10-K 1 d10k.txt FORM 10-K UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED) For the fiscal year ended March 31, 2001 [_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED) For the transition period from ___________ to _____________ Commission file number: 0-27801 DATA RETURN CORPORATION ----------------------- (Exact name of registrant as specified in its charter) Texas 75-2725998 (State of incorporation) (I.R.S. employer identification number) 222 West Las Colinas Boulevard, Suite 450, Irving, Texas 75039 (Address of principal executive offices) (Zip Code) Registrant's Telephone Number, Including Area Code: (972) 869-0770 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, Par Value $.001 Per Share Preferred Stock Purchase Rights Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [_] Indicated by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [_] Aggregate market value of Common Stock held by non-affiliates as of June 27, 2001: $23,789,112 Number of shares of Common Stock outstanding as of June 27, 2001: 36,043,550 DOCUMENTS INCORPORATED BY REFERENCE Listed below are documents parts of which are incorporated herein by reference and the part of this report into which the document is incorporated: (1) Proxy statement for the 2001 annual meeting of shareholders - Part III TABLE OF CONTENTS ---------------------------------------------------------------------------------------------------------------- PART ITEM 1. BUSINESS......................................................................... 2 I ITEM 2. PROPERTIES....................................................................... 8 ITEM 3. LEGAL PROCEEDINGS................................................................ 9 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS EXECUTIVE OFFICERS OF THE REGISTRANT............................................. 9 ---------------------------------------------------------------------------------------------------------------- PART ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER II MATTERS.......................................................................... 11 ITEM 6. SELECTED FINANCIAL DATA.......................................................... 12 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS....................................................................... 13 RISK FACTORS..................................................................... 20 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK................................................................ 32 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA...................................... 32 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE....................................................................... 32 ---------------------------------------------------------------------------------------------------------------- PART ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT............................... 33 III ITEM 11 EXECUTIVE COMPENSATION........................................................... 33 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT................... 33 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS .................................. 33 ---------------------------------------------------------------------------------------------------------------- PART ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS IV ON FORM 8-K...................................................................... 33 SIGNATURES................................................................................ 36
FORM 10-K The statements contained in this report that are not historical facts are "forward-looking statements" (as such term is defined in Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934). Forward-looking statements are typically identified by the use of terms such as "may," "will," "expect," "intend," "anticipate," "estimate" and similar words, or by discussions of strategy that involve risks and uncertainties, although some forward-looking statements are expressed differently. You should be aware that our actual results could differ materially from those contained in the forward-looking statements due to a number of factors, including without limitation, changes in external competitive market factors, changes in our business strategy or an inability to execute our strategy, changes in the hosting industry, changes in the economy in general and changes in the use of the Internet, the demand for our services and the viability of Internet-based businesses. We cannot guarantee future results, levels of activity, performance or achievements. Our actual results could differ materially from those anticipated in forward-looking statements as a result of certain factors, including those set forth in the section of this report entitled "Risk Factors." Readers are cautioned not to place undue reliance on any forward-looking statements contained in this report. All written and oral forward-looking statements made in connection with this report that are attributable to us or persons acting on our behalf are expressly qualified in their entirety by the "Risk Factors" and other cautionary statements included herein. We disclaim any obligation to update information contained in any forward-looking statement. We undertake no obligation to publish the results of any adjustments to these forward-looking statements that may be made to reflect events on or after the date of this report or to reflect the occurrence of unexpected events. PART I ITEM 1. BUSINESS Our Company Data Return provides advanced managed hosting services based on Microsoft technologies. We provide these services to businesses seeking to outsource the deployment, maintenance and support of their complex web sites. Our services include providing, configuring, operating and maintaining the hardware, software and network technologies necessary to implement and support these web sites. We also offer additional services options, such as scalability and architecture testing, storage solutions and a suite of security services, including firewalls. Data Return was incorporated in August 1997 by three former Microsoft product support engineers, and, as of March 31, 2001, hosted applications for approximately 800 customers across many industries. Our customers range in size from large Fortune 500 companies to smaller businesses, both conventional and web-based. Our customers include Compaq, H&R Block, Microsoft, RadioShack.com, Texas Instruments and The World Bank. Our advanced hosting services are designed for customers deploying sophisticated, high-end Internet applications that require a professionally-managed environment incorporating high performance network access, advanced system monitoring and technical support in secure, fault-tolerant facilities. Microsoft Corporation, Compaq Computer Corporation and Level 3 Communications, Inc. have invested in our company. We believe our relationships with these companies enhance our credibility with potential customers and provide us with early access to new products, superior technical services, training and new business opportunities. Our Solution Data Return is an advanced hosting provider dedicated to delivering scalable, reliable and high performance hosting services on the Microsoft platform. By combining our experience in managing Microsoft-based Internet technologies, a scalable deployment architecture and high performance content delivery, we have developed a family of services designed to address a wide range of customer needs. Advanced Managed Services Managing the deployment of business-critical web applications requires an in-depth understanding of the underlying software, hardware and network technologies. We use our expertise in Microsoft technologies to provide management services for our customers' hosting needs, including: . recommendations on standardized system architecture; 2 . installation, configuration and stress testing of hardware and software; . ongoing maintenance of hardware and software, including content back- ups and system upgrades; . a broad array of system and network monitoring and reporting services; and . technical support designed to respond to both simple and complex system issues. Scalable Deployment Architecture Our customers require system architecture that is flexible and can be expanded to meet increasing demand. We offer scalable deployment architecture for the Microsoft platform that enables customers to migrate to more robust service offerings, such as high-end multi-server clustered solutions and clustering across multiple data centers, as their site traffic grows. The flexibility of this architecture allows us to offer a wide range of hosting solutions to our customers. High Performance Content Delivery Overall application performance is an essential component to deploying an Internet-based application successfully. There are many factors that contribute to overall performance including the configuration and architecture for hardware, software and Internet access. Our private networking architecture bypasses the congested public exchange points, such as the Metropolitan Area Exchanges and Network Access Points, increasing speed and reliability. Pre-Packaged Solutions for Advanced Hosting We have standardized our services into packages with defined pricing and feature sets that can be used stand-alone or as components in a larger solution. These solutions include hardware, maintenance and network connectivity. We believe these pre-packaged solutions provide a more complete alternative than colocation. Colocation arrangements typically involve a vendor supplying space for the server and Internet connections and some level of professional services, often on an hourly basis. With colocation, the customer is usually responsible for defining and implementing the deployment architecture. Our pre-packaged solutions enable our customers to outsource these responsibilities to us for their Internet, extranet or intranet applications. Our Services We package our hosting services into standardized, definable product offerings that we believe include features desired by a wide range of customers from Fortune 2000 companies to smaller, web-focused businesses. Our services are designed to be comprehensive in terms of feature sets and to address our customers' outsourcing needs for a wide variety of requirements, including: . customers accessing public web sites on the Internet; . employees accessing private web sites through intranets; and . partners and other designated user groups accessing private or public web sites through extranets. Offerings Our advanced Microsoft hosting services allow us to support the Internet, intranets and extranets for both commercially developed applications and custom- developed applications. To address this wide variety of customer requirements, we have developed three distinct categories within our service family - clustered, dedicated and shared. We also offer a variety of additional services such as firewalls and other security services, private circuits, data storage offerings, and a scalability center that includes architecture, testing and stress labs. We also offer just the managed services portion of our hosting solution to some of our customers. Under these arrangements, we provide the monitoring, maintenance and management of the infrastructure and the customer provides its own servers, colocation and bandwidth. We can also provide these services from the data centers of other providers or in 3 our customers' data centers. For example, we are currently providing managed services for customers in Exodus and AboveNet facilities. Because it leverages our expertise in Microsoft technologies we believe that this offering is a natural extension of our traditional hosting services. Clustered Hosting Services. For customers that deploy e-commerce enabled or other business-critical applications and expect high traffic volumes or require a high level of availability for their applications, we have developed a family of clustered hosting services, including multi-site clusters. Our clustered service plans distribute content and functionality across multiple servers or, in the case of multi-site clusters, across multiple data centers. This technology allows our customers' applications to scale beyond a single server or data center. Additionally, our clustering services are designed to allow our customers' business-critical applications to continue operating in the event a server fails. These services are designed to provide enhanced system performance and system reliability for application and database services. Dedicated Hosting Services. Dedicated hosting services are designed for customers with complex requirements and high traffic volumes who are seeking greater control over the server environment but who do not require clustered servers. Our dedicated service plans provide each customer with its own server. These service plans offer a number of advantages over shared hosting packages, including: . improved service reliability and content delivery by limiting each server to a single developer environment; and . greater flexibility in configuration of the specific server environment. We offer several dedicated service options that range from entry-level web servers to high performance, multi-processor database servers. Shared Hosting Services. Shared hosting services, our entry level service plan, are for customers with relatively low volumes of traffic. We have designed our shared hosting package to minimize the cost for customers by providing these services on a server shared by multiple customers. This service plan includes many standard features and options for database support, commerce support and media services. Customers We typically provide hosting services directly to end user customers, both traditional enterprises and internet-focused businesses. However, we also provide hosting services to application service providers, web site development firms and other organizations that bundle our solution with a service or product they provide to their end user customers. Our customers are located primarily in North America and Europe. As of March 31, 2001, we hosted applications for approximately 800 customers ranging from Fortune 500 companies and small- and medium-sized businesses to start-up businesses, including Internet-focused businesses. Our top customers based on their monthly recurring revenue at the end of fiscal 2001 include: Goldpocket Interactive Texas Instruments H & R Block Compaq Microsoft Opus-i Radio Shack InformIT.com Denguri Codigent.com Houston Street Exchange Fallon Interactive (bmwusa.com and Americredit bmwfilms.com) Portum Gmbh Global Risk Exchange iVita Corporation During fiscal 2001, Goldpocket Interactive, Inc. accounted for 18% of revenue. Our results of operations will be adversely affected if we lose the revenues we expect to be generated by this customer. No other customer accounted for 10% or more of revenue during fiscal 2001, 2000 or 1999. 4 Key Relationships Level 3 We entered into a five-year relationship with Level 3 in July 1999. This strategic relationship allows us to leverage our advanced hosting and managed application services with their U.S. data center infrastructure. We have agreed that if Level 3 can provide substantially similar services to those we request we will purchase 90% of these services from Level 3 through June 2004. We route the network traffic of our customers through multiple backbone providers to increase network performance. To enable us to do this, we obtain Internet connectivity through a number of providers, and Level 3 may not be able to provide all of the connectivity services that we require. As a result, we may purchase less than the applicable percentages of these services from Level 3. Under our agreement with Level 3, we are required to purchase at least an additional $8.3 million of bandwidth and colocation services over the next four years. Our quarterly commitment is $300,000 per quarter through July 2001, $400,000 per quarter during the next 12 months, $600,000 per quarter during the next 12 months and $1.0 million per quarter during the final 12 months of the agreement. During fiscal 2001, we exceeded our purchase commitment to Level 3. The prices we will pay Level 3 for the services over the term of our agreement are based upon Level 3's then-current prices to other companies purchasing similar quantities. Level 3 can terminate our agreement if we default and do not cure the default within 30 days of notice or upon a change of control that results in Data Return being owned by a competitor of Level 3. Level 3 has acquired 1,952,940 shares of our common stock in exchange for $5.0 million in credit for future bandwidth purchases in excess of our quarterly purchase commitment. During the fourth quarter of fiscal 2001, the first quarter in which we were eligible to utilize this credit, we utilized $406,000 of the credit. Compaq We use Compaq servers to provide the hardware platform for our advanced hosting services. Our relationship with Compaq provides direct contact with product development engineers and management at multiple levels within the Compaq organization. In July 1999, we entered into a three-year agreement with Compaq under which we agreed to purchase from Compaq the lesser of 2,000 servers or the number of servers reasonably necessary to adequately operate our business consistent with our business plan. We are required to purchase these servers only if Compaq provides financing for the servers on competitive terms, if the price, performance and quality of the Compaq servers is reasonably satisfactory to us and if Compaq commits to deliver these servers on the schedule we request. Through March 31, 2001, we had purchased approximately 1,800 servers under this agreement. Compaq also owns 1,171,764 shares of our common stock. Microsoft In September 1999, we entered into a development, license and co-marketing agreement with Microsoft. Under this agreement we licensed proprietary installation tools for third-party hosted applications to Microsoft. Microsoft owns 454,546 shares of our common stock and a warrant to acquire an additional 340,910 shares of our common stock at an exercise price of $11 per share. We are recognized by Microsoft as one of the leading providers of advanced hosting services on the Microsoft platform. We were named the Microsoft Windows 2000 Global Hosting Partner of the Year. We believe that one of our key competitive advantages is the level of customer service and support that we can provide as a result of our relationship. However, except for our relationship with Microsoft under this development, license and co-marketing agreement, we do not have an agreement with Microsoft to continue our relationship, and Microsoft could discontinue its relationship with us at any time. Marketing and Sales Our marketing efforts are primarily focused on building the Data Return brand while generating demand for our services. We devote most of our marketing resources to direct mail and telemarketing targeted at Information Technology decision-makers and advertising in magazines targeted at developers and information service professionals. We also advertise online and exhibit at trade shows and conferences. Our sales force included 25 quota-bearing sales representatives at March 31, 2001. Each outside salesperson's territory included one or more Level 3 U.S. gateways. We intend to continue to expand our sales force. 5 Customer Support We believe a critical element of customer service is providing a high level of technical expertise within both customer support and systems organizations. Our technical support engineers are expected to be proficient in at least: . one major network operating system; . two applications from our supported product list; and . either one programming language or one database application. All systems are monitored and maintained on a 24 hours a day, seven days a week, or 24x7, basis. We provide business-critical customer support on a 24x7 basis. We also provide customer support for other issues from 9AM-8PM Central time Monday through Friday and 9PM-6PM Saturday and Sunday via both telephone and electronic request forms. Response times are published on our support web site and are prioritized according to severity levels. We have also created dedicated support teams that are available on a 24x7 basis to customers with especially complex deployments. These dedicated support teams provide a direct line of communication for our customers, which we believe provides a superior level of service. We also have developed a web-based customer care application, called the Customer Service Center, or CSC. Customers can access specific information about their application through the CSC, including application availability and performance, incident histories, account balances and payment histories and scheduled maintenance. Customers can also use the CSC to notify us of upcoming events or changes to their configuration. Infrastructure We use a platform that is comprised mostly of Internet-related software products running on Microsoft's Windows 2000 and NT operating systems and Compaq servers. We primarily use F5 clustering switches and load balancers along with Cisco switches and routers to connect our servers to the Internet. By focusing on standard platforms, we gain efficiency and effectiveness in terms of training, documentation, spare parts and overall support. We also maintain some hosting services running on other software platforms. In addition, we support application level services such as BizTalk, SQL Server, Application Center, Active Server Pages and Commerce Server. Specifically, our infrastructure consists of the following key elements: . secure, carrier-class data centers; . a scalable server platform; . automated deployment processes; . monitoring and systems management; and . advanced high performance network. Secure, Carrier-Class Data Centers Our primary data center is located within Level 3's Dallas gateway. Security for the data center is provided with a guard and entry restriction via access device. Power to the building is provided by redundant connections from separate transformers. The data center is also equipped with fire suppressant systems, environmental control systems and redundant networking hardware. The Level 3 facility provides us with access to Level 3's worldwide IP network. We also offer hosting services from other Level 3 gateways and provide managed services to customers in data centers of other providers. During fiscal 2001, we expanded our presence to Level 3 gateways in New York and London. 6 A Scalable Server Platform Our standard platform for service delivery uses Compaq servers. These servers generally run the Windows 2000 or NT operating system along with various application software, such as Microsoft SQL Server or Microsoft Internet Information Server. Compaq's Distributed Internet Server Array (DISA) architecture leverages the clustering and load balancing features of the Windows 2000 or Windows NT server platforms. This architecture enables us to support scalable, highly-available Internet-enabled applications. In addition, by focusing on standard platforms, we believe that we can gain efficiency and effectiveness in terms of training, documentation, spare parts and overall support. Automated Deployment Processes We configure and test our hardware and software through the use of both commercially available and internally built tools. The software installation process consists of a series of unattended scripts and batch files providing a fast, consistent and repeatable configuration. As the server is provisioned with user accounts, web sites and file transfer protocol sites, the automated script also tests each step to evaluate whether the server is functioning correctly. We also manually test the installation process to further evaluate the quality and integrity of the installation. Monitoring and Systems Management We combine commercial tools and internally built applications to provide monitoring, analysis and reporting of application, service and hardware performance on a 24x7 basis. Systems administration and management is remotely performed using an interface that encrypts all client-server communication with an encryption algorithm for added security. Additionally, we offer a customer control panel, which provides a standard user interface that allows customers to perform the most commonly performed web site administrative tasks. The customer control panel also allows customers to electronically submit more advanced administrative tasks and support requests to our service and support group. Advanced High Performance Network We have based our network hardware on Cisco and F5 technologies. Our network consists of multiple, diverse connections to the Internet that currently provide us with local access to multiple leading backbone providers. These multiple connections allow us to increase both performance and reliability by routing traffic over private connections to bypass congested public exchange points such as the Metropolitan Area Exchanges and Network Access Points. In addition to increased performance, our network architecture reduces our dependency on any one network provider, increasing network availability for our customers. Our network security solutions include firewalls, encryption techniques, virtual private networks and other security technologies and techniques. Competition The markets in which we operate are highly competitive, and competition is increasing because few apparent substantial barriers to entry exist in the Internet hosting market. Although it is impossible to quantify our relative competitive position in our market, many of our competitors have substantially greater financial, technical and marketing resources, larger customer bases, longer operating histories, greater name recognition and more established relationships in the industry than we have. We expect that we will face competition from existing competitors as well as new market entrants in the future. The primary competitive factors in our market are: . technical expertise in developing and delivering advanced hosting solutions; . quality of service, including network capability, scalability, reliability and functionality; . customer service; . number and quality of sales personnel; . variety of services and products offered; 7 . price; . brand name recognition; . Internet system engineering and technical expertise; . timing of introductions of value-added services and products; . network security; . relationships with partners; and . financial resources. Our current and potential competitors vary by size, product offering and geographic region and may elect to partner with each other or with focused companies like us to deliver service on the Microsoft platform. They include: . Microsoft advanced hosting providers; . web and application hosting service providers; . application-specific hosting service providers; . colocation providers; . managed service providers; . local, regional and international Internet service providers; . local, regional and international telecommunications companies; . systems integrators and large information technology outsourcing companies; . multimedia hosting companies; and . other hardware, software and technology companies. Our competitors may operate in one or more of these areas and include companies such as AboveNet, AT&T, British Telecommunications, Cable & Wireless, Concentric Network, Critical Path, Dell, Digex, Exodus Communications, Frontier/GlobalCenter, Globix, GTE, Genuity, IBM, Intel, Interliant, Level 3, Loudcloud, MCI WorldCom (including UUNET), Navisite, PSINet, Qwest Communications International, Usinternetworking, USWeb/CKS Group, Verio and Yahoo! Employees As of March 31, 2001, we had 531 employees (see "Part II, Item 4, Management's Discussion and Analysis of Financial Condition and Results of Operations -Recent Developments"). None of our employees are covered by collective bargaining agreements. We believe that our relations with our employees are good. 2. PROPERTIES Our corporate headquarters are currently located in Irving, Texas and consist of approximately 168,438 square feet of office space of which the majority is leased until May 31, 2003 with the remaining space expiring May 31, 2006. We also have an office in Dallas, Texas, consisting of 10,500 square feet of office space that is leased until May 31, 2004. 8 ITEM 3. LEGAL PROCEEDINGS We do not believe that we are subject to any pending or threatened legal proceedings. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. EXECUTIVE OFFICERS OF THE REGISTRANT The following sets forth information regarding our executive officers:
Name Age Position -------------- --- ---------------------- Sunny C. Vanderbeck............................... 28 Chairman of the Board and Chief Executive Officer Michelle R. Chambers.............................. 32 President and Director Robert A. Prosen.................................. 46 Chief Operating Officer Michael S. Shiff.................................. 47 Executive Vice President Kenneth S. Garber................................. 47 Senior Vice President - Marketing, Sales and Business Development Alonso M. Perales................................. 45 Senior Vice President - Operations J. Todd Steitle................................... 35 Senior Vice President - Product Development Stuart A. Walker.................................. 36 Senior Vice President - Chief Financial Officer and Treasurer
Sunny C. Vanderbeck, a co-founder of the Company, has served as Chairman and Chief Executive Officer since our incorporation in August 1997. Before founding Data Return, from July 1996 to January 1997, Mr. Vanderbeck was a technical product manager and Lead Internet/Intranet Consultant for Software Spectrum, a reseller of Microsoft products. From May 1995 to June 1996, while employed by Software Spectrum, Mr. Vanderbeck served as an independent consultant to Microsoft where he served as a team leader for Microsoft Messaging products and as a product support engineer. From July 1994 to May 1995, Mr. Vanderbeck was an independent consultant. From 1990 to 1994, Mr. Vanderbeck served as a Section Leader in the 2nd Ranger Battalion, a U.S. Army Special Operations unit. Michelle R. Chambers, a co-founder of the Company, has served as President and a director since our inception and served as Chief Operating Officer from April 1998 until March 2001. Before founding Data Return, from October 1996 to March 1997, Ms. Chambers was a Consultant at Microsoft, where she was a member of the Microsoft Consulting team responsible for the design and development of the migration plan for Audionet's (now Yahoo! Broadcast) platform conversion from Unix to Windows NT. Prior thereto, Ms. Chambers served as a product support engineer at Microsoft from February 1995 to October 1996, and was the Corporate E-mail Coordinator for Arco Exploration and Production Technology from August 1993 to February 1995. Ms. Chambers is a Microsoft Certified Systems Engineer. Robert A. Prosen has served as Chief Operating Officer since March 2001 and served as Senior Vice President - Operations from May 2000 until March 2001. Prior to joining Data Return, Mr. Prosen served as Senior Vice President of Sabre Technology Solutions, from 1997 to May 2000 where he led the Americas Region to become Sabre's top performing business unit. Before joining The Sabre Group, Mr. Prosen was Vice President of Professional Services at Hitachi Data Systems from 1995 to 1997, where he planned and directed business operations and technology planning, as well as network and year 2000 consulting. Prior to this, from 1993 to 1995, he served as managing partner of Professional Services for AT&T Global Information Solutions (currently NCR). His accomplishments at AT&T include building a nationally recognized management and technology consulting practice that offered services such as network and architecture consulting, program management, solutions engineering, and systems integration. Mr. Prosen also held various management positions with AT&T and Sprint in operations, sales, human resources, engineering, customer service, information systems and financial planning. Michael S. Shiff has served as Executive Vice President since April 2001 and served as Senior Vice President - Marketing, Sales and Business Development from June 1999 to April 2001. Mr. Shiff also previously served as Vice President - Marketing, Sales and Business Development from March 1998 to June 1999. Mr. Shiff served as 9 President of MicroVision Medical Systems, a manufacturer of medical imaging systems, from April 1996 to December 1996. From April 1993 to November 1995, Mr. Shiff was Vice President of Sales for Kodak Health Imaging Systems, a manufacturer of medical imaging systems. He also served as Vice President of Marketing and Sales for Vortech Data, a manufacturer of medical imaging systems, from March 1989 until Vortech's acquisition by Eastman Kodak in March 1993. Prior thereto, Mr. Shiff was Director of Strategic Sales Development for Hughes Network Systems, a manufacturer of telecommunications systems, and was Domestic Marketing Manager for the Satellite Communications Group of M/A-COM Telecommunications, a manufacturer of telecommunications systems, which was acquired by Hughes Aircraft. Kenneth S. Garber has served as served as Senior Vice President -Marketing, Sales and Business Development since April 2001 and prior to that served as Vice President - Worldwide Sales from October 2000. Mr. Garber also served as Vice President Sales from June 1999 to October 2000. From March 1996 to May 1999, Mr. Garber was Vice President of Sales and Business Development for Chroma Vision Medical Systems, Inc., a manufacturer of medical imaging systems. Prior to that, Mr. Garber served as Vice President and General Manager of the Imagelink Business Unit for Kodak Health Imaging Systems from 1994 to March 1996. Previously, Mr. Garber held various marketing and sales positions with Vortech Data, Hughes Network Systems, Satellite Business Systems and Federal Data Corporation. Alonso M. Perales has been Senior Vice President - Operations since March 2001 and served as Vice President - Service and Support from December 2000 until March 2001. Mr. Perales joined Data Return from Microsoft Corporation, where for the previous five years he had directed product support services for the Central United States, Canada, Latin America and the South Pacific regions. Prior to his tenure with Microsoft, Mr. Perales was a principal in Expert Business Systems, a software development and consulting company. Mr. Perales also spent 12 years in various management roles with IBM. J. Todd Steitle has served as served as Senior Vice President - Product Development since March 2001 and served as Vice President - Marketing Communications from June 1999 to March 2001. Previously, he served as our Director of Marketing from May 1998 to June 1999. Before joining Data Return, Mr. Steitle held various sales and marketing positions for the Tools Division of Sybase Corporation, formerly Powersoft Corporation, a software company, from May 1996 to May 1998. From September 1994 to May 1996, Mr. Steitle served as Manager of Business Development for Kodak Health Imaging Systems. Previously, Mr. Steitle held various marketing and sales positions for Apple Computer Corporation. Stuart A. Walker has served as our Senior Vice President - Chief Financial Officer and Treasurer since May 2000 and previously served as Vice President - Chief Financial Officer and Treasurer since June 1999 and as Chief Financial Officer since March 1999. He also served as Secretary from June 1999 until November 1999. Prior to joining Data Return, Mr. Walker was a consultant with Eubank, Wofford and Nichols, LLP, a public accounting firm, from June 1998. Mr. Walker served as Vice President and Chief Financial Officer of Aviation Group, Inc., an aviation services company, from September 1997 to April 1998. He served as Corporate Controller of Precept Business Products, Inc., a business products distribution company, from August 1996 to August 1997. He was Vice President Finance and Controller of DirectNet Corporation, an educational technology company, from March 1995 to August 1996. 10 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS Our common stock is traded on the Nasdaq National Market under the symbol "DRTN." The following table sets forth the range of the high and low closing sale prices of our common stock by quarter as reported on the Nasdaq National Market since October 27, 1999, the date our common stock commenced trading. Quarter High Low -------------------------------------------------------------------------------- Year Ending March 31, 2001: Fourth Quarter $ 9.81 $ 2.56 Third Quarter $19.94 $ 3.38 Second Quarter $37.75 $15.50 First Quarter $41.63 $13.25 Year Ending March 31, 2000: Fourth Quarter $94.25 $36.50 Third Quarter $67.13 $13.75 As of June 27, 2001, we had 100 shareholders of record. Because many of our shares are held by brokers and other institutions on behalf of shareholders, we are unable to estimate the total number of beneficial shareholders represented by these record holders. We have never declared or paid any cash dividends on our stock. We currently intend to retain any earnings for use in our business and do not anticipate paying any cash dividends in the foreseeable future. 11 ITEM 6. SELECTED FINANCIAL DATA
Years ended March 31, Period From --------------------- September 22, 1997 (inception) to 2001 2000 1999 March 31, 1998 ---- ---- ---- -------------- (dollars in thousands) Statements of Operations Data: Revenues....................................... $ 50,068 $ 11,833 $ 1,889 $ 336 Costs and expenses: Cost of revenue.............................. 45,444 9,277 1,105 198 General and administrative................... 23,418 7,575 1,061 230 Marketing and sales.......................... 24,492 6,212 663 39 Product research and development............. 4,778 548 2 0 Stock-based compensation..................... 171 1,779 349 61 -------- -------- ------- ------- Total costs and expenses....................... 98,303 25,391 3,180 528 -------- -------- ------- ------- Loss from operations........................... (48,235) (13,558) (1,291) (192) Other income, net.............................. 1,083 1,870 7 2 -------- -------- ------- ------- Loss before cumulative effect of change in accounting principle........................... $(47,152) $(11,688) $(1,284) $ (190) Cumulative effect of change in accounting principle...................................... $ (1,626) $ 0 $ 0 $ 0 -------- -------- ------- ------- Net loss....................................... $(48,778) $(11,688) $(1,284) $ (190) ======== ======== ======= ======= Net loss per common share before cumulative effect of change in accounting principle...................................... $ (1.32) $ (0.40) $ (0.07) $ (0.01) ======== ======== ======= ======= Net loss per common share after................ cumulative effect of change in accounting principle...................................... $ (1.37) $ (0.40) $ (0.07) $ (0.01) ======== ======== ======= ======= Shares used in per share computation........... 35,712 29,268 18,371 15,882 ======== ======== ======= ======= Other Financial Data: EBITDA (1)..................................... $(32,548) $ (9,565) $ (813) $ (118) Net cash used in operating Activities.................................... (29,105) (8,955) (645) 2 Net cash used in investing activities.......... (40,215) (5,828) (939) (55) Net cash (used in) provided by financing activities..................................... (9,538) 99,364 1,953 527 Purchases of property and equipment............ 13,415 5,953 814 55
March 31, -------- 2001 2000 1999 1998 ---- ---- ---- ---- (dollars in thousands) Balance Sheet Data: Working capital................................................ $17,734 $ 79,970 $ 561 $ 321 Total assets................................................... 87,632 114,857 2,214 734 Notes payable and capital lease obligations--long-term......... 18,173 11,324 166 36 Total shareholders' equity..................................... 44,161 91,301 1,245 430
(1) EBITDA consists of loss from operations of $48,235,000, $13,558,000 and $1,291,000 plus depreciation and amortization of $15,516,000, $2,214,000 and $129,000 plus amortization of unearned stock-based compensation of $171,000, $1,779,000 and $349,000 for the years ended March 31, 2001, 2000 and 1999, respectively. EBITDA does not represent funds available for management's discretionary use and is not intended to represent cash flow from operations as measured under generally accepted accounting principles. 12 EBITDA should not be considered as an alternative to net loss or net cash used in operating activities, but may be useful to investors as an indication of operating performance. Our calculations of EBITDA may not be consistent with calculations of EBITDA used by other companies. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS You should read the following discussion together with the financial statements and other financial information included in this Annual Report on Form 10-K. This report contains forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from those projected in the forward-looking statements. Our fiscal year ends on March 31. Overview Data Return provides advanced Internet hosting services based on Microsoft technologies. We provide these services to businesses seeking to outsource the deployment, maintenance and support of their complex web sites. Our services include providing, configuring, operating and maintaining the hardware, software and network technologies necessary to implement and support these web sites. Our business and the industry in which we operate are rapidly evolving, and we have a limited operating history. As a result, we believe that period-to- period comparisons of our revenue and operating results, including our cost of revenue and other operating expenses as a percentage of total revenue, may not be meaningful and should not be relied upon as indicators of future performance. We do not believe that our historical growth rates, particularly the high rates of growth we experienced in previous quarters, are indicative of future results. Currently, we derive substantially all of our revenue from hosting and managed services. This includes revenue from our dedicated server offerings, including clustered servers, and our shared server offering. With our dedicated server offerings, each server is dedicated to providing service to one customer. In a clustered configuration, we utilize two or more dedicated servers to distribute content and functionality across multiple servers or, in the case of multi-site clusters, across multiple data centers. Hosting and managed services revenue also includes shared hosting, in which more than one customer shares the same server. Historically, we have also derived a nominal amount of revenue from technical reviews and the resale of software and other products. Currently, most of our advanced hosting and managed services revenues are generated from recurring monthly fees. Substantially all of the remainder is derived from one- time set-up fees for installation and from sales of services, such as time and materials billing and certain lab or consulting services. Services are billed on a monthly basis and, except as described below, are recognized as the service is performed. As a result of our adoption of Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements ("SAB 101"), revenues from set-up, or installation, services are recognized over the initial term of the customer contract. See "- Recent Accounting Pronouncements" for a description of our adoption and the effect of SAB 101 and "Results of Operations - Comparison of fiscal 2001 and 2000 - Cumulative effect of change in accounting principle" and "Results of Operations - Comparison of fiscal 2001 and 2000 - Cumulative effect of change in accounting principle" for a discussion of the effect of this change in accounting principle during fiscal 2001. Our expenses are comprised of: . cost of revenue, which consists primarily of compensation and related expenses for technical operations, broadband services expenses, space in data centers and depreciation of equipment; . general and administrative, which consists primarily of compensation and related expenses and occupancy costs; . marketing and sales, which consists primarily of compensation and related expenses, advertising expenses and occupancy costs; 13 . product research and development, which consists primarily of compensation and related expenses and occupancy costs; and . stock-based compensation, which relates to employee stock options granted at prices less than fair value. We have incurred significant losses since our inception and, as of March 31, 2001, had an accumulated deficit of approximately $61.7 million. We intend to continue to invest in marketing and sales and the continued development of our network infrastructure and technology. We expect to continue to expand our operations and workforce, primarily in the sales and marketing areas. We expect to continue to incur substantial losses for the foreseeable future. We may not be able to successfully execute our expansion plans. Recent Developments On May 11, 2001, we reduced our workforce by 94 employees. The reduction in workforce was a result of slower than anticipated growth and increased process and other operational efficiencies. As a result of this workforce reduction, we anticipate a one-time restructuring charge of $1.0 million to $1.5 million in the first quarter of fiscal 2002. Giving effect to this reduction, on May 12, 2001, our employee base consisted of the following: 194 in systems operations and service and support, 90 in general and administrative functions, 110 in marketing and sales and 49 in product research and development. Results of Operations The following table sets forth selected financial data as a percent of revenue for the fiscal years ended March 31, 2001, 2000 and 1999.
% of Revenue ---------------------------------------------- Year Ended March 31, -------------------- 2001 2000 1999 ---- ---- ---- Revenues................................................... 100.0% 100.0% 100.0% Costs and expenses: Cost of revenue.......................................... 90.8 78.4 58.5 General and administrative............................... 46.8 64.0 56.2 Marketing and sales...................................... 48.9 52.5 35.1 Product research and development......................... 9.5 4.6 .1 Stock-based compensation................................. .3 15.1 18.5 ----- ------ ----- Loss from operations....................................... (96.3) (114.6) (68.4) Other income (expense): Interest income.......................................... 7.5 18.5 1.1 Interest expense......................................... (5.3) (2.7) (0.7) ----- ------ ----- Loss before cumulative effect of change in accounting principle)..................................... (94.1)% (98.8)% (68.0)% ===== ====== ===== Cumulative effect of change in accounting principle........ ( 3.3)% ( .0)% ( .0)% ===== ====== ===== Net loss................................................. (97.4)% (98.8)% (68.0)% ===== ====== =====
Comparison of fiscal 2001 and 2000 Revenues Our revenues increased $38,235,000 to $50,068,000 for fiscal 2001 from $11,833,000 for fiscal 2000. Dedicated hosting revenue increased $35,370,000 to $41,839,000, or 83.6% of revenue, for fiscal 2001 from $6,469,000, or 54.7% of revenue, for fiscal 2000. Shared hosting revenue increased $631,000 to $2,911,000, or 5.8% of revenue, for fiscal 2001 from $2,280,000, or 19.3% of revenue, for fiscal 2000. Set-up fees increased $1,072,000 to $3,722,000, or 7.4% of revenue, for fiscal 2001 from $2,650,000, or 22.4% of revenue, for fiscal 2000. Revenues from testing and other lab services were $352,000 during fiscal 2001 reflecting the opening of our 14 scalability lab in September 2000. The increase was primarily due to the addition of new customers that generated higher average monthly revenues. Growth from some existing customer accounts also contributed. Cost of revenue Our cost of revenue increased $36,167,000 to $45,444,000, or 90.8% of revenue, for fiscal 2001 from $9,277,000, or 78.4% of revenue, for fiscal 2000. The increase in cost of revenue was due primarily to increases in personnel and related costs, depreciation and amortization expenses, communication and bandwidth expenses, other hardware and software equipment costs, facilities and travel and professional services. Personnel and related expenses increased approximately $15,408,000 to $20,439,000, or 40.8% of revenue, for fiscal 2001 from $5,031,000, or 42.5% of revenue, for fiscal 2000, as we increased our systems operations and customer support personnel to 237 at March 31, 2001 from 167 at March 31, 2000. Depreciation and amortization expenses increased approximately $10,574,000 to $12,250,000 for fiscal 2001, from $1,676,000 for fiscal 2000, as we added approximately $23.5 million in computer and related equipment since March 31, 2000. Our communication and bandwidth expenses increased $6,772,000 to approximately $8,107,000 for fiscal 2001 from $1,335,000 for fiscal 2000 to support our increased business activities. Other hardware and software equipment costs increased $1,194,000 to $1,695,000 for fiscal 2001 to support the growth in our business. Facilities costs increased $1,159,000 to $1,427,000 for fiscal 2001 due to a move into a larger facility in September 1999. Travel and professional services increased $207,000 and $309,000, to $291,000 and $404,000, respectively, for fiscal 2001. We expect our cost of revenue to continue to increase as our overall business grows. General and administrative General and administrative expense increased $15,843,000 to $23,418,000, or 46.8% of revenue, during fiscal 2001 from $7,575,000, or 64.0% of revenue, during fiscal 2000. The increase is primarily due to increases in personnel and related expenses, bad debt, depreciation, professional services, facilities, supplies, insurance, travel, tax expense and amortization of warrants granted to vendors. Personnel and related expenses increased $5,835,000 to $10,475,000, or 20.9% of revenue, for fiscal 2001 from $4,640,000, or 39.2% of revenue, for fiscal 2000. We increased our number of employees in general and administrative functions to 117 employees at March 31, 2001 from 89 employees at March 31, 2000. Bad debt expense increased $3,020,000 to $3,547,000 as many of our customers, particularly Internet-based businesses, ceased operations or reduced or eliminated the web site operations hosted by us. We expect our financial results, including bad debt expense, to continue to be negatively impacted by the termination or reduction in service from these businesses. Depreciation expense increased $1,416,000 to $1,801,000 for fiscal 2001, which is a result of increased internal equipment necessary to support the growth of our business. Professional services fees increased approximately $1,057,000 to $1,556,000 for fiscal 2001 from $499,000 in the comparable period in 2000. Expenses for facilities, supplies, insurance and travel increased $1,852,000, $420,000, $353,000 and $74,000, to $2,298,000, $561,000, $568,000 and $518,000, respectively, for fiscal 2001 as a result of our move into a larger facility and to support the growth in general and administrative employees. Tax expense increased to $403,000 for fiscal 2001 due to franchise and other state and local taxes. Amortization costs related to the warrants we issued to Microsoft in September 1999 and Sicola Martin in March 2000 increased $375,000 to $553,000 in fiscal 2001. Marketing and sales Marketing and sales expense increased $18,280,000 to $24,492,000, or 48.9% of revenue, during fiscal 2001 from $6,212,000, or 52.5% of revenue, during fiscal 2000. The increase was due primarily to an increase in marketing and sales personnel and related expenses, advertising costs, including agency fees, promotional items, printing and trade shows, travel, depreciation, and facilities expenses. Personnel and related expenses increased $10,168,000 to $14,715,000, or 29.4% of revenue, for fiscal 2001 from $4,547,000, or 38.4% of revenue, for fiscal 2000. Advertising costs increased $5,232,000 to $6,078,000 for fiscal 2001 from $846,000 for fiscal 2000. Costs in this category include expenses for advertising, promotional items, printing, trade shows, and fees paid to advertising, public relations and other creative agencies. Travel expenses increased $1,423,000 to $1,685,000 for fiscal 2001 as a result of the growth in the marketing and sales personnel. Depreciation and facilities expenses increased $732,000 and $657,000, to $732,000 and $781,000, respectively, for fiscal 2001 due to our move into a larger facility. We increased our marketing and sales personnel to 114 at March 31, 2001 from 52 at March 31, 2000. 15 Product research and development Product research and development expense increased $4,230,000 to $4,778,000, or 9.5% of revenue, during fiscal 2001 from $548,000, or 4.6% of revenue, during fiscal 2000. The increase was due primarily to an increase in product research and development personnel and related expenses, facilities, depreciation and travel expenses. Personnel and related expenses increased $3,379,000 to $3,860,000, or 7.7% of revenue, for fiscal 2001 from $481,000, or 4.1% of revenue, for fiscal 2000. We increased our number of employees in product research and development to 63 at March 31, 2001 from 17 at March 31, 2000. Facilities, depreciation and travel expenses increased $327,000, $178,000 and $87,000 to $346,000, $180,000 and $127,000, respectively, for fiscal 2001 as a result of our move into a larger facility and the increase in the number of product research and development employees. Stock-based compensation Deferred stock compensation was recorded in connection with the grant of employee stock options below fair value in 1998 and 1999. Amortization of stock- based compensation totaled $171,000 for fiscal 2001 and $1,779,000 for fiscal 2000. The amortization of stock-based compensation is based on the vesting schedule of stock options held by our employees. Other income (expense) Other income (expense) consists primarily of interest income on our cash balances and investments in marketable securities and interest expense on our outstanding notes payable and capital lease obligations. Interest earned on our cash and cash equivalents increased $1,558,000 to $3,749,000 for fiscal 2001 from $2,191,000 for fiscal 2000. This increase was due primarily to the closing of our initial public offering in October 1999, which resulted in higher cash balances available for investment for the majority of fiscal 2001. During fiscal 2001, interest expense increased $2,345,000 to $2,666,000 related primarily to equipment acquired under capital leases during the last four quarters. Income taxes No provision for federal income taxes has been recorded as we have incurred net operating losses since our inception. We have recorded a full valuation allowance against our net deferred tax asset, which is primarily attributable to net operating loss carry forwards, due to uncertainty that we will generate sufficient taxable income during the carry forward period to realize the benefit of our net deferred tax asset. Cumulative effect of change in accounting principle Effective April 1, 2000, we changed our method of accounting for set-up fees in accordance with SAB 101. The net effect on fiscal 2001 of the change in accounting principle was to reduce our net loss by $408,000. We recognized set up revenues of $3.7 million under the new method of revenue recognition, including the $1.6 million cumulative adjustment that was recorded as of April 1, 2000 and amortized into income in fiscal 2001. We would have recognized $3.3 million in set up revenue under the prior method. With the adoption of SAB 101, there was no impact on our operations or cash flow. See "- Recent Accounting Pronouncements" for a description of our adoption and the effect of SAB 101. Net loss Net loss increased to $48,778,000 for fiscal 2001 from $11,688,000 for fiscal 2000. As more fully discussed above, the increased net loss is primarily attributable to increased costs as we continued to build our business for anticipated growth. EBITDA EBITDA, as defined below, decreased $23,012,000 to negative $32,548,000 for fiscal 2001 from negative $9,565,000 for fiscal 2000. The decrease is primarily attributable to costs associated with our growth strategy. We 16 expect to generate negative EBITDA for fiscal 2002. Costs associated with our expenditures in marketing and sales, the continued development of our network infrastructure and technology and expansions of our operations and workforce, including our network operations, technical support, sales, marketing, product research and development and administrative resources, will continue to represent a large portion of our expenses during our anticipated expansion. EBITDA for fiscal 2001 and 2000 consists of losses from operations of $48,235,000 and $13,558,000 plus depreciation and amortization of $15,516,000 and $2,214,000 plus amortization of unearned stock-based compensation of $171,000 and $1,779,000, respectively. EBITDA does not represent funds available for management's discretionary use and is not intended to represent cash flow from operations as measured under generally accepted accounting principles. EBITDA should not be considered as an alternative to net loss or net cash used in operating activities, but may be useful to investors as an indication of operating performance. This caption excludes components that are significant in understanding and assessing the results of operations and cash flows. In addition, EBITDA is not a term defined by generally accepted accounting principles and, as a result, our calculations of EBITDA may not be consistent with calculations of EBITDA used by others. However, we believe that EBITDA is relevant and useful information that is often reported and widely used by analysts, investors and other interested parties in the advanced hosting industry. Accordingly, we are disclosing this information to permit a more comprehensive analysis of our operating performance, as an additional meaningful measure of performance and liquidity and to provide additional information with respect to our ability to meet future working capital requirements. Comparison of fiscal 2000 and 1999 Revenues Our revenues increased $9,944,000 to $11,833,000 for fiscal 2000 from $1,889,000 for fiscal 1999. Dedicated hosting revenue increased $5,840,000 to $6,469,000, or 54.7% of revenue, for fiscal 2000 from $629,000, or 33.3% of revenue, for fiscal 1999. Shared hosting revenue increased $1,343,000 to $2,280,000, or 19.3% of revenue, for fiscal 2000 from $937,000, or 49.6% of revenue, for fiscal 1999. Set-up fees increased $2,384,000 to $2,650,000, or 22.4% of revenue, for fiscal 2000 from $266,000, or 14.1% of revenue, for fiscal 1999. The increase was primarily due to the addition of new customers that generated higher average monthly revenues. Organic growth from some existing customer accounts also contributed. Cost of revenue Our cost of revenue increased $8,172,000 to $9,277,000, or 78.4% of revenue, for fiscal 2000 from $1,105,000, or 58.5% of revenue, for fiscal 1999. The increase in cost of revenue was due primarily to increases in personnel and related costs, including employee recruiting fees, depreciation, bandwidth, other hardware and software equipment costs, facilities, travel and professional services. The increase as a percent of revenue was partially attributable to our incurring these costs in advance of revenues. Personnel and related expenses increased approximately $4,489,000 to $5,031,000, or 42.5% of revenue, for fiscal 2000 from $542,000, or 28.7% of revenue, for fiscal 1999, as we increased our systems and customer support personnel to 167 at March 31, 2000 from 19 at March 31, 1999. Depreciation expense increased approximately $1,587,000 to $1,676,000 for fiscal 2000 as we added approximately $23.2 million in computer and related equipment since March 31, 1999. Our broadband services expenses increased $994,000 to approximately $1,335,000 for fiscal 2000 from $342,000 for fiscal 1999, to support our increased business activities. Other hardware and software equipment costs increased $439,000 to $501,000 for fiscal 2000 to support the growth in our business. Facilities expense increased $268,000 during fiscal 2000 as a result of our move into a larger facility and the growth in employees and as a result of the addition of a customer build center. Travel and professional services increased $84,000 and $95,000, respectively, for fiscal 2000 reflecting the increased geographic dispersion of our customer base. General and administrative General and administrative expense increased $6,514,000 to $7,575,000, or 64.0% of revenue, during fiscal 2000 from $1,061,000, or 56.2% of revenue, during fiscal 1999. The increase is primarily due to increases in personnel and related expenses, including employee recruiting fees, travel professional services, depreciation, amortization of warrant, facilities, supplies, insurance and bad debt. Personnel and related expenses increased 17 $4,012,000 to $4,640,000, or 39.2% of revenue, for fiscal 2000 from $628,000, or 33.3% of revenue, for fiscal 1999. We increased our number of employees in general and administrative functions to 89 employees at March 31, 2000 from eight employees at March 31, 1999. Travel expenses increased approximately $400,000 to $444,000, or 3.8% of revenue, for fiscal 2000 from $44,000, or 2.4% of revenue, for fiscal 1999. Professional services fees increased approximately $414,000 to $499,000 for fiscal 2000 from $85,000 in the comparable period in 1999. Depreciation expense increased $344,000 in fiscal 2000, which is a result of increased internal equipment necessary to support the growth of our business. Amortization of product development costs related to the warrant we issued to Microsoft in September 1999 increased $178,000. Facilities, supplies, and insurance expense increased $338,000, $136,000 and $208,000, respectively, as a result of our move into a larger facility and the growth in general and administrative employees. Bad debt expense increased $493,000. Marketing and sales Marketing and sales expense increased $5,549,000 to $6,212,000, or 52.5% of revenue, during fiscal 2000 from $663,000, or 35.1% of revenue, during fiscal 1999. The increase was due primarily to an increase in marketing and sales personnel and related expenses, including employee recruiting fees and advertising costs. Personnel and related expenses increased $4,176,000 to $4,547,000, or 38.4% of revenue, for fiscal 2000 from $370,000, or 19.6% of revenue, for fiscal 1999. Advertising costs increased $549,000 to $846,000 for fiscal 2000 from $296,000 for fiscal 1999. We increased our marketing and sales personnel to 52 at March 31, 2000 from six at March 31, 1999. Product research and development Product research and development expense increased $546,000 to $548,000 or 4.6% of revenue, during fiscal 2000 from $2,000 or .1% of revenue, during fiscal 1999. The increase was due primarily to an increase in product research and development personnel and related expenses, facilities costs, depreciation and travel expenses. Personnel and related expenses increased $479,000 to $481,000, or 4.1% of revenue for fiscal 2000 from $2,000 or .1% of revenue, for fiscal 1999. We increased our number of employees in product research and development to 17 at March 31, 2000 from 1 at March 31, 1999. Facilities costs, depreciation and travel expenses increased $19,000, $2,000, and $40,000, respectively, as a result of our move into a larger facility and the increase in the number of product research and development employees. Stock-based compensation Deferred stock compensation was recorded in connection with the grant of employee stock options below fair value. Amortization of stock-based compensation totaled $1,779,000 for fiscal 2000 and $349,000 for fiscal 1999. The amortization of stock-based compensation is based on the vesting schedule of stock options held by the Company's employees. Stock based compensation in fiscal 2000 includes the effect of options whose vesting was accelerated to the date of our initial public offering, which closed in November 1999. Other income (expense) Other income (expense) consists primarily of interest income on our cash balances and interest expense on our outstanding notes payable and capital lease obligations. Interest earned on our cash and cash equivalents increased $2,171,000 to $2,191,000 for fiscal 2000 from $20,000 for fiscal 1999. This increase was due primarily to the closing of our initial public offering in October 1999, which resulted in larger cash balances available for investment. During fiscal 2000, we increased interest expense $308,000 to $321,000 related primarily to equipment capital leases entered into in the third and fourth quarter of fiscal 2000. Income taxes No provision for federal income taxes has been recorded as we have incurred net operating losses since our inception. We have recorded a valuation allowance against all of our net deferred tax asset, which is primarily attributable to net operating loss carry forwards, due to uncertainty that we will generate sufficient taxable income during the carry forward period to realize the benefit of our net deferred tax asset. 18 Net Loss Net loss increased $10,404,000 to $11,688,000 for fiscal 2000 from $1,284,000 for fiscal 1999. As more fully discussed above, the increased net loss is primarily attributable to increased costs as we continued to build our business for anticipated growth. EBITDA EBITDA decreased $8,723,000 to negative $9,565,000 for fiscal 2000 from negative $813,000 for fiscal 1999. The decrease is primarily attributable to costs associated with our growth strategy. EBITDA consisted of losses from operations of $13,558,0000 and $1,291,000 plus depreciation and amortization of $2,214,000 and $129,000 plus amortization of unearned stock-based compensation of $1,779,000 and $349,000 for fiscal 2000 and 1999, respectively. Liquidity and Capital Resources We have historically financed our operations primarily through sales of equity securities and capital leases. Since our inception, we have raised $15.9 million through private placements of our common stock. In November 1999, we raised $85.9 million in net proceeds from our initial public offering. As of March 31, 2001, we had cash and cash equivalents of $6.6 million and investments in marketable securities of $26.8 million. Net cash used in our operating activities for the twelve-month period ended March 31, 2001 was $29.1 million. The net cash used in operations was comprised primarily of working capital requirements and our net loss, net of depreciation and amortization. Net cash used in investing activities was $40.2 million for the twelve-month period ended March 31, 2001 and consisted of the purchase of marketable debt securities of $37.9 million, redemptions of marketable debt securities of $11.1 million and purchases of property and equipment of approximately $13.4 million. Our purchases of property and equipment consisted primarily of leasehold improvements, equipment to provide services to our customers and purchases of furniture and equipment for new employees. We acquired $23.7 million in computer and related equipment under capital leases for the twelve-month period ended March 31, 2001. Net cash used in financing activities was approximately $9.5 million for the twelve-month period ended March 31, 2001 and consisted primarily of principal payments on our notes payable and capital leases. Total borrowings under our notes payable and capital lease obligations as of March 31, 2001 were approximately $31.0 million. To help manage short-term liquidity needs without disrupting our investment strategies, in December 1999 we entered into a revolving credit facility with Bank One, Texas, N.A. This credit facility matures on July 31, 2001 and outstanding balances accrue interest at the bank's base rate. We may borrow up to $2.0 million under the credit facility but have not borrowed any amounts to date. The facility is secured by all of our equipment that was unencumbered on the date we entered into the facility and all accounts receivable outstanding from time to time. Under certain limited circumstances, we could be required to deposit cash with the bank to secure the loan. The credit facility contains standard events of default and other covenants. Under our agreement with Level 3, we are required to purchase at least an additional $8.3 million of bandwidth and colocation services over the next four years. Our quarterly commitment is $300,000 per quarter through July 2001, $400,000 per quarter during the next 12 months, $600,000 per quarter during the next 12 months and $1.0 million per quarter during the final 12 months of the agreement. We believe that our current cash and investment balances should be sufficient to meet our working capital and capital expenditure requirements through March 31, 2002. We will continue to incur negative cash flows during fiscal 2002 and thereafter. Therefore, we will be required to use our cash and other liquid resources to support our operations. If we do not achieve the results of operations that we expect as a result of lower than expected revenues, higher than expected expenses or other possible adverse developments, then we would be required either to secure additional sources of capital to continue operating at our current level or to curtail our current operations. Our operating activities on a long-term basis may require us to obtain additional equity or debt financing. We finance under capital or operating leases substantially all of the equipment we use to provide services to our customers. As a 19 result, our investments in this type of equipment will require us to obtain additional lease or other financing in the future. In addition, although we have no present understandings, commitments or agreements with respect to any acquisition of other businesses, products, services or technologies, we may evaluate potential acquisitions of other businesses, products and technologies from time to time. In order to consummate potential acquisitions, we may need additional equity or debt financings in the future. If we require additional financing for any reason, there can be no assurance that such additional financing will be available to us on acceptable terms, or at all. In the event we are unable to raise additional capital, we may be required to substantially reduce or curtail operations. Further, if additional funds are raised through the issuance of additional equity securities, the percentage ownership of our shareholders would be diluted. Any new equity securities may have rights, preferences or privileges senior to those of our common stock. Recent Accounting Pronouncements In December 1999, the Securities and Exchange Commission issued SAB 101 which summarizes some of the SEC staff's views in applying generally accepted accounting principles to revenue recognition in financial statements. We adopted the new guidance as a change in accounting principle in January 2001 but effective April 1, 2000. We changed our method of recognizing revenue on set up fees to defer the revenue and recognize it over the initial term of the contracts with our customers. The change in accounting method has been accounted for as a cumulative effect adjustment, which resulted in (a) the financial information for the quarters of fiscal 2001 prior to adoption of SAB 101 being restated and (b) the cumulative effect adjustment being reflected in the first quarter of the year of adoption of SAB 101. As a result of the cumulative effect adjustment on prior years, which totals approximately $1,626,000, revenue that has previously been recognized in our financial statements has been and will continue to be amortized to income in financial reporting periods subsequent to the period of adoption of SAB 101. Risk Factors The risks and uncertainties described below are not the only risks we face. Additional risks and uncertainties not presently known to us or that are currently deemed immaterial may also impair our business operations. If any of the following risks actually occur, our financial condition and operating results could be materially adversely affected. We have a history of substantial losses, and we anticipate continuing losses. We have experienced operating losses and negative cash flows from operations in each quarterly and annual period since incorporating in 1997. We experienced net losses of approximately $48.8 million, or negative 97.4% of revenues, for fiscal 2001. As of March 31, 2001, we had an accumulated deficit of approximately $61.7 million. We expect our operating expenses to increase significantly as we attempt to expand our business. We are required to purchase $300,000 of colocation and bandwidth services from Level 3 during the first quarter of fiscal 2002 and an additional $1.2 million during fiscal 2002. We anticipate increased expenses as we continue to expand and improve our infrastructure, introduce new services, develop our distribution channel, fund research and development, support and improve our operational and financial systems, broaden customer service and support, enhance our hosting and managed services capabilities, expand our sales and marketing efforts, expand internationally and pursue additional industry relationships. As a result, we expect to incur operating losses for at least the next fiscal year. We cannot assure you that we will ever be profitable on a quarterly or annual basis or that, if we achieve profitability, it will be sustainable. We may need additional capital to fund our operations, and we may not be able to obtain it on terms acceptable to us or at all. We believe that our existing capital resources, including the remaining proceeds from our initial public offering in October 1999 and the amounts available under our capital lease facilities, will enable us to maintain our current operations through March 31, 2002. However, we may require additional funds during or after that period. In particular, we would be required to secure additional sources of capital to continue operating at our current level or curtail our current operations if we do not achieve the results of operations that we expect as a result of lower than expected revenues, higher than expected expenses or other possible adverse developments. In addition, if we 20 expand our existing business plan to focus on growth in international markets, make acquisitions of businesses or technologies or modify our business plan in other ways, we would likely require additional funding. If we require additional financing for any reason, there can be no assurance that such additional financing will be available to us on acceptable terms, or at all. In the event we are unable to raise additional capital, we may be required to substantially reduce or curtail operations. Further, if additional funds are raised through the issuance of additional equity securities, the percentage ownership of our shareholders would be diluted. Any new equity securities may have rights, preferences or privileges senior to those of our common stock. Our business and prospects are difficult to evaluate because we have a limited operating history and our business model is still evolving. It is difficult to evaluate our business operations and our prospects because of our limited operating history and the pace of change in our business. We were incorporated in August 1997 and commenced operations in September of that year with a focus on hosting services, and our business model is still new and evolving. The revenue and income potential of our business is unproven. Our limited operating history and the relative newness of the industry in which we operate makes predicting future results difficult. We may not be able to successfully implement our business plan or adapt it to changes in the market. If we are not able to do so, our business, results of operations and financial condition will be adversely affected. Our quarterly and annual results may fluctuate, resulting in fluctuations in the price of our common stock. Our operating results may fluctuate significantly in the future on a quarterly and annual basis. Because of these fluctuations, comparisons of our operating results from period to period are not necessarily meaningful and should not be relied upon as an indicator of future performance. We expect to experience significant fluctuations as a result of a variety of factors, many of which are outside of our control. The following factors could affect our operating results: . demand for our services; . size and timing of customer installations and related payments; . reliable services and network availability; . ability and costs associated with increasing network and data center capacity; . fluctuations in data and voice communications costs; . fluctuations in hardware and software costs; . timing and magnitude of capital expenditures and other expenses; . costs relating to operations; . customer retention and satisfaction; . introduction by third parties, including our competitors, of new products and services; . termination or reduction of services by customers, including terminations by customers that do not have sufficient funding to continue their operations, either at all or at the level contemplated by our agreements with them; . customer discounts and credits; . timing and success of marketing efforts and service introductions by us; . changes in our pricing policies or those of our competitors; 21 . retention of our key personnel; and . economic conditions specific to the hosting industry, as well as general economic conditions. We expect that our operating expenses will continue to increase as we further develop our business. If our revenues do not increase as quickly as our expenses, our operating results will suffer. A portion of our operating costs are fixed at certain minimum levels, including our expenses for data center capacity, depreciation, interest, hardware lease payments, minimum bandwidth charges, real estate lease payments and personnel. Therefore, our results of operations are particularly sensitive to fluctuations in revenue. If our revenues do not increase as expected, we will still have to pay these fixed costs and our results of operations and financial condition would be adversely affected. Furthermore, many of our customers are relatively new business, or Internet-focused business initiatives of more established companies, and these businesses or initiatives may have negative cash flows or may not be successful, or both. As a result, we may not be able to collect revenues for the services we provide on a timely basis or at all. For these and other reasons, in future periods our operating results may fall below the expectations of securities analysts or investors, which could result in widely varying stock prices and negatively affect the market price of our common stock. Our customer base includes a significant number of businesses that currently face increasing difficulty in obtaining funding to support their operations. Many of our customers are businesses, including Internet-based businesses, that have traditionally been initially funded by venture capital firms and then through public securities offerings. Funding alternatives for these businesses have become more limited than in the past. The unproven business models of many of our customers and the uncertain economic climate make their continued viability uncertain. Many of these customers have ceased or reduced their operations, and it is has become increasingly difficult for us to collect our accounts receivable from these businesses. If the market for technology and Internet-based businesses is not supported by the private and public investors who have funded these customers or if their business models prove to be unsuccessful, we face the risk that these customers may cease, curtail or limit web site operations hosted by us. If this continues to occur, we would likely experience a loss of revenue associated with these customers and will then have to increase sales to other businesses in order to preserve and grow our revenue. If we are successful in increasing sales to other businesses, we will incur the expenses associated with these new customers, such as sales and marketing expenses, including commissions, and implementation costs. As a result, to preserve and grow our revenue, we will have to increase sales by substantially more than the amount of lost revenue. Because we operate in a new and evolving market with uncertain prospects for growth, we may be unable to sustain growth in our customer base and our operating results may suffer. Our market is new and rapidly evolving. Growth in demand for and acceptance of advanced hosting services is highly uncertain. Businesses may not be aware of the potential benefits of outsourcing or may find it less expensive, more secure or otherwise preferable to host their web sites internally. Internet technologies, such as e-commerce applications, which require advanced hosting, may not grow as rapidly as we expect. We currently incur costs that are greater than our revenues. If we cannot grow and retain our customer base, we will not be able to offset our fixed and operating costs. Our future growth, if any, will depend on businesses outsourcing the management of their Internet and other applications and our ability to sell our services to these businesses in a cost- effective manner to a sufficient number of these businesses. If the market for advanced hosting services fails to grow or grows more slowly than anticipated or if we are unable to respond effectively to changes in this market, our business, operating results and financial condition will be adversely affected. Growth in the demand for our products and services may be inhibited, and we may be unable to sustain growth in our customer base for a number of reasons, including: . our inability to market our products and services in a cost-effective manner to new customers; . the inability of customers to differentiate the products and services we offer from those of our competitors; 22 . our inability to strengthen awareness of our brand; and . reliability, quality or compatibility problems with our services. We rely on our strategic relationship with Level 3, and if this relationship is terminated or deteriorates our business may suffer. In July 1999, we entered into a strategic relationship with Level 3. Level 3 is a communications and information services company that is building an advanced facilities-based communications network through which it provides colocation, Internet connectivity and other services. As part of our relationship, we have committed to purchase a fixed amount of services from Level 3, including, among other things, bandwidth, colocation space, and installation and maintenance services, over the next three years. We will incur these expenses even if anticipated increases in sales do not materialize or, in some circumstances, if the agreement is terminated. We have also agreed that if Level 3 is capable of providing the services we request, and if those services are substantially similar to other services that we purchase, we will purchase 90% of these services from Level 3 through June 2004. We are required to purchase these services from Level 3 even if these services are available at lower prices from alternative vendors. We route the network traffic of our customers through multiple backbone providers to increase network performance. To enable us to do this, we obtain Internet connectivity through a number of providers, and Level 3 may not be able to provide all of the connectivity services that we require. As a result, we may purchase less than the applicable percentages of these services from Level 3. We also currently rely on Level 3 to provide substantially all of the data center capacity that we need to provide our hosting services, and in the future we may be required to purchase most of our data center capacity from Level 3. Further, Level 3 may provide personnel at these data centers to install equipment and assist with support as necessary for us to deliver service in these facilities. If Level 3 fails to provide this data center capacity or perform these services in a timely or effective manner, or at all, we would be required to make alternate arrangements. If demand for colocation space increases, Level 3 may not be able or willing to provide the data center capacity we require to deliver our services. If our relationship with Level 3 is terminated or if Level 3 does not provide the data center capacity that we need, or provide it on acceptable terms, we would be required to seek arrangements with other data center providers or construct our own data centers. We cannot be certain that alternate data center capacity will be available on commercially reasonable terms or at all. We currently rely, and for the foreseeable future will continue to rely, on Level 3 to provide a substantial part of our bandwidth and other networking services. If we were not able to obtain these services from Level 3, we would be required to seek arrangements with other providers of these services, and we cannot be certain that alternate services will be available on commercially reasonable terms or at all. Our success depends on Microsoft's continued success, and the loss or deterioration of our relationship with Microsoft could harm our business and have an adverse impact on our revenues. We focus on advanced hosting services for Microsoft-based Internet technologies. If these technologies are not widely used building blocks for advanced Internet sites in the future, the demand for our services would decrease and our business would be adversely affected. The final outcome of the antitrust case against Microsoft is uncertain, but the outcome could cause the acceptance of Microsoft products to decrease. Except for our relationship with Microsoft as a customer, and under the Development, License, and Co-Marketing Agreement, our relationship with Microsoft is generally informal. We believe this relationship provides us with access to developments in Microsoft products before they are generally available, which allows us to maintain and enhance our technical expertise. If our relationship with Microsoft deteriorates or if we lose some of the status or privileges we currently enjoy, our technical expertise could be adversely affected. Our ability to market our services as a provider of advanced hosting services for Microsoft-based Internet technologies would also be adversely affected if Microsoft does not continue to confer certifications and designations on us, or changes our current certifications and designations. We do not have a written agreement with Microsoft relating to all of these certifications or designations. Some of our competitors also have received these certifications and designations. Microsoft generally confers these certifications unilaterally and in its sole discretion and could change them at any time. We cannot be certain that we will continue to enjoy them. 23 We operate in an extremely competitive market, and our business would suffer if we are unable to compete effectively. The market for hosting and Internet services is highly competitive. There are few substantial barriers to entry to keep new competitors from entering this market. We expect that we will face additional competition from existing competitors and new market entrants in the future. Recently, many companies, including many large, established companies, have announced that they will begin to provide or plan to greatly expand their service offerings that are competitive with ours. These companies and many of our other competitors have substantially greater financial, technical and marketing resources, larger customer bases, longer operating histories, greater name recognition and more established relationships in the industry than we do. As a result, some of these competitors may be able to: . develop and expand their network infrastructures and service offerings more rapidly; . adapt to new or emerging technologies and changes in customer requirements more quickly; . take advantage of acquisition and other opportunities more readily; . devote greater resources to the marketing and sales of their services; and . adopt more aggressive pricing policies. In addition, some of our competitors have entered and will likely continue to enter into joint ventures or other arrangements to provide additional services competitive with those provided by us. The market in which we compete is has experienced consolidation, and we believe that it is likely to continue to experience consolidation in the future, which could result in increased competition on price and other factors that could adversely affect our business. Some of our competitors may be able to provide their customers with additional benefits in connection with their Internet system and network management solutions, including reduced communications costs, which could reduce the overall costs of their services relative to ours. We may not be able to offset the effects of any price reductions. In addition, we believe our market is likely to consolidate in the near future, which could result in increased competition, including price competition. In an effort to gain market share, some of our competitors have offered incentives not matched by us. In addition, some of our competitors may be able to provide customers with additional benefits that could reduce the overall costs of their services relative to ours. We may not be able to reduce the pricing of our services or offer incentives in response to the actions of our competitors without an adverse impact on our business. If we are unable to expand our network infrastructure to meet increasing demand for reliable and secure services, we could lose customers and our operating results could suffer. We must continue to expand and adapt our network infrastructure to accommodate an increasing number of customers, the amount of information they wish to transmit and their changing requirements. We face risks related to our network's ability to be scaled to meet increasing customer levels while maintaining acceptable performance levels. The continued expansion and adaptation of our networking and hosting infrastructure will continue to require substantial financial, operational and management resources as we negotiate bandwidth capacity with existing and other network infrastructure suppliers. If we are required to expand our network significantly and rapidly due to increased usage, additional stress will be placed upon our network hardware, traffic management systems and hosting facilities as well as our financial, operational and management resources. The ability of our network to support a substantially larger number of customers at high transmission speeds is unknown. Furthermore, it may be difficult for us to increase quickly our network capacity in light of current lead times to purchase circuits and other critical items. If the network providers upon which we rely fail to provide reliability, capacity and performance for our network, we could lose customers and our operating results could suffer. 24 If the networks through which we deliver services do not have sufficient capacity, reliability or security, we could lose customers and our business would suffer. Our success partly depends upon the capacity, reliability and security of our network infrastructure, including the capacity leased from our network suppliers. Our network currently delivers service through Level 3, InterNap, AT&T, GTE, Netcom/Mindspring, PSINet, Qwest, Verio, MCI WorldCom, Inc., including UUNET Technologies, Inc., Sprint Corporation, Digex Incorporated, Cable & Wireless plc and SAVVIS Communications Enterprises, LLC. Some of these suppliers are also our competitors. In the future, we will be required to purchase most of our network capacity from Level 3 to the extent that it provides capacity that is substantially similar to the capacity of other providers. We depend on these companies to provide uninterrupted and error-free service through their telecommunications networks. If our customers' usage of telecommunications capacity increases, we will need to make additional investments in our infrastructure to maintain adequate data transmission speeds, the availability of which may be limited or the cost of which may be significant. We monitor all network links to prevent their being utilized in excess of their recommended capacity. If our customers' usage increases and capacity is not available to us, our network may not be able to achieve or maintain sufficiently high data transmission capacity, reliability or performance. In addition, our business would suffer if our network suppliers increased the prices for their services and we were unable to pass along any increased costs to our customers. Any failure on our part or the part of our third-party suppliers to achieve or maintain high data transmission capacity, reliability or performance could significantly reduce customer demand for our services and damage our business. Increased costs associated with our private transit Internet connections could result in the loss of customers or significant increases in operating costs. Our private transit Internet connections are more costly than other arrangements commonly utilized to move Internet traffic. If providers increase the pricing associated with utilizing their bandwidth, we may be required to identify alternative methods to distribute our customers' digital content. We cannot assure you that our customers will continue to be willing to pay the higher costs associated with direct private transit or that we could effectively move to another network approach. If we are unable to access alternative networks to distribute our customers' digital content on a cost-effective basis or to pass any additional costs on to our customers, our operating costs would increase significantly. We may not be able to deliver our services and our business may suffer if our third-party suppliers do not provide us with key components of our network infrastructure. We depend on other companies to supply key components of our network infrastructure. Any failure to obtain needed products or services in a timely fashion or at an acceptable cost could adversely affect our business. We buy servers, routers and switches on an as-needed basis and therefore do not carry significant inventories of them. We also have no guaranteed supply arrangements with our vendors. We currently only use servers from Compaq and rely on Compaq to provide us with access to Compaq technical personnel. In July 1999, we entered into an agreement with Compaq under which we agreed during the immediately following three years to purchase from Compaq the lesser of 2,000 servers or the number of servers reasonably necessary to adequately operate our business consistent with our business plan. Through March 31, 2001, we had purchased approximately 1,800 servers from Compaq under this agreement. Our requirement to purchase these servers is contingent upon Compaq providing financing for the servers on competitive terms, upon the price, performance and quality of the Compaq servers being reasonably satisfactory to us and upon Compaq's commitment to deliver these servers on the schedule we request. In addition, we rely on Cisco Systems, Inc. and others to supply equipment critical to our network, but we do not have a supply agreement with any of them. If this equipment were to become unavailable on terms acceptable to us, we would be forced to find alternative equipment. The inability to obtain equipment or technical services from Compaq, Cisco or others on terms acceptable to us would force us to spend time and money selecting and obtaining new equipment, training our personnel to use different equipment and deploying alternative components needed to integrate the new equipment, and as a result our business could be adversely affected. In addition, if our sole or limited source suppliers do not provide products or components that comply with evolving Internet and telecommunications standards or that interoperate with other products or components we use, our business would be harmed. For example, we have experienced performance problems, including previously unknown software and firmware bugs, with routers and switches that have caused disruptions in and impairment of network performance. 25 We may not be able to adapt to evolving technologies and customer demands, which could cause our business to suffer. Our future success will depend on our ability to offer services that incorporate leading technology and address the increasingly sophisticated needs of our current and prospective customers. Our market is characterized by rapidly changing and unproven technology, evolving industry standards, changes in customer needs and frequent new product announcements. These characteristics are magnified by the growth of the Internet and the intense competition in our industry. We are also subject to risks from technological changes in the way hosting solutions are marketed and delivered. Future advances in technology may not be beneficial to or compatible with our business. To be successful, we must adapt to our rapidly changing market by continually improving the performance, features and reliability of our services and modifying our business strategies accordingly. We could also incur substantial costs if we need to modify our services or infrastructure in order to adapt to these changes. In addition, our internal costs to provide service to our customers could be adversely affected. Our business would suffer if we fail to respond to these changes in a timely and cost-effective manner or at all. Our business will suffer if Internet usage does not continue to increase or if the Internet fails to perform reliably. Our ability to successfully market our services could be substantially impaired if we are unable to deploy new Internet technologies or service offerings or if new Internet technologies or service offerings deployed by us prove to be unreliable, defective or incompatible. We cannot assure you that we will not experience difficulties that could delay or prevent the successful development, introduction or marketing of Internet technologies in the future. If any newly introduced Internet technologies or our service offerings suffer from reliability, quality or compatibility problems, market acceptance of our services could be greatly hindered and our ability to attract new customers could be adversely affected. In addition, technological advances may have the effect of encouraging our customers or prospective customers to rely on in-house personnel and equipment to provide the services we provide. We cannot assure you that new applications or services deployed by us will be free from any reliability, quality or compatibility problems. If we incur increased costs or are unable, for technical or other reasons, to offer and deploy new Internet technologies or enhancements of existing technologies, our ability to successfully market our services could be substantially impaired. We believe that our ability to successfully compete is also dependent upon the continued compatibility of our services with products, services and architectures offered by various other companies. While we work with many vendors to test newly developed products, these products may not be compatible with our infrastructure or adequate to address changing customer needs. Any incompatibility could require us to make significant investments to achieve compatibility. If industry standards emerge, we may not be able to comply with them. Our failure to conform with any industry standards, or the failure of a common standard to emerge, could adversely affect our business. Our business will not grow unless Internet usage grows and Internet performance remains adequate. Use of the Internet for retrieving, sharing and transferring information among businesses, consumers, suppliers and partners has increased rapidly. Our success depends in large part on continued growth in the use of the Internet. In addition, our business plan anticipates significant growth in the web site hosting and application hosting markets. The growth of the Internet, including the web site hosting and application hosting markets, is subject to a high level of uncertainty and Internet usage and growth may be inhibited for a number of reasons, such as: . inadequate network infrastructure; . security concerns, including viruses and denial of service attacks; . uncertainty of legal and regulatory issues concerning the use of the Internet; . inconsistent quality of service; 26 . the inability of Internet-based businesses to develop and maintain successful business models; . failure of Internet-based businesses; . lack of availability of cost-effective, reliable, high-speed service; and . failure of Internet use to expand internationally. If Internet usage grows, the Internet infrastructure may not be able to support the demands placed on it by this growth, or its performance and reliability may decline. For example, web sites have experienced interruptions in service as a result of outages and other delays occurring throughout the Internet network infrastructure. If these outages or delays occur frequently, use of the Internet as a commercial or business medium could in the future grow more slowly or decline, which would adversely affect our business. Any degradation in the performance of the web sites and other applications we host could undermine the benefits customers perceive in our services. Ultimately, the performance of the web sites and other applications we host relies upon the speed and reliability of networks operated by third parties. As a result, the growth of the market for our services and our ability to grow depends on the continued improvement of the entire Internet infrastructure. Many of the companies that have historically built new network capacity do not have access to the capital resources they did in the past. Consequently, they may not continue to invest in new network capacity at the same rates as they have in the past, or at all, which could adversely affect our business, operating results and financial condition. Failure of our operating and financial systems to keep pace with the anticipated growth in our business could result in customer dissatisfaction, operating inefficiencies and lost revenue opportunities. The rapid growth of our business and our service offerings has placed, and is likely to continue to place, a significant strain on our operating and financial resources. Our future performance will partly depend on our ability to manage our growth effectively, which will require that we further develop our operating and financial system capabilities and controls. If our information systems and other infrastructure, including customer service and support, are unable to support the demands placed on them by the rapid growth in our business, we may be forced to implement new systems. If we fail to improve our operational systems or to expand our customer service capabilities to keep pace with the growth of our business, we could experience customer dissatisfaction, cost inefficiencies and lost revenue opportunities, which could harm our operating results. We may not be able to successfully implement these systems when needed or they may not perform reliably. We are currently developing internally a software application on which we intend to run our business. We expect that this application will provide the framework in which we provide services to our customers, including provisioning and service and support. We have expended, and will continue to expend significant resources in developing this application. If we are unable to develop this system in a cost-effective and timely manner, or at all, or if the functionality we develop in this system does not support our business, our business, financial condition and operating results could be adversely affected. We may not be able to successfully sustain our growth if we are unable to retain and attract highly skilled personnel. Our business requires individuals with significant levels of specific technical expertise. Competition for such personnel is intense, making it increasingly difficult to retain and attract the highly skilled employees necessary to provide the level of services that our customers expect. In light of the recent reduction in our work force and the decline in our stock price over the last 12 months, it may be difficult for us to retain and attract qualified personnel. We expect that we will gradually expand our sales and marketing staff to generate increased revenues. We may not be able to attract qualified personnel to fill new positions or to replace any of our current employees that we lose. We may be forced to provide higher compensation to such personnel than we currently anticipate, and the costs associated with training and integrating such new employees could be significant. If we are unable to effectively retain and attract qualified personnel on a cost-efficient basis, our operations and financial results could be adversely affected. 27 We could experience system failures that could harm our business and reputation. To succeed, we must be able to operate our network management infrastructure without interruption. Our operations depend upon our ability to protect our network infrastructure, equipment and customer files against damage from human error, fire, earthquakes, hurricanes, floods, power loss, telecommunications failures, intrusion (including hackers), sabotage, intentional acts of vandalism and similar events. Our servers and network infrastructure are located primarily in the Dallas/Ft. Worth, Texas metropolitan area. The occurrence of a natural disaster or other unanticipated problems at any of the data centers from which we provide services could result in interruptions in the services we provide to our customers. Although we have attempted to build redundancy into our network and hosting infrastructure, we have experienced interruptions in service in the past. We have experienced partial system failures due to routing problems, hard drive failures, database corruption and other computer failures. Our network is subject to various points of failure, and a problem with our routers, switches or other equipment could cause an interruption in the services we provide to some or all of our customers. Any future interruptions could: . cause customers or end users to seek damages or service credits for losses incurred; . require us to replace existing equipment or add redundant facilities; . damage our reputation for reliable service; . cause existing customers to cancel their contracts; or . make it more difficult for us to attract new customers. Any of these results could damage our business. Our customer's satisfaction with our services is critical to our business. Our customers demand a high level of service. As customers outsource the hosting and management of business-critical applications to us, we are subject to liability claims and customer dissatisfaction if our systems fail or if we fail to maintain the availability of these applications. Our customer contracts generally provide some service level commitment that provides for remedies if their applications do not maintain a specified level of availability. If we incur significant service level commitment obligations in connection with downtime or system failures, we could be required to issue significant credits or pay significant damages, or both. Our liability insurance might not be adequate to cover such credits or damages. Any significant interruptions of service could result in claims and adversely affect our business, financial condition and results of operations. Disruption of our services caused by unknown software defects could harm our business and reputation. Our service offerings depend on complex software, including software licensed from third parties and our proprietary software tools. Complex software often contains defects, particularly when first introduced or when new versions are released. We may not discover software defects that affect our new or current services or enhancements until after they are deployed. These defects could cause service interruptions or performance issues, which could damage our reputation or increase our service costs, cause us to lose revenue, delay market acceptance or divert our development resources. Our business and reputation will suffer if we do not prevent security breaches. Unauthorized access, computer viruses, denial of service attacks, accidents, misconduct resulting in disruptions and other disruptions could occur. In addition, we may incur significant costs to prevent breaches in security or to alleviate problems caused by breaches. We work with Level 3 and other colocation vendors to protect our equipment and hardware against breaches in physical security and with other vendors of software and hardware to protect other breaches in security. We cannot be certain that they will provide adequate security. We have experienced and may in the future experience delays or interruptions in service as a result of the accidental or intentional actions of Internet 28 users, current and former employees of Data Return or others. Furthermore, inappropriate use of the network by third parties could also jeopardize the security of confidential information, such as customer and Data Return passwords as well as credit card and bank account numbers, stored in our computer systems or those of our customers. As a result, we could become liable to others and lose existing or potential customers. The costs required to eliminate computer viruses and alleviate other security problems could be prohibitively expensive. In addition, the efforts to address these problems could result in interruptions, delays or cessation of service to our customers. Providing services to customers with mission-critical web sites and web-based applications could potentially expose us to lawsuits for customers' lost profits or other damages. Because our hosting services are critical to many of our customers' businesses, any significant interruption in our services could result in lost profits or other indirect or consequential damages to our customers. Although many of our contracts disclaim our liability for any such damages, a customer could still bring a lawsuit against us claiming lost profits or other consequential damages as the result of a service interruption or other web site or application problems that the customer may ascribe to us. There can be no assurance a court would enforce any limitations on our liability, and the outcome of any lawsuit would depend on the specific facts of the case and legal and policy considerations. There can be no assurance we would prevail. In such cases, we could be liable for substantial damage awards. Such damage awards might exceed our liability insurance, which could seriously harm our business. Our limited ability or failure to protect our intellectual property may adversely affect our ability to compete. Third parties may infringe or misappropriate our technology or proprietary rights, which could have an adverse effect on our business, results of operations or financial condition. In addition, our competitors or potential competitors may independently develop technologies that are equivalent or superior to our technology. We rely on a combination of copyright, trademark, service mark and trade secret laws to protect our intellectual property. We have filed federal registrations for the mark "Data Return" and other marks. We also have internally developed software and other tools that are important to our business for which we rely on copyright protection. We have entered into contractual arrangements with some of our employees and contractors as well as suppliers, distributors and some of our customers in order to limit access to, and any disclosure of, our proprietary information. The steps we have taken to protect our intellectual property may be insufficient. We may need to take legal action to protect our intellectual property rights, which could be costly and divert the attention of our technical and management personnel. We may be accused of infringing the proprietary rights of others, which could subject us to costly and time-consuming litigation. In addition to the technologies we develop or have developed, we license certain technologies from third parties and may license additional technologies in the future. We could become subject to infringement actions based upon our internally developed technologies or technologies licensed from third parties. Any of these claims, with or without merit, could subject us to costly litigation and divert the attention of our technical and management personnel. In addition, third parties may change the terms of their license agreements in ways that would prevent us from using technologies licensed from them on commercially reasonable terms or that would prevent us from using them at all. We may not be able to replace those technologies with technologies that have the same features or functionality on commercially reasonable terms or at all. Regulatory and legal uncertainties could result in significant costs or otherwise harm our business. The success of our business depends on the growth of the Internet. Laws and regulations directly applicable to commerce or communications over the Internet are becoming increasingly prevalent. However, the law of the Internet remains largely unsettled. The adoption or modification of laws or regulations relating to the Internet could adversely affect our business if they impose a direct cost on us or if they curtail the growth of the Internet. If liability for materials carried on or disseminated through their systems is imposed on service providers, we would make efforts to implement measures to reduce our exposure to such liability. Such measures could require us to expend substantial resources or discontinue certain product or service offerings. In addition, increased attention to liability issues, as a result of lawsuits, legislation and legislative proposals, could divert management attention, result in 29 unanticipated expenses and harm our business. If legislation is adopted in the U.S. or internationally that makes transacting business over the Internet, such as e-commerce, less favorable or otherwise curtails the growth of the Internet, our business would suffer. We may be subject to legal claims in connection with the information disseminated through our network which could have the effect of diverting management's attention and require us to expend significant financial resources. We may face potential direct and indirect liability for claims of defamation, negligence, copyright, patent or trademark infringement, violation of securities laws and other claims based on the nature and content of the materials disseminated through our network. For example, lawsuits may be brought against us claiming that content distributed by some of our current or future customers may be regulated or banned. In these and other instances, we may be required to engage in protracted and expensive litigation which could have the effect of diverting management's attention and require us to expend significant financial resources. Our liability insurance may not cover any of these claims or may not be adequate to protect us against all liability that may be imposed or claimed. In addition, on a limited number of occasions in the past, businesses, organizations and individuals have sent unsolicited commercial e-mails from servers hosted at our facilities to massive numbers of people, typically to advertise products or services. This practice, known as "spamming," can lead to complaints against service providers that enable such activities, particularly where recipients view the materials received as offensive. We have in the past received, and may in the future receive, letters from recipients of information transmitted by our customers objecting to such transmission. Although we prohibit our customers by contract from spamming, we cannot assure you that our customers will not engage in this practice, which could subject us to claims for damages. The loss of key personnel including our Chairman and Chief Executive Officer, our President and our Chief Operating Officer could harm our business. We depend on the continued service of our key technical, sales and senior management personnel, including Sunny C. Vanderbeck, our Chairman and Chief Executive Officer, Michelle R. Chambers, our President, and Robert A. Prosen, our Chief Operating Officer. We have entered into employment agreements with Mr. Vanderbeck, Ms. Chambers and Mr. Prosen expiring in June 2002, but any of our officers or employees can quit at any time. Losing one or more of our key employees could harm our business. Difficulties presented by international economic, political, legal, accounting and business factors could harm our business in international markets. A component of our strategy is to expand into international markets. The rate of development and adoption of the Internet has been slower outside of the United States, and the cost of bandwidth has been higher, which may adversely affect our ability to expand operations and may increase our cost of operations internationally. The risks inherent in conducting business internationally include: . unexpected changes in regulatory requirements, export restrictions, tariffs and other trade barriers; . challenges in staffing and managing foreign operations; . differences in technology standards; . less protective intellectual property laws; . employment laws and practices in foreign countries; . longer payment cycles and problems in collecting accounts receivable; . political instability; . fluctuations in currency exchange rates and imposition of currency exchange controls; and 30 . potentially adverse tax consequences. Our management will have significant flexibility in applying the proceeds from our initial public offering and our use of proceeds may not yield a favorable return. We have used and intend generally to continue to use the net proceeds from our November 1999 initial public offering to fund our capital expenditures and for working capital and other general corporate purposes. We may also acquire or make investments in other businesses, products, services or technologies and, if we do, we may not be able to make those acquisitions or investments on commercially acceptable terms or we could have difficulty assimilating and integrating any acquired businesses, technologies, services or products. We have not yet determined all expected expenditures and thus cannot estimate the amounts to be used for each specified purpose. Our management has significant flexibility in applying the net proceeds of our initial public offering. We cannot be certain that our use of the proceeds will yield a favorable return. Our principal shareholders, directors and executive officers currently own approximately 63.5% of our common stock, which may allow them to exert influence over us or to prevent a change of control. Our directors and executive officers and shareholders who currently own over 5% of our common stock collectively beneficially own approximately 63.5% of our outstanding common stock. These shareholders would be able to exercise significant influence over all matters requiring shareholder approval, including the election of directors and approval of significant corporate transactions. This concentration of ownership could also delay or prevent a change in control of Data Return even if beneficial to our shareholders. Some provisions of our articles, bylaws and rights plan and of Texas law could delay or prevent a change of control, which could adversely affect our stock price. Our articles of incorporation and bylaws contain provisions that could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our shareholders. These provisions could limit the price that investors might be willing to pay in the future for shares of our common stock. Some of these provisions: . authorize the issuance of preferred stock which can be created and issued by our board of directors without prior shareholder approval, commonly referred to as "blank check" preferred stock, with rights senior to those of common stock; . prohibit certain shareholder actions by written consent; . establish advance notice requirements for submitting nominations for election to our board of directors and for proposing matters that can be acted upon by shareholders at a meeting; and . provide for a board of directors with staggered three-year terms. We have also adopted a shareholders' rights plan that could delay, deter or prevent a change in control of us. In September 1999, we adopted a shareholder rights plan. This plan entitles our shareholders to rights to acquire additional shares of our common stock when a third party acquires 15% of our common stock or commences or announces its intent to commence a tender offer for at least 15% of our common stock. This plan could delay, deter or prevent a change in control of us. Future sales of our common stock could cause our stock price to decline. At March 31, 2001, 35,978,944 shares of our common stock were issued and outstanding. We cannot be sure what effect, if any, future sales of our common stock or the availability of shares for future sale will have on the market price of our common stock. The market price of our common stock could drop due to sales of a large number of shares of our common stock in the market or the perception that these sales could occur. These factors could also make it more difficult to raise funds through future offerings of our common stock. 31 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK All our customer contracts are currently denominated in United States dollars, and we do not currently invest in derivative financial instruments. However, we invest our excess cash balances in cash equivalents and are therefore subject to market risk related to changes in interest rates. We believe, but cannot be certain, that the effect on our financial position, results of operations and cash flows of any reasonably likely changes in interest rates would not be material. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Financial Statement and Financial Statement Schedule ---------------------------------------------------- The following financial statements of the Company and the notes thereto and the related report thereon of the independent auditors, and financial statement schedule, are filed pursuant to Item 8 of this Report: Index to Consolidated Financial Statements
Page ---- Consolidated Financial Statements Report of Independent Auditors F-2 Consolidated Balance Sheets as of March 31, 2001 and 2000 F-3 Consolidated Statements of Operations for the years ended March 31, 2001, 2000 and 1999 F-4 Consolidated Statements of Shareholders' Equity for the years ended March 31, 2001, 2000 and 1999 F-5 Consolidated Statements of Cash Flows for the years ended March 31, 2001, 2000 and 1999 F-6 Notes to Consolidated Financial Statements F-7 Consolidated Financial Statement Schedules Schedule II - Valuation and Qualifying Accounts F-20
All other consolidated financial statement schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required pursuant to the instructions to Item 8 or are inapplicable and therefore have been omitted. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None 32 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The sections entitled "Election of Directors" and "Section 16(a) Beneficial Ownership Reporting Compliance" appearing in our proxy statement for the annual meeting of shareholders to be held on or about September 5, 2000 (the "2001 Proxy Statement"), set forth certain information with respect to the directors of Data Return and with respect to reporting under Section 16(a) of the Securities Exchange Act of 1934, and are incorporated herein by reference. Certain information with respect to the executive officers of Data Return is set forth under the caption "Executive Officers of the Registrant" in Part I of this report. ITEM 11. EXECUTIVE COMPENSATION The section entitled "Executive Compensation" appearing in the 2001 Proxy Statement sets forth certain information with respect to the compensation of our management, and, except for the report of the compensation committee of the board of directors of Data Return on executive compensation and the information therein under "Performance Graph," is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The sections entitled "Security Ownership of Certain Beneficial Owners" and "Security Ownership of Management" appearing in the 2001 Proxy Statement set forth certain information with respect to the ownership of voting securities and equity securities of Data Return, and are incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Not applicable. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULE AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this report: (1) A list of the financial statements and the schedule filed as a part of this report is set forth in Item 8 on page 32 and is incorporated herein by reference. All other schedules are omitted because they are either not applicable or required information is shown in the financial statements or notes thereto. (2) Exhibits:
Exhibit Number Description ------ ----------- 3.1(1) Amended and Restated Articles of Incorporation of the Registrant to be filed just prior to effectiveness of this Registration Statement. 3.2(1) Amended and Restated Bylaws of the Registrant 4.1(1) Form of Common Stock Certificate 4.2(1) Common Stock Warrant between Data Return Corporation and Microsoft Corporation. 4.3(1) Rights Agreement by and between Data Return Corporation and ChaseMellon Shareholder Services, LLC, as rights agent. 10.1(1) Strategic Marketing and Sales Agreement dated July 1, 1999, by and between Data Return
33 Corporation and Level 3 Communications, LLC. 10.2(1) Restricted Stock Purchase Agreement dated July 23, 1999, by and between Data Return Corporation and Level 3 Communications, LLC. 10.3(1) Service Credit Agreement dated July 23, 1999, by and between Data Return Corporation and Level 3 Communications, LLC. 10.4(1) Customer Order dated April 28, 1999, executed by Data Return Corporation and Level 3 Communications, LLC 10.5(1) Managed Services Proposal for Data Return dated March 6, 1997, by and between Data Return Corporation and American Communications Services, Inc. 10.6(1) Basic Internet Services Agreement dated December 12, 1997, between Data Return Corporation and Savvis Communications Enterprises, L.L.C. 10.7(4) Promissory Note to BankOne Texas, National Association dated July 31, 2000. 10.8(4) FIRST AMENDMENT TO CREDIT AGREEMENT dated as of July 31, 2000, by and between DATA RETURN CORPORATION and BANK ONE, TEXAS, NATIONAL ASSOCIATION. 10.9(1)* 1999 Long-Term Incentive Plan 10.10(1)* 1998 Stock Option Plan 10.11(1)* Employment Agreement effective as of May 3, 1998, between Data Return Corporation and J. Todd Steitle. 10.12(1)* Employment Agreement dated March 18, 1999, between Data Return Corporation and Kenneth S. Garber. 10.13(1)* Employment Agreement effective as of January 15, 1998, between Data Return Corporation and Michael S. Shiff. 10.14(1)* Form of Employment Agreement dated July 1, 1999 between Data Return Corporation and each of Sunny C. Vanderbeck, Michelle R. Chambers, Jason A. Lochhead, Stuart A. Walker, Robert A. Prosen, Mark A. Bowles, Scott W. Brewer, Mark C. Gunnin and Mark A. Warren. 10.15(1) Sublease dated June 28, 1999, between Data Return Corporation and Eastman Kodak Company, for approximately 22,663 square feet situated at 222 Las Colinas Boulevard in Irving, Texas. 10.16(1) Investor's Rights Agreement dated as of July 29, 1999, between Data Return Corporation and CPQ Holdings, Inc. 10.17(1) ASP and Server Agreement dated June 29, 1999, between Data Return Corporation and Compaq Computer Corporation. 10.18(1) Development, License and Co-Marketing Agreement dated September 3, 1999, between Data Return Corporation and Microsoft Corporation. 10.19(1) Stock Purchase Agreement dated September 2, 1999, between Data Return Corporation and Microsoft Corporation. 10.20(2) Credit Agreement dated December 29, 1999 between Data Return Corporation and Bank One, Texas, N.A. 10.21(2) Promissory Note dated December 29, 1999 to Bank One, Texas, N.A. 10.22(3) Office Lease entered into as of November 15, 1999, by and between 114 MILLENNIUM, LTD. and Data Return Corporation 10.23(3) First Amendment to Office Lease dated as of February 15, 2000, by and between 114 MILLENNIUM, LTD. and Data Return Corporation 10.24(3) Second Amendment to Office Lease dated as of May 10, 2000, by and between 114 MILLENNIUM, LTD. and Data Return Corporation 21.1(5) Subsidiaries of the Registrant 23.1(5) Consent of Ernst & Young LLP
____________ (1) Previously filed as an Exhibit to the Registrant's Registration Statement on Form S-1 (File No. 333-84011) and incorporated herein by this reference. (2) Previously filed as an Exhibit to the Registrant's Quarterly Report on Form 10-Q for the quarterly period ended December 31, 1999 and incorporated herein by this reference. (3) Previously filed as an Exhibit to the Registrant's Annual Report on Form 10- K for the year ended March 31, 2000 and incorporated herein by this reference. 34 (4) Previously filed as an Exhibit to the Registrant's Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2000 and incorporated herein by this reference. (5) Filed herewith. * Management contracts or compensatory plans required to be filed as an exhibit hereto. (b) No reports on Form 8-K were filed by the Company during the quarter ended March 31, 2001. 35 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Data Return Corporation Date: June 28, 2001 By: /s/ Sunny C. Vanderbeck ---------------------------------------- Sunny C. Vanderbeck Chairman and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following individuals on behalf of the Registrant and in the capacities and on the dates indicated.
-------------------------------------------------------------------------------------------- Signature Capacity in Which Signed Date --------- ------------------------ ---- -------------------------------------------------------------------------------------------- Chairman of the Board, Chief Executive Officer and Director /s/ Sunny C. Vanderbeck (Principal Executive Officer) June 28, 2001 ------------------------------ Sunny C. Vanderbeck -------------------------------------------------------------------------------------------- President, and Director /s/ Michelle R. Chambers June 28, 2001 ------------------------------ Michelle R. Chambers -------------------------------------------------------------------------------------------- Vice President - Chief Technology /s/ Jason A. Lochhead Officer and Director June 28, 2001 ------------------------------ Jason A. Lochhead -------------------------------------------------------------------------------------------- Senior Vice President - Chief Financial Officer and Treasurer (Principal Financial /s/ Stuart A. Walker and Accounting Officer) June 28, 2001 ------------------------------ Stuart A. Walker -------------------------------------------------------------------------------------------- /s/ Joseph M. Grant Director June 28, 2001 ------------------------------ Joseph M. Grant -------------------------------------------------------------------------------------------- /s/ Robert Ted Enloe, III Director June 28, 2001 ------------------------------ Robert Ted Enloe, III --------------------------------------------------------------------------------------------
36 DATA RETURN CORPORATION Index to Consolidated Financial Statements Page ---- Consolidated Financial Statements Report of Independent Auditors F-2 Consolidated Balance Sheets as of March 31, 2001 and 2000 F-3 Consolidated Statements of Operations for the years ended March 31, 2001, 2000 and 1999 F-4 Consolidated Statements of Shareholders' Equity for the years ended March 31, 2001, 2000 and 1999 F-5 Consolidated Statements of Cash Flows for the years ended March 31, 2001, 2000 and 1999 F-6 Notes to Consolidated Financial Statements F-7 Consolidated Financial Statement Schedule Schedule II - Valuation and Qualifying Accounts F-20 All other consolidated financial statement schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required pursuant to the instructions to Item 8 or are inapplicable and therefore have been omitted. F-1 Report of Independent Auditors The Board of Directors and Stockholders Data Return Corporation We have audited the accompanying consolidated balance sheets of Data Return Corporation as of March 31, 2001 and 2000, and the related consolidated statements of operations, shareholders' equity and cash flows for each of the three years in the period ended March 31, 2001. Our audits also included the financial statement schedules listed in the Index at Item 14. These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Data Return Corporation at March 31, 2001 and 2000, and the consolidated results of its operations and its cash flows for each of the three years in the period ended March 31, 2001, in conformity with accounting principles generally accepted in the United States. Also in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 1 to the consolidated financial statements, in fiscal 2001 the Company changed it's method of accounting for revenue recognition for set-up fees. /s/ Ernst & Young LLP Dallas, Texas June 22, 2001 F-2 DATA RETURN CORPORATION Consolidated Balance Sheets (in thousands)
March 31, ------------------------------- 2001 2000 -------- --------- Assets Current assets: Cash and equivalents $ 6,566 $ 85,424 Investment in available-for-sale securities 26,800 - Accounts receivable, net of allowance for doubtful accounts of $1,589 and $328 at March 31, 2001 and 2000, respectively 8,477 5,429 Prepaid expenses and other assets 1,189 1,349 -------- --------- Total current assets 43,032 92,202 Property and equipment, net 44,104 22,027 Other assets 496 628 -------- --------- Total assets $ 87,632 $ 114,857 ======== ========= Liabilities and shareholders' equity Current liabilities: Accounts payable $ 2,443 $ 2,021 Accrued expenses and other 4,265 2,205 Deferred revenue 5,717 2,207 Capital lease obligations and notes payable - current 12,873 5,799 -------- --------- Total current liabilities 25,298 12,232 Capital lease obligations and notes payable - long term 18,173 11,324 Commitments and contingencies - - Shareholders' equity: Preferred stock, $.001 par value; 20,000 shares authorized, none issued or outstanding - - Common stock, $.001 par value; 100,000 shares authorized; 35,979 and 35,398 issued and outstanding at March 31, 2001 and 2000, respectively 36 35 Additional paid-in capital 110,497 109,718 Prepaid broadband services (4,594) (5,000) Deferred stock compensation (119) (290) Accumulated other comprehensive income 281 - Accumulated deficit after comprehensive income (61,940) (13,162) -------- --------- Total shareholders' equity 44,161 91,301 -------- --------- Total liabilities and shareholders' equity $ 87,632 $ 114,857 ======== =========
See accompanying notes to consolidated financial statements. F-3 DATA RETURN CORPORATION Consolidated Statements of Operations (in thousands, except per share data)
Year Ended March 31, -------------------------------------------- 2001 2000 1999 ---------- ---------- --------- Revenues $ 50,068 $ 11,833 $ 1,889 Costs and expenses: Cost of revenue 45,444 9,277 1,105 General and administrative 23,418 7,575 1,061 Selling and marketing 24,492 6,212 663 Product research and development 4,778 548 2 Stock-based compensation 171 1,779 349 ---------- ---------- --------- Total costs and expenses 98,303 25,391 3,180 ---------- ---------- --------- Loss from operations (48,235) (13,558) (1,291) Other income (expense): Interest income 3,749 2,191 20 Interest expense (2,658) (321) (13) Other expense, net (8) -- -- ---------- ---------- --------- Loss before cumulative effect of change in accounting principle (47,152) (11,688) (1,284) Cumulative effect of change in accounting principle (1,626) -- -- ---------- ---------- --------- Net loss $ (48,778) $ (11,688) $ (1,284) ========== ========== ========= Basic and diluted net loss per common share: Before cumulative effect of change in accounting principle $ (1.32) $ (0.40) $ (0.07) Cumulative effect of change in accounting principle $ (0.05) $ -- $ -- ---------- ---------- --------- Net loss per common share $ (1.37) $ (0.40) $ (0.07) ========== ========== =========
Pro forma amounts, assuming the accounting change is applied retroactively: Net loss.......................................... $ (47,152) $ (13,182) $ (1,385) ========== ========== ========= Net loss per common share......................... $ (1.32) $ (0.45) $ (0.08) ========== ========== ========= Shares used in computing basic and diluted net loss per share....................... 35,712 29,268 18,371 ========== ========== =========
See accompanying notes to consolidated financial statements. F-4 DATA RETURN CORPORATION Consolidated Statements of Shareholders' Equity (in thousands, except share data)
Note Accumulated Common Stock Additional Receivable Prepaid Deferred Other Share ---------------- Paid-In for Shares Broadband Stock Comprehensive Accumulated holders' Shares Amount Capital Issued Services Compensation Income Deficit Equity ------ ------- ------- ------ -------- ------------ ------- ------- ------ Balance--March 31, 1998.......... 17,592,600 $ 18 $ 2,318 $(500) $ -- $(1,216) $ -- $ (190) $ 430 Issuance of common stock......... 2,959,000 3 1,247 500 -- -- -- -- 1,750 Deferred compensation related to stock options................ -- -- 328 -- -- (328) -- -- -- Amortization of deferred stock compensation.................... -- -- -- -- -- 349 -- -- 349 Net loss......................... -- -- -- -- -- -- -- (1,284) (1,284) ---------- ----- -------- ----- ------- ------- ------- ----------- -------- Balance--March 31, 1999.......... 20,551,600 21 3,893 -- -- (1,195) -- (1,474) 1,245 Issuance of common stock......... 12,893,464 12 99,775 -- -- -- -- -- 99,787 Deferred compensation related to stock options................ -- -- 874 -- -- (874) -- -- -- Amortization of deferred stock compensation.................... -- -- -- -- -- 1,779 -- -- 1,779 Issuance of common stock for broadband services.............. 1,952,940 2 4,998 -- (5,000) -- -- -- -- Amortization of cost of warrants issued for services.... -- -- 178 -- -- -- -- -- 178 Net loss......................... -- -- -- -- -- -- -- (11,688) (11,688) ---------- ----- -------- ----- ------- ------- ------- ----------- -------- Balance--March 31, 2000.......... 35,398,004 35 109,718 -- (5,000) (290) -- (13,162) 91,301 Issuance of common stock......... 580,940 1 225 -- -- -- -- -- 226 Amortization of deferred stock compensation.................... -- -- -- -- -- 171 -- -- 171 Application of credits for broadband services.............. -- -- -- -- 406 -- -- -- 406 Amortization of warrants issued for services.................... -- -- 554 -- -- -- -- -- 554 Unrealized gains on available- for-sale securities............. -- -- -- -- -- -- 281 -- 281 Net loss......................... -- -- -- -- -- -- -- (48,778) (48,778) ---------- ----- -------- ----- ------- ------- ------- ----------- -------- Balance--March 31, 2001.......... 35,978,944 $ 36 $110,497 $ -- $(4,594) $ (119) $ 281 $ (61,940) 44,161 ========== ===== ======== ===== ======= ======= ======= =========== ========
See accompanying notes to consolidated financial statements F-5 DATA RETURN CORPORATION Consolidated Statements of Cash Flows (in thousands)
Year Ended March 31 ------------------------------------------ 2001 2000 1999 -------- -------- -------- Operating activities: Net Loss $(48,778) $(11,688) $ (1,284) Adjustment to reconcile net loss to net cash used in operations: Noncash items included in net loss: Depreciation 14,082 2,036 129 Amortization 881 -- -- Stock based compensation expense 171 1,779 349 Provision for bad debts 3,547 526 40 Amortization of warrants issued for services 554 178 -- Loss on disposal of assets 63 -- -- Changes in operating assets and liabilities: Accounts receivable (6,595) (5,579) (317) Prepaids and other assets 573 (1,931) (23) Accounts payable and accrued expenses 2,887 3,803 252 Deferred revenue 3,510 1,921 209 -------- -------- -------- Net cash used in operations (29,105) (8,955) (645) Investing activities: Capital expenditures (13,415) (5,953) (814) Purchase of available-for-sale securities (37,889) -- -- Proceeds from available-for-sale securities 11,089 -- -- Restricted cash -- 125 (125) -------- -------- -------- Net cash used in investing activities (40,215) (5,828) (939) Financing activities: Proceeds from notes payable -- 804 250 Payments on notes payable and capital lease obligations (9,764) (1,227) (47) Net proceeds from issuance of common stock 226 99,787 1,750 -------- -------- -------- Net cash (used in) provided by financing activities (9,538) 99,364 1,953 Net (decrease) increase in cash (78,858) 84,581 369 Beginning cash 85,424 843 474 -------- -------- -------- Ending cash $ 6,566 $ 85,424 $ 843 ======== ======== ======== Supplemental disclosure of cash flows information: Cash paid for interest $ 2,950 $ 204 $ 11 ======== ======== ======== Non cash activities: Deferred compensation $ -- $ 874 $ 328 ======== ======== ======== Equipment acquired under capital lease $ 23,686 $ 17,232 $ 51 ======== ======== ======== Warrants to acquire common stock issued for services $ -- $ 2,225 $ -- ======== ======== ======== Common stock issued for broadband services $ -- $ 5,000 $ -- ======== ======== ========
See accompanying notes to consolidated financial statements. F-6 DATA RETURN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years Ended March 31, 2001, 2000 and 1999 1. Organization, Basis of Presentation and Significant Accounting Policies Organization Data Return Corporation (the "Company") was incorporated in August 1997 under the laws of the State of Texas and commenced operations on September 22, 1997 (inception). The Company primarily provides advanced Microsoft Internet hosting services to businesses, web site developers, application service providers, and other organizations. The Company's advanced Microsoft hosting services enable its customers to establish and maintain e-commerce and other applications through which they can conduct transactions and manage information on a worldwide basis over the Internet. The Company's computer equipment, principally servers, is primarily located in separate facilities owned by one of its vendors. The vendor provides data center facilities and bandwidth connectivity to the Company on a contractual basis. The Company closed completed its initial public offering of common stock on November 4, 1999. The Company sold 7,187,500 shares of common stock to the public, including the underwriters' overallotment, and received net proceeds of $85.9 million The Company believes that its current cash and investment balances should be sufficient to meet its working capital and capital expenditure requirements through March 31, 2002. The Company will continue to incur negative cash flows during fiscal 2002 and thereafter. Therefore, it will be required to use its cash and other liquid resources to support its operations. If the Company does not achieve the results of operations that it expects as a result of lower than expected revenues, higher than expected expenses or other possible adverse developments, then the Company would be required either to secure additional sources of capital to continue operating at its current level or to curtail its current operations. The Company's operating activities on a long-term basis may require it to obtain additional equity or debt financing. The Company finances under capital or operating leases substantially all of the equipment it uses to provide services to its customers. As a result, the Company's investments in this type of equipment will require it to obtain additional lease or other financing in the future. If the Company requires additional financing for any reason, there can be no assurance that such additional financing will be available to it on acceptable terms, or at all. In the event the Company is unable to raise additional capital, it may be required to substantially reduce or curtail operations. Significant Accounting Policies Principles of Consolidation The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. Use of Estimates The preparation of consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. Revenue Recognition Revenues are primarily derived from monthly recurring hosting service fees and from set-up fees. Shared hosting services, in which more than one customer shares the same server and typically generate $500 or less per month, do not require a contract. Dedicated server offerings, in which each customer has one or more servers that are dedicated for its use, More complex services require a contract that is generally 12 to 24 months in length. Dedicated server offerings include clustered configurations, in which we utilize two or more dedicated servers to distribute content and functionality across multiple servers or, in the case of multi-site clusters, across multiple data centers. Revenues from these contracts are recognized ratably over the contractual period as service is delivered. Payments received for billings in advance of providing services are deferred until the period such services are provided. F-7 DATA RETURN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(continued) Years Ended March 31, 2001, 2000 and 1999 Effective April 1, 2000, the Company changed its method of accounting for set- up fee revenue in accordance with Staff Accounting Bulletin No. 101 ("SAB 101"), Revenue Recognition in Financial Statements. Historically, the Company has recognized set-up revenue, in accordance with industry practice, upon completion of the deployment of the hardware and software used by the Company to provide services installation of the managed Web hosting solution. The direct costs associated with the installation are expensed as incurred. Under the new accounting method adopted in January 2001 retroactive to April 1, 2000, the Company now recognizes set-up revenue over the contract term, generally 12 months. The Company continues to expense direct costs associated with set-up as the costs are incurred. The cumulative effect of the change on prior years resulted in a net charge of $1.62 million, which is included in the Consolidated Statement of Operations for the year ended March 31, 2001. The effect of the change on the year ended March 31, 2001 was to decrease the net loss before the cumulative effect of the accounting change by $408,000 ($0.01 per share). For the year ended March 31, 2001, the Company recognized revenue of $1.62 million that was included in the cumulative effect adjustment as of April 1, 2000. With the adoption of SAB 101, there was no economic impact to the Company's business operations or cash flow. There was also no material effect to the Company's consolidated financial statements. The pro forma amounts presented in the Consolidated Statements of Operations were calculated assuming the accounting change was made retroactively to prior periods. Concentrations of Credit Risk Financial instruments that potentially expose the Company to credit risk consist primarily of cash, cash and equivalents, available-for-sale securities and accounts receivable. The Company places its cash, cash equivalents and available-for-sale securities with reputable institutions. The Company has not experienced any losses in such accounts and does not believe it is exposed to any significant credit risk with such respect to cash, cash equivalents and available-for-sale securities. Accounts receivable are due from commercial entities to which credit is extended based on evaluation of the customer's financial condition. Anticipated credit losses are provided for in the consolidated financial statements and have been within management's expectations for all periods presented. Customer and Geographic Concentrations The Company's largest customer accounted for approximately 18% of total revenues during the year ended March 31, 2001. No other customers accounted for greater than 10% of revenues for the years ended March 31, 2001, 2000 or 1999. Revenues from international customers were approximately $2,283,000, $516,000 and $189,000 for fiscal 2001, 2000 and 1999, respectively. The Company's international revenues were primarily generated from customers located in Europe and Canada. In fiscal 2001, revenues from customers located in Europe and Canada accounted for approximately 2.2% and 1.7% of total revenues, respectively. Total assets from international operations, comprised of accounts receivable, were 0.6% of total assets as of March 31, 2001. Cash and Equivalents Cash equivalents consist of highly liquid investments with original maturities of 90 days or less. As of March 31, 2001, cash equivalents consisted principally of money market funds at several financial institutions. Available-for-Sale Securities Available-for-sale securities are comprised of debt securities for which there is a determinable fair market value and for which there are no restrictions on the Company's ability to sell the security. In F-8 DATA RETURN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Years Ended March 31, 2001, 2000 and 1999 accordance with the provisions of SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, available-for-sale securities are carried at fair value, with unrealized gains and losses reported as a separate component of shareholders' equity. Realized gains and losses and declines in value deemed to be other-than-temporary on available-for-sale securities are included in other income. The cost basis for realized gains and losses on available-for-sale securities is determined on a specific identification basis. At March 31, 2001, the realized gains on sales of available-for-sale securities totaled $55,000. The net adjustment of unrealized gains of $281,000 has been recorded as a separate component of shareholders' equity. There were no available-for-sale securities in fiscal years 2000 and 1999.
Unrealized Unrealized Amortized Market Holding Holding Cost Value Gains Losses ------------- ---------- -------------- -------------- (in thousands) March 31, 2001: Corporate debt securities: Money market funds............................. $ 1,996 $ 1,996 $ - $ - Corporate bonds and notes...................... 10,696 10,794 98 - ------------- ---------- -------------- -------------- Total corporate debt securities........... 12,692 12,790 98 - Asset backed securities................................ 5,129 5,196 67 - U.S. government and government agency securities................................... 8,698 8,814 116 - ------------- ---------- -------------- -------------- Total investment in available-for-sale securities...... $ 26,519 $ 26,800 $ 281 $ - ============= ========== ============== ==============
The amortized cost and fair value of available-for-sale debt securities at March 31, 2001, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities as the issuers of the securities may have the right to prepay obligations without prepayment penalties. Estimated Cost Fair Value -------------- ------------ (in thousands) Due in one year or less $23,392 $23,602 Due after one year through three years 1,713 1,744 Due after three years 1,414 1,454 ------- ------- $26,519 $26,800 ======= ======= Property and Equipment Property and equipment is stated at cost. Depreciation is computed using the straight-line method over estimated useful lives of the property and equipment, generally three years for computer equipment and up to seven years for furniture and fixtures. Equipment acquired under capital leases is amortized using the straight-line method over the lesser of the lease term or the estimated useful life of the asset, generally three years. The costs of software licenses are amortized over the shorter of the term of the licenses or the F-9 DATA RETURN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Years Ended March 31, 2001, 2000 and 1999 estimated useful life of the software, generally two years. Leasehold improvements are amortized over the shorter of the lease term or the estimated useful life of the improvements. The Company capitalizes certain costs incurred for the development of internal use software. These costs include the costs associated with coding, software configuration, upgrades and enhancements. Software is amortized over its estimated useful life, generally two years. Impairment of Long-Lived Assets In accordance with SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of, the Company reviews its long-lived assets for impairment when events or changes in circumstances indicate the carrying value of such assets may not be recoverable. This review consists of a comparison of the carrying value of the asset with the asset's expected future undiscounted cash flows without interest costs. Estimates of expected future cash flows represent management's best estimate based on reasonable and supportable assumptions and projections. If the expected future cash flow exceeds the carrying value of the asset, no impairment indicator is considered present. If the carrying value exceeds the future cash flow, an impairment indicator is considered present. Such impairment would be measured and recognized using a discounted cash flow method. Fair Value of Financial Instruments The carrying amount of cash equivalents approximates fair value due to the short-term maturities of these instruments. Management believes the carrying amount of capital leases and notes payable are not materially different from the estimated fair value based on prevailing interest rates for similar financial instruments. Available-for-sale securities consist of investments in debt securities and are stated at fair market value as determined by quoted market prices. Gross unrealized gains, which have been included as a separate component of shareholders' equity, were $281,000 at March 31, 2001. No unrealized holding gains or losses were recognized during the years ended March 31, 2000 and 1999. Advertising Costs The Company expenses advertising costs as incurred. Advertising expense amounted to $3,413,000, $661,000, and $296,000 for the years ended March 31, 2001, 2000 and 1999, respectively. Stock-based Compensation In October 1995, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123 (SFAS 123), Accounting for Stock-Based Compensation. SFAS 123 defines a fair-value based method of accounting for an employee stock option or similar equity instrument. As permitted by SFAS 123, the Company has elected to continue to measure the cost of its stock-based compensation plans using the intrinsic-value based method of accounting prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees. Income Taxes Deferred income taxes are provided for the tax effects of differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Valuation reserves are provided for the deferred tax assets when it is more likely than not that the deferred tax assets will not be realized. F-10 DATA RETURN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Years Ended March 31, 2001, 2000 and 1999 Segment Reporting Under Statement of Financial Accounting Standards No. 131 (SFAS 131), Disclosures about Segments of an Enterprise and Related Information, the Company operated, for all periods presented, in a single segment. Recent Accounting Pronouncements In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133 (SFAS 133), Accounting for Derivative Instruments and Hedging Activities. SFAS 133 is effective for the Company April 1, 2001. SFAS 133, as amended, requires that all derivative instruments be recorded on the balance sheet at fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge transaction and the type of hedge transaction. The ineffective portion of all hedges will be recognized in earnings. Adoption of this standard is not expected to have a significant impact on the Company's financial position, results of operations or cash flows. Net Loss Per Share Net loss per share is computed using the weighted average number of shares of common stock outstanding during each period for basic and diluted earnings per share. Common stock equivalents are not considered in the calculation of diluted earnings per share as the Company has incurred a loss for all periods presented and the effect of common stock equivalents would be anti-dilutive. Thus, the 8,896,493 employee stock options and warrants to acquire 345,910 shares of common stock are not included in the calculation. Reclassifications Certain reclassifications have been made to conform the prior year amounts to the current year presentation. 2. Property and Equipment Property and equipment consists of the following: March 31, --------- (in thousands) 2001 2000 ---- ---- Electronics and computer equipment.............. $ 44,313 $ 20,910 Leasehold improvements.......................... 5,767 586 Furniture and office equipment.................. 4,592 792 Computer software............................... 3,961 1,397 Other depreciable assets........................ 2,547 520 -------- ------- 61,180 24,205 Less accumulated depreciation and amortization.. (17,076) (2,178) -------- ------- $ 44,104 $ 22,027 ======== ======= Property and equipment includes assets acquired under capital leases, principally computer equipment with a cost of $40,918,000 and $17,232,000 at March 31, 2001 and 2000, respectively. Related allowances for depreciation and amortization are $11,337,000 and $1,121,000, respectively. F-11 DATA RETURN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Years Ended March 31, 2001, 2000 and 1999 3. Accrued Expenses Accrued expenses consist of the following: March 31, --------- (in thousands) 2001 2000 ---- ---- Accrued payroll................................ $1,700 $1,013 Marketing costs................................ 1,306 -- Commissions.................................... 137 184 Professional fees.............................. 183 157 Other.......................................... 939 851 ------ ------ $4,265 $2,205 ====== ====== 4. Notes Payable On December 29, 1999, the Company entered into a $2 million revolving credit facility with Bank One, Texas, N.A. This credit facility matures on July 31, 2001 and outstanding balances accrue interest at the bank's base rate (8% at March 31, 2001). As of March 31, 2001, there was no outstanding balance under the facility, and no borrowings have occurred since entering into the agreement. The facility is secured by certain equipment that was unencumbered as of the date of the facility and all accounts receivable outstanding. Under certain limited circumstances, the Company could be required to deposit cash with the bank to secure the loan. The credit facility contains standard events of default and other covenants. In October 1999, the Company entered into a credit agreement with an insurance company to finance certain of its insurance obligations. The agreement bears interest at a rate of 10.5% per annum and required payments of $69,000 monthly through September 2000. The balance of the note payable was zero and $434,000 at March 31, 2001 and 2000, respectively. 5. Shareholders' Equity Common Stock The Company has issued 5,705,964 shares of common stock to private investors, including the transaction with Microsoft Corporation described below and Compaq Computer Corporation, for net proceeds of $13.9 million. The Company closed its initial public offering on November 4, 1999. The Company sold 7,187,500 shares of common stock to the public, including the underwriters' overallotment, and received net proceeds of $85.9 million. Pursuant to a Stock Sales Agreement (the Agreement) dated February 20, 1998, between the Company and a private investor, the Company sold 2,152,000 shares of its common stock for $0.46 per share. The Agreement provided for the issuance of the shares in return for $500,000 cash and a promissory note in the amount of $500,000 that was repaid in February 1999. The Agreement provided the investor the right to acquire an additional 2,690,000 shares of the Company's common stock during a specified period in 2001 for $0.37 per share and provided the Company the right to require the investor to purchase the shares for a period beginning in February 1999 through August 2001. In February of 1999, the Company exercised its rights under the Agreement and sold 2,690,000 shares of its common stock to the investor for $0.37 per share. F-12 DATA RETURN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Years Ended March 31, 2001, 2000 and 1999 On July 26, 1999, Level 3 Communications, Inc. (Level 3) acquired 1,952,940 shares of the Company's common stock in exchange for a $5.0 million credit to be applied to the purchase of future broadband services. The Company has recorded the prepaid broadband services acquired in the agreement as a contra equity account. The Company has begun applying credits against payments for services in excess of the minimum purchases required under the Strategic Marketing and Sales Agreement (See Note 6) beginning on January 1, 2001. The Company has a limited right to reacquire the stock in the event that Level 3 fails to fulfill its obligations under the Service Credit Agreement (See Note 6). The number of shares subject to the Company's right to reacquire the stock will be reduced pro rata in each quarter of calendar year 2001 by the greater of the credit applied to future purchases of bandwidth or 25% of the total shares. The stock can be reacquired by the Company at the original purchase price by the Company's forgiveness of the remaining balance of the credit. In the event the Company's right to reacquire the stock is exercised, Level 3 is required to pay the Company $750,000, reduced ratably, based on the amount of bandwidth credit used by the Company. During the fourth quarter of fiscal 2001, 25% of the shares acquired by Level 3 under this agreement (488,235 shares) vested. On October 28, 1999 the Company closed an equity transaction with Microsoft. The Company issued 454,546 shares of its common stock and an immediately exercisable five-year warrant to acquire an additional 340,910 shares of its common stock for $11 per share. The Company estimated the value of the warrant to be $2.1 million using a Black-Scholes pricing model. The value of the warrant is being amortized and recorded as additional paid-in capital over the five year term of the Development, License and Co-Marketing Agreement (See Note 6). Warrants In March 2000, the Company issued an immediately exercisable three-year warrant to an advertising agency to acquire 5,000 shares of common stock at an exercise price of $49.19 per share. The warrant was valued at $25.19 per share using a Black Sholes valuation model. The value of this warrant has been amortized and recorded as additional paid-in capital over the twelve-month term of the agreement entered into with the advertising agency. Stock Split On September 10, 1999, the Board of Directors approved a 269-for-1 split of the Company's common stock. All share and per share amounts have been retroactively restated to reflect the effect of the stock split. Shareholder Rights Plan On September 27, 1999, the Board of Directors adopted a Shareholders' Rights Plan (the Plan) and declared a dividend of one preferred stock purchase right for each share of common stock. Each right entitles its registered holder to purchase one one-hundredth of a share of newly designated series A junior participating preferred stock at a purchase price of $100.00. The rights are attached to and trade with shares of the Company's common stock, including future issuances of common stock. The rights are not currently exercisable and become exercisable upon the earlier to occur of (a) the public announcement that a person or group of persons has acquired 15% or more of the Company's common stock, except in connection with an offer approved by the Board of Directors, or (b) the close of business on the tenth business day, or a later date determined by the Board of Directors, after the commencement of, or announcement of an intention to commence, a tender or exchange offer that would result in a person or group of persons acquiring 15% or more of the Company's common stock. In the event the rights become exercisable, each holder of a right (except the Acquiring Person, as defined in the Plan) will have the right to receive shares of the Company's common stock having a market value of two times the exercise price of the right. Also, if the Company is F-13 DATA RETURN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Years Ended March 31, 2001, 2000 and 1999 acquired in a merger in which the Company is not the surviving corporation, or there is a sale of 50% or more of the Company's assets or earning power, each holder of a right may receive common stock of the acquiring company having a market value equal to two times the exercise price of the right. The rights expire September 27, 2009. Each share of series A junior participating preferred stock has dividend, liquidation and voting rights equal to those of 100 shares of the Company's common stock. The series A junior participating preferred stock is not redeemable. Stock-based Compensation Arrangements The Company's 1998 Stock Option Plan (the 1998 Plan) provides for the issuance to employees of options to acquire 3,308,700 shares of common stock. The options are to be issued at fair market value, as defined, and vest as approved by the Board of Directors. Options generally expire 10 years from the date of grant and generally expire 90 days after termination of employment. The vesting period for options to acquire 1,392,575 shares of common stock accelerated to the effective date of the registration statement filed by the Company for the initial public offering of its common stock. 1999 Long-Term Incentive Plan In July 1999, the Company adopted the 1999 Long-Term Incentive Plan (the 1999 Plan). The 1999 Plan provides for the issuance of up to 5,000,000 options to acquire its common stock. The following table summarizes the stock option activity related to the Company:
Weighted Number of Per Share Average Shares Exercise Price Exercise Price ------ -------------- -------------- Outstanding options--September 22, 1997.................. -- $ -- $ -- Granted............................................. 3,577,700 0.02 0.02 ----------- ------------- -------------- Outstanding options--March 31, 1998...................... 3,577,700 0.02 0.02 Granted............................................. 1,069,275 0.08-0.17 0.15 ----------- ------------- -------------- Outstanding options--March 31, 1999...................... 4,646,975 0.02-0.17 0.05 Granted............................................. 2,913,554 0.19-84.81 11.24 Forfeited........................................... (128,740) 0.23-58.13 4.17 ----------- ------------- -------------- Outstanding options-- March 31, 2000..................... 7,431,789 0.02-84.81 4.37 Granted............................................. 2,749,080 2.88-38.25 17.48 Exercised........................................... (580,940) 0.02-2.56 0.39 Forfeited........................................... (613,436) 0.17-70.13 18.58 ----------- ------------- -------------- Outstanding options-- March 31, 2001..................... 8,986,493 0.02-84.81 7.67 =========== Options exercisable--March 31, 2001...................... 5,355,918 0.02-84.81 1.81 ===========
The weighted-average fair value of options granted during the years ended March 31, 2001, 2000 and 1999 was $16.95, $7.24, and $ 0.32, respectively. F-14 DATA RETURN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Years Ended March 31, 2001, 2000 and 1999 The following table summarizes information about stock options outstanding as of March 31, 2001:
Weighted Average Weighted Range of Shares Remaining Weighted Average Number Average Exercise Prices Outstanding Contractual Life Exercise Price Exercisable Exercise Price --------------- ----------- ---------------- -------------- ------------ -------------- $0.02 - $ 0.02 3,408,250 6.80 $ 0.02 3,401,525 $ 0.02 $0.08 - $ 1.31 1,877,890 7.96 $ 0.28 1,524,731 $ 0.20 $1.66 - $18.94 1,967,142 9.09 $ 8.34 321,329 $10.54 $19.5 - $84.81 1,733,211 9.08 $29.96 108,333 $54.78 --------- --------- 8,986,993 5,355,918 ========= =========
Certain employees of the Company have been granted options under the 1998 Plan to purchase shares of the Company's common stock at less than fair market value. Under a separate plan, an employee was granted 3,308,700 options that vest over 4 years at a price below fair market value. The vesting period for the 3,308,700 options accelerated to the effective date of the registration statement filed by the Company. The Company recorded deferred stock compensation of zero, $874,000 and $328,000 for the years ended March 31, 2001, 2000 and 1999, respectively, for the difference between the exercise price and the deemed fair value of the Company's common stock underlying certain options granted. These amounts are being amortized over the vesting period of the individual options, generally four years. The stock compensation expense charged to income amounted to $171,000, $1,852,000 and $349,000 for the years ended March 31, 2001, 2000 and 1999, respectively. At March 31, 2001, there were 1,776,395 shares reserved for issuance under the Company's option plans. As discussed in Note 1, the Company accounts for its stock-based awards to employees using the intrinsic value method in accordance with APB Opinion No. 25, "Accounting for Stock Issued to Employees," and its related interpretations. SFAS No. 123 requires the disclosure of pro forma net loss and net loss per share as if the Company had adopted the fair value method since September 22, 1997 (inception). Under SFAS No. 123, the fair value of stock-based awards to employees is calculated through the use of option pricing models, even though such models were developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which significantly differ from the Company's stock option awards. These models also require subjective assumptions, including future price volatility and expected time to exercise, which greatly affect the calculated values. The Company's calculations for determining the fair value of employee option grants were made using the Black- Scholes Single Option Method using the following weighted average assumptions: Years Ended March 31 2001 2000 1999 ------------------------ Expected life 8.6 5.0 4.0 Risk-free interest rate 5.7% 6.3% 6.0% Volatility factor 1.4 0.8 0.0 Dividend rate 0.0% 0.0% 0.0% F-15 DATA RETURN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Years Ended March 31, 2001, 2000 and 1999 Had compensation cost been determined in accordance with SFAS No. 123 for all of the Company's stock-based compensation plans, net loss attributable to holders of common stock and net loss per share would have been changed to the amounts indicated below (in thousands, except per share data):
Years Ended March 31, 2001 2000 1999 -------------------------------- Net loss applicable to common shareholders: As reported: ($48,778) ($11,688) ($1,284) Pro Forma: ($63,252) ($14,643) ($1,375) Basic and diluted net loss per share: As reported: ($1.37) ($0.40) ($0.07) Pro Forma: ($1.77) ($0.50) ($0.07)
6. Significant Contracts Level 3 Agreements The Company entered into a Strategic Marketing and Sales Agreement (the Agreement) with Level 3 on July 1, 1999. The Strategic Marketing and Sales Agreement provides that the Company will acquire most of its requirements for co-location space, technical assistance, broadband service and private line service (collectively, the Services) from Level 3 over a five-year period commencing with the date of the Agreement. The Company is also required to purchase at least an additional $8.3 million of bandwidth and colocation services over the next four years. The quarterly commitment is $300,000 per quarter through July 2001, $400,000 per quarter during the next 12 months, $600,000 per quarter during the next 12 months and $1.0 million per quarter during the final 12 months of the agreement. The prices the Company will pay Level 3 for the Services over the term of the Agreement are based upon Level 3's then-current prices to other companies purchasing similar quantities. Management believes adequate alternative sources of the Services are available. Payments for the minimum annual purchase commitments will be required regardless of whether the Company uses the Services. The Company entered into a Service Credit Agreement on July 23, 1999. Under the Service Credit Agreement, Level 3 acquired 1,952,940 shares of the Company's stock in exchange for a $5.0 million credit. On January 1, 2001, the Company became eligible to apply the $5.0 million credit to purchases in excess of the minimum annual commitments required by the Strategic Marketing and Sales Agreement. As of March 31, 2001, the Company applied for a $406,000 credit, which was credited to the Company in May, 2001. Pricing of the services provided and paid for with the credit will be based on Level 3's established market prices at the time the service is provided. Microsoft Agreements On September 3, 1999, the Company entered into a five-year Development, License and Co-Marketing Agreement with Microsoft Corporation (See Note 5). Under the agreement, the Company delivered proprietary installation tools for three specific applications that are used on Microsoft NT. Modifications to the tools will be cross-licensed between Data Return and Microsoft. The Company also trained Microsoft's employees and customers in the use of the tools. Microsoft has the sole right to terminate the agreement if the Company fails to deliver the tools on a timely basis or if the Company fails to correct any errors in the tools on a timely basis. Also as part of the agreement, Microsoft provided one hundred hours of technical consulting and writing services during the development of the tools. Microsoft has the right to review certain installation tools that the Company may develop over the next five years and to receive a percentage of any revenues earned from the licensing or exploitation of those tools. F-16 DATA RETURN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Years Ended March 31, 2001, 2000 and 1999 ASP and Server Agreement In connection with a $3.0 million equity investment by Compaq, the Company entered into a three-year agreement in July 1999 to acquire the lesser of 2,000 servers or the number of servers reasonably necessary to operate the Company's business. At March 31, 2001, approximately 1,800 servers had been acquired under this agreement. The requirement to purchase the servers is contingent upon Compaq providing financing for the servers on competitive terms, upon the price, performance and quality of the servers being reasonably satisfactory to the Company and upon Compaq's commitment to deliver these servers on the schedule the Company requests. The Company has purchased substantially all of its computer hardware from Compaq. Management believes that adequate alternative sources of computer hardware are available. 7. Income Taxes At March 31, 2001, 2000 and 1999, the Company had temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and such amounts as measured by tax laws. Significant components of the Company's deferred tax assets and liabilities were as follows:
March 31, --------- (in thousands) 2001 2000 1999 ---- ---- ---- Deferred tax liability................................. $ - $ 750 $ - Deferred tax assets: Net operating loss carryforward................. $ 18,908 $ 4,443 $ 333 Stock-based compensation........................ 1,142 874 139 Accrued expenses................................ 855 124 22 Deferred revenue................................ 599 - - Allowance for bad debts......................... 588 122 7 Property and equipment.......................... 66 Other........................................... 4 - - -------- ------- ------- Total deferred tax assets.............................. 22,162 5,563 501 Less: valuation allowance....................... (22,162) (4,813) (501) -------- ------- ------- Deferred tax asset, net of valuation allowance......... $ - $ 750 $ - -------- ------- ------- Net deferred tax asset (liability)............ $ - $ - $ - ======== ======= =======
At March 31, 2001, the Company has approximately $51 million of federal net operating loss carryforwards, which begin to expire in 2019. The Company has approximately $50 million of state net operating losses as of March 31, 20001. At March 31, 2001, the Company has recorded a valuation allowance against its net deferred tax assets in accordance with SFAS 109 because management believes that, after considering all the available objective evidence, it is more likely than not that the deferred tax assets will not be realized. F-17 DATA RETURN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Years Ended March 31, 2001, 2000 and 1999 8. Commitments Leases The Company leases office space, office equipment, and revenue-generating equipment under capital and operating leases. Future non-cancelable lease payments under the Company's lease commitments at March 31, 2001 are as follows:
Operating Capital Leases -------- ------- 2002............................................................... $ 4,095 $ 15,882 2003............................................................... 4,041 15,158 2004............................................................... 1,476 4,344 2005............................................................... 899 356 2006............................................................... 886 0 ------- -------- Total.............................................................. $11,397 $ 35,740 ======= Less amount representing interest....................................... (4,694) -------- Present value of lease payments......................................... 31,046 Current portion of capital leases....................................... (12,873) -------- Noncurrent portion of capital leases.................................... $ 18,173 ========
The Company recorded rent expense of $3,631,000, $606,000, and $61,000 for the years ended March 31, 2001, 2000 and 1999, respectively. Bandwidth and CoLocation Agreements The Company has entered into agreements for bandwidth, colocation space and dedicated Internet access with multiple vendors, primarily Level 3. Future commitments for these services at March 31, 2001 are as follows: 2002..................................................... $ 3,806 2003..................................................... 4,269 2004..................................................... 5,095 2005..................................................... 2,035 ------- Total $15,205 ======= 9. Contingencies The Company may from time to time be subject to claims and litigation arising from the normal course of its business operations. In January 2001, the Company entered into a guarantee with a financial institution pursuant to which the Company guaranteed up to $5.0 million of the margin debt of a Texas family limited partnership (an estate planning entity) owned by Sunny C. Vanderbeck, the Chairman of the Board and Chief Executive Officer of the Company. In June 2001, this guarantee was replaced with a new guarantee that reduced the amount to $2.0 million. Based on a closing price of $1.95 on June 22, 2001, the value of the collateral in the limited partnership's account with this financial institution exceeded the amount of the margin debt by approximately 50%. Pursuant to a letter agreement with the limited partnership and Mr. Vanderbeck, if the Company is required to pay any amounts under the guarantee, the limited partnership and Mr. Vanderbeck would be required to repay any amounts paid by the Company under such guarantee. Mr. Vanderbeck and the Company have also agreed to grant the Company a security interest in certain properties. Mr. Vanderbeck and the limited partnership are required to take steps to reduce the amount of the margin debt to a sufficient level to allow the guarantee to be released as soon as reasonably practicable. The limited partnership also has margin debt with another financial institution; however, based on a closing price of $1.95 on June 22, 2001, the net assets of the limited partnership exceed the amount of the guarantee by more than 100%. 10. Subsequent Events On May 11, 2001, the Company reduced its workforce by 94 employees. The reduction in workforce was a result of slower than anticipated growth and increased process and other operational efficiencies. As a result of this workforce reduction, the Company anticipates a one-time restructuring charge of $1.0 million to $1.5 million in the first quarter of fiscal 2002. Giving effect to this reduction, on May 12, 2001, F-18 DATA RETURN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Years Ended March 31, 2001, 2000 and 1999 our employee base consisted of the following: 194 in systems operations and service and support, 90 in general and administrative functions, 110 in marketing and sales and 49 in product research and development. 11. Selected Quarterly Financial Data The following is a summary of unaudited quarterly results of operations for the years ended March 31, 2001 and 2000 (in thousands):
2001 (000's) First Quarter Second Quarter ------------- -------------- As previously As restated As previously As restated reported (1) (2) reported (1) -------- ------- -------- --- Revenue $ 9,247 $ 9,080 $ 12,372 $ 12,356 Net Loss before cumulative effect of accounting change (8,683) (8,850) (12,548) (12,564) Cumulative effect of accounting change - (1,626) - - Net loss (8,683) (10,476) (12,548) (12,564) Loss per share before cumulative effect of accounting change $ 0.24 $ (0.25) $ 0.35 $ 0.35 Loss per share for cumulative effect of accounting change - $ 0.05 - - Loss per share $ 0.24 $ 0.30 $ 0.35 $ 0.35 Third Quarter Fourth Quarter ------------- -------------- As previously As restated reported (1) -------- --- Revenue $ 14,063 $ 14,246 $ 14,386 Net Loss before cumulative effect of accounting change (13,055) (12,872) (12,866) Cumulative effect of accounting change - - - Net loss (13,055) (12,872) (12,866) Loss per share before cumulative effect of accounting change $ 0.36 $ 0.36 $ 0.36 Loss per share for cumulative effect of accounting change - - - Loss per share $ 0.36 $ 0.36 $ 0.36
2000 (000's) Second Fourth First Quarter Quarter Third Quarter Quarter ------------- ------- ------------- ------- Revenue $ 1,228 $ 1,726 $ 3,414 $ 5,466 Net Loss before cumulative effect of accounting change (638) (1,922) (4,033) (5,098) Net loss $ (635) $ (1,922) $ (4,033) $ (5,098) Loss per share $ (0.03) $ (0.07) $ (0.12) $ (0.14)
(1) Restated for the effect of the implementation of SAB 101 (See Note 1). (2) Of the $1,626,000 deferred on the implementation of SAB 101, $624,084, $524,911, $350,119 and $125,831 was recognized in revenue for the quarters ended June 30, 2000, September 30, 2000, December 31, 2000 and March 31, 2001, respectively. F-19 DATA RETURN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Years Ended March 31, 2001, 2000 and 1999 Schedule II Valuation and Qualifying Accounts (In thousands)
Balance at Charged to Balance at Beginning Costs and End Description of Period Expenses Deductions of Period ---------- --------- ---------- ---------- For the year ended March 31, 1999 Deduct from asset accounts: Allowance for doubtful accounts $ 7 $ 40 $ 27 (1) $ 20 Deferred tax valuation allowance 65 436 0 501 For the year ended March 31, 2000 Deduct from asset accounts: Allowance for doubtful accounts $ 20 $ 592 $ 284 (1) $ 327 Deferred tax valuation allowance 501 4,312 0 4,813 For the year ended March 31, 2001 Deduct from asset accounts: Allowance for doubtful accounts $ 327 $ 3,547 $ 2,285 (1) $ 1,589
(1) Uncollectible accounts written off, net of recoveries. F-20