfer of employees from the sales and marketing support function to the customer support function, whereby these positions were redefined and the reporting structure aligned under the customer support function.
General and Administrative . General and administrative costs during the year ended December 31, 2010 decreased 26% to $33.0 million from $44.6 million during the same period in 2009. The decrease was primarily due to (a) a $0.6 million decrease in severance incurred in 2009, (b) a benefit of $1.7 million related to cash-based and stock-based compensation for the transition of our former president and chief executive officer incurred in 2009, (c) a $1.3 million decrease due to capitalized payroll costs related to software development in 2010, (d) a $0.9 million HQC that we recorded in 2010, (e) a $1.5 million decrease in the provision for doubtful accounts, (f) a $0.5 million decrease in taxes and licenses and (g) a $4.7 million decrease in professional services. Professional services costs were higher in the prior period due primarily to the use of consultants for finance and temporary information technology, personnel recruiting services and higher accounting and audit fees.
Depreciation and Amortization . Depreciation and amortization, including other intangible assets but excluding acquired technologies, increased 7% to $30.2 million during the year ended December 31, 2010, compared to $28.3 million during the same period in 2009. The increase was primarily due to the effects of our expansion of company-controlled data centers and P-NAP infrastructure, partially offset by a decrease in amortization expense of $2.5 million related to certain other intangibles becoming fully amortized during 2010. Capital expenditures were $62.2 million during the year ended December 31, 2010 compared to $17.3 million during the same period in 2009.
Impairments and Restructuring. We did not record any impairments for the year ended December 31, 2010. The goodwill impairments during the year ended December 31, 2009 related to our IP services segment and included $48.0 million for goodwill related to our former CDN services segment and $3.5 million to adjust goodwill of our FCP products Similarly, the $4.1 million of impairments of acquired technology, included in direct costs of amortization, were related to advertising technology of our former CDN services segment. The CDN services goodwill and technology arose from our acquisition of VitalStream in February 2007.
Total restructuring charges during the year ended December 31, 2010 were $1.4 million, which primarily related to subsequent plan adjustments we made in sublease income assumptions for certain properties included in our previously-disclosed restructuring plans. Due to current economic conditions, these adjustments extend the period during which we do not anticipate receiving sublease income from those properties given our expectation that it will take longer to find sublease tenants and the increased availability of space in each of these markets where we have unused space.
Total restructuring charges during the year ended December 31, 2009 were $3.2 million, including $2.1 million for adjustments in sublease income assumptions for certain properties included in our previously-disclosed 2007 and 2001 restructuring plans, $0.9 million for a workforce reduction in March 2009 and $0.2 million for cessation of use of four smaller office and partner data center sites.
Interest Expense . Interest expense increased to $2.2 million during the year ended December 31, 2010, compared to $0.7 million during the same period in 2009. The increase in interest expense was primarily due to the $16.7 million in new capital lease obligations related to our expansion of company-controlled data center in Santa Clara and expansion of our data center in Seattle during 2010.
Provision for Income Taxes . The provision for income taxes was $1.0 million during the year ended December 31, 2010, compared to $0.4 million during the same period in 2009. Our effective income tax rate, as a percentage of pre-tax income, for the years ended December 31, 2010 and 2009 was (31%) and (1%), respectively. The fluctuation in the effective income tax rate was attributable to recognition of income taxes in the U.K., permanent tax adjustment items, a change in valuation allowance and state income taxes.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
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 statements regarding industry trends, our future financial position and performance, business strategy, revenues and expenses in future periods, projected levels of growth, impairments, levels of cash, utilization of borrowings and financing needs, performance of and demand for our IT infrastructure services, results of litigation and other matters that do not relate strictly to historical facts. These statements are often identified by the use of words such as “may,” “will,” “seeks,” “anticipates,” “believes,” “estimates,” “expects,” “projects,” “forecasts,” “plans,” “intends,” “continue,” “could,” “should” 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 this Quarterly Report on Form 10-Q under Part II 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,” “our” or “Internap” refer to Internap Network Services Corporation.
Overview
Internap provides high-performance IT infrastructure services that enable our customers to focus on their core business, improve service levels and lower the cost of IT operations. Our colocation, connectivity and managed hosting solutions are differentiated by superior performance, availability and support.
Data center services are comprised of colocation and managed hosting. Colocation allows our customers to deploy and manage their servers, storage and other equipment in our secure data centers. Our managed hosting services increase our customers’ operating flexibility while eliminating the need to provision and manage their own data centers, servers, storage and operating systems.
We sell our colocation and/or managed hosting services at 37 data centers across North America, Europe and the Asia-Pacific region. We refer to nine of these facilities as “company-controlled,” meaning we control the data centers’ operations and infrastructure and have directly negotiated long-term leases with the properties’ lessors. We refer to the remaining 28 data centers as “partner” sites. In these locations, we typically do not control operations and infrastructure and terms are shorter than those in company-controlled data centers. Our company-controlled facilities feature our enhanced IP connectivity, are designed and operated to be fully-secure and provide best-in-class power and environmental reliability.
IP services include our patented Performance IP™ service, XIP™ Acceleration-as-a-Service solution, content delivery network (“CDN”) and flow control platform (“FCP”) products. 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. Our IP services are sold through 77 Internet Protocol (“IP”) service points around the world, which include 18 CDN points of presence (“POPs”) and one additional standalone CDN POP. Our service level agreements (“SLAs”) guarantee performance across multiple networks covering a broader segment of the Internet in the United States, excluding local connections, than providers of conventional Internet connectivity, which typically only guarantee performance on their own network.
We currently have approximately 2,700 customers across 28 metropolitan markets, serving a variety of industries, such as entertainment and media, including gaming; financial services; business services; software, including software-as-a-service (“SaaS”); hosting and information technology infrastructure; and telecommunications. For the three months ended March 31, 2011, revenues generated and long-lived assets located outside the United States (“U.S.”) were each less than 10% of our total revenues and assets.
Operating Segments
Data Center Services
Our data center services segment includes colocation services, which involve physical space for hosting customers’ IT infrastructure network and other equipment as well as associated services such as redundant power and network connectivity, environmental controls and security. The segment also includes managed hosting services whereby our customers own and manage the software applications and content, while we provide and maintain the hardware, operating system, data center infrastructure and bandwidth. Managed hosting also includes our new public cloud storage service in its beta stage.
Our data center services enable us to have a broader product offering that provides customer flexibility and the ability to bundle these services with our high performance IP connectivity and CDN services, along with hosting customers’ infrastructure, data and applications. Our data center services provide a single source for network infrastructure, IP connectivity and security, all of which are designed to maximize solution performance while providing a more stable, dependable infrastructure, and are backed by SLAs and our team of dedicated support professionals.
We believe the demand for data center services continues to outpace industry-wide supply. To address this demand, during the three months ended March 31, 2011, we began to build-out our new company-controlled data center in Dallas, Texas. We expect this expansion to increase the footprint of our company-controlled data centers by 55,000 net sellable square feet over time.
As a service provider in today’s global economy, we must demonstrate that we have adequate controls and safeguards in place to protect our customers’ infrastructure in our data centers. To do this, we utilize a third-party service auditor (an independent accounting firm) to perform an examination in accordance with Statement on Auditing Standards No. 70 (commonly referred to as a “SAS 70” Audit) and issue a Type II report which includes a description of our controls, along with detailed testing of the design and operation of these controls. We have SAS 70 Audits performed at our company-controlled data centers every six months. Additionally, the underlying providers for several of our partner sites also have SAS 70 Audits performed and we have obtained and reviewed these reports to our satisfaction.
IP Services
IP services represent our IP transit activities and include our patented Performance IP service, XIP Acceleration-as-a-Service solution, CDN services and FCP products. Our intelligent routing technology facilitates traffic over multiple carriers’ networks, as opposed to just one carrier’s network, to ensure highly-reliable performance over the Internet. We believe that our unique managed multi-network approach provides better performance, control and reliability as compared to conventional Internet connectivity alternatives.
Our patented and patent-pending network route optimization technologies address the 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 information technology delivery models, in a reliable and predictable manner. Our services and products take into account the unique performance requirements of each business application to ensure performance as designed, without unnecessary cost. Our fees for IP services are based on a fixed fee, usage or a combination of both.
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 data POPs. Providing capacity-on-demand to handle large events and unanticipated traffic spikes, we deliver scalable high-quality content distribution and the analytic tools to allow our customers to refine their marketing programs.
Critical Accounting Policies and Estimates
In January 2011, we adopted new accounting guidance related to the accounting and disclosure for revenue recognition. This guidance, which was effective for us beginning January 1, 2011, modifies the criteria for recognizing revenue in multiple element arrangements and the scope of what constitutes a non-software deliverable. Adoption of this new guidance did not have a material impact on our consolidated financial statements.
We summarize our revenue recognition policies related to this new guidance in note 2 to the accompanying financial statements. For additional information regarding all of our revenue recognition accounting policies see our Annual Report on Form 10-K for the year ended December 31, 2010 and the condensed consolidated financial statements contained therein.
Three Months Ended March 31, 2011 and 2010
Data Center Services
Revenues for data center services decreased $2.2 million, or 6%, to $31.5 million for the three months ended March 31, 2011, compared to $33.7 million for the same period in 2010. The decrease in revenue in the three months ended March 31, 2011 was primarily due to our proactive churn program in the amount of $3.2 million, which was offset by underlying revenue growth of $1.0 million.
Direct costs of data center services, exclusive of depreciation and amortization, decreased $4.5 million, or 20%, to $18.5 million for the three months ended March 31, 2011, compared to $23.0 million for the same period in 2010. The decrease was primarily the result of our efforts to proactively churn less profitable customers and contracts in partner sites.
Direct costs of data center services, exclusive of depreciation and amortization, have substantial fixed cost components, primarily for rent, but also significant demand-based pricing variables, such as utilities. 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, as well as the utilization of total available space. While we recognize some of the initial operating costs of company-controlled data centers in advance of revenues, these sites are more profitable at certain levels of utilization than are partner sites. Conversely, costs in partner sites are more demand-based and therefore are more closely associated with the recognition of revenues.
IP Services
Revenues for IP services decreased $1.7 million, or 6%, to $27.9 million for the three months ended March 31, 2011, compared to $29.6 million for the same period in 2010. The decrease was driven by a decline in IP pricing for new and renewing customers and the loss of legacy contracts at higher effective prices, partially offset by an increase in overall traffic. IP traffic increased approximately 27% for the three months ended March 31, 2011, compared to the three months ended March 31, 2010, calculated based on an average over the sum of the months in the respective periods.
Direct costs of IP services, exclusive of depreciation and amortization, decreased $0.5 million, or 5%, to $10.5 million for the three months ended March 31, 2011, compared to $11.0 million for the same period in 2010. This decrease was due to lower connectivity costs, which vary based upon customer traffic volume and other demand-based pricing variables. In addition, costs for IP services are subject to ongoing negotiations for pricing and minimum commitments. We expect to obtain lower bandwidth rates and more opportunities to proactively manage network costs, such as utilization and traffic optimization among network service providers.
Other Operating Costs and Expenses
Compensation. Total compensation and benefits, including stock-based compensation, were $14.9 million and $13.7 million during the three months ended March 31, 2011 and 2010, respectively.
Cash-based compensation and benefits increased $1.3 million to $14.0 million during the three months ended March 31, 2011 from $12.7 million during the same period in 2010. The increase was primarily due to a $1.3 million increase in cash-based compensation and payroll taxes related to a higher employee headcount and increased salary levels, a $0.6 million increase in severance and a $0.2 million increase in commissions, offset by a $0.9 million decrease due to capitalized payroll and benefit costs related to software development in 2011.
Direct Costs of Customer Support . Direct costs of customer support increased 3% to $5.1 million during the three months ended March 31, 2011 from $4.9 million during the same period in 2010. The increase was primarily due to a $0.2 million increase in cash-based compensation related to a higher employee headcount and increased salary levels.
Direct Costs of Amortization of Acquired Technologies . Direct costs of amortization of acquired technologies were $0.9 million and $1.0 million during the three months ended March 31, 2011 and 2010, respectively.
Sales and Marketing . Sales and marketing costs during the three months ended March 31, 2011 increased 10% to $7.8 million from $7.1 million during the same period in 2010. The increase was primarily due to a $0.4 million increase in cash-based compensation related to a higher employee headcount, a $0.2 million increase in commissions and a $0.4 million increase in training related to conference costs, offset by a $0.3 million decrease in professional services related to recruiting fees.
General and Administrative . General and administrative costs during the three months ended March 31, 2011 increased 10% to $9.1 million from $8.3 million during the same period in 2010. The increase was primarily due to a $0.6 million increase in severance, a $0.5 million increase in cash-based compensation related to a higher employee headcount and increased salary levels, a $0.2 million increase in the 2011 bonus accrual and an $0.8 million increase in professional services, which includes $0.5 million related to increased legal and accounting and audit fees and $0.3 million related to the use of consultants for IT projects, offset by a $0.5 million decrease in taxes, licenses and fees for the capitalization of use tax on equipment purchases related to our expansion of company-controlled data centers and P-NAP infrastructure and a $0.9 million decrease due to capitalized payroll and benefit costs related to software development in 2011.
CONF CALL
Andrew McBath
Thanks, Matthew. Good afternoon, and thank you for listening in today. I'm joined by Eric Cooney, our President and Chief Executive Officer; and George Kilguss, our Chief Financial Officer. Following prepared remarks, we will open up the call for your questions.
We will reference slides in our conference call today. These slides are available in the presentation section of Internap's Investor Services website. Non-GAAP reconciliations in our supplemental data sheet, which includes additional operational and financial metrics, are available under the Financial Information Quarterly Results section of our Investor Services site.
Today's call contains forward-looking statements, including our expectations regarding future financial performance, including profitability and achievement of top line growth in both business segments, our expectations that first quarter 2011 is the last quarter in which we will be impacted by completed proactive churn program, industry growth rates, expected results from our strategy to invest in sales, marketing, engineering and operations staff, our business strategy including expected results from investing in company-controlled data centers which we expect to result in future growth, and our expectations regarding new markets, the timing for bringing new data centers online and our belief that we can accelerate selling into new company-controlled data center space.
Because these statements are not guarantees of future performance and involve risks and uncertainties, important factors could cause our actual results to differ materially from those in the forward-looking statements. We discussed these factors in our filings with the Securities and Exchange Commission. We undertake no obligation to amend, update or clarify these statements. In addition to reviewing first quarter 2011 results, we will also discuss recent developments.
Now let me turn the call over to Eric Cooney.
J. Cooney
Thank you, Drew, and good afternoon, everyone. Thank you for joining us for our first quarter 2011 financial results presentation.
I'll start off with a summary of our first quarter results and then George will detail our quarterly financial results and operating metrics. I will then conclude with a high-level summary, and we will open the call for your questions.
We've summarized revenue and segment profitability results in the period on Slide 3. Revenue decreased $4 million year-over-year and $0.6 million compared with the fourth quarter of 2010. The year-over-year and sequential declines were primarily driven by our initiative to exit low-margin and negative-margin contracts in select partner data centers. As I will detail in a moment, this program was completed in the fourth quarter of 2010, and the final revenue impact was evident in first quarter results. We expect that first quarter 2011 is the last quarter in which revenue is impacted by the now successfully completed proactive data center churn program.
Our segment profit and segment margin continues to improve steadily. Segment profit improved $0.9 million sequentially and $1.1 million over the same quarter last year. The combination of higher absolute segment profit on a smaller revenue base has significantly benefited our segment margin over the past year. Segment margin improved 490 basis points year-over-year. Sequentially, segment margin increased 200 basis points. Beyond the immediate benefit of higher segment profitability, the implication for future sales of company services into this significantly higher segment profit margin bodes well for the company's long-term profitable growth.
On Slide 4, we've detailed the basis for the sequential decline in revenue. Of the $0.6 million quarter-over-quarter decrease, $0.4 million came from IP services. Based on bookings and churn trends, we continue to expect the IP segment to show sequential revenue growth in the second quarter of 2011. As we described last quarter, we completed our data center profitability program at the end of fourth quarter 2010. $0.8 million of the quarter-over-quarter revenue decline was attributable to this program and the associated exit of low-margin contracts.
While we exited the contracts during the fourth quarter, the full revenue impact was not evident until the first quarter of 2011. We do not expect this flow-through effect to impact our future sequential quarterly comparisons in the Data Center Services segment. Beyond this proactive data center churn impact, the remaining Data Center Services revenue increased $0.6 million compared with the fourth quarter.
We were particularly pleased with the first quarter revenue growth rates in both our company-controlled Data Center and Managed Hosting businesses. We feel these businesses are delivering revenue growth at or above market rates, which we believe are in the 15% to 20% range.
Moving on to Slide 5. We generated $9.2 million in adjusted EBITDA in the quarter. Adjusted EBITDA decreased $0.7 million year-over-year and $1.1 million, sequentially. Improvements in segment profit were offset by higher operating costs in the quarter relative to both comparable quarters. Sequentially, operating costs increased by $2 million as we added more than 20 new staff in sales, marketing, engineering and operations while also incurring costs associated with our annual sales kickoff meeting and certain targeted marketing initiatives. We believe these investments are appropriate and are expected to support future top line growth.
I'll cover segment results on Slide 6. In Data Center Services, our results were similar to last quarter. A strong quarter-over-quarter profitability increase on essentially flat sequential revenue as we sold through the final remnants of the proactive data center churn program, Data Center Services revenue declined $2.2 million year-over-year and $0.2 million compared with the fourth quarter of 2010. Segment profit in Data Center Services improved $2.3 million compared with the first quarter of 2010 and $0.8 million sequentially, representing 22% and 7% increases, respectively. Data Center segment margin has also shown a strong improvement, rising 960 basis points over the first quarter of 2010, and 280 basis points compared with the fourth quarter of 2010 to 41.3%.
In IP Services, revenue decline continued to slow. Compared with the first quarter of 2010, IP revenue decreased 6%. Sequentially, the decline was 1% or $0.4 million. IP segment profit, while down year-over-year due to the decrease in revenue, increased sequentially for the first time since the fourth quarter of 2009. Segment margin in this business remained strong. First quarter IP segment margin increased 120 basis points quarter-over-quarter to 62.3%. Compared with the prior year's quarters, segment margin declined 50 basis points.
As mentioned earlier, we expect IP Services revenue to grow sequentially in the second quarter of 2011. Our IP business unit product offering, including both IP Transit and CDN Services, continues to provide a key element for the competitive differentiation of our Data Center Services offerings.
Our colocation and managed hosting customers continue to remind us that our IP products are a key factor in their purchase decision. The company's intelligent IT infrastructure solutions differentiated by best-in-class performance availability and support are a compelling offer for the enterprise IT customer.
Moving on to Slide 7. We announced today that we will construct a new data center in Los Angeles, marking our third new North American market and seventh expansion announcement since the fourth quarter of 2009. Our Los Angeles facility will total 55,000 net sellable square feet, likely opened in 5 phases. The first of which we expect to bring online in the second quarter of 2012 with approximately 15,000 net sellable square feet.
Clearly, our data centers provide the platform from which we expect to deliver profitable growth across the complete portfolio of IT infrastructure services, including connectivity, colocation, managed hosting and cloud. Over the past year, we've added 34,000 net sellable square feet to our company-controlled inventory.
Since the first quarter of 2008, we've increased our company-controlled footprint by 58,000 net sellable square feet. With 41% of our company-controlled data center footprint deployed within the past 3 years, we regularly see a competitive benefit derived from our use of the latest innovations in data center design, including scalable power and cooling densities, environmental efficiencies, and state-of-the-art high reliability architectural designs.
On Slide 8, we've broken out occupancy figures to give you a sense for the progress we are making in selling into the company-controlled capacity we are deploying. We expect we can accelerate this trend with an expanded focused sales force and new capacity in the Dallas and Los Angeles markets coming online over the next several quarters.
In the first quarter, company-controlled occupied square footage increased 16% year-over-year. Sequentially, occupancy increased 5%. Utilization on both partner and company-controlled data center footprint was 68% in the quarter as we brought online an incremental 7,000 square feet in Boston. Total data center revenue per square foot increased 4% year-over-year. Churn of customers at lower price points and partner data centers, combined with stable pricing in company-controlled data centers, helped increase this year-over-year per unit metric.
On Slide 9, we provide some visibility to a few recent key enterprise customer wins, which provide a sense of where we are winning and why. In the first quarter, we sold a complex managed hosting and connectivity solution to a large digital media publisher that required a highly skilled provisioning and support staff and flexible data center infrastructure. A medical device manufacturer looked to us to provide premium colocation and optimized connectivity. Our data center design and availability standards as well as our support capabilities proved pivotal in winning this deal. This is increasingly common feedback from customers that have selected our colocation services.
We also recently closed on an agreement to provide content delivery services to a digital media distribution company. A scalable and reliable network combined with a robust service level agreement and strong support staff helps drive this win.
In total, these deals represented approximately $2.2 million in annual contract value and reflect the type of enterprise customers who are increasingly drawn to intelligent IT infrastructure solutions. Now let me turn the presentation over to George to take you through some additional financial and operational results.
George Kilguss
Thank you, Eric, and good afternoon, everyone.
Beginning on Slide 10. Total revenue in the period declined by $600,000 compared with the fourth quarter of 2010 and $4 million compared with the first quarter last year. Both the year-over-year and the sequential decline was primarily driven by our data center proactive churn program, which we completed in the fourth quarter of 2010. Net of the forced churn program in Q4, total revenue increased modestly quarter-over-quarter.
Total segment profits improved $1.1 million year-over-year and $900,000 sequentially. This profitability increase reflects the impact of our churn initiative and our refocus on the development, deployment and the sale of higher-margin Internap-owned services. With the increased operating leverage we are building, particularly in our Data Center Services business, improvements in our revenue trajectory should help drive more profit for every incremental dollar of revenue that we generate.
Cash operating expense was $21.2 million in the first quarter, increasing $1.8 million year-over-year and $2 million sequentially. The primary contributor to this OpEx increase was the addition of 21 employees quarter-to-quarter in sales, marketing, operations and engineering, which increased our cash compensation cost. These investments are directed toward revenue-generating activities in an effort to enable top line growth which we believe will begin to emerge in the second quarter. In addition, approximately $600,000 of the sequential increase was due to executive severance cost that will not reoccur in the second quarter.
Adjusted EBITDA in the first quarter totaled $9.2 million and decreased $700,000 compared with the first quarter a year ago and $1.1 million compared with the fourth quarter of 2010. Increased cash operating expense more than offset the increased segment profit in both comparable periods.
Adjusted EBITDA margin was 15.5% compared with 15.6% in the first quarter of 2010 and 17.1% in the fourth quarter of last year. Our GAAP net loss was $1.5 million in the quarter, a decrease compared with the first quarter of 2010 and sequentially.
Normalized net loss, which excludes the impact of stock-based compensation and a $200,000 non-cash charge to restructuring expense, totaled $400,000 or $0.01 per share.
Turning to a summary of our cash flow and balance sheet on Slide 11. Capital expenditures outpaced adjusted EBITDA for the quarter by $3.5 million. First quarter capital expenditures totaled $12.7 million. Three quarters of this amount was spent in our Data Center Services business segment and was primarily attributable to our data center expansions in Boston and Dallas. We believe these investments are fundamental to our strategy of providing a full portfolio of high-performing IT infrastructure services and generate strong returns on capital in the coming years.
At March 31, 2011, cash and cash equivalents totaled more than $46 million. Funded debt totaled $19 million and remained flat compared with the prior quarter. Capital leases increased $9 million over December 31, 2010, to $29 million as we entered into a new lease agreement for our new company-controlled data center in Dallas.
A continuing strength for the company is our solid financial position. At the end of the first quarter, we maintained a liability-to-equity ratio of 56%, a figure well below the peer group. Days sales outstanding improved slightly to 25 days in the first quarter compared to 26 days last quarter.
Moving on to Slide 12. I'd like to cover our segment results in more detail. Data Center Services revenue totaled $31.5 million in the quarter, down from $2.2 million year-over-year and $200,000 sequentially. While our proactive churn program was completed at the end of the fourth quarter, we had a headwind of approximately 800,000 of low-margin partner revenue that was included in the fourth quarter revenue but was not present in our first quarter revenue as it was churned out late in the fourth quarter. This impact more than offset the quarter-over-quarter revenue growth of approximately $600,000 in Data Center Services.
Our data center profitability program continues to drive measurable increases in Data Center Services segment profit and margin. Absolute segment profit improved 22% year-over-year and 7% sequentially, despite decreases in revenue over the same periods. Data Center segment margin has also shown strong improvement, rising 960 basis points compared with the first quarter of 2010 and 280 basis points over the fourth quarter of 2010. Data Center revenue churn in the first quarter was 1.1% compared with 2.1%, both in the first and in the fourth quarters of 2010.
In our IP Services segment, revenue totaled $27.9 million, down from $29.6 million a year ago and $28.2 million compared with the prior quarter. Lower network costs and moderating revenue declines, however, allowed the IP segment profit and IP segment margin to improve sequentially in the first quarter.
IP churn totaled 1.4% in Q1 and remained in check, trending up only modestly versus historically low fourth quarter. As Eric mentioned in his remarks earlier, all of the products we sell within the IP Services segment helped differentiate our complete portfolio of IT infrastructure services. In addition to a flexible data center platform where customers can select colocation, managed hosting and ultimately, cloud, we have connectivity technologies like performance IP, zip application acceleration, and content delivery that provide superior performance and availability all the way to the end user.
I'll close on Slide 13. I'd like to point out that we've seen across-the-board section of our operating metrics improve over the past several quarters. Revenue churn, exclusive of our proactive churn program, has steadily trended down over the past 2 years, while bookings have continued to trend upward. Our quarterly net customer losses have moderated substantially since the fourth quarter of 2009, and our net promoter score, a measure that gauges the percentage of our customers likely to recommend us to others, has improved more than 20 points over the past 12 months. We believe the actions we have taken to improve operations, expand our set of higher-margin services and the refocusing of our sales and marketing teams are having positive effects.
Now let me turn the call back to Eric for his closing remarks before we take your questions.
J. Cooney
Thanks, George. I'll sum up on Slide 14.
With the return to revenue growth expected in the second quarter, we are continuing our investments in sales and marketing activities as well as engineering and operations to enable us to sustain and accelerate long-term profitable growth. In our Data Center Services segment, we are successfully executing on a number of fronts. We are actively filling existing company-controlled capacity and deploying additional company-controlled capacity in key markets to lay the foundation for future growth while simultaneously delivering substantial improvements to segment profitability. In IP Services, segment profit has stabilized, and we are executing the strategy to support revenue growth based, in part, on an expanded and enhanced product offering for both IP transit and content delivery services.
Looking ahead, we expect sequential revenue growth in both business units in the second quarter on a more profitable margin base. Our company-controlled data center investments in Boston, Seattle, Santa Clara, Dallas and now Los Angeles, along with ongoing product development initiatives, will help support this return to top line growth and provide the platform for sustained long-term profitable growth of the business.
Now we'd be happy to take your questions. Operator?
|
|
Fund Letters
