<PAGE>

================================================================================

                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C. 20549


                                   Form 10-Q

            [X]  QUARTERLY REPORT PURSUANT TO SECTION 13 OR
                 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

                 For The Quarterly Period Ended March 31, 2001

                                      OR

            [ ]  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:  000-26283

                             DIGITAL ISLAND, INC.
            (Exact name of Registrant as specified in its charter)

               Delaware                                  68-0322824
     (State or other jurisdiction of                 (I.R.S. Employer
     incorporation of organization)                 Identification No.)

        45 Fremont Street, 12th Floor                      94105
          San Francisco, California                     (Zip Code)
    (Address of principal executive offices)

      Registrant's telephone number, including area code: (415) 738-4100


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 [_]

As of May 11, 2001, there were 82,226,556 shares of the Registrant's Common
Stock outstanding, par value $0.001.

================================================================================
<PAGE>

                             DIGITAL ISLAND, INC.

                          Form 10-Q Quarterly Report
                     For the Quarter Ended March 31, 2001

                               TABLE OF CONTENTS

<TABLE>
<CAPTION>
                                                                                                                   Page
                                                                                                                  Number
                                                                                                              -------------
<S>                                                                                                           <C>
PART I.      Financial Information

Item 1       Financial Statements.............................................................................      3

             Condensed Consolidated Balance Sheets as of March 31, 2001 (unaudited) and
             September 30, 2000...............................................................................      3

             Condensed Consolidated Statements of Operations for the three and six months ended March 31,
             2001 and 2000 (unaudited)........................................................................      4

             Condensed Consolidated Statements of Cash Flows for the six months ended March 31, 2001 and 2000
             (unaudited)......................................................................................      5

             Notes to Condensed Consolidated Financial Statements (unaudited).................................      6

Item 2       Management's Discussion and Analysis of Financial Condition and Results of Operations............     12

Item 3       Quantitative and Qualitative Disclosures About Market Risk.......................................     16

PART II.     Other Information

Item 1       Legal Proceedings................................................................................     29

Item 2       Changes in Securities and Use of Proceeds........................................................     29

Item 3       Defaults Upon Senior Securities..................................................................     29

Item 4       Submission of Matters to a Vote of Security Holders..............................................     29

Item 5       Other Information................................................................................     29

Item 6       Exhibits and Reports on Form 8-K.................................................................     30

Signatures....................................................................................................     30
</TABLE>

                                       2
<PAGE>

                         PART I--FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

                     DIGITAL ISLAND, INC. AND SUBSIDIARIES

                     CONDENSED CONSOLIDATED BALANCE SHEETS
                (In thousands, except share and per share data)

<TABLE>
<CAPTION>
                                                                                                       March 31,       September 30,
                                                                                                         2001              2000
                                                                                                     ------------------------------
                                                 ASSETS                                                (Unaudited)
<S>                                                                                                  <C>               <C>
Current assets:
 Cash and cash equivalents....................................................................       $    197,392      $   176,929
 Investments..................................................................................             65,937          289,458
 Accounts receivable, net of allowance of $7,328 (unaudited) and $2,329, respectively.........             30,639           21,298
 Inventory....................................................................................             15,126              554
 Restricted cash..............................................................................             21,894           10,838
 Prepaid expenses and other...................................................................             23,426           22,785
                                                                                                     ------------      -----------
      Total current assets....................................................................            354,414          521,862
Property and equipment, net...................................................................            256,652          166,766
Goodwill, net.................................................................................                 --        1,119,174
Intangible assets, net........................................................................            109,881          170,080
Convertible note issuance costs...............................................................              8,598            9,695
Investments...................................................................................             76,399          124,213
Other assets..................................................................................             10,379            4,336
                                                                                                     ------------      -----------
        Total assets..........................................................................       $    816,323      $ 2,116,126
                                                                                                     ============      ===========

                     LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
 Accounts payable.............................................................................       $     44,674      $    32,325
 Accrued liabilities..........................................................................             20,696           21,852
 Capital lease obligations....................................................................             19,254           10,159
 Cash overdraft...............................................................................             10,753            8,922
 Interest payable.............................................................................              2,588            2,588
 Deferred revenue.............................................................................              1,914            2,605
                                                                                                     ------------      -----------
      Total current liabilities...............................................................             99,879           78,451
Convertible notes.............................................................................            345,000          345,000
Capital lease obligations, less current portion...............................................             13,532           10,077
Other.........................................................................................              2,021              613
                                                                                                     ------------      -----------
      Total liabilities.......................................................................            460,432          434,141
                                                                                                     ------------      -----------

Commitments and contingencies

Stockholders' equity:
 Preferred stock, $0.001 par value:
   Authorized: 10,000,000 shares; no shares issued and outstanding............................                 --               --
 Common stock, $0.001 par value:
   Authorized: 100,000,000 shares in 2001 and 2000; issued and outstanding:
        80,725,324 shares at March 31, 2001 (unaudited) and 79,683,686 shares
        at September 31, 2000.................................................................                 80               80
 Additional paid-in capital...................................................................          2,098,955        2,094,566
 Treasury stock...............................................................................               (116)              --
 Deferred compensation........................................................................             (8,225)         (13,310)
 Stockholder note receivable..................................................................             (1,625)          (2,264)
 Common stock warrants........................................................................              3,730            5,850
 Accumulated deficit..........................................................................         (1,736,908)        (402,937)
                                                                                                     ------------      -----------
      Total stockholders' equity..............................................................            355,891        1,681,985
                                                                                                     ------------      -----------
        Total liabilities and stockholders' equity............................................       $    816,323      $ 2,116,126
                                                                                                     ============      ===========
</TABLE>

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

                                       3
<PAGE>

                     DIGITAL ISLAND, INC. AND SUBSIDIARIES

                CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
                (In thousands, except share and per share data)


<TABLE>
<CAPTION>
                                                                   Three Months Ended                   Six Months Ended
                                                                       March 31,                            March 31,
                                                              -------------------------------    ------------------------------
                                                                   2001            2000              2001               2000
                                                                   ----            ----              ----               ----
                                                                (Unaudited)    (Unaudited)       (Unaudited)         (Unaudited)
<S>                                                          <C>               <C>               <C>               <C>
Revenue:
    Internet infrastructure services revenue..............   $     27,167      $     11,018      $     54,426      $     18,371
    Hosting equipment revenue.............................          5,663               311            10,044               558
                                                             ------------      ------------      ------------      ------------
  Total revenue...........................................         32,830            11,329            64,470            18,929

Cost of revenue:
 Cost of internet infrastructure services revenue
  (including non-cash compensation expense of $412, $296,
  $866 and $751, respectively)............................         42,271            23,410            85,620            39,402
 Cost of hosting equipment revenue........................          5,017               264             8,510               495
                                                             ------------      ------------      ------------      ------------
  Total cost of revenue...................................         47,288            23,674            94,130            39,897
                                                             ------------      ------------      ------------      ------------

  Gross profit (loss).....................................        (14,458)          (12,345)          (29,660)          (20,968)

Operating expenses:
 Sales and marketing (including non-cash compensation
  expense of $829, $186, $1,711 and $410, respectively)...         19,870            13,963            38,313            20,502
 Product development (including non-cash compensation
  expense of $410, $71, $845 and $157, respectively)......          9,932             4,563            19,887             7,192
 General and administrative (including non-cash
  compensation expense of $820, $75, $1,693 and $165,
  respectively)...........................................         18,195             5,701            31,772             8,757
 Depreciation.............................................         18,394             6,130            33,412             8,371
 Amortization of intangible assets........................         73,010            51,799           145,998            53,383
 Impairment of goodwill and intangible assets.............      1,039,200                --         1,039,200                --
                                                             ------------      ------------      ------------      ------------

  Total operating expenses................................      1,178,601            82,156         1,308,582            98,205
                                                             ------------      ------------      ------------      ------------

  Loss from operations....................................     (1,193,059)          (94,501)       (1,338,242)         (119,173)
                                                             ------------      ------------      ------------      ------------

Interest income...........................................          6,595             3,997            14,976             4,914
Interest expense..........................................         (5,824)           (2,162)          (11,660)           (2,382)
Other income, net.........................................            958               (43)            1,446               (43)
                                                             ------------      ------------      ------------      ------------

    Loss before income taxes..............................     (1,191,330)          (92,709)       (1,333,480)         (116,684)

Provision for income taxes................................            140                 2               491                 7
                                                             ------------      ------------      ------------      ------------

    Net loss..............................................   $ (1,191,470)     $    (92,711)     $ (1,333,971)     $   (116,691)
                                                             ============      ============      ============      ============

Basic and diluted net loss per share......................   $     (15.11)     $      (1.49)     $     (16.99)     $      (2.36)
                                                             ============      ============      ============      ============
Weighted average shares outstanding
 used in per share calculation.............................    78,838,125        62,209,533        78,522,835        49,386,278
                                                             ============      ============      ============      ============
</TABLE>

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

                                       4
<PAGE>

                     DIGITAL ISLAND, INC. AND SUBSIDIARIES

                CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                                (In thousands)

<TABLE>
<CAPTION>
                                                                                                               Six Months
                                                                                                              Ended March 31,
                                                                                                      ----------------------------

                                                                                                        2001                2000
                                                                                                        ----                ----
                                                                                                     (Unaudited)         (Unaudited)
<S>                                                                                                <C>                 <C>
Cash flows from operating activities:
 Net loss.......................................................................................   $ (1,333,971)       $   (116,691)
 Adjustments to reconcile net loss to net cash used in operating activities:....................
   Impairment of goodwill and intangible assets.................................................      1,039,200                  --
   Depreciation and amortization................................................................        180,095              61,776
   Stock compensation expense...................................................................          5,111               1,383
   Amortization of discounts on investments.....................................................         (3,199)               (986)
   Gain on disposal of property and equipment...................................................         (1,330)                 --
     Change in operating assets and liabilities, net of business acquisition....................        (16,809)            (19,413)
                                                                                                   ------------        ------------
    Net cash used in operating activities.......................................................       (130,903)            (73,931)
                                                                                                   ------------        ------------

Cash flows from investing activities:
 Purchases of property and equipment............................................................       (108,079)            (52,412)
 Proceeds from sale of property and equipment...................................................          5,351                  --
 Purchases of investments.......................................................................       (104,264)            (94,632)
 Proceeds from maturities of investments........................................................        374,931              34,454
 Increase in restricted cash....................................................................        (11,056)             (1,300)
 Purchase of intangible assets..................................................................         (4,732)                 --
 Business acquisitions, net of cash acquired....................................................             --                (543)
                                                                                                   ------------        ------------
    Net cash provided by (used in) investing activities.........................................        152,151            (114,433)
                                                                                                   ------------        ------------

Cash flows from financing activities:
 Proceeds from repayment of stockholder note....................................................            462                  90
 Proceeds from issuance of common stock, net....................................................          1,494             437,802
 Proceeds from issuance of convertible notes, net...............................................             --             334,289
 Repurchase of common stock.....................................................................           (116)                 --
 Repayments of bank borrowings..................................................................             --              (1,077)
 Repayments of capital lease obligations........................................................         (3,856)             (1,503)
 Issuance of notes to officers..................................................................           (600)                 --
 Increase in cash overdraft.....................................................................          1,831               2,490
                                                                                                   ------------        ------------
    Net provided by (used in) financing activities..............................................           (785)            772,091
                                                                                                   ------------        ------------

     Net increase in cash and cash equivalents..................................................         20,463             583,727

Cash and cash equivalents, beginning of period..................................................        176,929              43,315
                                                                                                   ------------        ------------

Cash and cash equivalents, end of period........................................................   $    197,392        $    627,042
                                                                                                   ============        ============
Supplemental schedule of non-cash investing and financing activities:
 Fixed asset acquired in exchange for stock.....................................................   $      2,889        $      5,965
                                                                                                   ============        ============
 Acquisition of subsidiaries in exchange for stock..............................................   $         --        $  1,033,516
                                                                                                   ============        ============
 Capital lease obligations for equipment........................................................   $     16,406        $      6,977
                                                                                                   ============        ============
 Warrants issued in exchange for services.......................................................   $         --        $      1,530
                                                                                                   ============        ============
</TABLE>

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

                                       5
<PAGE>

                     DIGITAL ISLAND, INC. AND SUBSIDIARIES

       NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)


1.   Basis of Presentation

     The accompanying consolidated financial statements of the Company include
the accounts of Digital Island, Inc. and its wholly-owned subsidiaries, Digital
Island (Belgium) SPRL, Digital Island France SAS, Digital Island (Germany) GmbH,
Digital Island (Hong Kong), Ltd., Digital Island Management (Ireland) Ltd.,
Digital Island (Japan) KK, Digital Island (Netherlands) B.V., Digital Island
(Sweden) AB, Digital Island (Switzerland) SA and Digital Island (United Kingdom)
Ltd. (collectively, "Digital Island" or the "Company"). The Company's wholly-
owned subsidiaries, Live On Line, Inc., Sandpiper Networks, Inc. and SoftAware,
Inc., were merged into Digital Island on March 5, 2001, February 2, 2001 and
February 2, 2001, respectively, pursuant to short-form mergers under the
Internal Revenue Service Code Section 368. All intercompany accounts and
transactions are eliminated in the accompanying condensed consolidated financial
statements.

     The interim financial data as of March 31, 2001 and for the three and six
months ended March 31, 2001 and 2000 is unaudited; however in the opinion of
management, the condensed consolidated financial statements reflect all
adjustments which are normal and recurring that are necessary for a fair
statement of the results for the periods shown. The results of operations for
such periods are not necessarily indicative of the results expected for the full
fiscal year or for any future period.

     Certain reclassifications have been made to the prior year balances in
order to conform to the current year presentation.

     Since inception, the Company has incurred net losses and experienced
negative cash flow from operations.  The Company's ability to achieve
profitability and positive cash flow from operations will be dependent upon its
ability to grow its revenues substantially and achieve other operating
efficiencies.  The execution of the Company's business plan will require
substantial additional capital to fund its operating losses, working capital
leases, sales and marketing expenses, lease payments and capital expenditures.
The Company intends to consider its future financing alternatives, which may
include the incurrence of indebtedness, additional public or private equity
offerings or an equity investment by potential strategic partners.

2.   Acquisitions

     On December 28, 1999, the Company merged with Sandpiper Networks, Inc.
("Sandpiper"). The acquisition price included approximately 24.6 million shares
of the Company's common stock with a fair market value of $857.0 million, 3.1
million vested and unvested stock options and warrants with a fair market value
of $96.6 million and direct transaction costs of $14.0 million. The transaction
was accounted for as a purchase and resulted in intangible assets of $2.0
million of assembled workforce, $121.1 million of core technology and $850.8
million of goodwill.

     On January 18, 2000, the Company acquired Live On Line, Inc. ("Live On
Line"). The acquisition price included 799,989 shares of the Company's common
stock with a fair market value of $65.9 million and $5.2 million in cash. The
transaction was accounted for as a purchase and resulted in intangible assets of
$500,000 of assembled workforce, $3.1 million of core technology and $67.4
million of goodwill. Had the acquisition occurred at the beginning of the fiscal
year in which the acquisition was completed, combined pro forma revenue and net
income would not have been materially different from that currently being
reported.

     On September 15, 2000, the Company acquired SoftAware, Inc. ("SoftAware").
The acquisition price included 9,301,892 shares of the Company's common stock
with a fair market value of $390.5 million, 73,108 vested and unvested stock
options with a fair market value of $3.0 million, $20.0 million in cash and
estimated direct transaction costs of approximately $5.2 million. The fair value
of the common stock options was estimated using the value of the underlying
common stock of $41.98, risk-free interest rate of 5.8%, expected life of 4.5
years, expected dividend rate of 0% and volatility rate of 205%. The transaction
was accounted for as a purchase and resulted in intangible assets of $44.0
million of customer relationship, $10.3 million of software and technology, $2.1
million of assembled workforce, $3.4 million of trademarks and tradenames,
$343.2 million of goodwill and $11.9 million of deferred compensation. Deferred
compensation

                                       6
<PAGE>

will be amortized over the remaining vesting terms of the related unvested
common shares and unvested options using the amortization method under FIN 28.

     In March 2001, the Company recorded a $1,039.2 million impairment charge
upon performing an assessment of the goodwill and identifiable intangible assets
recorded in the acquisitions of Sandpiper, Live On Line and SoftAware.  (See
Note 9.)  The remaining intangible assets will be amortized over their estimated
useful lives of 5 years.

     The following unaudited pro forma combined summary financial information is
based on the historical consolidated results of operations of the Company,
Sandpiper, and SoftAware as if the Sandpiper and SoftAware acquisitions had
occurred as of the beginning of the six-month period presented October 1, 1999.
This pro forma financial information is presented for informational purposes
only and may not be indicative of what the actual consolidated results of
operations would have been if the acquisitions had been effective as of the
beginning of the six-month period presented October 1, 1999. Pro forma
adjustments were applied to the respective historical financial statements to
account for the Sandpiper and SoftAware acquisitions as purchases.

          Pro Forma - Six Months Ended March 31, 2000
          (in thousands, except per share amounts)
          -------------------------------------------------------------------
          Revenues..........................................    $    27,465
          Loss from operations..............................    $  (319,437)
          Net loss..........................................    $  (317,035)
          Basic and diluted loss per share..................    $     (3.99)

3.   Property and Equipment:

     Property and equipment consists of the following (in thousands):

<TABLE>
<CAPTION>
                                                                                         March 31,      September 30,
                                                                                           2001             2000
                                                                                    ------------------------------------
          <S>                                                                         <C>               <C>
          Network equipment and technology..........................................     $ 86,257         $ 66,180
          Communications equipment..................................................        3,880            2,826
          Computer equipment and software...........................................       57,922           40,265
          Furniture, fixtures, and leasehold improvements...........................      117,665           59,262
          Indefeasible right of use agreements......................................        9,098                -
          Equipment and fixtures under capital leases...............................       46,171           29,916
                                                                                         --------         --------
                                                                                          320,993          198,449
          Less accumulated depreciation and amortization............................       64,341           31,683
                                                                                         --------         --------
          Total property and equipment, net.........................................     $256,652         $166,766
                                                                                         --------         --------
</TABLE>

     The Company has recently begun a program of obtaining bandwidth under
indefeasible-right-of-use (IRU) agreements. Under the terms of the agreements,
the Company will have the authority to utilize certain capacity for a defined
number of years ranging from 15-25 years in duration. Full payment is made at
the beginning of the agreement in exchange for the right of usage, which will be
amortized to cost of revenue over the respective terms of the agreements.

4.   Contingencies and Commitments

Carrier Line Agreements:

     The Company has entered into various bandwidth capacity agreements with
domestic and foreign carriers. The agreements are generally cancelable and
provide for termination fees if canceled by the Company prior to expiration. The
cancellation clauses have not been routinely enforced by the carriers in the
past. The Company canceled a number of these agreements during the quarter ended
March 31, 2001. However, the termination fees for these agreements are subject
to negotiation and due to the early stage of negotiations, the estimated loss
related to cancellation of the agreements cannot reasonably be determined. The
Company has therefore not recorded any liability in connection with this
contingency.

Litigation:

     On September 13, 2000, Akamai Technologies, Inc. ("Akamai") and the
Massachusetts Institute of Technology ("MIT") filed a Complaint in the U.S.
District Court of Massachusetts (No. 00ev1181RWZ) alleging that the Company
infringes U.S. Patent No. 6,108,703 (the 703 Patent). Based on a preliminary
investigation, the Company believes that it has

                                       7
<PAGE>

meritorious defenses to Akamai and MIT's claim and intends to vigorously defend
itself in any litigation that arises from this claim. In addition, because the
Company believes that it was the first to invent the technologies claimed in the
703 Patent, it has instituted proceedings with the U.S. Patent and Trademark
Office (the "PTO") to confirm its ownership of any such inventions (the
"Interference Action").

     On September 20, 2000, Akamai filed a Motion in the U.S. District Court of
Massachusetts requesting Leave to File A Second Amended Complaint in which it
alleges that the Company infringes U.S. Patent No. 6,003,030 (the "030 Patent"),
which Motion was granted by the Court. Based on a preliminary investigation, the
Company believes that it has meritorious defenses to Akamai's claim and intends
to vigorously defend itself in any litigation that arises from this claim. On
October 18, 2000 Akamai and MIT filed a Motion in the U.S. District Court of
Massachusetts requesting that the Company be enjoined from offering for sale its
Footprint 2.0 content delivery service. On March 28, 2001, Akamai's Motion was
denied. On April 23, 2001, the Company filed a Motion seeking Summary Judgment
with respect to its non-infringement of the 030 Patent. Based on confirmation
from the PTO that our claims are in condition for allowance, on May 14, 2001,
the Company filed a motion seeking to stay further proceedings in this case
until the PTO has formally declared an interference.

     On September 21, 2000, Akamai filed a Compliant in the U.S. District Court,
Northern District of California, alleging that the Company's distribution of
certain marketing materials constituted False Advertising, Unfair Competition,
Intentional Interference With Contractual Relationships and Intentional
Interference With Prospective Business Advantage and requesting, among other
things, a Temporary Restraining Order prohibiting the Company from disseminating
the materials at issue and publicly commenting on certain related issues. Based
on a preliminary investigation, the Company believes that it has meritorious
defenses to Akamai's claims and intends to vigorously defend itself in any
litigation that arises from these claims. On October 13, 2000, the Court denied
Akamai's request for a Temporary Restraining Order. On October 26, 2000, the
Company filed counterclaims in this case for equitable relief and damages,
alleging that Akamai's distribution of certain marketing material constituted
false advertising, unfair competition, interference with contract and
interference with prospective economic relationships.

     The Company and SRI International ("SRI") are involved in a contract
dispute relating to the timing of the issuance and registration of the shares
issued to SRI as consideration for technology and related patent and consulting
services purchased by the Company under the Technology Purchase Agreement and
Research Alliance dated November 22, 1999 (the "SRI Agreement"). SRI asserts
that it is owed an additional $2.4 million of Common Stock. The Company believes
that it has meritorious defenses to SRI's claims. As required by the SRI
Agreement, the parties intend to submit the matter to mediation and if that
process is unsuccessful, to binding arbitration. This dispute has not affected,
and the Company does not believe that it will affect, our research alliance with
SRI.

5.  Calculation of Net Loss Per Share

     Shares used in computing basic and diluted net loss per share are based on
the weighted average shares outstanding in each period. The effect of
outstanding stock options and warrants is excluded from the calculation of
diluted net loss per share as their inclusion would be antidilutive.

     The following is a reconciliation of the numerator and denominator of the
basic and diluted earnings per share (EPS) calculation (in thousands, except for
share and per share amounts):

<TABLE>
<CAPTION>
                                                                  Three Months Ended            Six Months Ended
                                                                       March 31,                    March 31,
                                                              ------------------------------------------------------

                                                                  2001          2000           2001          2000
                                                                  ----          ----           ----          ----
                                                               (Unaudited)    (Unaudited)    (Unaudited)  (Unaudited)
<S>                                                            <C>           <C>            <C>           <C>
Numerator--Basic and Diluted EPS
 Net Loss.................................................     $(1,191,470)  $   (92,711)   $(1,333,971)  $  (116,691)
                                                               ===========   ===========    ===========   ===========
Denominator--Basic and Diluted EPS
 Weighted average Common Stock outstanding................      80,548,048    63,784,282     80,237,487    50,186,509
 Common Stock subject to repurchase.......................      (1,709,923)   (1,574,749)    (1,714,652)     (800,231)
                                                               -----------   -----------    -----------   -----------
 Total weighted average Common Stock outstanding..........      78,838,125    62,209,533     78,522,835    49,386,278
                                                               ===========   ===========    ===========   ===========
Basic and diluted loss per share..........................     $    (15.11)  $     (1.49)   $    (16.99)  $     (2.36)
                                                               ===========   ===========    ===========   ===========
</TABLE>

     Diluted net loss per share for the three and six months ended March 31,
2001 and 2000 does not include the effect of 13,157,858 and 7,545,207 stock
options, respectively, or 120,393 and 26,817 common stock warrants,
respectively, as the effect of their inclusion is antidilutive during each
period.

                                       8
<PAGE>

6.  Segment Reporting


     The Company has determined that its reportable segments are those that are
based on the Company's method of internal reporting, which disaggregates its
business by product category. The Company's reportable segments are network
services, hosting services, and content delivery. Application services and
professional services are reflected in an "all other" category. Network services
include the use of the Company's dedicated private network to transport e-
Business applications. Hosting services include solutions that provide companies
with outsourced Web hosting, including server management. Content delivery
includes the use of Footprint, our global content delivery network, which moves
all types of rich media content closer to its end-users around the globe.
Application services consist of a portfolio of tools, including TraceWare and
VistaWare, used to improve deployment, local relevance, security and scale of
Internet applications. Professional services both integrate with and extend the
standard product offerings to customize the products to a customer's specific
needs. The Company evaluates the performance of its operating segments based on
revenue and gross profit. Accordingly, the Company does not include sales and
marketing expenses, product development expenses, general and administrative
expenses, depreciation expense, amortization expense, interest income (expense),
other income (expense), and income tax expense in segment profitability. The
table below presents financial information for the reportable segments:

<TABLE>
<CAPTION>
                                                               Network        Hosting       Content
                                                              Services        Services      Delivery    All Other    Total
                                                                                  (in thousands)
<S>                                                            <C>           <C>           <C>          <C>       <C>
Three Months Ended March 31, 2001
Revenues..............................................         $ 3,511       $ 16,942      $ 10,946     $ 1,431   $ 32,830
Gross profit..........................................             471         (6,531)       (8,074)       (324)   (14,458)
Three Months Ended March 31, 2000
Revenues..............................................           1,259          4,018         5,210         842     11,329
Gross profit..........................................          (1,685)        (2,211)       (7,271)     (1,178)   (12,345)

Six Months Ended March 31, 2001
Revenues..............................................           6,504         32,393        22,151       3,422     64,470
Gross profit..........................................             668        (12,897)      (17,720)        289    (29,660)
Six Months Ended March 31, 2000
Revenues..............................................           2,542          6,713         8,629       1,045     18,929
Gross profit..........................................          (2,567)        (3,169)      (14,257)       (975)   (20,968)
</TABLE>

Asset information by reportable segment is not reported, since the Company does
not produce such information internally.

Revenues by geographic area are as follows (in thousands):

<TABLE>
<CAPTION>
                                                                      Three Months Ended               Six Months Ended
                                                                            March 31,                       March 31,
                                                                     -----------------------------------------------------
                                                                       2001            2000            2001          2000
                                                                       ----            ----            ----          ----
<S>                                                                   <C>            <C>             <C>           <C>
Revenues:
  United States...............................................        $29,407        $ 9,279         $57,345       $15,689
  Foreign.....................................................          3,423          2,050           7,125         3,240
                                                                      -------        -------         -------       -------
Total.........................................................        $32,830        $11,329         $64,470       $18,929
                                                                      =======        =======         =======       =======
</TABLE>

Property and equipment, net by geographic area are as follows (in thousands):


                                          March 31,     September 30,
                                            2001            2000
                                          ---------------------------

Property and equipment, net:
  United States.......................    $198,915        $140,649
  Foreign.............................      57,737          26,117
                                          --------        --------
Total.................................    $256,652        $166,766
                                          ========        ========

7.  Purchase of Technology

                                       9
<PAGE>

     In November 1999, the Company agreed to purchase certain patented
technology from SRI International (SRI). Under the terms of the technology
purchase agreement, the Company acquired the technology in exchange for $6.0
million of common stock, which was issued in November 1999. In addition, the
Company agreed to issue $4.0 million of common stock in exchange for consulting
services to incorporate and integrate the purchased technology from SRI, of
which shares valued at $2.0 million were issued in August 2000. In November
2000, January 2001 and February 2001, the Company issued 338,627, 103,081 and
97,103 shares of common stock, respectively, with values of $2.0 million,
$490,000 and $413,000, respectively, to SRI International pursuant to the terms
of these agreements. The value of stock issued under the agreement is recorded
as network equipment and technology.

8.   Related Party Transactions

     In November 2000, the Company loaned an executive officer of the Company
$600,000 through the execution of two promissory notes. The first promissory
note is for $150,000 and accrues interest at 8% per annum. The first principal
payment of $100,000 is due upon the sale of the officer's previous residence.
The final principal payment, together with accrued interest is due in November
2001. The second promissory note is for $450,000 and accrues interest at 8% per
annum. Principal payments commence in November 2002 on a monthly basis until the
final payment date in November 2004. The proceeds of the loan are collateralized
by the officer's principal residence.

     In December 2000, the Company forgave $109,333 of a loan made to an
executive officer on June 14, 1999.  The original proceeds of the promissory
note were intended to finance the tax liability associated with the exercise of
stock options. The remaining balance of the June 14, 1999 promissory note from
the officer was $18,667 as of March 31, 2001.


9.   Impairment of Intangible Assets

     During the quarter ended March 31, 2001, management performed an impairment
assessment of the goodwill and identifiable intangible assets recorded upon the
acquisitions of Sandpiper Networks, Live On Line and SoftAware, which were
completed in December 1999, January 2000 and September 2000, respectively. The
assessment was performed primarily due to the significant decline in stock price
since the date the shares issued in each acquisition were valued. As a result of
this review, management recorded a $1,039.2 million impairment charge to reduce
goodwill and acquisition-related intangible assets. The charge was determined as
the excess of the carrying value of the assets over the related estimated
discounted cash flows. After the impairment charge, the net book value of
goodwill and acquisition-related identifiable intangible assets as of March 31,
2001 was $0 and $106.0 million, respectively.


10.  Recently Issued Accounting Pronouncements

     In December 1999, the Securities Exchange Commission issued Staff
Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB
101"). SAB 101 is effective no later than the quarter ended September 30, 2001.
The Company has adopted SAB 101 and has determined that it has no material
effect on its consolidated results of operations or financial position.


11.  Subsequent Events

     On April 3, 2001, the Company's stockholders approved an amendment to the
Company's Amended and Restated Certificate of Incorporation to increase the
authorized number of shares of Common Stock of the Company from 100 million to
200 million shares.

     On April 6, 2001, the Company issued additional stock options to all
employees under the level of Vice President. The Company granted eligible
employees a new option to purchase shares of Digital Island's common stock at
$1.281 per share, the market price of the Company's common stock on the date of
grant. The number of options granted

                                       10
<PAGE>

was equal to 40% of the number of unexercised options held by each employee
that had an exercise price equal to $10 or more. The new options will vest over
a two-year period after the grant date. The new option grants are in addition
to, rather than a replacement of, those outstanding options held by employees.

     On April 24, 2001, the Company issued 1,339,916 shares of its common stock
to certain members of its senior management team in exchange for 3,108,750
unexercised options to purchase common stock of the Company held by those
individuals. The common stock vests in a series of installments over a 3-year
period of continued service with the Company. The Company recorded deferred
compensation of $3.1 million for the issuance of the restricted stock, which
will be amortized to expense over the vesting term of the restricted stock.

                                       11
<PAGE>

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

Forward-Looking Statements

     THE FOLLOWING DISCUSSION OF THE FINANCIAL CONDITION AND RESULTS OF
OPERATIONS OF DIGITAL ISLAND CONTAINS FORWARD-LOOKING STATEMENTS WITHIN THE
MEANING OF SECTION 27A OF THE SECURITIES ACT OF 1933, AS AMENDED, AND SECTION
21E OF THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED. DIGITAL ISLAND'S ACTUAL
RESULTS AND THE TIMING OF CERTAIN EVENTS COULD DIFFER MATERIALLY FROM THOSE
ANTICIPATED IN THESE FORWARD-LOOKING STATEMENTS AS A RESULT OF CERTAIN FACTORS,
INCLUDING, BUT NOT LIMITED TO, THOSE SET FORTH UNDER "RISK FACTORS" AND
ELSEWHERE IN THIS QUARTERLY REPORT AND IN OTHER DOCUMENTS FILED BY DIGITAL
ISLAND WITH THE SECURITIES AND EXCHANGE COMMISSION.

Overview

     We provide a global e-Business delivery network and suite of services for
enterprises that use the Internet to deploy critical business applications and
conduct e-commerce worldwide. We offer a managed Internet infrastructure that
integrates content delivery, hosting, intelligent networking and applications
services. We target global enterprises that increasingly rely on the Internet to
conduct business, but are constrained by the unreliability, slow performance and
limited range of functions of the public Internet. Our customers use our
services and proprietary technology to facilitate the deployment of a wide
variety of electronic commerce applications, including online marketing and
sales, customer service, fulfillment, software, document and multimedia
distribution and online training. As of March 31, 2001, we had contracts with
881 customers, of which 797 were deployed, including ABN AMRO, America Online,
Autodesk, Blue Mountain, BMG Entertainment, British Sky Broadcasting, Charles
Schwab & Co., Cisco Systems, CNBC.com, E*TRADE, FT.com, Glaxo Wellcome, Hewlett-
Packard, Intuit, JP Morgan Chase, Microsoft, National Semiconductor, Reuters,
Sony Entertainment, UBS Warburg and Universal Music Group.

     Since inception, we have incurred net losses and experienced negative cash
flow from operations. We expect to continue to operate at a net loss and to
experience negative cash flows at least into fiscal year 2002. At present, we
believe we have sufficient resources to fund our operations through June 2002.
Our ability to achieve profitability and positive cash flow from operations will
be dependent upon our ability to grow our revenues substantially and achieve
other operating efficiencies.

      We derive our revenues from a suite of services, which include content
delivery, hosting, sale of hosting equipment, intelligent networking,
professional services and application services. We currently sell the majority
of our services under contracts with terms of one or more years. Revenues are
comprised primarily of bandwidth charges, equipment co-location and storage
fees, professional services, streaming events, equipment sales and one-time fees
for installation if required to provide services. Bandwidth charges are billed
and recognized monthly based on customer usage. Professional services and fees
for streaming events are billed and recognized as the related services are
performed. Equipment sales are recognized when the equipment is delivered. All
other revenues are based on flat-rate monthly charges and recognized as the
related services are performed. Installation fees are generally paid in advance,
and are recognized ratably over the term of the related contract, generally one
to three years.

     Cost of revenues consists primarily of the cost of contracting for lines
from telecommunication service providers worldwide and the cost of our network
and data center operations. We lease lines under contracts of varying terms. The
leasing of transoceanic lines comprises the largest component of our
telecommunications expense, with additional costs arising from leasing local
circuits between our data centers and points of presence in the United States
and international markets. In the future, we expect to increase the size and
number of circuits leased based on increases in network volume and geographic
expansion. We have recently begun a program of obtaining bandwidth under
indefeasible-right-of-use ("IRU") agreements, replacing circuit leases. Under
the terms of the majority of the agreements, we enter into a capital lease and
will have the exclusive use of a specified portion of a specific fiber cable for
a defined number of years ranging from 15-25 years in duration. Payment for such
contracts is made at the beginning of the contract and recorded as an owned
asset, which will be amortized to depreciation expense over the respective terms
of the agreements. Over the term of the agreements, we expect to pay less than
we would have paid under the lease contracts that we currently have. We expect
the use of IRU agreements to increase the gross profit margins in our
Intelligent Networking business by reducing the overall cost of bandwidth. The
cost of our network and data center operations is comprised primarily of data
centers, equipment maintenance, personnel and related costs associated with the
management and maintenance of the network.

                                       12
<PAGE>

     Due to an increase in contracted customers from March 31, 2000 to March 31,
2001, both revenues and cost of revenues have increased significantly over the
course of the year. However, gross margin percentages improved 65 percentage
points from both the three months ended March 31, 2000 to the three months ended
March 31, 2001 and the six months ended March 31, 2000 to the six months ended
March 31, 2001 as a result of the increased utilization of our network, data
centers and content delivery infrastructure. We expect the increases in revenues
and cost of revenues to continue in absolute dollar terms in future quarters.
Our cost of revenues consists of many fixed costs related to the build-out of
our infrastructure. Therefore, as the utilization of our existing network, data
centers and content delivery infrastructure continues to increase, we expect a
corresponding increase in our gross margin.

     Our operating expenses, specifically sales and marketing, product
development and general and administrative expenses, have increased
significantly from the prior year periods as our business has grown.  Although
we do not expect large fluctuations in these operating expenses from quarter to
quarter, we do anticipate a decrease in expenses as a percentage of revenue.  A
portion of these expenses is variable in nature and will increase with the
anticipated increase in revenues.  However, we are implementing cost reduction
plans to maintain a path towards profitability.  We have announced a total
headcount reduction and consolidation of regional sites as part of these cost
reduction measures.  Although these cost reduction plans will not have an
immediate impact on our expenses, we expect the effects will be felt in future
quarters.

     The recent economic slowdown has adversely impacted the high technology
industry and has generally affected small and medium size companies in that
industry to a greater degree. Although our customer base includes some of these
small and medium size companies, the majority of our revenues are derived from
our large enterprise customers. As with many companies in the high technology
industry, we have suffered a depressed stock price and an increase in the aging
of our receivables. We have taken additional provisions for bad debt, which
resulted in an overall decrease to our days sales in accounts receivable.

     The following discussion comparing our historical results of operations
does not reflect the results of operations of SoftAware for the three months and
six months ended March 31, 2000 and only reflects the results of operations of
Sandpiper from December 28, 1999 and the results of operations of Live On Line
from January 18, 2000, the dates of the respective acquisitions.  SoftAware was
acquired on September 15, 2000.

Results of Operations

Three Months Ended March 31, 2001 and 2000

     Revenue. Revenue increased to $32.8 million for the three months ended
March 31, 2001 from $11.3 million for the three months ended March 31, 2000.
Increases in usage per customer and in the number of deployed customers to 797
from 194 drove revenues to increase in all of the Company's product categories.
Specifically, revenue from Network Services increased by $2.3 million, Hosting
services by $12.9 million, Content Delivery by $5.7 million and Application and
Professional Services by $589,000. Revenue derived from the sale of hosting
equipment, included in the Hosting services product category, increased $5.4
million due to an increase in the volume of equipment sales.

     Cost of Revenue. Cost of revenue increased to $47.3 million for the three
months ended March 31, 2001 from $23.7 million for the three months ended March
31, 2000. The increase in cost of revenue was due to $8.0 million of spending
for additional network capacity, $4.8 million in recruitment and compensation
costs relating to the addition of network and data center operations personnel,
$6.0 million in additional costs associated with expansion of existing data
center facilities and the deployment of the San Jose and Japan data center
facilities and $4.8 million of equipment-related costs.

     Sales and Marketing. Sales and marketing expenses increased to $19.9
million for the three months ended March 31, 2001 from $14.0 million for the
three months ended March 31, 2000. This increase was due to $7.1 million of
growth in personnel and related costs offset by a decrease of $1.2 million of
advertising, promotions and other marketing program expenses.

     Product Development. Product development expenses increased to $9.9 million
for the three months ended March 31, 2001 from $4.6 million for the three months
ended March 31, 2000. This increase was due to $4.5 million in growth of
personnel and related costs and $0.8 million of costs arising from new product
initiatives, developing intellectual property in content aware routing such as
TraceWare and VistaWare and developing new technologies to support our Content
Delivery and Managed Hosting service offerings.

     General and Administrative. General and administrative expenses increased
to $18.2 million for the three months ended March 31, 2001 from $5.7 million for
the three months ended March 31, 2000. This increase was due to $4.6 million of
growth in personnel and related expenses and $7.9 million office facility
expenses, legal and accounting fees and other administrative related expenses,
including an additional $4.5 million bad debt expense.

     Depreciation. Depreciation expense increased to $18.4 million for the three
months ended March 31, 2001 from $6.1 million for the three months ended March
31, 2000. This increase was attributed to a significant increase in property and
equipment balances. As we continue to build our infrastructure, we expect future
increases to our property and equipment balances and therefore expect
corresponding increases to depreciation expense.

     Amortization of intangible assets. Amortization expense increased to $73.0
million for the three months ended March 31, 2001 from $51.8 million for the
three months ended March 31, 2000. This increase was primarily due to a full
period of amortization of the goodwill and intangibles related to the
acquisitions of Live On Line and SoftAware, which were completed during January
2000 and September 2000, respectively. Amortization of intangible assets is
expected to decrease in future quarters due to an impairment charge on goodwill
and intangible assets in the quarter ended March 31, 2001.

                                       13

<PAGE>

     Impairment of Goodwill and Intangible Assets. Impairment of goodwill and
intangible assets was recorded in the amount of $1,039.2 million. The impairment
charge was based on management performing an impairment assessment of the
goodwill and identifiable intangible assets recorded upon the acquisitions of
Sandpiper, Live On Line and SoftAware, which were completed during the year
ended September 30, 2000. The assessment was performed primarily due to the
significant decline in stock price since the date the shares issued in each
acquisition were valued. As a result of this review, management recorded the
impairment charge to reduce goodwill and acquisition-related intangible assets.
The charge was determined as the excess of the carrying value of the assets over
the related estimated discounted cash flows. After the impairment charge, the
net book value of goodwill and acquisition-related identifiable intangible
assets as of March 31, 2001 was $0 and $106.0 million, respectively.

     Interest Income, Interest Expense and Other Income, Net. Interest income,
interest expense and other income, net, decreased to $1.7 million for the three
months ended March 31, 2001 from $1.8 million for the three months ended March
31, 2000. This decrease was due to a full period of interest expense on the
convertible subordinated notes, offset by interest income earned on a higher
average cash balance, primarily from proceeds from the issuance of shares of our
common stock in our secondary stock offering in February 2000 and of the
convertible subordinated notes, and gains on the sale of property and equipment.

Six Months Ended March 31, 2001 and 2000

     Revenue. Revenue increased to $64.5 million for the six months ended March
31, 2001 from $18.9 million for the six months ended March 31, 2000. Increases
in usage per customer and in the number of deployed customers to 797 from 194
drove revenues to increase in all of the Company's product categories.
Specifically, revenue from Network Services increased by $4.0 million, Hosting
services by $25.7, Content Delivery by $13.5 million and Application and
Professional Services by $2.4 million. Revenue derived from the sale of hosting
equipment, included in the Hosting services product category, increased $9.5
million due to an increase in the volume of equipment sales.

     Cost of Revenue. Cost of revenue increased to $94.1 million for the six
months ended March 31, 2001 from $39.9 million for the six months ended March
31, 2000. The increase in cost of revenue was due to $23.0 million of spending
for additional network capacity, $12.1 million in recruitment and compensation
costs relating to the addition of network and data center operations personnel,
$11.1 million in additional costs associated with expansion of existing data
center facilities and the deployment of the San Jose and Japan data center
facilities and $8.0 million of equipment-related costs.

     Sales and Marketing. Sales and marketing expenses increased to $38.3
million for the six months ended March 31, 2001 from $20.5 million for the six
months ended March 31, 2000. This increase was due to $16.1 million of growth in
personnel and related costs and $1.7 million of advertising, promotions and
other marketing program expenses.

     Product Development. Product development expenses increased to $19.9
million for the six months ended March 31, 2001 from $7.2 million for the six
months ended March 31, 2000. This increase was due to $11.0 million in growth of
personnel and related costs and $1.7 million of costs arising from new product
initiatives, developing intellectual property in content aware routing such as
TraceWare and VistaWare and developing new technologies to support our Content
Delivery and Managed Hosting service offerings.

     General and Administrative. General and administrative expenses increased
to $31.8 million for the six months ended March 31, 2001 from $8.8 million for
the six months ended March 31, 2000. This increase was due to $10.3 million of
growth in personnel and related expenses and $12.7 million office facility
expenses, legal and accounting fees and other administrative related expenses,
including an additional $6.2 million of bad debt expense.

     Depreciation. Depreciation expense increased to $33.4 million for the six
months ended March 31, 2001 from $8.4 million for the six months ended March 31,
2000. This increase was attributed to a significant increase in property and
equipment balances. As we continue to build our infrastructure, we expect future
increases to our property and equipment balances and therefore expect
corresponding increases to depreciation expense.

     Amortization of intangible assets. Amortization expense increased to $146.0
million for the six months ended March 31, 2001 from $53.4 million for the six
months ended March 31, 2000. This increase was primarily due to a full period of
amortization of the goodwill and intangibles related to the acquisitions of
Sandpiper, Live On Line and SoftAware, which were completed in December 1999,
January 2000 and September 2000, respectively. Amortization of intangible assets
is expected to decrease in future quarters due to an impairment charge on
goodwill and intangible assets in the quarter ended March 31, 2001.

     Impairment of Goodwill and Intangible Assets. Impairment of goodwill and
intangible assets was recorded in the amount of $1,039.2 million. The impairment
charge was based on management performing an impairment assessment of the
goodwill and identifiable intangible assets recorded upon the acquisitions of
Sandpiper, Live On Line and SoftAware, which were completed during the year
ended September 30, 2000. The assessment was performed primarily due to the
significant decline in stock price since the


                                       14

<PAGE>

date the shares issued in each acquisition were valued. As a result of this
review, management recorded the impairment charge to reduce goodwill and
acquisition-related intangible assets. The charge was determined as the excess
of the carrying value of the assets over the related estimated discounted cash
flows. After the impairment charge, the net book value of goodwill and
acquisition-related identifiable intangible assets as of March 31, 2001 was $0
and $106.0 million, respectively.

     Interest Income, Interest Expense and Other Income, Net. Interest income,
interest expense and other income, net, increased to $4.8 million for the six
months ended March 31, 2001 from $2.5 million for the six months ended March 31,
2000. This increase was due to a higher average cash balance for the six-month
period, primarily from proceeds from the issuance of shares of our common stock
in our secondary stock offering in February 2000 and of the convertible
subordinated notes, and gains on the sale of property and equipment, and was
offset by a full period of interest expense on the convertible notes.

Liquidity and Capital Resources

     From inception through our initial public offering on June 29, 1999, we
financed our operations primarily through private equity placements of $86.9
million dollars and borrowings under notes payable and capital leases from
financial institutions of $5.7 million. We raised $63.1 million in net proceeds
from our initial public offering. In February 2000, we raised $744.0 million in
net proceeds from our secondary offering of our common stock and issuance of
convertible subordinated notes. As of March 31, 2001, we had cash, cash
equivalents and marketable securities totaling $334.8 million.

     Net cash used in our operating activities for the six months ended March
31, 2001 was $130.9 million. The net cash used by operations was primarily due
to working capital requirements and net losses, net of an impairment charge on
goodwill and intangible assets and depreciation and amortization. Net cash
provided by investment activities was $152.2 million for the six months ended
March 31, 2001 and was comprised primarily of proceeds from investments which
matured of $374.9 million and proceeds from the sale of equipment of $5.4
million, which were offset by equipment purchases of $108.0 million, investment
purchases of $104.3 million, a $11.1 million increase in restricted cash and
$4.7 million of intangible asset purchases. Net cash used in financing
activities was approximately $785,000 and was related primarily to the
repayments of capital lease obligations of $3.9 million, loans made to an
executive officer of $600,000 and the repurchase of common stock of $116,000,
offset by an increase in the cash overdraft balance of $1.8 million, proceeds
from the issuance of common stock of $1.5 million and the repayment of
shareholder notes of $462,000.

     It is also our policy to periodically perform analyses of short-term
assets, such as reviewing accounts receivable balances for collectibility and
reviewing inventory balances to ensure inventory is carried at the lower of cost
or market.  During the quarter ended March 31, 2001, we recorded $4.5 million of
bad debt expense based on a review of accounts receivable balances.   If the
collectibility of our accounts receivable balances declines, we may recognize
more bad debt expense in future periods.  If the market value of our inventory
falls below the cost at which it is recorded, we may recognize a write-down of
inventory.

     Pursuant to the merger with Sandpiper, we assumed from Sandpiper a
promissory note with a financial institution in the amount of $84,000 at a
stated interest rate of 7% per annum, principal and interest due monthly for 36
months and collateralized by equipment.  As of March 31, 2001, $21,000 remains
outstanding.

     In December 1999, Sun Microsystems agreed to provide $100 million of lease
financing, subject to certain milestones, for the acquisition of equipment. As
of March 31, 2001, $30 million of lease financing has been made available under
this agreement. Total borrowings under this lease line were $12.4 million at
March 31, 2001 and are collateralized by the equipment.

     In June 2000, Compaq Computer Corporation agreed to provide $50 million,
which may be increased to $80 million under certain circumstances, of lease
financing for the acquisition of equipment. We have not drawn any amounts under
the financing agreement.

     In addition, we have several other lease lines of credit. Total borrowings
under these other lease lines of credit were $20.4 million at March 31, 2001, of
which $296,000 and $105,000 were assumed pursuant to the mergers with Sandpiper
and SoftAware, respectively. The equipment collateralizes all of these
borrowings.

     The execution of our business plan will require substantial additional
capital to fund our operating losses, working capital needs, sales and marketing
expenses, lease payments and capital expenditures. We intend to consider our
future financing alternatives, which may include the incurrence of indebtedness,
additional public or private equity offerings or an equity investment by
potential strategic partners. Actual capital requirements may vary based upon
the timing and success of the expansion of our operations. Our capital
requirements may change based upon technological and competitive developments.
In addition, several factors may affect our capital requirements:

 .  demand for our services or our anticipated cash flow from operations being
   less than expected;

 .  our development plans or projections proving to be inaccurate;

                                       15
<PAGE>

 .  our engaging in acquisitions or other strategic transactions; or

 .  altering deployment of our network services or the schedule of our
   expansion plan.

     Other than the lease financing, we have no present commitments or
arrangements assuring us of any future equity or debt financing, and there can
be no assurance that any such equity or debt financing will be available to us
on favorable terms, or at all. If we do not obtain additional financing, we
believe that our existing cash resources will be adequate to continue expanding
operations on a reduced scale at least through June 2002.

Recent Accounting Pronouncements

     In December 1999, the Securities Exchange Commission issued Staff
Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB
101"). SAB 101 is effective no later than the quarter ended September 30, 2001.
We have adopted SAB 101 and have determined that it has no material effect on
our consolidated results of operations or financial position.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     We develop global network and related services and sell such services in
North America, Asia and Europe. As a result, our financial results could be
affected by factors such as changes in foreign currency exchange rates or weak
economic conditions in foreign markets. As substantially all sales are currently
made in U.S. dollars, a strengthening of the dollar could make our services less
competitive in foreign markets. We do not use derivative instruments to hedge
our foreign exchange risks. Our interest income is sensitive to changes in the
general level of U.S. interest rates, particularly since the majority of our
investments are in short-term instruments. Due to the nature of our investments,
we have concluded there is no material market risk exposure. Therefore, no
quantitative tabular disclosures are required.

                  RISK FACTORS THAT MAY AFFECT FUTURE RESULTS

                              Risks related to us

We have a short operating history.

     Our limited operating history makes it difficult for us to predict future
results of operations, and makes it difficult to evaluate us or our prospects.
We were incorporated in 1994, and began offering our e-Business delivery network
services in January 1997.

     We completed a merger with Sandpiper Networks, Inc. in December 1999, an
acquisition of Live on Line, Inc. in January 2000 and an acquisition of
SoftAware, Inc. in September 2000. Sandpiper commenced operations in December
1996 and introduced its service in September 1998. Live On Line commenced
operations and introduced its service in December 1995. SoftAware commenced
operations and introduced its service in January 1994. The limited operating
history of the combined company and the limited operating histories of Digital
Island, Sandpiper, Live On Line and SoftAware as individual entities may limit
your ability to evaluate our prospects and performance, due to:

 .  our unproven ability to generate profits;

 .  our limited historical financial data;

 .  our limited experience in operating as a combined entity; and

                                       16
<PAGE>

 .  our limited experience in addressing emerging trends that may affect our
   combined business.

     You should consider our prospects in light of the risks, expenses and
difficulties we may encounter as an early stage company in the new and rapidly
evolving market for Internet content delivery solutions. As a result of such
risks, expenses and difficulties, we may not be able to:

 .  successfully market our content delivery solution;

 .  maintain and expand our market share in the highly competitive market for
   Internet content delivery solutions;

 .  timely and effectively introduce new services and service enhancements that
   are responsive to the needs of our customers; and

 .  attract, train and retain qualified sales, technical and customer support
   personnel.

We have incurred operating losses since our inception and expect continued
operating losses for the foreseeable future.

     The revenue and income potential of our business and market is unproven.
From inception, we have experienced operating losses, negative cash flows from
operations and net losses in each quarterly and annual period. For the six
months ended March 31, 2001, our operating loss, negative cash flow from
operations and net loss were $1.3 billion, $130.9 million and $1.3 billion,
respectively.

     Our operating expenses are largely based on anticipated revenue trends, and
a high percentage of our expenses are, and will continue to be, fixed in the
short term. In addition, we expect to continue to incur increasing expenses in
order to:

 .  expand sales and marketing activities through new programs and additional
   personnel;

 .  increase product development activities;

 .  continue to grow our network infrastructure to maintain and increase our
   ability to service new and existing customers;

 .  obtain access to additional bandwidth for the transport of increasing
   volumes of data over our network; and

 .  expand our channels of distribution to increase our presence in our target
   markets.

     We will need to generate significantly higher revenues to achieve and then
maintain profitability. Although we have experienced growth in revenues in
recent periods, this growth rate may not be indicative of future operating
results. We may never be able to achieve or sustain profitability.

Our quarterly results have varied significantly and we expect this to continue.

     We expect our revenues and operating results to vary significantly from
quarter to quarter due to a number of factors, many of which we cannot control.
These factors include the following:

 .  demand for and market acceptance of our products and services may decline
   or fail to increase enough to offset our costs;

 .  the introduction of new products and services or enhancements by us and our
   competitors may increase our costs or make our existing products or services
   obsolete;

 .  the prices we can charge our customers may decline due to price competition
   with our competitors;

 .  demand for our global network may increase beyond our capacity and we may
   incur significant expenses to increase such capacity;

 .  continuity of our service and network availability could be interrupted,
   reducing revenue;

                                       17
<PAGE>

 .  the availability and cost of bandwidth may reduce our ability to increase
   bandwidth as necessary;

 .  the length of our sales cycle and timing of customer installations and
   expansion of our network infrastructure may vary from quarter to quarter;

 .  the mix of products and services we sell may change and the new mix may
   generate less revenue;

 .  the timing and magnitude of our capital expenditures, including costs
   relating to the expansion of operations, may vary from quarter to quarter;

 .  bandwidth used by customers may fluctuate from quarter to quarter; and

 .  conditions specific to the Internet industry and other general economic
   factors may affect the prices we can charge or the expenses we incur.

     Because a relatively large portion of our expenses are fixed in the short-
term, particularly with respect to telecommunications capacity, depreciation,
real estate and interest expenses and personnel, our results of operations are
particularly sensitive to fluctuations in revenues. Due to the foregoing, we
believe that period-to-period comparisons of our operating results are not
necessarily meaningful and that such comparisons cannot be relied upon as
indicators of future performance. It is possible that, in some future quarters,
our operating results may not meet the expectations of public market analysts
and investors, as is the case in the current quarter ended March 31, 2001. In
that event, the price of our common stock may fall and our ability to obtain
additional financing may be impaired.

We must offer services priced above the overall cost of bandwidth, and any
failure to do so would jeopardize our operating results.

     If we do not obtain adequate bandwidth capacity on acceptable terms and
realize appropriate customer volume for such bandwidth, we will not achieve a
positive gross margin. We purchase our bandwidth capacity on a fixed-price basis
in advance of the sale of our services. We sell our services, by contract, on
the basis of actual usage. Our bandwidth costs currently exceed our revenues
from the sale of services, which results in negative gross profit.

     The bandwidth capacity agreements are generally cancelable and provide for
termination fees if canceled by us prior to expiration.  The Company canceled a
number of these agreements during the quarter ended March 31, 2001.  The loss
associated with the termination fees cannot be reasonably estimated at this
point and may cause a charge to income in future periods.

     We have also recently begun a program of obtaining bandwidth under
indefeasible-right-of-use ("IRU") agreements, with terms of 15 to 25 years.
Although we expect this to increase the gross profit margin by entering these
agreements, we also commit to a specific purchased bandwidth capacity for a
period of at least 15 years.

     Our data replication (mirroring) and storage (caching) business is
attractive to customers primarily because these services eliminate a significant
portion of the cost of transporting data by deploying data in close proximity to
the end users. To the extent bandwidth costs decrease, the prices we may charge
for these services will decrease as well. If the cost of bandwidth decreases
more than we expect, the value of these services could be substantially reduced,
which would harm our business and financial results.

     We expect that the cost of obtaining bandwidth for the transport of data
over our network will decline over time as a result of, among other things, the
large amount of capital currently being invested to build infrastructure. We
expect the prices we charge for data transported over our network will also
decline over time as a result of, among other things, the lower cost of
obtaining bandwidth and existing and new competition in the markets we address.
If we fail to accurately predict the decline in costs of bandwidth, are unable
to sell our services at acceptable prices, or fail to offer additional services
from which we can derive additional revenues, our revenues may decrease or fail
to increase as anticipated, and our business and financial results will suffer.

We must retain and expand our customer base or else we will continue to be
unprofitable.

     As of March 31, 2001, we had contracts with 881 customers of which 797 were
deployed. We have experienced an overall decrease in the numbers of contracted
and deployed customers as a result of efforts to increase revenue per customer

                                       18
<PAGE>

by discontinuing service with low revenue-generating customers. We currently
incur costs greater than our revenues and need to increase customer revenue to
become profitable. If we are unable to retain or grow our customer base and
revenues, we will not be able to achieve the economies of scale necessary to
offset our fixed and variable operating costs. Our ability to attract new
customers depends on a variety of factors, including:

 .  the willingness of businesses to outsource their Internet operations;

 .  the reliability and cost-effectiveness of our services; and

 .  our ability to effectively market such services.

     To attract new customers we intend to increase our sales and marketing
expenditures. However, our efforts might not result in more sales as a result of
the following factors:

 .  we may be unsuccessful in implementing our marketing strategies;

 .  we may be unsuccessful in hiring a sufficient number of qualified sales and
   marketing personnel; and

 .  our marketing strategies may not result in increased sales.

Our network infrastructure may be subject to failure or disruptions, which would
seriously harm our business.

     Our business is dependent on providing our customers with fast, efficient
and reliable network services. To meet these customer requirements we must
protect our network infrastructure against damage from:

 .  human error;

 .  fire;

 .  natural disasters;

 .  power loss;

 .  sabotage or vandalism;

 .  telecommunications failures; and

 .  similar events.

     Despite precautions taken by us, the occurrence of a natural disaster or
other unanticipated problems at one or more of our data centers could result in
service interruptions or significant damage to equipment. We have experienced
temporary service interruptions in the past, and we could experience similar
interruptions in the future. We may be subject to legal claims and be liable for
losses suffered by our customers for disruptions resulting from failures on our
network. We have business interruption insurance to minimize the impact of these
types of failures. Our agreements with our customers generally attempt to
eliminate our liability for consequential or punitive damages not caused by our
gross negligence or willful acts. However, those provisions may not protect us
from being held liable for such damages. If our disruption rate is high, clients
may seek to terminate their contracts with us and our reputation could be
harmed, which would materially harm our business.


Prolonged electrical power outages or shortages could harm our business.

     Our data centers are susceptible to regional electrical power shortages and
planned or unplanned power outages caused by these shortages.  Although we have
been subject to "rolling blackouts" due to the uncertainty of California's
electricity supply, we have not experienced any interruption of service as a
result.  We attempt to limit exposure to system downtime by using several backup
generators per data center.  We also maintain two network-operating centers in
Hawaii and in the UK, which would serve to keep the network operational in the
event of an outage.  The overall power shortage in

                                       19
<PAGE>

California has increased the cost of energy, which we may not be able to pass on
to our customers. Power outages, which last beyond our backup arrangements,
could harm our customers and our business. Any material interruptions of service
could result in material claims and have an adverse effect on our financial
position and results of operations.

Our Internet content delivery service is complex and may have errors or defects
that could seriously harm our business.

     Our Internet content delivery service is highly complex and is designed to
be deployed in very large and complex networks. Because of the nature of this
service, we can only fully test it when it is fully deployed in very large
networks with high traffic. We and our customers have discovered errors and
defects from time to time during the deployment of our service. In the future,
there may be additional errors and defects that may adversely affect our
service. If we are unable efficiently to fix errors or other problems that may
be identified in the future, we could experience:

 .  loss of or delay in revenue;

 .  loss of customers;

 .  failure to attract new customers or achieve market acceptance;

 .  diversion of development resources;

 .  loss of reputation and credibility;

 .  increased service costs; and

 .  legal actions by our customers.

Future customer warranty claims based on service failures could exceed our
insurance coverage.

     Our customer contracts currently provide a limited service level warranty
related to the continuous availability of service 24 hours a day, seven days per
week, except for certain scheduled maintenance periods. This warranty is
generally limited to a credit consisting of free service for a specified period
of time for disruptions in Internet transmission services. To date, we have
incurred no material expense related to such service level warranty. Should we
incur significant obligations in connection with system downtime, our liability
insurance may not be adequate to cover such expenses. Although our customer
contracts typically provide for no recovery with respect to incidental,
punitive, indirect and consequential damages resulting from damages to equipment
or disruption of service, in the event of such damages, we may be found liable,
and such damages may exceed our liability insurance.

Our business will suffer if we do not anticipate and meet specific customer
requirements or respond to technological change.

     The market for Internet content delivery and network services is
characterized by rapid technological change, frequent new product introductions
and changes in customer requirements. We may be unable to respond quickly or
effectively to these developments. Our future success will depend to a
substantial degree on our ability to offer services that incorporate leading
technology, address the increasingly sophisticated and varied needs of our
current and prospective customers and respond to technological advances and
emerging industry standards and practices on a timely and cost-effective basis.
You should be aware that:

 .  our technology or systems may become obsolete upon the introduction of
   alternative technologies;

 .  we may not have sufficient resources to develop or acquire new technologies
   or to introduce new services capable of competing with future technologies or
   service offerings; and

 .  the price of our services is likely to decline as rapidly as the cost of
   any competitive alternatives.

     The development of new or enhanced services through technology development
activities is a complex and uncertain process that requires the accurate
anticipation of technological and market trends. We may experience design,

                                       20
<PAGE>

manufacturing, marketing and other difficulties that could delay or prevent the
development, introduction or marketing of new services and enhancements. In
addition, our inability to effectively manage the transition from older services
to newer services could cause disruptions to customer orders and harm our
business and prospects.

If we do not successfully increase the capacity of our network and data centers,
demand for our services may decrease.

     Our network and data centers may not be able to serve expected customer
levels or meet performance expectations and we may be unable to obtain
additional network capacity from third-party suppliers or build or expand data
centers. In addition, as customers' usage of bandwidth increases, we will need
to make additional investments in our infrastructure to maintain adequate
downstream data transmission speeds, the cost of which may be significant.
Upgrading our infrastructure may cause delays or failures in our network. As a
result, our network may be unable to achieve or maintain a sufficiently high
capacity of data transmission, which could significantly reduce demand for our
services, reducing our revenues and adversely affecting our business.

If our market does not grow as we expect, our revenues will be below our
expectations and our business and financial results will suffer.

The market for our services is new and unproven. If our customer base does not
expand or if there is not a widespread acceptance of our products and our
services, our business and prospects will be harmed. The market for our services
depends on several uncertain events and factors, including:

 .  the effectiveness of our marketing strategy and efforts;

 .  our product and service differentiation and quality;

 .  the extent of our network coverage;

 .  our ability to provide timely, effective customer support;

 .  our distribution and pricing strategies as compared to our competitors;

 .  our industry reputation; and

 .  general economic conditions such as downturns in the e-Business or software
   markets.

     If the market for our services fails to develop, or develops more slowly
than expected, our business will be adversely affected.

We will require significant additional capital, and if we cannot obtain this
financing on commercially reasonable terms, our business will suffer.

     Our ability to meet our planned growth will require substantial cash
resources. The timing and amount of future capital requirements may vary
significantly depending on numerous factors including regulatory, technological,
competitive and other developments in our industry. We do not expect to generate
sufficient cash flow from operations in the near term. Accordingly, our ability
to meet additional future capital needs will depend on future equity or debt
financing, which we may not be able to obtain on satisfactory terms or at all.
In addition, our credit agreements contain covenants restricting our ability to
incur further indebtedness, and future borrowing instruments such as credit
facilities and lease agreements are likely to contain similar or more
restrictive covenants and will likely require us to pledge assets as security
for borrowings there under.

     Additional equity financing may not be available and/or may be dilutive to
existing stockholders. Our inability to obtain additional capital on
satisfactory terms may delay or prevent the expansion of our business and cause
us to forego market opportunities, which could materially adversely affect our
growth and ability to compete.

Rapid growth in our business could cause a significant strain on our business.

                                       21
<PAGE>

     The planned expansion of our operations will place a significant strain on
our management, financial controls, operations systems, personnel and other
resources. We expect that our customers increasingly will demand additional
information and reports with respect to the services we provide. To handle these
demands and enable future traffic growth, we must develop and implement an
automated customer service system. In addition, if we are successful in
implementing our marketing strategy, we also expect the demands on our network
and data center infrastructure and technical support resources to grow rapidly.
We expect that these demands will require investments in our infrastructure, the
addition of new management personnel, the development of additional expertise by
existing management personnel and the establishment of long-term relationships
with third-party service vendors. We may not be able to keep pace with such
growth, successfully implement and maintain our operational and financial
systems or successfully obtain, integrate and utilize the employees, facilities,
third-party vendors and equipment, or management, operational and financial
resources necessary to manage a developing and expanding business in our
evolving and increasingly competitive industry. If we are unable to manage
growth effectively, our business and financial results will suffer.

We could lose customers and expose our company to liability if breaches of our
network security disrupt service to our customers or jeopardize the security of
confidential information stored in our computer systems.

     Despite the implementation of network security measures, our network
infrastructure is vulnerable to computer viruses, break-ins and similar
disruptive problems caused by our customers or Internet users. Any of these acts
could lead to interruptions, delays or cessation in service to our customers and
subscribers. Furthermore, such inappropriate use of the network by third parties
could also potentially jeopardize the security of confidential information
stored in our computer systems and our customers computer systems, which may
result in liability to us and may deter potential customers. Although we intend
to continue to implement industry-standard security measures, any measures we
implement may be circumvented in the future. The costs and resources required to
eliminate computer viruses and alleviate other security problems may divert
resources from other activities and may result in interruptions or delays to our
customers that could cause our business and financial results to suffer.

We must retain and attract key employees or else we may not grow or be
successful.

     Effective April 30, 2001, T.L. Thompson has resigned as the Chief Financial
Officer of the Company.  The Company's current Treasurer, Addo Barrows, will
assume the duties and the title of Interim Chief Financial Officer.  David
White, Corporate Controller, was appointed Chief Accounting Officer, Vice
President in April 2001.

     We are highly dependent on key members of our management and engineering
staff. The loss of one or more of these individuals might impede the achievement
of our business objectives. Furthermore, recruiting and retaining qualified
technical personnel to perform research, development and technical support work
is critical to our success. If our business grows, we will also need to recruit
a significant number of additional management, technical and other personnel.
Competition for employees in our industry is intense. We may not be able to
continue to attract and retain skilled and experienced personnel on acceptable
terms. The loss of the services of any of our key employees, the inability to
integrate new employees or our failure to attract or retain qualified personnel
in the future in a timely manner could harm our business.

We depend on a limited number of suppliers for key components of our network
infrastructure, and the loss of one or more suppliers may slow our growth or
cause us to lose customers.

      We are dependent on a limited number of providers to supply key components
of our infrastructure, including bandwidth capacity leased from
telecommunications network providers and networking equipment that, in the
quantities and quality demanded by us, are available only from sole or limited
sources. While we have entered into various agreements for carrier line
capacity, any failure to obtain additional capacity, if required, would impede
the growth of our business and cause our financial results to suffer. The
routers and switches used in our infrastructure are currently supplied primarily
by Cisco Systems. We purchase these components pursuant to purchase orders
placed from time to time, we do not carry significant inventories of these
components and we have no guaranteed supply arrangements with this vendor. Any
failures to obtain required products or services on a timely basis and at an
acceptable cost would impede the growth of our business and cause our financial
results to suffer. In addition, any failure of our suppliers to provide products
or components that comply with evolving Internet and telecommunications
standards could cause our business and financial results to suffer.

Our failure to adequately protect our proprietary rights may harm our
competitive position.

                                       22
<PAGE>

     We rely on a combination of copyrights, trademark, service mark and trade
secret laws and contractual restrictions to establish and protect proprietary
rights in our products and services. However, we will not be able to protect our
intellectual property if we are unable to enforce our rights or if we do not
detect unauthorized use of our intellectual property.

     Although we have patents issued and claims pending with the United States
Patent and Trademark Office with respect to our Footprint content delivery
service, as well as certain Internet technology acquired from SRI International,
and were recently issued a U.S. patent with respect to TraceWare, we currently
may not have sufficient patented technology to preclude or substantially inhibit
competitors from entering our market. Moreover, none of our technology is
patented abroad, although we currently have international patent applications
pending. We cannot be certain that any pending or future patent applications
will be granted, that any future patent will not be challenged, invalidated or
circumvented, or that rights granted under any patent that may be issued will
provide competitive advantages to us.

     We have applied for (and in some instances, received) trademarks and
service marks on certain terms and symbols that we believe are important for our
business. In addition, we generally enter into confidentiality or license
agreements with our employees and consultants and with our customers and
corporations with whom we have strategic relationships, and we attempt to
maintain control over access to and distribution of our software documentation
and other proprietary information.

     The steps we have taken to protect our technology or intellectual property
may be inadequate. Our competitors may independently develop technologies that
are substantially equivalent or superior to ours. Moreover, in other countries
where we do business, there may not be effective legal protection of patents and
other proprietary rights that we believe are important to our business.
Unauthorized use of any of our proprietary information could seriously harm our
business.

If we do not effectively manage the integration of future acquisitions, it could
disrupt our business and cause increased losses.

Part of our expansion strategy includes acquiring businesses and technologies
that we believe will complement our existing business. In the event of any
future acquisitions, we may:

 .  issue stock that would dilute the ownership of our stockholders;

 .  incur debt;

 .  assume liabilities;

 .  incur amortization expenses related to goodwill and other intangible assets;
   and

 .  incur large and immediate write-offs.

     Acquisition transactions require a significant commitment of resources and
are accompanied by a number of risks, including:

 .  the difficulty of assimilating the operations and personnel of the acquired
   companies;

 .  the potential disruption of our ongoing business and distraction of
   management;

 .  the difficulty of incorporating acquired technology and rights into our
   products and services;

 .  unanticipated expenses related to technology integration;

 .  the maintenance of uniform standards, controls, procedures and policies;

 .  the impairment of relationships with employees and customers as a result of
   any integration of new management personnel; and

 .  potential unknown liabilities associated with acquired businesses.

                                       23
<PAGE>

     We may need to complete these transactions to remain competitive. We cannot
be sure that we will succeed in addressing these risks or any other problems
encountered in connection with potential business combinations and acquisitions.

We have anti-takeover defenses that could delay or prevent a takeover that
stockholders may consider favorable.

     Certain provisions of our certificate of incorporation and bylaws and the
provisions of Delaware law could have the effect of delaying, deferring or
preventing an acquisition of Digital Island. For example, our board of directors
is divided into three classes to serve staggered three-year terms, we may
authorize the issuance of up to 10,000,000 shares of "blank check" preferred
stock, our stockholders may not take actions by written consent and our
stockholders are limited in their ability to make proposals at stockholder
meetings.

We may be unable to license necessary technology, and we may be subject to
infringement claims by third parties.

     In addition to the risks inherent in the litigation with Akamai
Technologies described in Part II, Item 1 below, our commercial success will
also depend in part on our not infringing the proprietary rights of others and
not breaching technology licenses that cover technology used in our products. It
is uncertain whether any third party patents will require us to develop
alternative technology, alter our products or processes, obtain licenses or
cease activities that infringe on third party's intellectual property rights. If
any such licenses are required, we may not be able to obtain such licenses on
commercially favorable terms, if at all. Our failure to obtain a license to any
technology that we may require to commercialize our products and services could
cause our business and prospects to suffer.

     Companies in the Internet market are increasingly bringing suits alleging
infringement of their proprietary rights, particularly patent rights. Any
litigation or claims, whether or not valid, could result in substantial costs
and diversion of resources. Intellectual property litigation or claims could
force us to do one or more of the following:

 .  cease selling, incorporating or using products or services that incorporate
   the challenged intellectual property;

 .  obtain a license from the holder of the infringed intellectual property
   right, which license, if available at all, may not be available on
   commercially favorable terms; and

 .  redesign products or services.

     If we are forced to take any of the foregoing actions, our business may be
seriously harmed. We expect that our insurance may not cover potential claims of
this type or may not be adequate to indemnify us in the event we are found
liable.

Our participation in joint ventures and strategic relationships may involve risk
associated with inconsistent goals, exposure to unknown liabilities and
unexpected obligations.

     As part of our international expansion, we pursue relationships and joint
ventures with local Internet service providers and telecommunications carriers
in other countries. We may not have a majority interest or control of the
governing body of any such local operating joint venture and there is a risk
that the other joint venture partner may at any time have economic, business or
legal interests or goals that are inconsistent with those of the joint venture
or us. The risk also will be present that a joint venture partner may be unable
to meet its economic or other obligations and that we may be required to fulfill
those obligations. In addition, in any joint venture in which we do not have a
majority interest, we may not have control over the operations or assets of such
joint venture. We may not be able to establish peering relationships or joint
ventures with local Internet service providers and telecommunications carriers
in other countries on favorable terms or at all. Our failure to establish these
relationships may cause us to lose customers or slow our growth and harm our
business.

     Sandpiper entered into strategic relationships with America Online ("AOL"),
in April 1999 and with Microsoft in October 1999 for the joint development of
technology, services and/or products. We may not be successful in developing
such products. The AOL agreement expires in December 2001, and the agreement
with Microsoft expires in August 2002. Either party may terminate each agreement
if the other party materially breaches the agreement. A termination of, or
significant adverse change in, our relationship with AOL or Microsoft could have
a material adverse effect on our business.

     We entered into a strategic relationship with SRI International ("SRI") in
November 1999 through our acquisition of a patent pending technology developed
by SRI in exchange for shares of the Company's common stock.  Due to the decline

                                       24
<PAGE>

in our stock price since the inception of the agreement, the Company and SRI
have been involved in a contract dispute relating to the value of the shares
issued, as describe in Part II, Item 1 below.

     We entered into strategic relationships with Sun Microsystems, Inc. and
Inktomi Corporation in December 1999 to expand the global electronic business
content delivery network through deployment of up to 5,000 Sun servers equipped
with Inktomi's Traffic Server and Content Delivery Suite. We may not be
successful in such an expansion. A termination of, or significant adverse change
in, our relationship with Sun or Inktomi could have a material adverse effect on
our business.

     We entered into strategic relationships with Compaq Computer Corporation,
Intel Corporation and Microsoft Corporation in June 2000 to extend our
infrastructure and to provide broadcast-scale streaming media over the Internet.
We may not be successful in such an extension of our infrastructure. A
termination of, or significant adverse change in, our relationship with Compaq,
Intel or Microsoft could have a material adverse effect on our business.

The carrying value of our assets could be subject to impairment write-downs.

     It is our policy to assess the impairment of long-lived assets, such as
fixed assets, goodwill and intangible assets, when events or changes in
circumstances indicate that the carrying value of an asset may not be
recoverable. If our market capitalization is consistently lower than the
carrying value of our assets, this may trigger an impairment analysis.
Additionally, if the projected future undiscounted cash flows of our enterprise-
wide assets were determined to be less than the carrying value of those assets,
we would recognize an impairment loss. During the quarter ended March 31, 2001,
we recorded a $1,039.2 million impairment charge based on an impairment
assessment of the goodwill and identifiable intangible assets recorded upon the
acquisition of Sandpiper, Live On Line and SoftAware. After the impairment
charge, the net book value of goodwill and acquisition-related identifiable
intangible assets as of March 31, 2001 was $0 and $106.0 million, respectively.
We currently have excess capacity in our data centers and we may, in future
quarters, recognize an impairment loss related to our fixed assets if their book
value exceeds their fair value.

     It is also our policy to periodically perform analyses of short-term
assets, such as reviewing accounts receivable balances for collectibility and
reviewing inventory balances to ensure inventory is carried at the lower of cost
or market.  During the quarter ended March 31, 2001, we recorded $4.5 million of
bad debt expense based on a review of accounts receivable balances.   If the
collectibility of our accounts receivable balances declines, we may recognize
more bad debt expense in future periods.  If the market value of our inventory
falls below the cost at which it is recorded, we may recognize a write-down of
inventory.

                        Risks Related to Our Industry.

Competition in our industry is intense and growing and we may be unable to
compete effectively.

     Our market is highly competitive and fragmented. Our competitors include
companies such as AboveNet Communications, Akamai, AT&T, Digex, Exodus
Communications, Genuity, Globix, iBeam, InterNAP, MCI WorldCom, Mirror Image and
Qwest. Many of our competitors have substantially greater financial, technical
and marketing resources, larger customer bases, longer operating histories,
greater name recognition and more established relationships in the industry than
we do. Some of our current and potential competitors have the financial
resources to withstand substantial price competition, and many may be able to
respond more quickly than we can to new or emerging technologies and changes in
customer requirements. Our competitors with more extensive customer bases,
broader customer relationships and broader industry alliances may be able to use
such resources to their advantage in competitive situations, including
relationships with many of our current and potential customers. In particular,
certain competitors have strategic alliances with entities that have entered
into similar alliances with us, including Microsoft.

     There are few substantial barriers to entry, and we expect that we will
face additional competition from existing competitors and new market entrants in
the future. We compete against information technology and Internet outsourcing
firms, national and regional Internet service providers, and global, regional
and local telecommunications companies. Our larger competitors may be able to
provide customers with additional benefits in connection with their Internet
systems and network solutions, including reduced communications costs. As a
result, these companies may be able to price their products and services more
competitively than we can and respond more quickly than us to new or emerging
technologies and changes in customer requirements. If we are unable to compete
successfully against our current or future competitors, we may lose market share
and our business and prospects would suffer.

                                       25
<PAGE>

     We face competition, and in the future may face additional competition,
from providers of Internet content delivery services, including networking
hardware and software manufacturers, content distribution providers, traditional
hardware manufacturers, telecommunications providers, software database
companies, and large diversified software and technology companies. Some of
these competitors may bundle their services with other software or hardware in a
manner that may discourage website owners from purchasing our services or
Internet service providers from installing our servers. In addition, if those
third party telecommunications providers upon which we are currently dependent
for transmission capacity determine to compete with us in the Internet content
delivery market, their refusal to provide us with capacity, could result in a
degradation or termination of service to certain of our customers. As a result,
we could lose customers or generate reduced revenue from such customers, and our
business and financial results could suffer.

     In addition, no assurances can be given that the Internet content delivery
market will develop in a way that we currently anticipate. For example, while we
currently intend to offer our customers the most comprehensive solution
available in the marketplace today, there currently exists an array of
competitors that offer partial solutions to the problems that we address or
intend to address, and a number of these companies have been and are likely to
continue to be quite successful. To the extent Internet service providers
utilize other technology that reduces the need for content delivery solutions,
demand for our services could decrease.

     Increased competition could result in:

 .  price and revenue reductions and lower profit margins;

 .  increased cost of service from telecommunications providers;

 .  loss of customers or failure to obtain additional customers; and

 .  loss of market share.

Liability laws are unsettled in our industry and potential liability associated
with information disseminated through our network could harm our business and
prospects.

     The law relating to the liability of online services companies and Internet
access providers for communications and commerce carried on or disseminated
through their networks is currently unsettled. The United States Congress has
already enacted Internet laws regarding children's privacy, copyrights, taxation
and the transmission of sexually explicit material. The European Union issued a
directive in December 1997 that required member states to initiate the process
for the adoption of privacy regulations by October 1998. The European Union is
also currently considering copyright legislation that may extend the right of
reproduction held by copyright holders to include the right to make temporary
copies for any reason. It is possible that claims could be made against online
services companies and Internet access providers under both United States and
foreign law for defamation, negligence, copyright or trademark infringement, or
other theories based on the nature of the data or the content of the materials
disseminated through their networks. Several private lawsuits seeking to impose
such liability upon online services companies and Internet access providers are
currently pending.

     In addition, the growth and development of the market for online commerce
may prompt calls for more stringent consumer protection laws, both in the United
States and abroad, which may impose additional burdens on companies conducting
business online. Some countries may regulate or prohibit the transport of
telephony data in their territories. The imposition upon us and other Internet
network providers of potential liability for information carried on or
disseminated through our systems could require us to implement measures to
reduce our exposure to such liability, which may require the expenditure of
substantial resources, or to discontinue some of our service or product
offerings. Our ability to limit the types of data or content distributed through
our network is limited. Failure to comply with such regulation in a particular
jurisdiction could result in fines or penalties or the termination of our
service in such jurisdiction. The increased attention focused upon liability
issues as a result of these lawsuits and legislative proposals could impact the
growth of Internet use. Our professional liability insurance may not be adequate
to compensate or may not cover us in the event we become liable for information
carried on or disseminated through our networks. Any costs not covered by
insurance incurred as a result of such liability or asserted liability could
harm our business and prospects.

Risks associated with operating in international markets could restrict our
ability to expand globally and harm our business and prospects.

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<PAGE>

     We market and sell our network services and products in the United States
and internationally. While the United States currently represents the majority
of our revenues, we expect the percentage of our international sales to increase
over time and expect to commit significant resources to expand our international
sales and marketing activities throughout fiscal year 2001. However, we may not
be able to successfully market, sell, deliver and support our networking
services and products internationally. We presently conduct international sales
through local subsidiaries in Belgium, France, Germany, Hong Kong, Japan, the
Netherlands, Sweden, Switzerland and the United Kingdom and through distributor
relationships with third parties in countries where we have no physical
presence. Our failure to manage our international operations effectively could
limit the future growth of our business, increase our costs, lengthen our sales
cycle and require significant management attention.

     There are certain risks inherent in conducting our business
internationally, such as:

 .  changes in telecommunications regulatory requirements that may restrict our
   ability to deliver services to our international customers;

 .  export restrictions, tariffs, differing regulatory regimes and other trade
   barriers that may impede us from adequately equipping our network facilities;

 .  challenges in recruiting, retaining, and managing qualified staff who
   understand the highly technical aspects of our business that could hinder our
   ability to grow and compete;

 .  differing technology standards across countries that may impede our ability
   to integrate our product offerings across international borders;

 .  limited international collection experience in collecting accounts receivable
   in foreign jurisdictions;

 .  political and economic instability that could lead to appropriation of our
   physical assets, impeding our ability to deliver our services to customers
   and harming our financial results;

 .  protectionist laws and business practices favoring local competition that may
   give unequal bargaining leverage to key vendors in countries where
   competition is scarce, significantly increasing our operating costs;

 .  increased expenses associated with marketing services in foreign countries;

 .  potentially adverse tax consequences, including restrictions on the
   repatriation of earnings due to unfavorable changes in tax laws or our
   physical presence in foreign countries; and

 .  the risks related to the global economic turbulence.

     Any of these risks could harm our international operations. For example,
some European countries already have laws and regulations related to content
distributed on the Internet and technologies used on the Internet that are more
strict than those currently in force in the United States. Furthermore, there is
an on-going debate in Europe as to the regulation of certain technologies we
use, including caching and mirroring. That debate could result in a directive
relating to the reform of copyright laws in the European Community that may, if
made into law, restrict caching and mirroring. Any or all of these factors could
cause our business and prospects to suffer.

Foreign exchange fluctuations could decrease our revenues or cause us to lose
money, especially since we do not hedge against currency fluctuations.

     Although to date substantially all of our customers have paid for our
services in U.S. dollars, we currently pay some of our suppliers in a foreign
currency, which subjects us to currency fluctuation risks. For fiscal 1998,
fiscal 1999 and fiscal 2000, costs denominated in foreign currencies were
nominal and we had insignificant foreign currency losses during those periods.
However, we believe that in the future an increasing portion of our revenues and
costs will be denominated in foreign currencies. In particular, as the Euro has
been introduced, we expect that an increasing portion of our international sales
may be Euro-denominated. We currently do not engage in foreign exchange hedging
activities and, although we have not yet experienced any material losses due to
foreign currency fluctuation, our international revenues are subject to the
risks of foreign currency fluctuations and such risks will increase as our
international revenues increase.

                                       27
<PAGE>

Government regulation and legal uncertainties could limit our business or slow
our growth.

     Our services include the transmission of data over public telephone lines.
These transmissions are subject to the regulatory authority of the Federal
Communications Commission and the state public utility commissions although, to
date, neither has elected to exercise such authority. Our services could be
affected by changes in federal and state law or regulation in the
telecommunications arena, and the Internet in particular. Such changes could
directly or indirectly affect our costs, limit usage or subscriber-related
information, and increase the likelihood or scope of competition from
telecommunications companies.

     As our services become available over the Internet in additional foreign
countries, and as we facilitate sales by our customers to end users located in
such foreign countries, these foreign jurisdictions may decide that we are
required to qualify to do business in their jurisdictions, which may subject us
to taxes and other costs. It is also possible that claims could be made against
online service companies and Internet service providers under foreign law for
defamation, negligence, copyright or trademark infringement, or other theories
based on the nature and content of the materials disseminated through their
networks.

     Implementation of any future changes in law or regulation, including those
discussed herein, could cause our business and prospects to suffer. Our business
and prospects may also be harmed by the imposition of certain tariffs, duties
and other import restrictions on facilities and resources that we obtain from
non-domestic suppliers. As a result, changes in law or regulation in the United
States or elsewhere could cause our business and prospects to suffer.

Substantial leverage and debt service obligations may adversely affect our cash
flow.

     We have substantial amounts of outstanding indebtedness, primarily
consisting of the convertible subordinated notes that were issued in February
2000. As a result of this indebtedness, our principal and interest payment
obligations have increased substantially. There is the possibility that we may
be unable to generate cash sufficient to pay the principal of, interest on and
other amounts due in respect of our indebtedness when due. We may also obtain
additional long term debt and working capital lines of credit to meet future
financing needs. There can be no assurance that any financing arrangements will
be available.

     Our substantial leverage could have significant negative consequences,
including:

 .  increasing our vulnerability to general adverse economic and industry
   factors;

 .  limiting our ability to obtain additional financing;

 .  requiring the dedication of a substantial portion of our expected cash flow
   from operations to service our indebtedness, thereby reducing the amount of
   our expected cash flow available for other purposes, including capital
   expenditures;

 .  limiting our flexibility in planning for, or reacting to, changes in our
   business and the industry in which we compete; and

 .  placing us at a possible competitive disadvantage vis-a-vis less leveraged
   competitors and competitors that have better access to capital resources.

Our stock has been and will likely continue to be subject to substantial price
and volume fluctuations due to a number of factors, some of which are beyond our
control.

     Stock prices and trading volumes for many Internet companies fluctuate
widely for a number of reasons, including some reasons that may be unrelated to
their businesses or results of operations. This market volatility, as well as
general domestic or international economic, market and political conditions
could materially adversely affect the price of our common stock without regard
to our operating performance. In addition, our operating results may fall below
the expectations of public market analysts and investors. If this were to occur,
the market price of our common stock would be likely to significantly decrease.
Sales of substantial amounts of our common stock (including shares issued upon
the exercise of outstanding options and warrants) in the public, or the
appearance that a large number of shares is available for sale, could depress
the market price for our common stock.

                                       28
<PAGE>

                          PART II--OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS.

     On September 13, 2000, Akamai Technologies, Inc. (Akamai) and the
Massachusetts Institute of Technology ("MIT") filed a Complaint in the U.S.
District Court of Massachusetts (No. 00ev1181RWZ) alleging that Digital Island
infringes U.S. Patent No. 6,108,703 (the 703 Patent). Based on our preliminary
investigation, we believe that we have meritorious defenses to Akamai and MIT's
claim and intend to vigorously defend ourselves in any litigation that arises
from this claim. In addition, because we believe that we were the first to
invent the technologies claimed in the 703 Patent, we have instituted
proceedings with the U.S. Patent and Trademark Office (the "PTO") to confirm
our ownership of any such inventions (the "Interference Action").

     On September 20, 2000, Akamai filed a Motion in the U.S. District Court of
Massachusetts requesting Leave to File A Second Amended Complaint in which it
alleges that Digital Island infringes U.S. Patent No. 6,003,030 (the "030
Patent"), which Motion was granted by the Court. Based on our preliminary
investigation, we believe that we have meritorious defenses to Akamai's claim
and intend to vigorously defend ourselves in any litigation that arises from
this claim. On October 18, 2000 Akamai and MIT filed a Motion in the U.S.
District Court of Massachusetts requesting that Digital Island be enjoined from
offering for sale its Footprint 2.0 content delivery service. On March 28, 2001,
Akamai's Motion was denied. On April 23, 2001, the Company filed a Motion
seeking Summary Judgment with respect to its non-infringement of the 030 Patent.
Based on confirmation from the PTO that our claims are in condition for
allowance, on May 14, 2001, the Company filed a Motion seeking to stay further
proceedings in this case until the PTO has formally declared an interference.

     On September 21, 2000, Akamai filed a Compliant in the U.S. District Court,
Northern District of California, alleging that Digital Island's distribution of
certain marketing materials constituted False Advertising, Unfair Competition,
Intentional Interference With Contractual Relationships and Intentional
Interference With Prospective Business Advantage and requesting, among other
things, a Temporary Restraining Order prohibiting Digital Island from
disseminating the materials at issue and publicly commenting on certain related
issues. Based on our preliminary investigation, we believe that we have
meritorious defenses to Akamai's claims and intend to vigorously defend
ourselves in any litigation that arises from these claims. On October 13, 2000,
the Court denied Akamai's request for a Temporary Restraining Order. On October
26, 2000, we filed counterclaims in this case for equitable relief and damages,
alleging that Akamai's distribution of certain marketing material constituted
false advertising, unfair competition, interference with contract and
interference with prospective economic relationships.

     The Company and SRI International (SRI) are involved in a contract dispute
relating to the timing of the issuance and registration of the shares issued to
SRI as consideration for technology and related patent and consulting work
purchased by the Company under the Technology Purchase Agreement and Research
Alliance dated November 22, 1999 (the SRI Agreement). SRI asserts that it is
owed an additional $2.4 million of Common Stock. We believe that we have
meritorious defenses to SRI's claims. As required by the SRI Agreement, the
parties intend to submit the matter to mediation and if that process is
unsuccessful, to binding arbitration. This dispute has not and we do not believe
that it will effect our research alliance with SRI.

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS.

     In January 2001 and February 2001, the Company issued 103,081 and 97,103
shares of its common stock, respectively, to SRI International as payment for
consulting services related to Internet technology acquired pursuant to a
technology purchase agreement executed in November 1999. The shares of common
stock were issued pursuant to an exemption from registration under Section 4(2)
of the Securities Act of 1933, as amended.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES.

     None.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF STOCKHOLDERS

     None.

ITEM 5. OTHER INFORMATION.

Subsequent Events

     On May 1, 2001, T.L. Thompson resigned from his position as Chief Financial
Officer of the Company in order to pursue personal interests. Addo Barrows, the
Company's treasurer, will assume the duties of Chief Financial Officer and will
have the title of interim Chief Financial Officer. The Company has initiated a
search for a new Chief Financial Officer.

     On May 13, 2001, Digital Island, Inc. ("Digital Island"), Cable and
Wireless plc ("Cable and Wireless") and Dali Acquisition Corp., a wholly-owned
subsidiary of Cable and Wireless, entered into an Agreement and Plan of Merger
(the "Merger Agreement"), pursuant to which Cable and Wireless would acquire
Digital Island in a cash tender offer.

     The Merger Agreement provides that Dali Acquisition Corp. will commence a
tender offer for the outstanding shares of Digital Island's common stock at a
purchase price of $3.40 per share, upon the terms and subject to the conditions
set forth in the Merger Agreement. The Merger Agreement further provides that,
as soon as practicable after Dali Acquisition Corp. has accepted for payment the
shares tendered in the offer, Digital Island will be merged with Dali
Acquisition Corp., such that Digital Island will become a wholly-owned
subsidiary of Cable and Wireless. Each stockholder of Digital Island would
receive in the merger $3.40 in cash for each share of Digital Island common
stock then held.

     Attached and incorporated by reference in its entirety as Exhibit 2.1 is a
copy of the Merger Agreement.

                                       29
<PAGE>

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.

(a) Exhibits.

    2.1 Agreement and Plan of Merger, dated May 14, 2001, by and among Cable &
        Wireless plc, Digital Island, Inc. and Dali Acquisition Corp.

    3.1 Certificate of Amendment to the Company's Certificate of Incorporation
        dated April 12, 2001

    3.2 Amended and Restated Certificate of Incorporation dated July 2, 1999

(b) Reports on Form 8-K.

    None.


                                  SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended,
the Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.


Date: May 15, 2001                      DIGITAL ISLAND, INC.
                                        (Registrant)


Date: May 15, 2001                      By: /s/ Ruann F. Ernst
                                        Ruann F. Ernst,
                                        Chief Executive Officer and President
                                        (Principal Executive Officer)


Date: May 15, 2001                      By: /s/ David White
                                        David White,
                                        Vice President and Chief Accounting
                                        Officer


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