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INTERNAP NETWORK SERVICES CORP - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULT OF OPERATIONS

July 29, 2014

This Quarterly Report on Form 10-Q contains "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include statements regarding industry trends, our future financial position and performance, business strategy, revenues and expenses in future periods, projected levels of growth and other matters that do not relate strictly to historical facts. These statements are often identified by words such as "may," "will," "seeks," "anticipates," "believes," "vision," "estimates," "expects," "projects," "forecasts," "plans," "intends," "continue," "could" or "should," statements regarding our vision or similar expressions or variations. These statements are based on the beliefs and expectations of our management team based on information currently available. Such forward-looking statements are not guarantees of future performance and are subject to risks and uncertainties that could cause actual results to differ materially from those contemplated by forward-looking statements. Important factors currently known to our management that could cause or contribute to such differences include, but are not limited to, those referenced in our Annual Report on Form 10-K for the year ended December 31, 2013 under Item 1A "Risk Factors." We undertake no obligation to update any forward-looking statements as a result of new information, future events or otherwise.



As used herein, except as otherwise indicated by context, references to "we," "us" or "our" refer to Internap Network Services Corporation and our subsidiaries.

Overview

We strive to help people build and manage the world's best performing Internet infrastructure. Today, our infrastructure services power many of the applications that shape the way we live, work and play. Our hybrid Internet infrastructure services blend virtual and bare-metal cloud, hosting and colocation services across a global network of data centers, optimized from the application to the end user and backed by our customer support. We believe many of the world's most innovative companies rely on us to make their applications faster and more scalable. Operating Segments Data Center Services Our data center services segment includes colocation, hosting and cloud services. Colocation involves providing physical space within data centers and associated services such as power, interconnection, environmental controls, monitoring and security while allowing our customers to deploy and manage their servers, storage and other equipment in our secure data centers. Hosting and cloud services involve the provision and maintenance of hardware, operating system software, management and monitoring software, data center infrastructure and interconnection, while allowing our customers to own and manage their software applications and content. We sell our data center services at 52 data centers across North America, Europe and the Asia-Pacific region. We refer to 17 of these facilities as "company-controlled," meaning we control the data centers' operations, staffing and infrastructure and have negotiated long-term leases for the facilities. For company-controlled facilities, in most cases we design the data center infrastructure, procure the capital equipment, deploy the infrastructure and are responsible for the operation and maintenance of the facility. We refer to the remaining 35 data centers as "partner" sites. In these locations, a third-party designs and deploys the infrastructure and provides for the operation and maintenance of the facility. Within the data center services segment, we identify between "core" and "partner colocation" revenues. Core revenues are from our company-controlled colocation, hosting and cloud services and include all revenue from iWeb Technologies Inc., formerly known as iWeb Group Inc., ("iWeb"), which we acquired in November 2013. Partner colocation revenues are from our third-party colocation sites.



IP Services

Our Internet Protocol ("IP") services segment includes our patented Performance IPô service, content delivery network ("CDN") services and IP routing hardware and software platform. By intelligently routing traffic with redundant, high-speed connections over multiple, major Internet backbones, our IP services provide high-performance and highly-reliable delivery of content, applications and communications to end users globally. We deliver our IP services through 88 IP service points around the world, which include 25 CDN points of presence ("POPs"). Our patented and patent-pending network route optimization technologies address inherent weaknesses of the Internet, allowing businesses to take advantage of the convenience, flexibility and reach of the Internet to connect to customers, suppliers and partners, and to adopt new IT delivery models, in a scalable, reliable and predictable manner. 8 Our CDN services enable our customers to quickly and securely stream and distribute rich media and content, such as video, audio software and applications, to audiences across the globe through strategically located POPs. Providing capacity-on-demand to handle large events and unanticipated traffic spikes, we deliver scalable high-quality content distribution and audience-analytic tools.



Recent Accounting Pronouncements

Recent accounting pronouncements are summarized in note 8 to the accompanying consolidated financial statements. Currently, we do not expect any recent accounting pronouncements that we have not yet adopted to have a material impact on our consolidated financial statements.



Results of Operations

As of June 30, 2014, we had approximately 12,000 customers. Our customer base is not concentrated in any particular industry and, for the three and six months ended June 30, 2014, no single customer accounted for 10% or more of our revenues.



Three Months Ended June 30, 2014 and 2013

The following table sets forth selected consolidated statements of operations and comprehensive loss data during the periods presented, including comparative information between the periods (dollars in thousands): Three Months Ended Increase (decrease) from June 30, 2013 to 2014 2014 2013 Amount Percent Revenues: Data center services: Core $ 49,390$ 32,473$ 16,917 52 % Partner colocation 12,005 13,107 (1,102 ) (8 ) Total data center services 61,395 45,580

15,815 35 IP services 22,673 24,403 (1,730 ) (7 ) Total revenues 84,068 69,983 14,085 20 Operating costs and expenses: Direct costs of network, sales and services, exclusive of depreciation and amortization, shown below: Data center services 26,563 22,643 3,920 17 IP services 9,999 10,010 (11 ) -

Direct costs of customer support 9,553 7,372 2,181 30 Direct costs of amortization of acquired technologies 1,551 1,190 361 30 Sales and marketing 9,977 8,077 1,900 24 General and administrative 11,429 9,555 1,874 20 Depreciation and amortization 17,917 11,554 6,363 55 Loss (gain) on disposal of property and equipment, net 32 (2 ) 34 - Exit activities, restructuring and impairments 1,561 683 878 129 Total operating costs and expenses 88,582 71,082

17,500 25 Loss from operations $ (4,514 )$ (1,099 )$ (3,415 ) 311 Interest expense $ 6,806$ 2,474 $ 4,332 175 Data Center Services

Revenues for data center services increased $15.8 million, or 35%, to $61.4 million for the three months ended June 30, 2014, compared to $45.6 million for the same period in 2013. The increase was primarily due to growth in our core revenues, of which $11.5 million is attributable to iWeb, and $2.7 million related to the renegotiation of customer contracts. Direct costs of data center services, exclusive of depreciation and amortization, increased $3.9 million, or 17%, to $26.6 million for the three months ended June 30, 2014, compared to $22.6 million for the same period in 2013. The increase in direct costs was primarily due to revenue growth, $2.1 million of costs attributable to iWeb and $0.9 million of costs related to the renegotiation of customer contracts. Direct costs of data center services, exclusive of depreciation and amortization, have substantial fixed cost components, primarily rent for operating leases, but also significant demand-based pricing variables, such as utilities attributable to seasonal costs and customers' changing power requirements. Direct costs of data center services as a percentage of revenues vary with the mix of usage between company-controlled data centers and partner sites, and the utilization of total available space. Since we recognize some of the initial operating costs of company-controlled data centers in advance of revenues or in advance of sites being fully utilized, these sites are less profitable in the early years of operation compared to partner sites and we expect them to be more profitable as occupancy increases. Conversely, costs in partner sites are more demand-based and therefore are more closely associated with the level of utilization. 9 We will continue to focus on increasing revenues from company-controlled facilities as compared to partner sites. We also expect direct costs of data center services as a percentage of corresponding revenues to decrease as our new and recently-expanded company-controlled data centers continue to contribute to revenue and become more fully occupied. This is evidenced by the improvement in direct costs of data center services as a percentage of corresponding revenues of 43% during the three month ended June 30, 2014, compared to 50% during the same period in 2013. IP Services Revenues for IP services decreased $1.7 million, or 7%, to $22.7 million for the three months ended June 30, 2014, compared to $24.4 million for the same period in 2013. The decrease continues to be driven by a decline in IP pricing for new and renewing customers and the loss of legacy contracts, partially offset by an increase in overall traffic. IP traffic increased approximately 15% for the three months ended June 30, 2014, compared to the same period in 2013, calculated based on an average over the number of months in the respective periods.



Direct costs of IP services, exclusive of depreciation and amortization, remained constant at $10.0 million for the three months ended June 30, 2014 and 2013.

There have been ongoing industry-wide pricing declines over the last several years and this trend continued during the three months ended June 30, 2014 and 2013. Technological improvements and excess capacity have been the primary drivers for lower pricing of IP services. The increase in IP traffic resulted from both new and existing customers using more applications and the nature of applications consuming greater amounts of bandwidth.



Other Operating Costs and Expenses

Compensation. Total compensation and benefits, including stock-based compensation, were $21.5 million and $17.2 million for the three months ended June 30, 2014 and 2013, respectively. The increase was primarily due to a $0.3 million increase in bonuses related to annual salary increases, a $0.3 million decrease in capitalized payroll costs related to software development and $3.7 million of expenses attributable to iWeb. Stock-based compensation, net of amount capitalized, increased to $2.0 million during the three months ended June 30, 2014 from $1.7 million during the same period in 2013. The increase was primarily due to stock-based compensation awarded to certain iWeb employees subsequent to the acquisition. The following table summarizes the amount of stock-based compensation, net of estimated forfeitures, included in the accompanying consolidated statements of operations and comprehensive loss (in thousands): 2014 2013 Direct costs of customer support $ 333$ 329 Sales and marketing 289 342 General and administrative 1,334 1,070 $ 1,956$ 1,741 Direct Costs of Customer Support. Direct costs of customer support increased 30% to $9.6 million during the three months ended June 30, 2014 from $7.4 million during the same period in 2013. The increase was primarily due to $2.0 million of expenses attributable to iWeb. Sales and Marketing. Sales and marketing costs increased 24% to $10.0 million during the three months ended June 30, 2014 from $8.1 million during the same period in 2013. The increase was primarily due to $2.1 million of expenses attributable to iWeb. General and Administrative. General and administrative costs increased 20% to $11.4 million during the three months ended June 30, 2014 from $9.6 million during the same period in 2013. The increase was primarily due to a $0.4 million increase in cash-based compensation and payroll costs, a $0.3 million increase in bonuses related to annual salary increases and $2.1 million of expenses attributable to iWeb, partially offset by a $0.5 million decrease in bad debt expense and a $0.3 million decrease in taxes and licenses. Depreciation and Amortization. Depreciation and amortization increased 55% to $17.9 million during the three months ended June 30, 2014 from $11.6 million during the same period in 2013. The increase was primarily due to the effects of expanding our company-controlled data centers, private network access point infrastructure and capitalized software, including $2.9 million of expenses

related to iWeb. 10 Exit Activities, Restructuring and Impairments. Exit activities, restructuring and impairments increased to $1.6 million during the three months ended June 30, 2014 from $0.7 million during the same period in 2013. The increase was primarily due to $1.1 million of subsequent plan adjustments and a $0.4 million impairment charge for certain leasehold improvements. Interest Expense. Interest expense increased to $6.8 million during the three months ended June 30, 2014 from $2.5 million during the same period in 2013. The increase in interest expense was primarily due to increased borrowings and interest rate under our current credit agreement executed in November 2013.



Six Months Ended June 30, 2014 and 2013

The following table sets forth selected consolidated statements of operations and comprehensive loss data during the periods presented, including comparative information between the periods (dollars in thousands): Six Months Ended



Increase (decrease) from

June 30, 2013 to 2014 2014 2013 Amount Percent Revenues: Data center services: Core $ 95,738$ 63,750$ 31,988 50 % Partner colocation 23,940 26,223 (2,283 ) (9 )

Total data center services 119,678 89,973

29,705 33 IP services 46,351 49,710 (3,359 ) (7 ) Total revenues 166,029 139,683 26,346 19 Operating costs and expenses: Direct costs of network, sales and services, exclusive of depreciation and amortization, shown below: Data center services 52,454 45,290 7,164 16 IP services 19,869 20,234 (365 ) (2 )

Direct costs of customer support 18,480 14,523 3,957 27 Direct costs of amortization of acquired technologies 3,012 2,369 643 27 Sales and marketing 20,080 15,561 4,519 29 General and administrative 22,826 19,242 3,584 19 Depreciation and amortization 35,382 21,811 13,571 62 Loss on disposal of property and equipment, net 32 - 32 - Exit activities, restructuring and impairments 2,945 932 2,013 216 Total operating costs and expenses 175,080 139,962

35,118 25 Loss from operations $ (9,051 )$ (279 )$ (8,772 ) 3144 Interest expense $ 13,297$ 4,895$ 8,402 172 Benefit for income taxes $ (853 )$ (352 ) $ (501 ) 142 Data Center Services Revenues for data center services increased $29.7 million, or 33%, to $119.7 million for the six months ended June 30, 2014, compared to $90.0 million for the same period in 2013. The increase was primarily due to growth in our core revenues, of which $22.9 million is attributable to iWeb, and $2.7 million related to the renegotiation of customer contracts. Direct costs of data center services, exclusive of depreciation and amortization, increased $7.2 million, or 16%, to $52.5 million for the six months ended June 30, 2014, compared to $45.3 million for the same period in 2013. The increase in direct costs was primarily due to revenue growth, $4.3 million of direct costs attributable to iWeb and $0.9 million of costs related to the renegotiation of customer contracts. Direct costs of data center services as a percentage of corresponding revenues of 44% during the six month ended June 30, 2014, compared to 50% during the same period in 2013.



IP Services

Revenues for IP services decreased $3.4 million, or 7%, to $46.4 million for the six months ended June 30, 2014, compared to $49.7 million for the same period in 2013. The decrease continues to be driven by a decline in IP pricing for new and renewing customers and the loss of legacy contracts, partially offset by an increase in overall traffic. IP traffic increased approximately 17% for the six months ended June 30, 2014, compared to the same period in 2013, calculated based on an average over the number of months in the respective periods. Direct costs of IP services, exclusive of depreciation and amortization, decreased $0.4 million, or 2%, to $19.9 million for the six months ended June 30, 2014, compared to $20.2 million for the same period in 2013. This decrease was primarily due to renegotiation of vendor contracts and cost reduction efforts. 11



Other Operating Costs and Expenses

Compensation. Total compensation and benefits, including stock-based compensation, were $42.8 million and $34.5 million for the six months ended June 30, 2014 and 2013, respectively. The increase was primarily due to a $0.6 million increase in commissions, a $0.5 million increase related to a higher employee headcount and increased salary levels and $7.1 million of expenses attributable to iWeb. Stock-based compensation, net of amount capitalized, increased to $3.9 million during the six months ended June 30, 2014 from $3.4 million during the same period in 2013. The increase was primarily due to stock-based compensation awarded to certain iWeb employees subsequent to the acquisition. The following table summarizes the amount of stock-based compensation, net of estimated forfeitures, included in the accompanying consolidated statements of operations and comprehensive loss (in thousands): 2014 2013 Direct costs of customer support $ 617$ 551 Sales and marketing 540 601 General and administrative 2,740 2,226 $ 3,897$ 3,378 Direct Costs of Customer Support. Direct costs of customer support increased 27% to $18.5 million during the six months ended June 30, 2014 from $14.5 million during the same period in 2013. The increase was primarily due to a $0.4 million decrease in capitalized payroll costs related to software development and $3.6 million of expenses attributable to iWeb. Direct Costs of Amortization of Acquired Technologies. Direct costs of amortization of acquired technologies increased 27% to $3.0 million during the six months ended June 30, 2014 from $2.4 million during the same period in 2013. The increase was primarily due to amortization of technologies from the iWeb acquisition. Sales and Marketing. Sales and marketing costs increased 29% to $20.1 million during the six months ended June 30, 2014 from $15.6 million during the same period in 2013. The increase was primarily due to a $0.6 million increase in commissions, a $0.4 million increase in agent fees, and $3.9 million of expenses attributable to iWeb, partially offset by a $0.4 million decrease in cash-based compensation and payroll taxes. General and Administrative. General and administrative costs increased 19% to $22.8 million during the six months ended June 30, 2014 from $19.2 million during the same period in 2013. The increase was primarily due to a $1.0 million increase in cash-based compensation and payroll costs, a $0.4 million increase in bonuses related to annual salary increases, and $4.4 million of expenses related to iWeb, partially offset by a $0.8 million decrease in bad debt expense, a $0.4 million increase in capitalized payroll costs related to software development, a $0.4 million decrease in taxes and licenses and a $0.4 million decrease in legal fees. Depreciation and Amortization. Depreciation and amortization increased 62% to $35.4 million during the six months ended June 30, 2014 from $21.8 million during the same period in 2013. The increase was primarily due to the effects of expanding our company-controlled data centers, private network access point infrastructure and capitalized software, including $6.5 million of expenses related to iWeb. Exit Activities, Restructuring and Impairments. Exit activities, restructuring and impairments increased to $2.9 million during the six months ended June 30, 2014 from $0.9 million during the same period in 2013. The increase was primarily due to $1.3 million of initial exit activity charges related to ceasing use of a portion of data center space, $1.1 million of subsequent plan adjustments and a $0.4 million impairment charge for certain leasehold improvements. Interest Expense. Interest expense increased to $13.3 million during the six months ended June 30, 2014 from $4.9 million during the same period in 2013. The increase in interest expense was primarily due to increased borrowings and interest rate under our current credit agreement executed in November 2013. Benefit for Income Taxes. The benefit for income taxes increased to $0.9 million during the six months ended June 30, 2014 from $0.4 million during the same period in 2013. Our effective tax rates for the six months ended June 30, 2014 and 2013 were 3.7% and 6.1%, respectively. The majority of fluctuation in the effective income tax rate was primarily due to the recognition of income tax benefit from the reversal of uncertain tax position in 2013 and from the operations of iWeb in 2014.



Non-GAAP Financial Measure

We report our consolidated financial statements in accordance with accounting principles generally accepted in the United States of America ("GAAP"). We present the non-GAAP performance measure of adjusted EBITDA to assist us in explaining underlying performance trends in our business, which we believe will enhance investors' ability to analyze trends in our business and evaluate our performance relative to other companies. We define adjusted EBTIDA as (loss) income from operations plus depreciation and amortization, loss (gain) on disposal of property and equipment, exit activities, restructuring and impairments, stock-based compensation and acquisition costs. 12 As a non-GAAP financial measure, adjusted EBITDA should not be considered in isolation of, or as a substitute for, net loss or other GAAP measures as an indicator of operating performance. In addition, adjusted EBITDA should not be considered as an alternative to income from operations or net loss as a measure of operating performance. Our calculation of adjusted EBITDA may differ from others in our industry and is not necessarily comparable with similar titles used by other companies. The following table reconciles adjusted EBITDA to loss from operations as presented in our consolidated statements of operations and comprehensive loss: Three Months Ended June 30, 2014 2013 Loss from operations $ (4,514 )$ (1,099 )



Depreciation and amortization, including

amortization of acquired technologies 19,468



12,744

Loss (gain) on disposal of property and equipment, net 32 (2 ) Exit activities, restructuring and impairments 1,561 683 Stock-based compensation 1,956

1,741 Adjusted EBITDA $ 18,503$ 14,067



Liquidity and Capital Resources

Liquidity

We monitor and review our performance and operations in light of global economic conditions, which could impact the ability of our customers to meet their obligations to us, which could result in delayed collection of accounts receivable and an increase in our provision for doubtful accounts.

We expect to meet our cash requirements for the next 12 months through a combination of net cash provided by operating activities, existing cash on hand and utilizing additional borrowings under our credit agreement described below in "Capital Resources-Credit Agreement." Our capital requirements depend on a number of factors, including the continued market acceptance of our services and the ability to expand and retain our customer base. If our cash requirements vary materially from what we expect or if we fail to generate sufficient cash flows from selling our services, we may require additional financing sooner than anticipated. We can offer no assurance that we will be able to obtain additional financing on commercially favorable terms, or at all, and provisions in our credit agreement limit our ability to incur additional indebtedness. Our anticipated uses of cash include capital expenditures, working capital needs and required payments on our credit agreement and other commitments. We have a history of quarterly and annual period net losses. During the three and six months ended June 30, 2014, we had a net loss of $11.2 million and $21.9 million, respectively. As of June 30, 2014, our accumulated deficit was $1.1 billion. We continue to analyze our business to control our costs, principally through making process enhancements and renegotiating network contracts for more favorable pricing and terms. We may not be able to sustain or increase profitability on a quarterly basis, and our failure to do so may adversely affect our business, including our ability to raise additional funds.



Capital Resources

Credit Agreement. We have a $350.0 million credit agreement, which provides for a $300.0 million term loan and a $50.0 million revolving credit facility. As of June 30, 2014, the revolving credit facility, expiring in November 2018, had an outstanding balance of $5.0 million and we issued $6.6 million letters of credit, resulting in $38.4 million in borrowing capacity. As of June 30, 2014, the term loan had an outstanding principal amount of $298.5 million, which we will repay in $750,000 quarterly installments on the last day of each fiscal quarter with the remaining unpaid balance due November 26, 2019. As of June 30, 2014, the interest rate on the revolving credit facility was 5.0% and term loan was 6.0%. The credit agreement includes customary representations, warranties, negative and affirmative covenants, including certain financial covenants relating to maximum total leverage ratio, minimum consolidated interest coverage ratio and limitation on capital expenditures. As of June 30, 2014, we were in compliance with these covenants. Cash Flows Operating Activities

Net cash provided by operating activities during the six months ended June 30, 2014 was $24.3 million. We generated cash from operations of $22.9 million as a result of adjustments for non-cash items from our net loss, while changes in operating assets and liabilities generated cash from operations of $1.4 million. We expect to use cash flows from operating activities to fund a portion of our capital expenditures and other requirements and to meet our other commitments and obligations, including outstanding debt. 13 Investing Activities



Net cash used in investing activities during the six months ended June 30, 2014 was $38.5 million, primarily due to capital expenditures related to the continued expansion and upgrade of our company-controlled data centers and network infrastructure.

Financing Activities

Net cash provided by financing activities during the six months ended June 30, 2014 was $7.0 million, primarily due to $5.0 million of proceeds from the revolving credit facility, a return of deposit collateral of $6.2 million, partially offset by principal payments of $4.2 million on the credit agreement and capital lease obligations.


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