Internap Corporation
INTERNAP NETWORK SERVICES CORP (Form: 10-Q, Received: 11/05/2009 17:17:54)


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
 
 
FORM 10-Q
 

   
(Mark One)
 
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
   
For the quarterly period ended September 30, 2009
   
OR
   
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
   
For the transition period from _______ to ______
 
Commission File Number: 000-27265
 
 
INTERNAP NETWORK SERVICES CORPORATION
(Exact Name of Registrant as Specified in Its Charter)

   
DELAWARE
91-2145721
(State or Other Jurisdiction of
(I.R.S. Employer
Incorporation or Organization)
Identification No.)
   
250 Williams Street
Atlanta, Georgia 30303
(Address of Principal Executive Offices, Including Zip Code)
 
(404) 302-9700
(Registrant’s Telephone Number, Including Area Code)
 

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 o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
(Check one):
     
Large accelerated filer
o
Accelerated filer
x
Non-accelerated filer
o
Smaller reporting company
o
(Do not check if a smaller reporting company)
   

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
 
As of October 31, 2009, 50,759,900 shares of the registrant’s outstanding common stock, $0.001 par value per share, were outstanding.
 
 


 
 

 
INTERNAP NETWORK SERVICES CORPORATION
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2009
TABLE OF CONTENTS
       
     
Pages
       
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
   
     
PART I – FINANCIAL INFORMATION
   
       
Item 1.
Financial Statements
   
       
 
Unaudited Condensed Consolidated Statements of Operations
    2
       
 
Unaudited Condensed Consolidated Balance Sheets
    3
       
 
Unaudited Condensed Consolidated Statements of Cash Flows
    4
       
 
Unaudited Condensed Consolidated Statements of Stockholders’ Equity and Comprehensive Loss
    5
       
 
Unaudited Condensed Notes to Consolidated Financial Statements
    6
       
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
    17
       
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
    27
       
Item 4.
Controls and Procedures
    28
       
PART II – OTHER INFORMATION
   
       
Item 1.
Legal Proceedings
    28
       
Item 1a.
Risk Factors
    28
       
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
    28
       
Item 6.
Exhibits
    29
       
SIGNATURES
   
 
 
 

 
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
 
This Quarterly Report on Form 10-Q contains “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. 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 the use of words such as “may,” “will,” “seeks,” “anticipates,” “believes,” “estimates,” “expects,” “projects,” “forecasts,” “plans,” “intends,” “continue,” “could,” “should” or similar expressions or variations. These statements are based on the beliefs and expectations of our management team based on information currently available. Such forward-looking statements are not guarantees of future performance and are subject to risks and uncertainties that could cause actual results to differ materially from those contemplated by forward-looking statements. Important factors currently known to us that could cause or contribute to such differences include, but are not limited to, those set forth in this Form 10-Q 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.
 
 
1

 
PART I – FINANCIAL INFORMATION
 
ITEM 1. FINANCIAL STATEMENTS
 
INTERNAP NETWORK SERVICES CORPORATION
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
                         
   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2009
   
2008
   
2009
   
2008
 
Revenues:
                       
Internet protocol (IP) services
 
$
30,867
   
$
35,467
   
$
95,175
   
$
105,787
 
Data center services
   
33,547
     
29,932
     
97,535
     
83,990
 
Total revenues
   
64,414
     
65,399
     
192,710
     
189,777
 
Operating costs and expenses:
                               
Direct costs of network, sales and services, exclusive of depreciation and amortization shown below:
                               
IP services
   
12,047
     
12,654
     
36,844
     
38,840
 
Data center services
   
24,450
     
22,750
     
71,896
     
61,412
 
Direct costs of customer support
   
4,767
     
3,950
     
13,608
     
12,518
 
Direct costs of amortization of acquired technologies
   
979
     
3,049
     
7,370
     
5,506
 
Sales and marketing
   
5,955
     
7,394
     
20,701
     
23,934
 
General and administrative
   
10,626
     
10,713
     
35,062
     
34,579
 
Depreciation and amortization
   
7,313
     
6,146
     
20,895
     
17,226
 
Loss (gain) on disposals of property and equipment
   
20
     
     
20
     
(16
)
Goodwill impairment and restructuring
   
     
100,415
     
54,608
     
100,415
 
Total operating costs and expenses
   
66,157
     
167,071
     
261,004
     
294,414
 
Loss from operations
   
(1,743
)
   
(101,672
)
   
(68,294
)
   
(104,637
)
                                 
Non-operating expense (income)
   
170
     
(109
)
   
301
     
(724
)
                                 
Loss before income taxes and equity in (earnings) loss of equity method investment
   
(1,913
)
   
(101,563
)
   
(68,595
)
   
(103,913
)
Provision (benefit) for income taxes
   
93
     
(65
   
575
     
232
 
Equity in (earnings) loss of equity-method investment, net of taxes
   
(31
   
(93
)
   
57
     
(242
)
Net loss
 
$
(1,975
)
 
$
(101,405
)
 
$
(69,227
)
 
$
(103,903
)
                                 
Net loss per share:
                               
Basic and diluted
 
$
(0.04
)
 
$
(2.06
)
 
$
(1.41
)
 
$
(2.11
)

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
 
 
2

 
INTERNAP NETWORK SERVICES CORPORATION
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)
             
   
September 30,
2009
   
December 31,
2008
 
ASSETS
           
Current assets:
           
Cash and cash equivalents
 
$
67,798
   
$
46,870
 
Short-term investments in marketable securities
   
7,150
     
7,199
 
Accounts receivable, net of allowance for doubtful accounts of $2,525 and $2,777, respectively
   
24,064
     
28,634
 
Inventory
   
392
     
381
 
Prepaid expenses and other assets
   
7,988
     
10,866
 
Deferred tax asset, current portion, net
   
     
1
 
Total current assets
   
107,392
     
93,951
 
Property and equipment, net of accumulated depreciation of $200,819 and $185,895, respectively
   
92,524
     
97,350
 
Investments and other related assets, of which $— and $7,027, respectively, are measured at fair value
   
1,605
     
8,650
 
Intangible assets, net of accumulated amortization of $36,736 and $30,351, respectively
   
23,423
     
33,942
 
Goodwill
   
39,464
     
90,977
 
Deposits and other assets
   
2,726
     
2,763
 
Deferred tax asset, non-current, net
   
2,744
     
2,450
 
Total assets
 
$
269,878
   
$
330,083
 
                 
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Current liabilities:
               
Accounts payable
 
$
21,128
   
$
19,642
 
Accrued liabilities
   
9,413
     
8,756
 
Deferred revenues, current portion
   
4,257
     
3,710
 
Capital lease obligations, current portion
   
50
     
274
 
Restructuring liability, current portion
   
2,756
     
2,800
 
Other current liabilities
   
123
     
116
 
Total current liabilities
   
37,727
     
35,298
 
Revolving line of credit, due after one year
   
20,000
     
20,000
 
Deferred revenues, less current portion
   
2,691
     
2,248
 
Capital lease obligations, less current portion
   
3,222
     
3,244
 
Restructuring liability, less current portion
   
6,684
     
6,222
 
Deferred rent
   
15,396
     
14,114
 
Other long-term liabilities
   
668
     
762
 
Total liabilities
   
86,388
     
81,888
 
Commitments and contingencies
               
Stockholders’ equity:
               
Preferred stock, $0.001 par value, 20,000 shares authorized; no shares issued or outstanding
   
     
 
Common stock, $0.001 par value; 60,000 shares authorized; 50,705 and 50,224 shares issued, respectively
   
51
     
50
 
Additional paid-in capital
   
1,220,206
     
1,216,267
 
Treasury stock, at cost, 39 and 83 shares, respectively
   
(113
)
   
(370
)
Accumulated deficit
   
(1,036,050
)
   
(966,823
)
Accumulated other comprehensive loss
   
(604
)
   
(929
)
Total stockholders’ equity
   
183,490
     
248,195
 
Total liabilities and stockholders’ equity
 
$
269,878
   
$
330,083
 

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
 
 
3

 
INTERNAP NETWORK SERVICES CORPORATION
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
             
   
Nine Months Ended
September 30,
 
   
2009
   
2008
 
CASH FLOWS FROM OPERATING ACTIVITIES
           
Net loss
 
$
(69,227
)
 
$
(103,903
)
Adjustments to reconcile net loss to net cash provided by operating activities:
               
Goodwill and other intangible asset impairments
   
55,647
     
102,336
 
Depreciation and amortization
   
24,131
     
20,883
 
Provision for doubtful accounts
   
2,081
     
4,829
 
Equity in loss (earnings) from equity-method investment
   
57
     
(242
)
Non-cash changes in deferred rent
   
1,282
     
2,443
 
Stock-based compensation expense
   
4,434
     
6,371
 
Deferred income taxes
   
(293
)
   
271
 
Other, net
   
151
     
(48
)
Changes in operating assets and liabilities:
               
Accounts receivable
   
2,489
     
(1,037
)
Inventory
   
(11
)
   
(143
)
Prepaid expenses, deposits and other assets
   
2,897
     
(1,489
)
Accounts payable
   
1,486
     
2,987
 
Accrued and other liabilities
   
657
     
(481
)
Deferred revenue
   
990
     
(511
)
Accrued restructuring liability
   
418
     
(1,498
)
Net cash flows provided by operating activities
   
27,189
     
30,768
 
                 
CASH FLOWS FROM INVESTING ACTIVITIES
               
Purchases of property and equipment
   
(12,930
)
   
(34,063
)
Purchases of investments in marketable securities
   
     
(19,925
)
Maturities of investments in marketable securities
   
7,224
     
19,452
 
Change in restricted cash
   
     
4,120
 
Net cash flows used in investing activities
   
(5,706
)
   
(30,416
)
                 
CASH FLOWS FROM FINANCING ACTIVITIES
               
Proceeds from revolving line of credit, due after one year
   
59,000
     
 
Principal payments on revolving line of credit, due after one year
   
(59,000
)
   
 
Payments on capital lease obligations
   
(246
)
   
(601
)
Stock-based compensation plans
   
(252
)
   
78
 
Other, net
   
(87
)
   
(96
)
Net cash flows used in financing activities
   
(585
)
   
(619
)
                 
Effect of exchange rates on cash and cash equivalents
   
30
     
(177
)
                 
Net increase (decrease) in cash and cash equivalents
   
20,928
     
(444
)
Cash and cash equivalents at beginning of period
   
46,870
     
52,030
 
Cash and cash equivalents at end of period
 
$
67,798
   
$
51,586
 

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
 
 
4

 
INTERNAP NETWORK SERVICES CORPORATION
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF
STOCKHOLDERS’ EQUITY AND COMPREHENSIVE LOSS
(In thousands)
                                           
   
Common Stock
                               
   
Shares
   
Par
Value
   
Additional
Paid-In
Capital
   
Treasury
Stock
   
Accumulated
Deficit
   
Accumulated
Other
Comprehensive
Loss
   
Total
Stockholders’
Equity
 
                                           
NINE MONTHS ENDED SEPTEMBER 30, 2009:
                                         
Balance, December 31, 2008
   
50,224
   
$
50
   
$
1,216,267
   
$
(370
)
 
$
(966,823
)
 
$
(929
)
 
$
248,195
 
Net loss
   
     
     
     
     
 (69,227
)
   
     
(69,227
)
Change in unrealized gains and losses on investments, net of taxes
   
     
     
     
     
     
25
     
25
 
Foreign currency translation adjustment
   
     
     
     
     
     
300
     
300
 
Total comprehensive loss 1
                                                   
(68,902
)
Stock compensation plans activity and stock-based compensation expense
   
481
     
1
     
3,939
     
257
     
     
     
4,197
 
Balance, September 30, 2009
   
50,705
   
$
51
   
$
1,220,206
   
$
(113
)
 
$
(1,036,050
)
 
$
(604
)
 
$
183,490
 
                                                         
NINE MONTHS ENDED SEPTEMBER 30, 2008:
                                                       
Balance, December 31, 2007
   
49,759
   
$
50
   
$
1,208,191
   
$
   
$
(862,010
)
 
$
402
   
$
346,633
 
Net loss
   
     
     
     
     
(103,903
)
   
     
(103,903
)
Change in unrealized gains and losses on investments, net of taxes
   
     
     
     
     
     
(677
)
   
(677
)
Foreign currency translation adjustment
   
     
     
     
     
     
(471
)
   
(471
Total comprehensive loss 1
                                                   
(105,051
)
Stock compensation plans activity and stock-based compensation expense
   
454
     
     
6,494
     
(339
)
   
     
     
6,155
 
Balance, September 30, 2008
   
50,213
   
$
50
   
$
1,214,685
   
$
(339
)
 
$
(965,913
)
 
$
(746
)
 
$
247,737
 

 
1
Total comprehensive loss was $(2,021) and $(102,090) for the three months ended September 30, 2009 and 2008, respectively.

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
 
 
5

 
INTERNAP NETWORK SERVICES CORPORATION
UNAUDITED CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
   
1.
Nature of Operations and Basis of Presentation

Internap Network Services Corporation (“we,” “us” or “our”) delivers services through 74 Internet protocol, or IP, service points of presense, or POPs, and 49 data centers across North America, Europe and the Asia-Pacific region. Our Private Network Access Points, or P-NAPs, feature multiple direct high-speed connections to major Internet backbones, also referred to as network service providers, including AT&T Inc.; Verizon Communications Inc.; Global Crossing Limited; Level 3 Communications, Inc.; and Sprint Nextel Corporation. As described in note 2, we operate in two business segments: IP services and data center services. These segments reflect a change from our historical segments, which also included content delivery network, or CDN, services as a separate segment.

We have prepared our unaudited condensed consolidated financial statements pursuant to the rules and regulations of the Securities and Exchange Commission, or SEC, which include all of our accounts and those of our wholly owned subsidiaries. We have condensed or omitted certain information and note disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States, or U.S. GAAP, pursuant to such rules and regulations. The unaudited condensed consolidated financial statements reflect all adjustments, which consist of normal recurring adjustments, necessary for a fair statement of our financial position as of September 30, 2009 and our operating results, cash flows and changes in stockholders’ equity for the interim periods presented. We derived the balance sheet at December 31, 2008 from our audited financial statements as of that date. These financial statements and the related notes should be read in conjunction with our financial statements and notes thereto contained in our Annual Report on Form 10-K for the year ended December 31, 2008 filed with the SEC.

The preparation of financial statements in accordance with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and revenues and expenses in the financial statements. Examples of estimates subject to possible revision based upon the outcome of future events include, among others, the provision for doubtful accounts, network cost accruals, income taxes, sales, use and other taxes, recoverability of long-lived assets and goodwill, depreciation of property and equipment, the valuation of investments, restructuring allowances and stock-based compensation. Actual results could differ from those estimates.

The results of operations for the three and nine months ended September 30, 2009 are not necessarily indicative of the results that may be expected for any future periods or for the year ending December 31, 2009 or subsequent years.

In addition to reclassifications for changes in our segments, discussed in note 2 below, we also have reclassified other prior period amounts to conform to the current period presentation.
   
2.
Segments

We operate in two business segments: IP services and data center services. IP services represent our IP transit activities and include our high-performance Internet connectivity, CDN services and flow control platform, or FCP, products. Data center services primarily include physical space for hosting customers’ network and other equipment plus associated services such as redundant power and network connectivity, environmental controls and security.

During the three months ended June 30, 2009, we changed how we view and manage our business. We now operate our IP services and the majority of our CDN services on a combined basis while we operate the managed hosting portion of our CDN services as part of our data center services. The change from our historical segments reflects management’s views of the business and aligns our segments with our operational and organizational structure. We have integrated the primary components of our CDN services with our IP services in the IP services segment. This includes integration of our CDN POPs into our P-NAPs, along with combining engineering and operations teams and internal financial reporting.   In addition, a single manager reports directly to our chief executive officer for the integrated IP services. Historically, CDN services also included managed hosting, or maintaining network equipment on behalf of customers. Since these CDN services are a hosting activity, they are more similar to our data center services and therefore we have included these services in our data center services segment. We have reclassified financial information for 2008 to conform to the current period presentation.
 
 
6

 
INTERNAP NETWORK SERVICES CORPORATION
UNAUDITED CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

The following table shows operating results for our business segments, along with reconciliations from segment profit to loss before income taxes and equity in (earnings) loss of equity-method investment (in thousands):
                   
   
IP
Services
   
Data
Center
Services
   
Total
 
                   
Three Months Ended September 30, 2009:
                 
Revenues
 
$
30,867
   
$
33,547
   
$
64,414
 
Direct costs of network, sales and services, exclusive of depreciation and amortization, included below
   
12,047
     
24,450
     
36,497
 
Segment profit
 
$
18,820
   
$
9,097
     
27,917
 
Other operating expenses, including depreciation and amortization
                   
29,660
 
Loss from operations
                   
(1,743
)
Non-operating (expense)
                   
(170
Loss before income taxes and equity in (earnings) loss of equity-method investment
                 
$
(1,913
)
                         
Three Months Ended September 30, 2008:
                       
Revenues
 
$
35,467
   
$
29,932
   
$
65,399
 
Direct costs of network, sales and services, exclusive of depreciation and amortization, included below
   
12,654
     
22,750
     
35,404
 
Segment profit
 
$
22,813
   
$
7,182
     
29,995
 
Goodwill impairment and restructuring                     100,415  
Other operating expenses, including depreciation and amortization
                   
31,252
 
Loss from operations
                   
(101,672
)
Non-operating income
                   
109
 
Loss before income taxes and equity in (earnings) loss of equity-method investment
                 
$
(101,563
)
                         
Nine Months Ended September 30, 2009:
                       
Revenues
 
$
95,175
   
$
97,535
   
$
192,710
 
Direct costs of network, sales and services, exclusive of depreciation and amortization, included below
   
36,844
     
71,896
     
108,740
 
Segment profit
 
$
58,331
   
$
25,639
     
83,970
 
Goodwill impairment and restructuring                      54,608  
Other operating expenses, including depreciation and amortization
                   
97,656
 
Loss from operations
                   
(68,294
)
Non-operating (expense)
                   
(301
)
Loss before income taxes and equity in (earnings) loss of equity-method investment
                 
$
(68,595
)
                         
Nine Months Ended September 30, 2008:
                       
Revenues
 
$
105,787
   
$
83,990
   
$
189,777
 
Direct costs of network, sales and services, exclusive of depreciation and amortization, included below
   
38,840
     
61,412
     
100,252
 
Segment profit
 
$
66,947
   
$
22,578
     
89,525
 
Goodwill impairment and restructuring                     100,415  
Other operating expenses, including depreciation and amortization
                   
93,747
 
Loss from operations
                   
(104,637
)
Non-operating income
                   
724
 
Loss before income taxes and equity in (earnings) loss of equity-method investment
                 
$
(103,913
)
 
 
7

 
INTERNAP NETWORK SERVICES CORPORATION
UNAUDITED CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 
 Segment profit is segment revenues less direct costs of network, sales and services, exclusive of depreciation and amortization and does not include direct costs of customer support, direct costs of acquired technologies or any other depreciation or amortization associated with direct costs. Depreciation and amortization associated with direct costs, including amortization of acquired technologies, was $6.3 million and $8.4 million for the three months ended September 30, 2009 and 2008, respectively, and $24.1 million and $20.4 million for the nine months ended September 30, 2009 and 2008, respectively. Depreciation and amortization associated with direct costs also included impairment charges of $4.1 million for the nine months ended September 30, 2009 and $1.9 million for each of the three and nine months ended September 30, 2008. Other operating expenses including, depreciation and amortization, also included product development costs of $1.6 million and $2.1 million for the three months ended September 30, 2009 and 2008, respectively, and $5.0 million and $6.4 million for the nine months ended September 30, 2009 and 2008, respectively.

The following table presents selected segment financial information as of September 30, 2009 and December 31, 2008, related to goodwill and total assets (in thousands):
 
   
IP Services
   
Data
Center
Services
   
Total
 
                   
September 30, 2009:
                 
Goodwill
 
$
39,464
   
$
   
$
39,464
 
Total assets
   
182,053
     
87,825
     
269,878
 
                         
December 31, 2008:
                       
Goodwill
 
$
77,312
   
$
13,665
   
$
90,977
 
Total assets
   
225,382
     
104,701
     
330,083
 

Following our decision to consolidate our business segments, we completed an assessment of goodwill and other intangible assets for impairment as of June 1, 2009, which, as further discussed in note 3, resulted in aggregate impairment charges of $51.5 million for goodwill and $4.1 million for acquired developed CDN advertising technology. We subsequently reallocated the remaining goodwill of the former CDN services segment (after our June 1, 2009 impairment charge) to the IP services and the data center services segments.
   
3.
Goodwill and Other Intangible Assets

Goodwill

We test goodwill for impairment at least annually as of August 1 of each calendar year. As discussed in note 2, during the three months ended June 30, 2009, we changed how we view and manage our business. We now operate our IP services and the majority of our CDN services on a combined basis while we operate the managed hosting portion of our CDN services as part of our data center services. Our assessment of goodwill for impairment includes comparing the fair value of our reporting units to the net book value. We estimate fair value using a combination of discounted cash flow models and market approaches. If the fair value of a reporting unit exceeds its net book value, goodwill is not impaired and no further testing is necessary. If the net book value of a reporting unit exceeds its fair value, we perform a second test to measure the amount of impairment to goodwill, if any. To measure the amount of any impairment, we determine the implied fair value of goodwill in the same manner as if the affected reporting unit were being acquired in a business combination. Specifically, we allocate the fair value of the affected reporting unit to all of the assets and liabilities of that unit, including any unrecognized intangible assets, in a hypothetical calculation that would yield the implied fair value of goodwill. If the implied fair value of goodwill is less than the goodwill recorded on our balance sheet, we record an impairment charge for the difference. We did not identify an impairment as a result of the annual impairment test.

The decision to consolidate segments required acceleration of our 2009 annual impairment test of goodwill to June 1, 2009, the date we changed how we view and manage our business. As a result of our assessment using an earlier measurement date of June 1, 2009, we recorded an aggregate goodwill impairment charge of $51.5 million during the three months ended June 30, 2009. This charge included $48.0 million for goodwill related to our former CDN services segment and $3.5 million to adjust goodwill in our IP services segment related to our FCP products. We present the aggregate goodwill impairment charge in “Goodwill impairment and restructuring” in the accompanying statements of operations for the nine months ended September 30, 2009.

The goodwill impairment in our former CDN services segment was primarily due to declines in CDN services revenues and operating results compared to our expectations and declining multiples of comparable companies. The CDN services goodwill arose from our acquisition of VitalStream Holdings, Inc., or VitalStream, in February 2007, which we initially recorded at a value of $154.7 million, representing 72% of the $214.0 million purchase price. These declines in CDN services revenues and operating results were primarily attributable to continued pricing pressures, which were partially offset by traffic increases. This was combined with higher costs of sales related to traffic mix, as well as a weakened economy and steadily increasing levels of customer churn. This led to a renewed emphasis on and dedication of our internal resources within our IP services to strengthen our services offering and leverage our entire IP backbone and cost structure. Similarly, the goodwill impairment in our IP services segment was due to declines in our FCP products revenues and operating results. The declines in FCP products revenues were primarily attributable to lower sales associated with a reduced marketing effort as we reevaluated our equipment sales strategy for FCP products. The impairment charges did not impact our current cash balance or result in violation of any covenants of our debt instruments.
 
 
8

 
INTERNAP NETWORK SERVICES CORPORATION
UNAUDITED CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 
The changes in the carrying amount of goodwill for the year ended December 31, 2008 and nine months ended September 30, 2009 are as follows (in thousands):

         
Data
       
   
IP
   
Center
       
   
Services
   
Services
   
Total
 
 Balance, December 31, 2007:
                 
Goodwill
 
$
152,087
   
$
38,590
   
$
190,677
 
Impairment
   
(74,775
)
   
(24,925
)
   
(99,700
)
Subtotal
   
77,312
     
13,665
     
90,977
 
 Balance, December 31, 2008:
                       
Goodwill
   
152,087
     
38,590
     
190,677
 
Accumulated impairment losses
   
(74,775
)
   
(24,925
)
   
(99,700
)
Subtotal
   
77,312
     
13,665
     
90,977
 
Impairment
   
(37,848
)
   
(13,665
)
   
(51,513
)
Subtotal
   
39,464
     
     
39,464
 
 Balance, September 30, 2009:
                       
Goodwill
   
152,087
     
38,590
     
190,677
 
Accumulated impairment losses
   
(112,623
)
   
(38,590
)
   
(151,213
)
Total
 
$
39,464
   
$
   
$
39,464
 

The assumptions, inputs and judgments used in performing the valuation analysis are inherently subjective and reflect estimates based on known facts and circumstances at the time we perform the valuation. These estimates and assumptions primarily include, but are not limited to, the discount rate, terminal growth rate, earnings before interest, taxes, depreciation and amortization, or EBITDA, and capital expenditures forecasts. The use of different assumptions, inputs and judgments, or changes in circumstances, could materially affect the results of the valuation. Due to the inherent uncertainty involved in making these estimates, actual results could differ from our estimates. The following is a description of the valuation methodologies we used to derive the fair value of the former CDN services segment:
     
 
Income Approach : To determine fair value, we discounted the expected cash flows of the former CDN services segment and the FCP products reporting unit within the IP services segment. We calculated expected cash flows using a compounded annual revenue growth rate of approximately 20% for CDN services and 3% for FCP products, forecasting existing cost structures and considering capital reinvestment requirements. We used a discount rate of 16% for CDN services and 18% for FCP products, representing the estimated weighted average cost of capital, which reflects the overall level of inherent risk involved in the respective operations and the rate of return an outside investor could expect to earn. To estimate cash flows beyond the final year of our model, we used a terminal value and incorporated the present value of the resulting terminal value into our estimate of fair value.
     
 
Market-Based Approach : To corroborate the results of the income approach described above, we estimated the fair value of our CDN services segment and FCP products reporting unit within the IP services segment using several market-based approaches, including the enterprise value that we derive based on our stock price. We also used the guideline company method, which focuses on comparing our risk profile and growth prospects, to select reasonably similar/guideline publicly traded companies. Using the guideline company method, we selected revenue multiples below the median for our comparable companies.

We will continue to perform our annual impairment testing as of August 1 of each calendar year absent any impairment indicators or other changes that may cause more frequent analysis.
 
 
9

 
INTERNAP NETWORK SERVICES CORPORATION
UNAUDITED CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Other Intangible Assets

In conjunction with reorganizing our business segments and the associated review of our long-term financial outlook, we also performed an analysis of the potential impairment and re-assessed the remaining asset lives of other identifiable intangible assets. The analysis and re-assessment of other identifiable intangible assets resulted in:
     
 
an impairment charge of $4.1 million in acquired developed CDN advertising technology due to a strategic change in market focus,
 
a change in estimates that resulted in acceleration of amortization expense of our acquired CDN customer relationships over a shorter estimated remaining useful life (from 38 months remaining as of June 1, 2009 to 11 months) to reflect our historical churn rate for acquired CDN customers,
 
a change in estimates that resulted in acceleration of amortization expense of our acquired CDN trade names over a shorter estimated remaining useful life (from 32 months remaining as of June 1, 2009 to 17 months) to reflect the decreased value of the acquired trade names to our business, and
 
a change in estimates that resulted in acceleration of amortization expense of our CDN non-compete agreements over a shorter estimated remaining useful life (from nine months remaining as of June 1, 2009 to one month) to reflect the decreased value of the non-compete agreements to our business.

We include the impairment charge of $4.1 million for acquired developed CDN advertising technology in “Direct costs of amortization of acquired technologies” in the accompanying statements of operations. The change in estimates of remaining useful lives for certain of our intangible assets related to acquired CDN customer relationships, trade names and non-compete agreements resulted in an increase to our net loss of $1.1 million and $1.6 million, or $0.02 and $0.03 per share, for the three and nine months ended September 30, 2009, respectively. The impairment charges and changes in estimated remaining useful lives of CDN intangible assets did not impact our cash balances or result in violation of any covenants of our debt instruments. We continue to believe that our remaining intangible assets are not impaired.

The components of our amortizing intangible assets are as follows (in thousands):

   
September 30, 2009
   
December 31, 2008
 
   
Gross
Carrying
Amount
   
Accumulated
Amortization
   
Gross
Carrying
Amount
   
Accumulated
Amortization
 
                         
Technology based
 
$
35,927
   
$
(16,553
)
 
$
40,061
   
$
(13,317
)
Contract based
   
24,232
     
(20,183
)
   
24,232
     
(17,034
)
Total
 
$
60,159
   
$
(36,736
)
 
$
64,293
   
$
(30,351
)

4.
Restructuring

On March 31, 2009, we implemented a restructuring plan to reduce our workforce by 45 employees, representing 10% of our total workforce at that time. The reductions were primarily in back-office functions as well as the elimination of certain senior management positions. We recorded $0.9 million of associated non-recurring severance during the nine months ended September 30, 2009. Substantially all of these charges were cash expenditures, most of which we have paid. Following the March 2009 reduction in force, we incurred an additional $0.1 million related to two leased facilities. Due to the short remaining terms of these leases, we do not expect to earn any sublease income in future periods. All amounts related to these leases are due within the next 12 months.

During the nine months ended September 30, 2009, we reviewed and made adjustments in sublease income assumptions for certain properties included in our previously-disclosed 2007 and 2001 restructuring plans. We made the adjustments to extend the period during which we do not anticipate receiving sublease income from these properties given our belief that it will take longer to find sublease tenants and the increased availability of space in each of these markets. The related analyses were based on discounted cash flows using the same credit-adjusted risk-free rate that we used to measure the initial restructuring liability for leases that were part of the 2007 restructuring plan and undiscounted cash flows for leases that were part of the 2001 restructuring plan. The new assumptions resulted in an increase to our restructuring accrual of $2.1 million, which we recorded as an addition to restructuring expense and an increase to the related liability.
 
 
10

 
INTERNAP NETWORK SERVICES CORPORATION
UNAUDITED CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

We report all of these charges and adjustments to the restructuring liability in “Goodwill impairment and restructuring” in the accompanying statements of operations. The following table displays the activity and balances for the restructuring activity for the nine months ended September 30, 2009 (in thousands):
                               
   
December 31,
2008
Restructuring
Liability
   
Initial
Restructuring
Charges
   
Subsequent
Plan
Adjustments 1
   
Cash
Payments
   
September 30,
2009
Restructuring
Liability
 
Activity for 2009 restructuring charge:
                             
Employee separations
 
$
   
$
877
   
$
31
   
$
(818
)
 
$
90
 
Real estate obligations
   
     
129
     
5
     
(38
)
   
96
 
     
     
1,006
     
36
     
(856
)
   
186
 
                                         
Activity for 2007 restructuring charge:
                                       
Real estate obligations
   
6,276
     
     
1,693
     
(1,358
)
   
6,611
 
                                         
Activity for 2001 restructuring charge:
                                       
Real estate obligations
   
2,746
     
     
324
     
(427
)
   
2,643
 
                                         
Total
 
$
9,022
   
$
1,006
   
$
2,053
   
$
(2,641
)
 
$
9,440
 

1
Includes a reclassification of accrued liabilities and deferred rent of approximately $0.1 million related to the 2007 and 2009 restructuring plans.

5.
Stock-Based Compensation and Executive Transition

During the three and nine months ended September 30, 2009, we granted 0.2 million and 2.0 million stock options, respectively, and 0.1 million and 0.9 million shares of unvested restricted common stock, respectively. During the nine months ended September 30, 2009, these grants included 1.1 million stock options and 0.4 million shares of unvested restricted common stock granted in conjunction with annual performance evaluations. The unvested restricted common stock included reissuance of 0.2 million shares of treasury stock, having a cost of $0.6 million. We acquire shares of treasury stock from time-to-time as payment of taxes due from employees for stock-based compensation, including less than $0.1 million for both the three months ended September 30, 2009 and 2008, and $0.3 million for both the nine months ended September 30, 2009 and 2008. Total stock-based compensation was $1.1 million and $1.9 million for the three months ended September 30, 2009 and 2008, respectively, and $4.4 million and $6.4 million for the nine months ended September 30, 2009 and 2008, respectively. Stock-based compensation for the nine months ended September 30, 2009 also included $0.8 million of expense associated with the resignation of our former president and chief executive officer, which resulted in a modification of his stock options and restricted common stock, as discussed below. We use the Black-Scholes option valuation model to determine our equity-classified stock-based compensation expense.

On March 16, 2009, J. Eric Cooney became our president and chief executive officer and a member of our board of directors following the resignation of James P. DeBlasio. Mr. Cooney’s employment letter provides for (1) an annual base salary of $0.6 million, (2) a cash signing bonus of $0.3 million (under certain circumstances, Mr. Cooney will be obligated to reimburse us for one half of the signing bonus if his employment terminates prior to March 1, 2011), (3) an option to purchase 0.6 million shares of our common stock at a purchase price of $2.24, the closing price on the day of commencement of work, 25% of which will vest on March 16, 2010 and the remainder to vest in 36 equal monthly installments thereafter, (4) a new hire grant of 0.3 million shares of restricted stock, which will vest in four equal annual installments, (5) a grant of 0.2 million shares of restricted stock on each of the first and  second anniversary of his commencement of work, both such grants to vest in four equal annual installments, (6) an annual incentive bonus based upon criteria established by our board of directors, with a target level of 100% of base salary and a maximum level of 200% of base salary and (7) customary benefits including vacation. The fair value of Mr. Cooney’s stock-based compensation awards was $2.4 million, including the restricted stock that may be issued on the first and second anniversaries of his commencement of work. We record all executive transition costs with general and administrative costs and expenses in the accompanying statements of operations.

Pursuant to the terms of a separation agreement with Mr. DeBlasio, he received (1) a cash payment of $0.9 million, one half of which we paid in March 2009 and the remainder in September 2009, (2) full vesting of all equity awards previously granted to him, which had an incremental value of $0.8 million and (3) if he so elects, continued health, dental and vision insurance coverage under our group health plan until September 16, 2010. Mr. DeBlasio has until March 16, 2010 to exercise any stock options that were vested as of March 16, 2009.
 
 
11

 
INTERNAP NETWORK SERVICES CORPORATION
UNAUDITED CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 
6.
Income Taxes

At the end of each interim reporting period, we estimate the effective income tax rate expected to be applicable for the full year. We use the effective income tax rate to provide for income taxes on a year-to-date basis. We reflect the tax effect of any tax law changes and certain other discrete events in the period in which they occur.

Our overall effective income tax rate, as a percentage of pre-tax ordinary income, was less than (1%) for both the nine months ended September 30, 2009 and 2008. The nominal negative effective income tax rate was attributable to permanent tax items, including goodwill and acquired developed CDN advertising technology impairments recorded during the nine months ended September 30, 2009, along with changes in our valuation allowance, and state and United Kingdom income tax expense.

The annual effective tax rate for 2009 could change due to a number of factors including, but not limited to, our geographic profit mix between the United States, the United Kingdom and other foreign jurisdictions, enactments of new tax laws, new interpretations of existing tax law and rulings by and settlements with taxing authorities.

We continue to maintain a valuation allowance against our deferred tax assets of $131.2 million. The total deferred tax assets primarily consist of net operating loss carryforwards, particularly in the United States. We may recognize deferred tax assets in the United States and/or foreign jurisdictions in future periods when we estimate them to be realizable. Based on an analysis of our projected future pre-tax income in the United States, we do not have sufficient positive evidence for the release of our valuation allowance against our deferred tax assets in the United States within the next 12 months; therefore, we continue to maintain the full valuation allowance in the United States and all foreign jurisdictions, other than the United Kingdom. We will continue to monitor the need for a valuation allowance on the deferred tax assets in the United Kingdom. Based on historic profitability and assumptions of future earnings, we may partially or fully reserve the benefit of the United Kingdom deferred tax assets in a future period. 

For the nine months ended September 30, 2009, there were no new material uncertain tax positions. Also, we do not expect the total amount of unrecognized tax benefits to significantly increase or decrease within the next 12 months. 
   
7.
Net Loss Per Share

We compute basic net loss per share by dividing net loss attributable to our common stockholders by the weighted average number of shares of common stock outstanding, including participating securities outstanding as discussed below, during the period. We have excluded all outstanding options and unvested restricted stock awards as such securities are anti-dilutive for all periods presented.
 
On January 1, 2009, we adopted a recently-issued accounting standard related to whether instruments granted in share-based payment transactions are participating securities for calculating earnings per share. This new accounting standard causes all unvested share-based payment awards that contain non-forfeitable rights to dividends or dividend equivalents (whether paid or unpaid) to be participating securities. The new accounting standard further requires participating securities to be included in the computation of earnings per share pursuant to the two-class method. Under the two-class method, earnings (after any dividends) are allocated to common stock and participating securities to the extent that each security may share in earnings. While our unvested restricted stock awards participate in any dividends equally with common stock, no losses are attributed to the awards. Upon adoption, we adjusted all prior-period earnings per share data presented retrospectively. The adoption of this new accounting standard did not have any impact on our basic or diluted net loss per share for the three or nine months ended September 30, 2009 or 2008.

We calculated basic and diluted net loss per share for the three and nine months ended September 30, 2009, and 2008 as follows (in thousands, except per share amounts):
                         
   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2009
   
2008
   
2009
   
2008
 
Net loss and net loss available to common stockholders
 
$
(1,975
)
 
$
(101,405
)
 
$
(69,227
)
 
$
(103,903
)
Weighted average shares outstanding, basic and diluted
   
49,638
     
49,294
     
49,058
     
49,204
 
Net loss per share, basic and diluted
 
$
(0.04
)
 
$
(2.06
)
 
$
(1.41
)
 
$
(2.11
)
                                 
Total anti-dilutive securities excluded from diluted net loss per share calculation for stock-based compensation plans
   
5,258
     
3,847
     
5,258
     
3,847
 
 
 
12

 
INTERNAP NETWORK SERVICES CORPORATION
UNAUDITED CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

8.
Fair Value Measurements

 On January 1, 2008, we adopted a new accounting standard as it related to financial assets and liabilities measured on a recurring basis, and on January 1, 2009, we adopted the new standard for nonfinancial assets and liabilities that we recognize or disclose at fair value in the financial statements on a nonrecurring basis. The major categories of nonfinancial assets and liabilities that we measure at fair value include reporting units measured at fair value in the first step of a goodwill impairment test. Our adoption for measuring nonfinancial assets and liabilities beginning in 2009 did not have a material impact on our consolidated financial statements.

The new accounting standard describes a fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable, that may be used to measure fair value. The fair value hierarchy is summarized as follows:
   
 
Level 1: Quoted prices in active markets for identical assets or liabilities;
 
Level 2: Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities; and
 
Level 3: Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

We also adopted an optional accounting standard to record certain financial assets and financial liabilities at fair value. The accounting standard permitted us to choose to measure, on an instrument-by-instrument basis, many financial instruments and certain other assets and liabilities at fair value that are not currently required to be measured at fair value. We applied this optional accounting standard to rights, or the ARS Rights, from one of our investment providers to sell at par value our auction rate securities originally purchased from the investment provider at anytime during a two-year period beginning June 30, 2010. We discuss the ARS Rights below.

The following table represents the fair value hierarchy for our financial assets (cash equivalents and investments in marketable securities) measured at fair value on a recurring basis as of September 30, 2009 (in thousands):
                         
   
Level 1
   
Level 2
   
Level 3
   
Total
 
Available for sale securities:
                       
Money market funds 1
 
$
25,851
   
$
   
$
   
$
25,851
 
Trading securities:
                               
Auction rate securities 2
   
     
     
6,583
     
6,583
 
ARS Rights 2
   
     
     
567
     
567
 
Total
 
$
25,851
   
$
   
$
7,150
   
$
33,001
 

 
1
Included in “Cash and cash equivalents” in the accompanying balance sheets as of September 30, 2009 in addition to $41,947 of cash.
 
2
Included in “Short-term investments in marketable securities” in the accompanying balance sheets as of September 30, 2009.

Our Level 3 assets consist of auction rate securities and the corresponding ARS Rights. Auction rate securities are variable rate bonds tied to short-term interest rates with maturities on the face of the securities in excess of 90 days and have interest rate resets through a modified Dutch auction, at predetermined short-term intervals, usually every seven, 28 or 35 days. The securities have historically traded at par value and are callable at par value on any interest payment date at the option of the issuer. Interest received during a given period is based upon the interest rate determined through the auction process. The underlying assets of our auction rate securities are state-issued student and educational loans that are substantially backed by the federal government and carried AAA/Aaa ratings as of September 30, 2009. Although these securities are issued and rated as long-term bonds, they have historically been priced and traded as short-term instruments because of the liquidity provided through the interest rate resets.

While we continue to earn and accrue interest on our auction rate securities at contractual rates, these investments are not actively trading at the present time and therefore do not currently have a readily determinable market value. Accordingly, the estimated fair value of auction rate securities no longer approximates par value. Given that observable auction rate securities market information was not available to determine the fair value of our auction rate securities, we estimated the fair value of the auction rate securities based on a wide array of market evidence related to each security’s collateral, ratings and insurance to assess default risk, credit spread risk and downgrade risk that we believe market participants would use in pricing the securities in a current transaction. These assumptions could change significantly over time based on market conditions.

Beginning in early 2008, auctions failed to attract sufficient buyers and, as a result, the auction rate securities lost their liquidity. Accordingly, we changed the classification of the auction rate securities to non-current investments. In conjunction with our acceptance of the ARS Rights in November 2008, we changed the investment classification of our auction rate securities from available for sale to trading. As a result, we included changes in fair value in earnings in “Non-operating expense (income)” in the accompanying statements of operations. We intend to exercise the ARS Rights within the next 12 months and, therefore, have reclassified both the underlying securities and the corresponding ARS Rights from non-current to current as of September 30, 2009. The investment classification of the underlying securities and the corresponding ARS Rights continues to be trading.
 
 
13

 
INTERNAP NETWORK SERVICES CORPORATION
UNAUDITED CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

The following table summarizes changes in fair value of our Level 3 financial assets for the nine months ended September 30, 2009 (in thousands):

 
   
Auction
Rate
Securities
   
ARS
Rights
   
Total
 
Balance, December 31, 2008
   
$
6,378
   
$
649
   
$
7,027
 
Total gains or (losses) (realized/unrealized) included in earnings 1
     
205
     
(82
)
   
123
 
Balance, September 30, 2009
   
$
6,583
   
$
567
   
$
7,150
 

 
1
All gains and losses are unrealized and relate to assets still held as of September 30, 2009.

The following table summarizes our nonfinancial assets measured at fair value on a nonrecurring basis as of September 30, 2009 (in thousands):

   
Level 1
   
Level 2
   
Level 3
   
  Total
 
Goodwill
 
$
   
$
   
$
39,464
   
$
39,464
 
Other intangible assets
   
     
     
23,423
     
23,423
 
Total
 
$
   
$
   
$
62,887
   
$
62,887
 

We wrote down goodwill and other intangible assets with carrying amounts of $91.0 million and $31.1 million, respectively, to their fair values of $39.5 million and $27.0 million (before additional amortization expense of $3.6 million), respectively. We included the aggregate impairment charge of $55.6 million in the net loss for the nine months ended September 30, 2009.

Market risk associated with our variable rate revolving line of credit and fixed rate other liabilities relates to the potential negative impact to future earnings and reduction in fair value, respectively, from an increase in interest rates. The following table presents information about our revolving line of credit and other liabilities at September 30, 2009 and December 31, 2008 (in thousands):

   
As of September 30, 2009
   
As of December 31, 2008
 
   
Carrying
Amount
   
Fair Value
   
Carrying
Amount
   
Fair Value
 
Revolving line of credit
 
$
20,000
   
$
20,000
   
$
20,000
   
$
20,000
 
Other liabilities
   
791
     
826
     
878
     
897
 
Total
 
$
20,791
   
$
20,826
   
$
20,878
   
$
20,897
 

We estimate the fair values of our revolving line of credit and other liabilities based on current market rates of interest.
   
9.
Contingencies and Litigation

We currently, and from time-to-time, are involved in litigation incidental to the conduct of our business. Although we cannot ascertain the amount of liability that may result from these matters, we do not currently believe that, in the aggregate, such matters will result in liabilities material to our consolidated financial statements. 
   
10.
Recent Accounting Pronouncements
 
Recently Issued Accounting Pronouncements That We Have Adopted
 
In June 2009, the Financial Accounting Standards board (“FASB”) issued authoritative guidance codifying U.S. GAAP. While the guidance was not intended to change U.S. GAAP, it did change the way we reference these accounting principles in our unaudited condensed notes to consolidated financial statements. This guidance was effective for interim and annual reporting periods ending after September 15, 2009. Our adoption of this authoritative guidance as of September 30, 2009 changed how we reference U.S. GAAP in our disclosures.
 
 
14

 
INTERNAP NETWORK SERVICES CORPORATION
UNAUDITED CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

On January 1, 2009, we adopted new accounting guidance for business combinations as issued by the FASB. The new accounting guidance establishes principles and requirements for how an acquirer in a business combination recognizes and measures in its financial statements the identifiable assets acquired, liabilities assumed and any noncontrolling interests in the acquiree, as well as the goodwill acquired and determination of the useful life of intangible assets. The new guidance also amends provisions related to the initial recognition and measurement, subsequent measurement and accounting and disclosures for assets and liabilities arising from contingencies in business combinations. In addition, the new guidance amends the factors that an acquirer should consider in developing the renewal or extension assumptions used to determine the useful life of a recognized intangible asset. Significant changes from previous guidance resulting from this new guidance include expanded definitions of “business” and “business combination,” expanded disclosure regarding the determination of intangible asset useful lives and the elimination of the distinction between contractual and non-contractual contingencies, including initial recognition and measurement. For all business combinations (whether partial, full or step acquisitions): (1) the acquirer must record 100% of all assets and liabilities of the acquired business, including goodwill, generally at their fair values; (2) the acquirer must recognize contingent consideration at its fair value on the acquisition date; (3) for certain arrangements, the acquirer must recognize changes in fair value in earnings until settlement; and (4) the acquirer must expense acquisition-related transaction and restructuring costs rather than treat them as part of the cost of the acquisition. The new accounting guidance also establishes disclosure requirements to enable users to evaluate the nature and financial effects of the business combination. The adoption of this accounting guidance did not have a material impact on our consolidated financial statements, although it could have a material impact on any business combinations we enter into in 2009 or future periods.

On January 1, 2009, we adopted new accounting guidance as issued by the FASB for the determination of whether instruments granted in share-based payment transactions are participating securities. This guidance provides that unvested share-based payment awards that contain nonforfeitable rights to dividends are participating securities that we must include in the computation of earnings per share pursuant to the two class method. The adoption of this accounting guidance did not have an impact on net loss per share for the three or nine months ended September 30, 2009. See note 7 for additional information.

On January 1, 2009, we adopted new accounting guidance as issued by the FASB which clarifies the accounting for certain transactions and impairment considerations involving equity method investments. The adoption of this accounting guidance did not have a material impact on our consolidated financial statements.
 
On January 1, 2009, we adopted new accounting guidance as issued by the FASB which previously delayed the effective date by one year for nonfinancial assets and liabilities that we recognize or disclose at fair value in the financial statements on a non-recurring basis. The major categories of nonfinancial assets and liabilities that we measure at fair value include reporting units in the first step of a goodwill impairment test. The adoption of this accounting guidance did not have a material impact on our consolidated financial statements. See note 8 for additional information.
 
On July 1, 2009, we adopted three related sets of accounting guidance as issued by the FASB. The accounting guidance sets forth rules related to determining the fair value of financial assets and financial liabilities when the activity levels have significantly decreased in relation to the normal market, guidance related to the determination of other-than-temporary impairments to include the intent and ability of the holder as an indicator in the determination of whether an other-than-temporary impairment exists and interim disclosure requirements for the fair value of financial instruments. The adoption of the three sets of accounting guidance did not have a material impact on our consolidated financial statements.
 
On July 1, 2009, we adopted new accounting guidance related to subsequent events as issued by the FASB. The new requirement establishes the accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. It requires the disclosure of the date through which an entity has evaluated subsequent events and the basis for that date, that is, whether that date represents the date the financial statements were issued or were available to be issued. The adoption of this accounting guidance did not have a material impact on our consolidated financial statements.

Recently Issued Accounting Pronouncements That We Have Not Yet Adopted
 
In June 2009, the FASB issued new accounting guidance which amends the evaluation criteria to identify the primary beneficiary of a variable interest entity, or VIE, and requires ongoing reassessment of whether an enterprise is the primary beneficiary of the VIE. The new guidance significantly changes the consolidation rules for VIEs including the consolidation of common structures, such as joint ventures, equity method investments and collaboration arrangements. The guidance is applicable to all new and existing VIEs. The provisions of this new accounting guidance is effective for interim and annual reporting periods ending after November 15, 2009 and will become effective for us beginning in the first quarter of 2010. We are currently evaluating the impact of this accounting guidance on our consolidated financial statements.
 
 
15

 
INTERNAP NETWORK SERVICES CORPORATION
UNAUDITED CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

In September 2009, the FASB issued new accounting guidance related to revenue recognition of multiple element arrangements. The new guidance states that if vendor specific objective evidence or third party evidence for deliverables in an arrangement cannot be determined, companies will be required to develop a best estimate of the selling price to separate deliverables and allocate arrangement consideration using the relative selling price method. The accounting guidance will be applied prospectively and will become effective during the first quarter of 2011. Early adoption is allowed. We are currently evaluating the impact of this accounting guidance on our consolidated financial statements.
 
In September 2009, the FASB issued new accounting guidance related to certain revenue arrangements that include software elements. Previously, companies that sold tangible products with “more than incidental” software were required to apply software revenue recognition guidance. This guidance often delayed revenue recognition for the delivery of the tangible product. Under the new guidance, tangible products that have software components that are “essential to the functionality” of the tangible product will be excluded from the software revenue recognition guidance. The new guidance includes factors to help companies determine what is “essential to the functionality.” Software-enabled products will not be subject to other revenue recognition guidance and will likely follow the guidance for multiple deliverable arrangements issued by the FASB in September 2009, noted above. The new guidance is to be applied on a prospective basis for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with early application permitted. If a company elects earlier application and the first reporting period of adoption is not the first reporting period in the company’s fiscal year, the guidance must be applied through retrospective application from the beginning of the company’s fiscal year and the company must disclose the effect of the change to those previously reported periods. We are currently evaluating the impact of this accounting guidance on our consolidated financial statements.
 
In addition to the accounting pronouncements described above, we have adopted and considered other recent accounting pronouncements that either did not have a material effect on our consolidated financial statements or are not relevant to our business. We do not expect other recently issued accounting pronouncements that are not yet effective will have a material effect on our consolidated financial statements.
   
11.
Subsequent Events

We have evaluated all subsequent events through November 5, 2009, which represents the filing date of this Quarterly Report on Form 10-Q with the SEC, to ensure that this Form 10-Q includes appropriate disclosure of events both recognized in the financial statements as of September 30, 2009, and events which occurred subsequent to September 30, 2009 but were not recognized in the financial statements. As of November 5, 2009, there were no subsequent events which required recognition or disclosure.
 
 
16

 
INTERNAP NETWORK SERVICES CORPORATION

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with the unaudited condensed consolidated financial statements and accompanying notes provided under Part I, Item 1 of this Quarterly Report on Form 10-Q.

Overview

We are an Internet solutions company providing a suite of network optimization and delivery products and services that manage, deliver and distribute applications and content with a 100% availability service level agreement. With a global platform of data centers and managed Internet services, we help our customers innovate their business, improve service levels and lower the cost of information technology operations. These solutions, combined with progressive and proactive technical support, enable our customers to migrate business-critical applications from private to public networks.

We deliver services through 74 Internet protocol, or IP, service points of presence, or POPs, and 49 data centers across North America, Europe and the Asia-Pacific region. Our Private Network Access Points, or P-NAPs, feature multiple direct high-speed connections to major Internet backbones, also referred to as network service providers or NSPs, including AT&T Inc.; Verizon Communications Inc.; Global Crossing Limited; Level 3 Communications, Inc.; and Sprint Nextel Corporation. We operate in two business segments: IP services and data center services, as further described below and in note 2 to the accompanying consolidated financial statements. These segments reflect a change from our historical segments, which also included content delivery network, or CDN, services as a separate segment. We now operate our IP services and the majority of our CDN services on a combined basis while we operate the managed hosting portion of our CDN services as part of our data center services. We discuss the determination of and changes in our business segments below in “Segments,” along with the associated operating results for our business segments.

Our intelligent routing technology can facilitate traffic over multiple carriers, as opposed to just one carrier’s network, to ensure highly-reliable performance over the Internet. Our data center, or colocation, services allow us to expand the reach of our high performance IP services to customers who wish to take advantage of locating their network and application assets in secure, high-performance facilities. We believe that our unique managed multi-network approach provides better performance, control and reliability compared to conventional Internet connectivity alternatives. Our service level agreements guarantee performance across a broader segment of the Internet in the United States, excluding local connections, whereas providers of conventional Internet connectivity typically only guarantee performance on their own network.

We currently have approximately 3,000 customers across more than 25 metropolitan markets, serving a variety of industries, including entertainment and media, financial services, healthcare, travel, e-commerce, retail and technology.

Segments

During the three months ended June 30, 2009, we changed how we view and manage our business. We now operate our IP services and the majority of our CDN services on a combined basis while we operate the managed hosting portion of our CDN services as part of our data center services. The change from our historical segments reflects management’s views of the business and aligns our segments with our operational and organizational structure. We have integrated the primary components of our CDN services with our IP services in the IP services segment. This includes integration of our CDN POPs into our P-NAPs along with combining engineering and operations teams and internal financial reporting.   In addition, a single manager reports directly to our chief executive officer for the integrated IP services. Historically, CDN services also included managed hosting, or maintaining network equipment on behalf of customers. Since these CDN services are a hosting activity, they are more similar to our data center services, and therefore we have included these services in our data center services segment. We have reclassified financial information for 2008 to conform to the current period presentation.

IP Services . IP services represent our IP transit activities and include our high-performance Internet connectivity, CDN services and FCP products.

Our patented and patent-pending network route optimization solutions address the inherent weaknesses of the Internet, allowing enterprises to take advantage of the convenience, flexibility and reach of the Internet to connect to customers, suppliers and partners. Our solutions take into account the unique performance requirements of each business application to ensure performance as designed, without unnecessary cost. When recommending an appropriate network solution for our customers’ applications, we consider key objectives such as bandwidth capacity needed, expected bandwidth usage, location of services and cost objectives.

Our CDN services enable our customers to quickly and securely stream and distribute video, audio and software to audiences across the globe through strategically located data centers. Providing capacity-on-demand to handle large events and unanticipated traffic spikes, we deliver high-quality content regardless of audience size or geographic location.
 
 
17

 
INTERNAP NETWORK SERVICES CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Our FCP product is a premise-based intelligent routing hardware product for customers who run their own multiple network architectures, known as multi-homing. The FCP functions similarly to our P-NAP. We offer FCP as either a one-time hardware purchase or as a monthly subscription service. Sales of FCP also generate annual maintenance fees and professional service fees for installation and ongoing network configuration. This product represents less than 5% of our IP services revenue for each of the three and nine months ended September 30, 2009 and 2008.

Data Center Services . Data center services primarily include physical space for hosting customers’ network and other equipment plus associated services such as redundant power and network connectivity, environmental controls and security and the managed hosting portion of CDN services.

Our data center services allow us to expand the reach of our high performance IP services to customers who wish to take advantage of locating their network and application assets in secure, high-performance facilities. We operate data centers where customers can host their applications directly on our network to eliminate the issues associated with the quality of local connections. Data center services also enable us to have a more flexible product offering, such as bundling our high performance IP connectivity and content delivery, along with hosting customers’ applications. Our data center services provide a single source for network infrastructure, IP and security, all of which are designed to maximize solution performance while providing a more stable, dependable infrastructure, and are backed by guaranteed service levels and our team of dedicated support professionals. We also provide a managed hosting solution that leverages our IP services. With this service, our customers own and manage the software applications and content, while we provide and maintain the hardware, operating system, colocation and bandwidth.

We use a combination of facilities operated by us and by third parties, referred to as company-controlled facilities and partner sites, respectively. We offer a comprehensive solution at 49 service points, including nine locations that we operate and 40 locations operated by third parties. We charge monthly fees for data center services based on the amount of square footage and power that customers use in our facilities. We have relationships with various providers to extend our IP services into markets with high demand.

Goodwill and Other Intangible Assets

We test goodwill for impairment at least annually as of August 1 of each calendar year.  Our assessment of goodwill for impairment includes comparing the fair value of our reporting units to the net book value. We estimate fair value using a combination of discounted cash flow models and market approaches. If the fair value of a reporting unit exceeds its net book value, goodwill is not impaired and no further testing is necessary. If the net book value of a reporting unit exceeds its fair value, we perform a second test to measure the amount of impairment to goodwill, if any. To measure the amount of any impairment, we determine the implied fair value of goodwill in the same manner as if the affected reporting unit were being acquired in a business combination. Specifically, we allocate the fair value of the affected reporting unit to all of the assets and liabilities of that unit, including any unrecognized intangible assets, in a hypothetical calculation that would yield the implied fair value of goodwill. If the implied fair value of goodwill is less than the goodwill recorded on our balance sheet, we record an impairment charge for the difference. We did not identify any additional impairment as a result of the annual August 1, 2009 impairment test following our June 1, 2009 impairment, described below.

As previously discussed, during the three months ended June 30, 2009, we changed how we view and manage our business. We now operate our IP services and the majority of our CDN services on a combined basis while we operate the managed hosting portion of our CDN services as part of our data center services. The decision to consolidate segments required acceleration of our 2009 annual impairment test of goodwill to June 1, 2009, the date we changed how we view and manage our business. As a result of our assessment using an earlier measurement date of June 1, 2009, we recorded an aggregate goodwill impairment charge of $51.5 million during the three months ended June 30, 2009. This charge included $48.0 million for goodwill related to our former CDN services segment and $3.5 million to adjust goodwill in our IP services segment related to our FCP products. We present the aggregate goodwill impairment charge in “Goodwill impairment and restructuring” in the accompanying statements of operations for the nine months ended September 30, 2009.

The goodwill impairment in our former CDN services segment was primarily due to declines in CDN services revenues and operating results compared to our expectations and declining multiples of comparable companies. The CDN services goodwill arose from our acquisition of VitalStream Holdings, Inc., or VitalStream, in February 2007, which we initially recorded at a value of $154.7 million, representing 72% of the $214.0 purchase price. These declines in CDN services revenues and operating results were primarily attributable to continued pricing pressures, which were partially offset by traffic increases. This was combined with higher costs of sales related to traffic mix, as well as a weakened economy and steadily increasing levels of customer churn. This led to a renewed emphasis on and dedication of our internal resources within our IP services to strengthen our services offering and leverage our entire IP backbone and cost structure. Similarly, the goodwill impairment in our IP services segment was due to declines in our FCP products revenues and operating results. The decline in FCP products revenues was primarily attributable to lower sales associated with a reduced marketing effort as we reevaluated our equipment sales strategy for FCP products. The impairment charges did not impact our current cash balance or result in violation of any covenants of our debt instruments.
 
 
18

 
INTERNAP NETWORK SERVICES CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)
 
In conjunction with reorganizing our business segments and the associated review of our long-term financial outlook, we also performed an analysis of the potential impairment and re-assessed the remaining asset lives of other identifiable intangible assets as of June 1, 2009. The analysis and re-assessment of other identifiable intangible assets resulted in:
     
 
an impairment charge of $4.1 million in acquired developed CDN advertising technology due to a strategic change in market focus,
 
a change in estimates that resulted in acceleration of amortization expense of our acquired CDN customer relationships over a shorter estimated remaining useful life (38 months remaining as of June 1, 2009 to 11 months) to reflect our historical churn rate for acquired CDN customers,
 
a change in estimates that resulted in acceleration of amortization expense of our acquired CDN trade names over a shorter estimated remaining useful life (32 months remaining as of June 1, 2009 to 17 months) to reflect the decreased value of the acquired trade names to our business, and
 
a change in estimates that resulted in acceleration of amortization expense of our CDN non-compete agreements over a shorter estimated remaining useful life (nine months remaining as of June 1, 2009 to one month) to reflect the decreased value of the non-compete agreements to our business.

We include the impairment charge of $4.1 million for acquired developed CDN advertising technology in “Direct costs of amortization of acquired technologies” in the accompanying statements of operations. The change in estimates of remaining useful lives for certain of our intangible assets related to acquired CDN customer relationships, trade names and non-compete agreements resulted in an increase to our net loss of $1.1 million and $1.6 million, or $0.02 and $0.03 per share, for the three and nine months ended September 30, 2009, respectively. The impairment charges and changes in estimated remaining useful lives of CDN intangible assets did not impact our cash balances or result in violation of any covenants of our debt instruments. We continue to believe that our remaining intangible assets are not impaired.

Restructuring

On March 31, 2009, we implemented a restructuring plan to reduce our workforce by 45 employees, representing 10% of our total workforce at that time. The reductions were primarily in back-office functions as well as the elimination of certain senior management positions. We recorded $0.9 million of associated non-recurring severance during the nine months ended September 30, 2009. Substantially all of these charges were cash expenditures, most of which we have paid. Following the March 2009 reduction in force, we incurred an additional $0.1 million expense related to two leased facilities affected by the reduction in force. Due to the short remaining terms of these leases, we do not expect to earn any sublease income in future periods. All amounts related to these leases are due within the next 12 months.

During the nine months ended September 30, 2009, we reviewed and made adjustments in sublease income assumptions for certain properties included in our previously-disclosed 2007 and 2001 restructuring plans. We made the adjustments to extend the period during which we do not anticipate receiving sublease income from these properties given our belief that it will take longer to find sublease tenants and an increase in availability of space in each of these markets. The related analyses were based on discounted cash flows using the same credit-adjusted risk-free rate that we used to measure the initial restructuring liability for leases that were part of the 2007 restructuring plan and undiscounted cash flows for leases that were part of the 2001 restructuring plan. The new assumptions resulted in an increase to our restructuring accrual of $2.1 million, which we recorded as an addition to restructuring expense and an increase to the related liability.

Recent Accounting Pronouncements

Recent accounting pronouncements are summarized in note 10 to the accompanying consolidated financial statements.

Results of Operations

Revenues. We generate revenues primarily from the sale of IP services and data center services. Our revenues typically consist of monthly recurring revenues from contracts with terms of one year or more. These contracts usually have fixed minimum commitments based on a certain level of usage with additional charges for any usage over a specified limit. We also provide CDN services and premise-based route optimization products and other ancillary services, such as server management and installation services, virtual private networking services, managed security services, data back-up, remote storage, restoration services and professional services.
 
 
19

 
INTERNAP NETWORK SERVICES CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)
 
Direct Costs of Network, Sales and Services. Direct costs of network, sales and services are comprised primarily of:
     
 
costs for connecting to and accessing  NSPs and competitive local exchange providers;
 
facility and occupancy costs for housing and operating our and our customers’ network equipment;
 
costs of FCP products sold;
 
costs incurred for providing additional third party services to our customers; and
 
royalties and costs of license fees for operating systems software.

To the extent a network access point is located a distance from the respective Internet service provider, we may incur additional local loop charges on a recurring basis. Connectivity costs vary depending on customer demands and pricing variables while network access point facility costs are generally fixed in nature. Direct costs of network, sales and services do not include compensation, depreciation or amortization.

Direct Costs of Customer Support . Direct costs of customer support consist primarily of compensation and other personnel costs for employees engaged in connecting customers to our network, installing customer equipment into network access point facilities and servicing customers through our network operations centers. In addition, we include facilities costs associated with the network operations centers in direct costs of customer support.

Direct Costs of Amortization of Acquired Technologies. Direct costs of amortization of acquired technologies are for technologies acquired through business combinations that are an integral part of the services and products we sell. We amortize the cost of the acquired technologies over useful lives of three to eight years. The weighted average of remaining life at September 30, 2009 was approximately five years. These direct costs also include impairment of the acquired developed CDN advertising technology in the nine months ended September 30, 2009 and both the three and nine months ended September 30, 2008, as discussed below.

Sales and Marketing Costs. Sales and marketing costs consist of compensation, commissions and other costs for personnel engaged in marketing, sales and field service support functions, as well as advertising, tradeshows, direct response programs, new service point launch events, management of our external web site and other promotional costs.

General and Administrative Costs. General and administrative costs consist primarily of compensation and other expense for executive, finance, product development, human resources and administrative personnel, professional fees and other general corporate costs. General and administrative costs also include consultant fees and prototype costs related to the design, development and testing of our proprietary technology, enhancement of our network management software and development of internal systems. We capitalize costs for software to be sold, leased or otherwise marketed once we establish technological feasibility until the software is available for general release to customers. We capitalize costs associated with internal use software when the software enters the application development stage until the software is ready for its intended use. We expense all other product development costs as incurred.

Three and Nine Months Ended September 30, 2009 and 2008

Following is a summary of our results of operations and financial condition, which is followed by more in-depth discussion and analysis.
 
Total revenues were $64.4 million for the three months ended September 30, 2009, a decrease of $1.0 million, or 1.5%, compared to $65.4 million for the three months ended September 30, 2008. Data center services revenues were $33.5 million and IP services revenues were $30.9 million for the three months ended September 30, 2009. For the three months ended September 30, 2009, data center services revenues increased $3.6 million, or 12%, while IP services revenues decreased $4.6 million, or 13% compared to the same period in 2008. The decrease in IP services revenues was driven by a decline in IP pricing for new and renewing customers and the loss of older customers who paid higher effective prices, partially offset by an increase in overall traffic.
 
Total operating costs and expenses, excluding goodwill impairment and restructuring disclosed separately, were $66.2 million and $66.7 million for the three months ended September 30, 2009 and 2008, respectively. We experienced period-to-period increases in direct costs of network, sales and services for data center services and depreciation and amortization, primarily from our expansion of data center space. These increases were largely offset by lower direct costs of amortization after impairment of acquired developed CDN advertising technology as of June 1, 2009. In the three months ended September 30, 2009, we also reduced our direct costs of network, sales and services for IP services, the provision for doubtful accounts and outside professional services compared to the same period in 2008. Total operating costs and expenses also included separately disclosed goodwill impairment and restructuring of $100.4 million in each of the three and nine months ended September 30, 2008 and $54.6 million in the nine months ended September 30, 2009.
 
Our financial position and liquidity remain strong. We ended the quarter with more than $67.8 million in cash and cash equivalents and $23.3 million in debt obligations, including $3.3 million for capital leases. Net cash flows provided by operations were $27.2 million. Quarterly days sales outstanding at September 30, 2009 were 34 days, down from 40 days at December 31, 2008.
 
20

 
INTERNAP NETWORK SERVICES CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)
 
The following table sets forth, as a percentage of total revenues, selected statements of operations data for the periods indicated:
                         
   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2009
   
2008
   
2009
   
2008
 
Revenues:
                       
IP services
   
47.9
 %
   
54.2
 %
   
49.4
 %
   
55.7
 %
Data center services
   
52.1
     
45.8
     
50.6
     
44.3
 
Total revenues
   
100.0
     
100.0
     
100.0
     
100.0
 
                                 
Operating costs and expenses:
                               
Direct costs of network, sales and services, exclusive of depreciation and amortization shown below:
                               
IP services
   
18.7
     
19.4
     
19.1
     
20.5
 
Data center services
   
38.0
     
34.8
     
37.3
     
32.3
 
Direct costs of customer support
   
7.4
     
6.0
     
7.1
     
6.6
 
Direct costs of amortization of acquired technologies
   
1.5
     
4.7
     
3.8
     
2.9
 
Sales and marketing
   
9.2
     
11.3
     
10.7
     
12.6
 
General and administrative
   
16.5
     
16.4
     
18.2
     
18.2
 
Depreciation and amortization
   
11.4
     
9.4
     
10.8
     
9.1
 
Goodwill impairment and restructuring
   
0
     
153.5
     
28.3
     
52.9
 
Total operating costs and expenses
   
102.7
     
255.5
     
135.3
     
155.1
 
Loss from operations
   
(2.7
)%
   
(155.5
)%
   
(35.3
)%
   
(55.1
)%

As described above, during the three months ended June 30, 2009, we reevaluated our business segments and consolidated our business segments from three to two. The historical comparative financial information below has been reclassified to reflect the consolidation of our business segments.

IP Services . Revenues for IP services decreased $4.6 million, or 13%, to $30.9 million for the three months ended September 30, 2009, compared to $35.5 million for the same period in 2008. Revenues for IP services decreased $10.6 million, or 10%, to $95.2 million for the nine months ended September 30, 2009, compared to $105.8 million for the same period in 2008. The decrease in IP services revenues was driven by a decline in IP pricing for new and renewing customers and the loss of older customers who were paying higher effective prices, partially offset by an increase in overall traffic. There have been ongoing industry-wide pricing declines over the last several years and this trend continued during the three and nine months ended September 30, 2009. Despite price declines, we continue to experience increasing volume in our traditional IP services. IP traffic increased on average approximately 26% from the three months ended September 30, 2008 to the three months ended September 30, 2009 calculated based on a sum of the months in the respective periods. The increase in IP traffic resulted from our customers using more applications, as well as the nature of applications consuming greater amounts of bandwidth. We believe we remain well-positioned to benefit from an increasing reliance on the Internet as the medium for business applications, media distribution, communication and entertainment. IP services revenues also included FCP product and other hardware sales of $0.5 million and $1.1 million for the three months ended September 30, 2009 and 2008, respectively, and $0.8 million and $1.9 million for the nine months ended September 30, 2009 and 2008, respectively. This revenue data for FCP products does not include FCP-related services or subscription revenue.

Direct costs of IP network, sales and services, exclusive of depreciation and amortization, decreased $0.6 million, or 5%, to $12.0 million for the three months ended September 30, 2009, compared to $12.7 million for the same period in 2008. The related direct costs decreased $2.0 million, or 5%, to $36.8 million for the nine months ended September 30, 2009, compared to $38.8 million for the same period in 2008. Direct costs of IP network, sales and services were 39% and 36% of IP service revenues for the three months ended September 30, 2009 and 2008, respectively, and 39% and 37% for the nine months ended September 30, 2009 and 2008, respectively. IP services segment profit decreased $4.0 million to $18.8 million for the three months ended September 30, 2009 from $22.8 million for the same period in 2008, and decreased $8.6 million to $58.3 million for the nine months ended September 30, 2009 from $66.9 million for the same period in 2008. The increase in direct costs as a percentage of revenues and the decrease in segment profit were primarily due to lower revenue from ongoing pricing pressure as noted above. Connectivity costs vary based upon customer traffic and other demand-based pricing variables. Costs for IP services are subject to ongoing negotiations for pricing and minimum commitments. During the three and nine months ended September 30, 2009, we continued to renegotiate our agreements with our major network service providers, which included cancellation and consolidation of certain contracts that, in the aggregate, resulted in both lower minimum commitments and bandwidth rates. As our IP traffic continues to grow, we expect to realize lower bandwidth rates and more opportunities to proactively manage network costs, such as utilization and traffic optimization among network service providers.
 
 
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INTERNAP NETWORK SERVICES CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)
 
Data Center Services. Revenues for data center services increased $3.6 million, or 12%, to $33.5 million for the three months ended September 30, 2009, compared to $29.9 million for the same period in 2008. Data center services revenues increased $13.5 million, or 16%, to $97.5 million for the nine months ended September 30, 2009 from $84.0 million for the same period in 2008. During the nine months ended September 30, 2009, we completed data center expansions and upgrades in New York, Boston and Seattle.

The direct costs of data center services, exclusive of depreciation and amortization, increased $1.7 million, or 7%, to $24.5 million for the three months ended September 30, 2009 from $22.8 million for the same period in 2008. For the nine-month period, related direct costs increased $10.5 million, or 17%, to $71.9 million for the nine months ended September 30, 2009 from $61.4 million for the same period in 2008. Direct costs of data center services as a percentage of corresponding revenues decreased to 73% for the three months ended September 30, 2009 from 76% for the same period in 2008 and increased to 74% for the nine months ended September 30, 2009 from 73% for the same period in 2008. Data center services contributed $9.1 million of segment profit for the three months ended September 30, 2009, an increase of $1.9 million from $7.2 million for the same period in 2008 and increased more than $3.0 million to $25.6 million for the nine months ended September 30, 2009 from $22.6 million for the same period in 2008. 

The growth in data center revenues and direct costs of data center services largely follows our expansion of data center space. We believe the demand for data center services continues to outpace industry-wide supply and expect to continue investing in and expanding our data center business. This includes a plan that committed $50.0 million in capital expenditures over the next 12-18 months to expand our data center footprint in key markets. Direct costs of data center services, exclusive of depreciation and amortization, have substantial fixed cost components, primarily for rent, but also significant demand-based pricing variables, such as utilities, which are highest in the summer for cooling the facilities. Direct costs of data center services as a percentage of revenues vary with the mix of usage between facilities operated by us and third parties, referred to as company-controlled facilities and partner sites, respectively, as well as the occupancy of total available space. While we recognize some of the initial operating costs, especially rent, of company-controlled facilities in advance of revenues, these sites are more profitable at certain levels of occupancy than the use of partner sites. Conversely, costs in partner sites are more demand-based and therefore are more closely associated with the recognition of revenues. We expect to increase the proportion of revenues from company-controlled facilities compared to partner sites over the next several quarters. However, initial operating costs in company-controlled facilities resulted in higher direct costs as a percentage of corresponding data center services revenues for the nine months ended September 30, 2009 compared to the same period in 2008. We also expect direct costs of data center services as a percentage of corresponding data center services revenues to decrease as the recently-expanded company-controlled facilities 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 data center services revenues of 73% for the three months ended September 30, 2009 compared to 76% for the same period in 2008, especially for space added during the three months ended September 30, 2008.

Operating Expenses. Other than direct costs of network, sales and services, our compensation and facilities-related costs have the most pervasive impact on recurring operating expenses.

Compensation . Compensation and benefits comprise our next largest recurring expense after direct costs of network, sales and services. Total compensation and benefits, including stock-based, was $14.1 million and $44.9 million for the three and nine months ended September 30, 2009, respectively, compared to $14.5 million and $46.3 million for the same periods in 2008, respectively. Headcount was 397 as of September 30, 2009 compared to 430 as of September 30, 2008. The lower period-over-period headcount reflects our March 2009 reduction in force that reduced headcount by 45 employees, or 10% or our workforce at that time. As discussed in note 4 to the accompanying financial statements, the reductions were primarily in back-office functions as well as the elimination of certain senior management positions. For the three and nine months ended September 30, 2009, salaries and wages were lower by $0.5 million and $1.1 million, respectively, compared to the same periods in 2008. In the nine months ended September 30, 2009, the lower salaries and wages were offset by severance payments, including $0.9 million to our former president and chief executive officer, and a $0.3 million signing bonus paid to our new president and chief executive officer. However, severance does not include $0.9 million associated with the March 2009 reduction in force noted above. The expense for the reduction in force is recorded in the caption “Goodwill impairment and restructuring” in the accompanying financial statements. Commission expense was also lower by $0.2 million and $1.2 million for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008 primarily due to lower revenue bookings for earned commissions.
 
 
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INTERNAP NETWORK SERVICES CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)
 
Stock-based compensation decreased $0.8 million to $1.1 million for the three months ended September 30, 2009 from $1.9 million for the same period in 2008 and decreased $2.0 million to $4.4 million for the nine months ended September 30, 2009 from $6.4 million for the same period in 2008. The decreases were due to an increase in adjustments for actual and estimated forfeitures of unvested awards through employee turnover and a lower fair value for new awards based on our lower stock price. Stock-based compensation for the nine months ended September 30, 2009 also included $0.8 million related to the resignation of our former president and chief executive officer, as discussed above, which resulted in the full vesting as of March 16, 2009 of all equity awards previously granted to him. Stock-based compensation is summarized by the following financial statement captions (in thousands):
                                 
   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2009
   
2008
   
2009
   
2008
 
Direct costs of customer support
  $ 285     $ 277     $ 827     $ 1,089  
Sales and marketing
    362       448       1,102       1,396  
General and administrative
    424       1,197       2,505       3,886  
Total
  $ 1,071     $ 1,922     $ 4,434     $ 6,371  

Facilities. Facilities and related costs, including repairs and maintenance, communications and office supplies but excluding direct costs of network, sales and services, are our next largest recurring expense. These costs increased $0.1 million to $2.0 million for the three months ended September 30, 2009 from $1.9 million for the same period in 2008 and increased $0.4 million to $6.1 million for the nine months ended September 30, 2009 from $5.7 million for the same period in 2008 due to the expansion of data centers.

We further discuss additional operating expenses with the financial statement captions below.

Direct Costs of Customer Support. Direct costs of customer support increased 23% to $4.8 million for the three months ended September 30, 2009 from $3.9 million for the same period in 2008. This increase was due to a $0.4 million increase in cash-based compensation and an increase in professional services of $0.3 million. For the nine months ended September 30, 2009, direct costs of customer support increased 9% to $13.6 million from $12.5 million for the same period in 2008. This increase was primarily due to a $1.0 million increase in cash-based compensation and benefits and a $0.5 million increase in professional services, partially offset by a $0.3 million decrease in stock-based compensation and a $0.1 million decrease in training. The increase in cash-based compensation and benefits included severance related to a former vice president who was terminated separately from the March 2009 restructuring plan.

Direct Costs of Amortization of Acquired Technologies . Direct costs of amortization of acquired technologies decreased to $1.0 million for the three months ended September 30, 2009 from $3.0 million for the same period in 2008. Direct costs of amortization of acquired technologies increased to $7.4 million for the nine months ended September 30, 2009 from $5.5 million for the same period in 2008. In conjunction with consolidating our business segments, we also performed an analysis of the potential impairment and re-assessed the remaining asset lives of other identifiable intangible assets. The analysis and re-assessment of other identifiable intangible assets resulted in an impairment charge of $4.1 million as of June 1, 2009 in acquired developed CDN advertising technology due to a strategic change in market focus. We also recorded a similar impairment charge of $1.9 million as of August 1, 2008. We expect amortization expense to continue to be approximately $1.0 million each quarter, excluding the acquisition of any new technology, additional impairments or changes in estimated lives.

Sales and Marketing. Sales and marketing costs for the three months ended September 30, 2009 decreased 19% to $6.0 million from $7.4 million for the same period in 2008. For the nine months ended September 30, 2009, sales and marketing costs decreased 13% to $20.7 million from $23.9 million for the same period in 2008. The decreases in both periods were primarily due to lower sales commissions, decreased cash-based and stock-based compensation, described above, as well as a reduction in outside professional services.

General and Administrative. General and administrative costs for the three months ended September 30, 2009 decreased 1% to $10.6 million from $10.7 million for the same period in 2008. This decrease included lower stock-based compensation and the provision for doubtful accounts, partially offset by increases in cash-based compensation. For the nine months ended September 30, 2009, general and administrative costs increased 1% to $35.1 million from $34.6 million for the same period in 2008. The increase included higher outside professional services and cash-based compensation, partially offset by decreases in the provision for doubtful accounts and stock-based compensation. The increases in cash-based compensation and benefits and the decreases in stock-based compensation for both the three and nine months ended September 30, 2009 over the same periods in 2008 are discussed above in “Operating Expenses—Compensation.”
 
 
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INTERNAP NETWORK SERVICES CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)
 
The provision for doubtful accounts decreased to $0.6 million for the three months ended September 30, 2009, from $1.1 million for the same period in 2008 and decreased to $2.1 million for the nine months ended September 30, 2009, from $4.8 million for the same period in 2008. The higher provisions in 2008 were primarily attributed to our former CDN services and IP services segments. A number of the CDN customers that we reserved as doubtful accounts were customers in 2007 and early 2008, but we disconnected their service in 2008 for failing to make payment. In addition, bankruptcies of certain of our customers in the financial services industry negatively impacted IP services. We continue to place a strong emphasis on the credit worthiness of our customers and their ability to meet obligations to us. To mitigate default risk with certain new customers, we place additional upfront requirements such as prepayments or deposits before commencing delivery of our services. These recent enhancements to our credit and collection procedures have enabled us to mitigate credit and collection risk, which has resulted in reduced bad debt expense.

Professional services costs increased $2.1 million for the nine months ended September 30, 2009 compared to the same period in 2008, primarily due to the use of consultants for contract labor, process improvements and other outside services, particularly in finance and information technology, and for personnel recruiting fees. However, professional service costs decreased $0.3 million for the three months ended September 30, 2009 compared to the same period in 2008 as we reduced the number of consultants that we utilize. We continue to work to control costs related to professional services.

Depreciation and Amortization. Depreciation and amortization, including other intangible assets but excluding acquired technologies, increased 19% to $7.3 million for the three months ended September 30, 2009 from $6.1 million for the same period in 2008. For the nine months ended September 30, 2009, depreciation and amortization increased 21% to $20.9 million from $17.2 million for the same period in 2008. The increases for both periods included the effects of our recent expansion of data centers and P-NAP capabilities and the change in estimates of remaining lives for certain of our other intangible assets.

Goodwill Impairment and Restructuring.   Refer to the discussion of our goodwill impairment and restructuring costs above in “Goodwill and Other Intangible Assets” and “Restructuring,” as well as in notes 3 and 4 to the accompanying statements of operations.

Non-operating Expense (Income). For the three months ended September 30, 2009, we had non-operating expense of $0.2 million compared to income of $0.1 million for the same period in 2008. For the nine months ended September 30, 2009, we had non-operating expense of $0.3 million compared to income of $0.7 million for the same period in 2008. The decreases in both periods were primarily due to lower interest income resulting from a reduction in total interest-earning investments, a move toward lower-risk investments and lower overall interest rates.

Provision (Benefit) for Income Taxes. We recorded a provision for income taxes of $0.1 million for the three months ended September 30, 2009 and a benefit of less than $0.1 million for the same period in 2008. We recorded a provision for income taxes of $0.6 million and $0.2 million for the nine months ended September 30, 2009 and 2008, respectively. Our overall effective income tax rate, as a percentage of pre-tax ordinary income, was less than (1%) for both the nine months ended September 30, 2009 and 2008. The nominal negative effective income tax rate was attributable to permanent tax items, including goodwill and acquired developed CDN advertising technology impairments recorded during the nine months ended September 30, 2009 and 2008, along with changes in our valuation allowance, and state and United Kingdom income tax expense.

We continue to maintain a valuation allowance against our deferred tax assets of $131.2 million. The total deferred tax assets primarily consist of net operating loss carryforwards, particularly in the United States. We may recognize deferred tax assets in the United States and/or foreign jurisdictions in future periods when we estimate them to be realizable. Based on an analysis of our projected future pre-tax income in the United States, we do not have sufficient positive evidence for the release of our valuation allowance against our deferred tax assets in the United States within the next 12 months; therefore, we continue to maintain the full valuation allowance in the United States and all foreign jurisdictions, other than the United Kingdom. Based on historic profitability and assumptions of future earnings, we may partially or fully reserve the benefit of the United Kingdom deferred tax assets in a future period. 

Liquidity and Capital Resources

Cash Flow for the Nine Months Ended September 30, 2009 and 2008

Net Cash from Operating Activities.   Net cash provided by operating activities was $27.2 million for the nine months ended September 30, 2009. Our net loss, after adjustments for non-cash items, generated cash from operations of $18.3 million, while changes in operating assets and liabilities generated cash from operations of $8.9 million. We anticipate continuing to generate cash flows from our results of operations, or net loss adjusted for non-cash items. We also expect to use cash flows from operating activities and cash on hand to fund a significant portion of our capital expenditures and other requirements and to meet our other commitments and obligations, including outstanding debt, as they become due.
 
 
24

 
INTERNAP NETWORK SERVICES CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)
 
The primary non-cash adjustment in the nine months ended September 30, 2009 was $55.6 million for impairment of goodwill and other intangible assets, further discussed above in “Goodwill and Other Intangible Assets” and “Results of Operations.” Non-cash adjustments also included $24.1 million for depreciation and amortization, which included the effects of the expansion of our network and data center facilities, and $4.4 million for stock-based compensation expense, which we also discuss above in “Results of Operations.” Changes in operating assets and liabilities had a net favorable impact on cash provided by operations, particularly from accounts receivable, prepaid expenses and accounts payable. Net accounts receivable decreased $2.5 million from December 31, 2008 to September 30, 2009, primarily as a result of our focus on credit and collections and a continued focus on mitigating default risk in our customer base. Quarterly days sales outstanding at September 30, 2009 decreased to 34 days from 40 days at December 31, 2008. Prepaid expenses, deposits and other assets decreased $2.9 million from December 31, 2008 to September 30, 2009, primarily from amortization of annual prepaid insurance premiums and lower prepaid colocation expenses at our partner sites as we concentrate on selling into company-controlled facilities. Accounts payable increased $1.5 million from December 31, 2008 to September 30, 2009, primarily as a result of paying vendors at the maximum allowable contractual terms.

Net cash provided by operating activities was $30.8 million for the nine months ended September 30, 2008. Our net loss, after adjustments for non-cash items, generated cash from operations of $32.9 million while changes in operating assets and liabilities represented a use of cash from operations of $2.2 million. The primary non-cash adjustment was $102.3 million for impairment of goodwill and other intangible assets. There was also a non-cash adjustment of $20.9 million for depreciation and amortization, which included the amortizable intangible assets acquired through the acquisition of VitalStream in 2007 and the expansion of our P-NAP and data center facilities throughout 2007 and 2008. Non-cash adjustments in 2008 also included $6.4 million for stock-based compensation expense and $4.8 million for the provision for doubtful accounts. The changes in operating assets and liabilities included increases in prepaid expenses, deposits and other assets of $1.5 million, mostly due to an increase in prepaid colocation setup costs and two additional deposits for real estate leases, and a change of $1.0 million in accounts receivable due to current economic conditions, including a few customers who have filed for bankruptcy. There were also decreases in accrued restructuring, deferred revenues and accrued liabilities of $1.5 million, $0.5 million and $0.5 million, respectively. Accrued restructuring decreased due to scheduled cash payments during the nine months ended September 30, 2008. The decrease in deferred revenues was caused by less deferred revenues related to reduced sales of our FCP product and the decrease in accrued liabilities was mainly caused by lower bonus accruals. These changes were partially offset by an increase in accounts payable of $3.0 million, which was primarily caused by amounts due to vendors related to our continued expansion of data center facilities. Quarterly days sales outstanding at September 30, 2008 decreased to 45 days from 53 days at December 31, 2007. The 53 days sales outstanding at December 31, 2007 was unusually high and related to collection delays on certain larger, high credit quality customers that tended to pay over longer terms and the migration of certain former VitalStream and other customers to Internap billing and systems platforms.

Net Cash from Investing Activities. Net cash used in investing activities for the nine months ended September 30, 2009 was $5.7 million, due to capital expenditures of $13.0 million, offset by maturities of investments in marketable securities of $7.2 million. Our capital expenditures were principally for the continued expansion of our data center facilities and upgrading our network infrastructure.

Net cash used in investing activities for the nine months ended September 30, 2008 was $30.4 million, primarily due to capital expenditures of $34.1 million, offset by decreases in restricted cash of $4.1 million. Our capital expenditures were principally for the expansion of our data center facilities, CDN infrastructure and upgrading our P-NAP facilities.

Net Cash from Financing Activities. Net cash used in financing activities for the nine months ended September 30, 2009 was $0.6 million, primarily due to $0.3 million for the acquisition of shares of treasury stock as payment of taxes due from employees for stock-based compensation and payments on capital leases of $0.2 million. We also repaid and re-borrowed $59.0 million on our credit agreement to manage net interest income and expense. As a result of these activities, we had balances of $20.0 million on our revolving line of credit and $3.3 million in capital lease obligations as of September 30, 2009 with $0.1 million in the capital leases scheduled as due within the next 12 months. We may also borrow additional funds under our credit agreement if we consider it economically favorable to do so.

Net cash used in financing activities for the nine months ended September 30, 2008 was $0.6 million, primarily due to principal payments on capital leases.

Liquidity

We continue to monitor and review our performance and operations in light of the continuing negative global economic conditions. The current economic recession has negatively impacted spending by our customers, resulting in a decline in demand for our products and services. In addition, the current economic recession may make it more difficult for 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 monitor all of our investments in marketable securities to ensure, to the extent possible, that instability in liquidity and credit markets do not adversely impact the fair value of these investments. This resulted in transferring investments in corporate debt securities to money market accounts as the debt securities matured. We do not believe that the recent instability in the credit markets has or will have a material adverse effect on our liquidity or capital resources, although we continue to monitor these markets closely.
 
 
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INTERNAP NETWORK SERVICES CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)
 
We expect to meet our cash requirements for the remainder of 2009 and in 2010 through a combination of net cash provided by operating activities and existing cash, cash equivalents and short-term investments in marketable securities. This includes a plan that committed $50.0 million in capital expenditures over the next 12-18 months to grow our data center business in key markets. We may also utilize additional borrowings under our credit agreement, particularly if we consider it economically favorable to do so. Our capital requirements depend on a number of factors, including the continued market acceptance of our services and products and the ability to expand and retain our customer base. If our cash requirements vary materially from those currently planned, if our cost reduction initiatives have unanticipated adverse effects on our business or if we fail to generate sufficient cash flows from the sales of our services and products, we may require greater or 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 existing credit agreement limit our ability to incur additional indebtedness. We believe we have sufficient cash to operate our business for the foreseeable future.

We have experienced significant impairments and operational restructurings in recent years, which included substantial changes in our senior management team, streamlining our cost structure, consolidating network access points and terminating certain non-strategic real estate leases and license arrangements. We have a history of quarterly and annual net losses. For the three and nine months ended September 30, 2009, we recorded net losses of $2.0 million and $69.2 million, respectively. As of September 30, 2009, our accumulated deficit was $1,036.1 million. Our net loss for the nine months ended September 30, 2009 included $51.5 million in impairment charges for goodwill and $4.1 million in impairment charges for acquired developed CDN advertising technology, $3.1 million in restructuring charges and $2.2 million for transition of our president and chief executive officer. We do not expect to incur these charges on a regular basis, but we cannot guarantee that we will not incur other similar charges in the future or that we will be profitable in the future, due in part to the competitive and evolving nature of the industry in which we operate. Also, due to the negative global economic conditions, we have seen signs of slowdowns and cautious behavior from our customers. 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 achieve or sustain profitability on a quarterly basis, and our failure to do so would adversely affect our business, including our abilit