<PAGE>   1
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                                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 JUNE 30, 2001

                                      OR

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


                       COMMISSION FILE NUMBER 000-25759


                          APPLIEDTHEORY CORPORATION
            (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)


                     DELAWARE                                   16-1491253
         (STATE OR OTHER JURISDICTION OF                     (I.R.S. EMPLOYER
          INCORPORATION OR ORGANIZATION)                   IDENTIFICATION  NO.)



             1500 BROADWAY, 3RD FLOOR                             10036
                  NEW YORK, N.Y.                                (ZIP CODE)
     (ADDRESS OF PRINCIPAL EXECUTIVE OFFICE)

                                (212) 398-7070
              REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE

                                NOT APPLICABLE
           (FORMER NAME, FORMER ADDRESS AND FORMER FISCAL YEAR, IF
                       CHANGED SINCE LAST REPORT DATE)


Indicate by check mark whether the registrant (1) has filed all reports 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 July 31, 2001, there were 28,377,890 shares of AppliedTheory Corporation
common stock, par value $.01, outstanding.


                     The Exhibit Index appears on page 45

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



<PAGE>   2


                          APPLIEDTHEORY CORPORATION


                              TABLE OF CONTENTS



<TABLE>
<S>     <C>
PART I.  FINANCIAL INFORMATION

Item 1.       Financial Statements (Unaudited):

              Consolidated Balance Sheets as of December 31, 2000 and June 30, 2001..........3

              Consolidated Statements of Operations for the three and six months ended
              June 30, 2000 and June 30, 2001................................................4

              Consolidated Statements of Stockholders' Equity and Comprehensive Income
              (Loss) for the year ended December 31, 2000 and the six months ended
              June 30, 2001..................................................................5

              Consolidated Statements of Cash Flows for the six months ended
              June 30, 2000 and June 30, 2001................................................6

              Notes to Consolidated Financial Statements.....................................7


Item 2.       Management's Discussion and Analysis of Financial Condition
              and Results of Operations.....................................................17

Item 3.       Quantitative and Qualitative Disclosures about Market Risk....................26

PART II.  OTHER INFORMATION

Item 1.       Legal Proceedings.............................................................27

Item 2.       Changes in Securities and Use of Proceeds.....................................28

Item 3.       Defaults Upon Senior Securities...............................................28

Item 4.       Submission of Matters to a Vote of Security Holders...........................28

Item 5.       Other Information.............................................................30

Item 6.       Exhibits and Reports on Form 8K...............................................43

Signatures    ..............................................................................44

Exhibit Index...............................................................................45
</TABLE>


<PAGE>   3



PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

                  APPLIEDTHEORY CORPORATION AND SUBSIDIARIES
                         CONSOLIDATED BALANCE SHEETS
                      (IN THOUSANDS, EXCEPT SHARE DATA)

<TABLE>
<CAPTION>
                                                                                          December 31,         June 30,
                                                                                              2000               2001
                                                                                              ----               ----
                                                                                     (Derived from Audited    (Unaudited)
                                   ASSETS                                            Financial Statements)
<S>                                                                                  <C>                      <C>
Current assets
    Cash and cash equivalents                                                              $  5,733            $   2,846
    Due from broker                                                                                                1,973
    Marketable securities                                                                     4,098                  217
    Accounts receivable, net of allowance of $1,031 and $1,069, respectively                 15,379               13,087
    Costs in excess of billings                                                                 702                1,141
    Due from related parties                                                                  1,436                1,190
    Prepaid expenses and other current assets                                                 1,920                1,657
                                                                                           --------            ---------
           Total current assets                                                              29,268               22,111

Property and equipment, net                                                                  30,632               26,447
Investment, at cost                                                                           5,250                  760
Goodwill                                                                                     61,946               54,939
Other assets                                                                                  3,150                2,293
                                                                                           --------            ---------
           Total assets                                                                    $130,246            $ 106,550
                                                                                           ========            =========

                    LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities
    Accounts payable                                                                       $  6,028            $  11,566
    Lines of credit                                                                             687                6,050
    Accrued payroll                                                                           3,088                1,877
    Accrued expenses                                                                          4,385                3,271
    Deferred revenue                                                                          4,270                5,068
    Current portion of convertible debentures                                                13,804
    Current portion of long-term debt and capital lease obligations                           4,394                6,163
                                                                                           --------            ---------
           Total current liabilities                                                         36,656               33,995

Long-term debt and capital lease obligations                                                 11,655                4,422
Convertible debentures                                                                       13,804               30,311
Other liabilities                                                                               404                  287
Temporary equity                                                                             10,000               10,000
Commitments and contingencies
Stockholders' equity
    Common stock, $.01 par value; 90,000,000 shares authorized;
       issued and outstanding: 25,986,947 shares at December 31, 2000
       and 27,555,238 shares at June 30, 2001                                                   260                  276
    Additional paid-in capital                                                              139,900              141,842
    Accumulated deficit                                                                     (82,439)            (114,470)
    Accumulated other comprehensive income (loss)                                                 6                 (113)
                                                                                           --------            ---------
           Total stockholders' equity                                                        57,727               27,535
                                                                                           --------            ---------
           Total liabilities and stockholders' equity                                      $130,246            $ 106,550
                                                                                           ========            =========
</TABLE>

       The accompanying notes are an integral part of these statements.

                                      3



<PAGE>   4


                  APPLIEDTHEORY CORPORATION AND SUBSIDIARIES
                    CONSOLIDATED STATEMENTS OF OPERATIONS
              (IN THOUSANDS, EXCEPT PER SHARE AND SHARE AMOUNTS)
                                 (UNAUDITED)

<TABLE>
<CAPTION>
                                                                Three months ended                Six months ended
                                                                     June 30,                         June 30,
                                                                     --------                         --------

                                                               2000            2001            2000             2001
                                                               ----            ----            ----             ----
<S>                                                       <C>              <C>            <C>              <C>
Net revenues
     Web hosting                                           $     2,045      $    6,773     $     3,775      $    14,214
     Internet solutions                                          8,079           4,690          14,706            9,964
     Internet connectivity                                       7,864           7,463          15,329           14,936
                                                           -----------      ----------     -----------      -----------

     Total net revenues                                         17,988          18,926          33,810           39,114
                                                           -----------      ----------     -----------      -----------

Costs and expenses
     Cost of revenues                                           12,746          12,220          23,788           26,010
     Sales and marketing                                         7,459           5,665          14,170           11,760
     General and administrative                                  4,864           4,683           9,773           10,055
     Research and development                                      181             658             347            1,252
     Depreciation                                                2,626           3,164           4,465            6,190
     Amortization                                                2,518           3,671           4,797            7,378
     Other (income) expenses                                      (186)                           (206)             (22)
     Non-recurring charges                                                       4,491                            6,202
                                                           -----------      ----------     -----------      -----------

     Total costs and expenses                                   30,208          34,552          57,134           68,825
                                                           -----------      ----------     -----------      -----------

     Loss from operations                                      (12,220)        (15,626)        (23,324)         (29,711)

Interest income                                                   (284)            (38)           (677)            (140)
Interest expense                                                   972           1,269           1,250            2,460
                                                           -----------      ----------     -----------      -----------

     Net loss attributable to common stockholders          $   (12,908)     $  (16,857)    $   (23,897)     $   (32,031)
                                                           ===========      ===========    ===========      ===========

Basic and diluted loss per common share                    $    ( 0.54)     $    (0.62)    $    ( 1.02)     $     (1.20)
                                                           ===========      ===========    ===========      ===========

Shares used in computing basic and diluted loss per
share                                                       23,841,598       27,066,490     23,472,056       26,624,221
                                                           ===========      ===========    ===========      ===========
</TABLE>


       The accompanying notes are an integral part of these statements.


                                      4


<PAGE>   5



                  APPLIEDTHEORY CORPORATION AND SUBSIDIARIES
               CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                       AND COMPREHENSIVE INCOME (LOSS)
         YEAR ENDED DECEMBER 31, 2000 (DERIVED FROM AUDITED FINANCIAL
          STATEMENTS) AND SIX MONTHS ENDED JUNE 30, 2001 (UNAUDITED)
                      (IN THOUSANDS, EXCEPT SHARE DATA)

<TABLE>
<CAPTION>

                                                                                                Accumu-
                                                                                                lated
                                                                                                other
                                                   Common stock    Additional    Accumu-       compre-                  Compre-
                                              -------------------   paid-in       lated        hensive                  hensive
                                              Shares       Amount   capital      deficit    income (loss)    Total   income (loss)
                                              ------       ------ ------------ -----------  -------------  --------- -------------
<S>                                           <C>          <C>    <C>          <C>          <C>            <C>       <C>

BALANCE, JANUARY 1, 2000                       21,413,362    $214  $  84,052   $ (29,806)         $(251)    $ 54,209
                                               ==========     ===     ======     ========          =====     =======

Issuance of common stock for acquisitions       3,828,471      38     48,327                                  48,365
Issuance of common stock pursuant to
  exercise of stock options                       515,441       5      1,004                                   1,009
Issuance of common stock pursuant to
  Employee Stock Purchase Plan                    229,673       3      1,189                                   1,192
Compensation expense related to stock
  option plan                                                          1,236                                   1,236
Discount on convertible debenture                                      4,092                                   4,092
Unrealized gain (loss) on marketable
  securities                                                                                        257          257          257
Net loss                                                                         (52,633)                    (52,633)     (52,633)
                                               ----------     ---   --------     --------          ----      --------     --------

Comprehensive loss                                                                                                      $ (52,376)
                                                                                                                          ========

BALANCE, DECEMBER 31, 2000                     25,986,947    $260  $ 139,900   $ (82,439)         $   6     $ 57,727
                                               ==========     ===    =======     ========             =      =======

Issuance of common stock for acquisitions         174,000       2        127                                     129
Issuance of common stock pursuant to
  exercise of stock options                       295,827       3         45                                      48
Issuance of common stock pursuant to
  Employee Stock Purchase Plan                    537,105       5        332                                     337
Issuance of common stock pursuant to
  conversion of convertible debentures,
  net of debt discount and issuance costs         561,358       6        838                                     844
Compensation expense related to stock option
  plan                                                                   600                                     600
Unrealized gain (loss) on marketable
  securities                                                                                       (119)        (119)        (119)
Net loss                                                                         (32,031)                    (32,031)     (32,031)
                                               ----------     ---   --------     --------          -----     --------     --------

Comprehensive loss                                                                                                      $ (32,150)
                                                                                                                          ========

BALANCE, JUNE 30, 2001                         27,555,237    $276  $ 141,842  $ (114,470)         $(113)    $ 27,535
                                               ==========     ===    =======    =========          =====     =======

</TABLE>

       The accompanying notes are an integral part of these statements.

                                      5

<PAGE>   6



                  APPLIEDTHEORY CORPORATION AND SUBSIDIARIES
                    CONSOLIDATED STATEMENTS OF CASH FLOWS
                                (IN THOUSANDS)
                                 (UNAUDITED)
<TABLE>
<CAPTION>
                                                                                           Six months ended
                                                                                               June 30,
                                                                                     -----------------------------
                                                                                         2000           2001
                                                                                         ----           ----
<S>                                                                                  <C>            <C>
Cash flows from operating activities
         Net loss                                                                      $ (23,897)     $ (32,031)
         Adjustments to reconcile net loss to net cash used in operating activities
              Depreciation                                                                 4,465          6,190
              Amortization of goodwill                                                     4,797          7,378
              Amortization of debt discount                                                  589            637
              Write-off of debt discount                                                                  2,167
              Provision for bad debts                                                        133            575
              Realized loss on marketable securities                                                      2,970
              Gain on sale of property and equipment                                         (16)           (23)
              Compensation expense related to stock option plans                             618            600
              Changes in assets and liabilities, net of acquisitions
                Accounts receivable                                                       (5,868)           957
                Due from related parties                                                    (158)           132
                Prepaid expenses, other current assets and other assets                     (827)        (1,072)
                Accounts payable                                                           1,830          5,538
                Accrued payroll, expenses and other liabilities                           (1,510)        (1,680)
                Deferred revenue                                                             823            358
                                                                                       ---------      ---------
              Net cash used in operating activities                                      (19,021)        (7,304)
                                                                                       ---------      ---------

Cash flows from investing activities
         Purchases of property and equipment                                             (13,224)        (1,444)
         Purchase of marketable securities                                               (23,930)
         Proceeds from sales of marketable securities                                     29,782          6,042
         Investment in certain businesses, net of cash acquired                          (11,183)          (128)
         Payments received on notes receivable                                                 3              3
         Proceeds from sale of property and equipment                                         16            218
                                                                                       ---------      ---------
              Net cash provided by (used in) investing activities                        (18,536)         4,691
                                                                                       ----------     ---------

Cash flows from financing activities
         Issuance of common stock, net of issuance costs                                   1,526            385
         Issuance of convertible debentures                                               30,000
         Convertible debenture issue costs                                                  (970)           (62)
         Proceeds from (payments on) line of credit borrowings, net                         (170)          (137)
         Principal payments on long-term debt and capital leases                          (2,783)        (2,791)
         Proceeds received from long-term debt and capital leases                          2,997          2,331
                                                                                       ---------      ---------
              Net cash (used in) provided by financing activities                         30,600           (274)
                                                                                       ---------      ----------

              Net decrease in cash and cash equivalents                                   (6,957)        (2,887)

Cash and cash equivalents, beginning of period                                            14,834          5,733
                                                                                       ---------      ---------

Cash and cash equivalents, end of period                                               $   7,877      $   2,846
                                                                                       =========      =========

Supplemental disclosures of cash flow information
         Cash paid during the period for interest                                      $     536      $     955

Non-cash investing and financing transactions
         Fixed asset acquisitions financed through capital lease obligations           $   5,029      $     477
         Conversion of convertible debentures to equity                                                     844
         Acquired stock in exchange for cancellation of accounts receivable                                 760
         Unrealized holding (loss) gain on available for sale securities                     197           (119)
         Investment in businesses
               Fair value of assets acquired, net of cash acquired                        65,220            257
              Liabilities assumed                                                          6,881
              Issuance of common stock for investment in businesses                       37,156            129
              Issuance of temporary equity for investment in businesses                   10,000
</TABLE>

       The accompanying notes are an integral part of these statements.


                                      6

<PAGE>   7


                  APPLIEDTHEORY CORPORATION AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 (UNAUDITED)


NOTE A - NATURE OF OPERATIONS AND BASIS OF PRESENTATION

     AppliedTheory Corporation was incorporated in the State of New York in
     November 1995 and reorganized as a Delaware corporation on January 28,
     1999.

     The Company is a provider of Internet business solutions offering a full
     suite of web hosting, Internet solutions, Internet connectivity and
     security services to give customers a single source for all their
     Internet needs.

     The Company operates as one business segment and follows the requirements
     of Statement of Financial Accounting Standards No. 131 ("SFAS No. 131"),
     "Disclosures About Segments of an Enterprise and Related Information."

     The consolidated financial statements include the accounts of the Company
     and its wholly owned subsidiaries. All significant intercompany
     transactions have been eliminated in consolidation. These financial
     statements for the three and six months ended June 30, 2000 and 2001 and
     the related footnote information are unaudited and have been prepared on
     a basis substantially consistent with the audited consolidated financial
     statements of the Company as of and for the year ended December 31, 2000
     included in our Annual Report on Form 10-K filed with the Securities and
     Exchange Commission (SEC). The accompanying unaudited consolidated
     financial statements of the Company have been prepared in accordance with
     generally accepted accounting principles for interim financial
     information, with the instructions to Form 10-Q and Article 10 of
     Regulation S-X. All material adjustments, consisting of only normal and
     recurring adjustments, which, in the opinion of management, are necessary
     for fair presentation of the results for the interim periods have been
     reflected. Operating results for the three and six month periods ended
     June 30, 2000 and 2001 are not necessarily indicative of the results that
     may be expected for any succeeding quarters or for the full year. The
     consolidated financial statements and notes thereto should be read in
     conjunction with the Company's audited consolidated financial statements
     for the year ended December 31, 2000.

     In response to current market conditions and as a part of its ongoing
     corporate strategy, the Company is pursuing several initiatives intended
     to increase liquidity and better position the Company under current
     market conditions. There can be no assurance that the Company will be
     able to increase its liquidity or strengthen its financial position. The
     Company has also completed the consolidation of duplicate network
     operations facilities and is continuing ongoing initiatives to reduce
     non-essential personnel and controllable costs such as travel and capital
     expenditures. In addition, the Company is pursuing various financing
     arrangements to allow the execution of our business plan. Management
     believes, although there can be no assurance, that implementation of
     these initiatives, and assuming no unfavorable resolution of the
     litigation with the former CRL shareholders (see Note L), there will be
     sufficient cash flow for the next twelve months.

     Certain prior period amounts have been reclassified to conform to the
     current period presentation.



                                      7

<PAGE>   8


                  APPLIEDTHEORY CORPORATION AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 (UNAUDITED)

NOTE B - ACCOUNTING FOR ACQUISITIONS, INTANGIBLE ASSETS AND GOODWILL

     In connection with the acquisition of CRL Network Services, Inc. ("CRL")
     in January 2000, the Company entered into a put option agreement
     requiring the Company, at the option of the holders, to repurchase a
     total of up to 625,000 shares of AppliedTheory common stock in two equal
     installments, not to exceed $10,000,000 in the aggregate, on the first
     and second anniversary of the acquisition. In the event that the average
     closing price for AppliedTheory common stock as reported on the Nasdaq
     National Market for any period of at least 30 consecutive days beginning
     180 days after the closing of the merger shall exceed $24.00, the second
     put option will terminate. The Company has classified the redemption
     price of $10,000,000 as temporary equity. No amounts have been paid as of
     June 30, 2001 (see Note L for further discussion).

     Under escrow provisions of the merger agreements in connection with the
     acquisitions of CRL and Team Tech International, Inc. in 2000, the
     Company has placed 285,507 and 51,628 shares, respectively, of its common
     stock in escrow. These shares are issuable to the former owners of the
     companies but may be forfeited, in whole or in part, in the event that
     various contingencies as defined in the merger agreements occur. Such
     amounts will be recorded as additional cost of the acquired company when
     the number of shares to be issued, if any, becomes determinable beyond a
     reasonable doubt. At June 30, 2001, the aforementioned shares held in
     escrow had not been issued since the outcome of the contingencies was not
     determinable.

     In July 2001, the Financial Accounting Standards Board issued SFAS No.
     141, "Business Combinations" and SFAS 142, "Goodwill and Other Intangible
     Assets". The new standards require that all business combinations
     initiated after June 30, 2001 must be accounted for under the purchase
     method. In addition, all intangible assets acquired that are obtained
     through contractual or legal right, or are capable of being sold,
     transferred, licensed, rented or exchanged shall be recognized as an
     asset apart from goodwill. Goodwill and intangibles with indefinite lives
     will no longer be subject to amortization, but will be subject to at
     least an annual assessment for impairment by applying a fair value based
     test.

     The Company will continue to amortize goodwill existing at June 30, 2001
     under its current method until January 1, 2002 (the adoption date).
     Thereafter, annual and quarterly goodwill amortization of approximately
     $3.7 million and $14.7 million, respectively, will no longer be
     recognized. In accordance with the new standards, by June 30, 2002, the
     Company will perform a transitional fair value based impairment test. If
     the fair value is less than the recorded value at January 1, 2002, the
     Company will record an impairment loss in the March 31, 2002 quarter, as
     a cumulative effect of a change in accounting principle.





                                      8

<PAGE>   9


                  APPLIEDTHEORY CORPORATION AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 (UNAUDITED)


NOTE C - COMPREHENSIVE LOSS

     Comprehensive loss for the three and six months ended June 30, 2000 and
     2001, was as follows:

<TABLE>
<CAPTION>
                                            Three months ended                  Six months ended
                                                  June 30,                          June 30,
                                      ------------------------------    -------------------------
                                          2000             2001             2000          2001
                                      ------------    --------------    ------------   ----------
                                              (in thousands)                   (in thousands)
<S>                                   <C>             <C>               <C>            <C>
 Net loss attributable to common
  stockholders                         $  (12,908)      $  (16,857)     $  (23,897)     $  (32,031)
 Other comprehensive (income) loss:
   Unrealized gain (loss) on
      marketable securities, net of
      income tax                               29              247             197            (119)
                                       ----------       ----------      ----------      ----------
 Comprehensive loss                    $  (12,879)      $  (16,610)     $  (23,700)     $  (32,150)
                                       ==========       ==========      ==========      ==========
</TABLE>


NOTE D - LOSS PER SHARE

     Basic loss per share is computed using the weighted average number of
     shares of common stock outstanding during the period. Diluted loss per
     share is computed using the weighted average number of shares of common
     stock, adjusted for the dilutive effect of potential common shares issued
     or issuable pursuant to stock options, stock appreciation rights,
     warrants and convertible securities. Potential common shares issued are
     calculated using the treasury stock method. All potential common shares
     have been excluded from the computation of diluted loss per share as
     their effect would be antidilutive and, accordingly, there is no
     reconciliation of basic and diluted loss per share for each of the
     periods presented. Potential common shares that were excluded from the
     computation of diluted loss per share consisted of stock options,
     warrants and convertible debentures outstanding of 5,998,916 and
     26,599,979 at June 30, 2000 and 2001, respectively.


NOTE E - OTHER LIABILITIES

     The Company acquired CRL Network Services, Inc. in January 2000. In the
     fourth quarter 2000, the Company recorded $1.1 million in accrued
     liabilities for planned terminations of certain network and
     facility-related contracts and severance for certain employees in
     connection with the acquisition. Such terminations and severance were
     substantially completed as of June 30, 2001. The Company has charged $0.4
     million and $0.9 million, respectively, against these liabilities for the
     three and six months ended June 30, 2001.


NOTE F - LONG-TERM DEBT

     Line of Credit

     On January 20, 2001, the Company renewed a credit agreement with a
     commercial bank for an aggregate amount of $7,500,000 through January 19,
     2002. Interest is charged and payable on a monthly basis as determined by
     the Company, either on the LIBOR plus 40 basis points

                                      9

<PAGE>   10


                  APPLIEDTHEORY CORPORATION AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 (UNAUDITED)

     or a prime rate basis less 200 basis points (4.75% on June 30, 2001). The
     credit facility is collateralized by either cash and cash equivalents,
     government securities, corporate securities or corporate equities pledged
     by NYSERNet.net, Inc. ("NET"). NET must post collateral equaling 100% of
     the draw if the collateral is cash and cash equivalents or collateral
     equaling 130% of the draw if the collateral is government securities,
     corporate securities or corporate equities.

     In accordance with the terms of the credit agreement, the bank issued
     standby letters of credit in the Company's name for $1,450,000, expiring
     January 19, 2002, pursuant to the credit agreement, collateralizing the
     Company's obligation to third parties for real property leases. The
     Company's available credit under its line of credit agreement is
     effectively reduced by the outstanding amount of these letters of credit.

     At June 30, 2001, the Company had $6,050,000 outstanding and no
     availability under lines of credit. The average interest rate on
     outstanding borrowings was 4.75% at June 30, 2001.

     Revolving Credit Agreement

     On July 10, 2001, the Company entered into a one-year revolving credit
     agreement with seven lenders (referred to as the "Investors" in Note G)
     for a principal amount of up to $6,000,000. The total amount that the
     Company may borrow is limited by its borrowing base, which is measured at
     any time of borrowing by multiplying the total value of the Company's
     eligible account receivables by 44.44%. Amounts borrowed will be
     evidenced by a note, which will be secured by the Company's assets.
     Amounts borrowed under the credit agreement bear interest for the first
     60 days outstanding at the prime rate plus two hundred basis points and
     thereafter at the prime rate plus four hundred basis points.

     The Company and the lenders have also entered into a security agreement,
     which grants the lenders a first priority lien on the assets of the
     Company to secure the payment in full of all amounts due and payable
     under the aforementioned credit agreement and the convertible debentures
     (see Note G).

     Equipment Financing

     The Company has entered into various equipment financing agreements with
     secured lenders. Borrowings under these agreements are repayable in
     monthly installments with interest at fixed rates ranging from 10.3% to
     13.5% through June 2003. In connection with these equipment financings,
     the Company was required to place on deposit $753,000 as additional
     collateral. The security deposits are included in "Other assets" at June
     30, 2001 and earn interest at a rate of approximately 5.0% per annum. One
     half of the security deposit is refundable on September 1, 2001 and the
     remaining balance will be used for monthly lease payments commencing May
     1, 2002.


     Capital Lease Obligations

     The Company leases certain equipment under agreements accounted for as
     capital leases. The obligations for the equipment require the Company to
     make monthly payments through December 2005, with implicit interest rates
     ranging from 10.0% to 22.8%. In connection with the financing, the
     Company was required to maintain a cash deposit of $540,000 as additional
     collateral. This deposit comprises a portion of the total restricted cash
     balance of approximately $682,000 at June 30, 2001.

                                      10

<PAGE>   11

                  APPLIEDTHEORY CORPORATION AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 (UNAUDITED)

     The following is a summary of future minimum lease payments under capital
leases as of June 30, 2001.

<TABLE>
<CAPTION>
                                                      (in thousands)
<S>                                                  <C>
   Year ending December 31,
   2001                                                   $ 2,532
   2002                                                     4,591
   2003                                                     1,969
   2004                                                       132
   2005                                                        10
                                                            -----

   Total minimum lease payments                             9,234

   Less amounts representing interest                       1,240
                                                            -----

   Present value of minimum lease obligation              $ 7,994
                                                            =====

</TABLE>


NOTE G - CONVERTIBLE DEBENTURES

     On June 5, 2000 the Company entered into a purchase agreement with seven
     institutional investors (the "Investors") and issued $30 million in 5%
     convertible debt financing (the "Debentures"). On January 9, 2001, the
     Company amended the agreements with the Investors whereby the Company and
     the Investors modified certain significant components of the June 5, 2000
     purchase agreement and the registration rights agreement. The amended and
     restated agreement eliminated the Investors' option to purchase up to $10
     million of the Company's common stock. It also eliminated the Company's
     option to require the Investors to purchase an additional $10 million of
     the Company's common stock. On July 10, 2001, the Company entered into an
     amendment agreement (the "Amendment Agreement") with the Investors
     whereby certain provisions of the January 9, 2001 amended and restated
     purchase agreement and related documents were modified.

     The Debentures earn interest at 5% per annum, payable semi-annually in
     June and December, and mature on June 5, 2003. At the Company's option,
     interest can be accrued, paid in cash, paid in common stock, or take the
     form of PIK interest (interest paid in kind and added to the principal of
     the Debentures). At June 30, 2001, the outstanding principal balance of
     the Debentures (including PIK interest) was $30,310,633 and interest
     accrued on the Debentures was $127,337.

     Under the Amendment Agreement the Investors are granted the right to
     convert the Debentures, in whole or in part, into shares of common stock
     from time to time. The Debentures' conversion prices and amounts are as
     follows:



                                      11

<PAGE>   12


                  APPLIEDTHEORY CORPORATION AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 (UNAUDITED)


<TABLE>
<CAPTION>
          Conversion Price                    Conversion Amount
          ----------------                    -----------------
          <S>                 <C>
               $0.90          for the first $6,500,000 of principal, plus PIK
                              interest and accrued but unpaid interest thereon

               $1.22          for the next $6,500,000 of principal, plus PIK
                              interest and accrued but unpaid interest thereon

               $1.80          for the next $6,500,000 of principal, plus PIK
                              interest and accrued but unpaid interest thereon

               $2.70          for the next $6,500,000 of principal, plus PIK
                              interest and accrued but unpaid interest thereon

               $3.60          for the aggregate principal amount) of the
                              Debentures outstanding in excess of $26,000,000
                              plus PIK interest and accrued but unpaid
                              interest thereon
</TABLE>

     Unless otherwise specified by the Investor, the Debentures submitted for
     conversion shall be converted at the lowest conversion price available to
     the Investor with respect to such Debentures. The outstanding principal
     amount of a Debenture, together with accrued interest, that is so converted
     shall be convertible into shares of the Company's common stock. Based on
     these conversion prices, the Debentures are presently convertible into
     approximately 22.4 million shares of common stock at any time until
     maturity. During the three and six months ended June 30, 2001, $145,000 and
     $844,000, respectively, of the convertible debentures' principal, net of
     debt discount and issuance costs, was converted into 195,024 and 561,358
     shares, respectively, of common stock under the conversion terms of the
     prior agreements.

     Upon the occurrence of an event of default and until such event of
     default is cured, amounts due and outstanding under the Debentures bear
     interest at the per annum rate equal to the lower of the Citibank Prime
     Rate per annum plus six (6%) percent or the highest rate permitted by
     law. The Investors have the option to receive such interest in the form
     of cash, PIK interest or common stock. The Investors may also require the
     Company to repurchase the Debentures at 120% of the outstanding principal
     amounts of the Debentures if the Company defaults in its obligations to
     them under any agreements between the Investors and the Company.

     Subject to limited exceptions, the right to convert the Debentures
     terminates upon the closing of a relevant sale of the Company as defined
     in the Amendment Agreement. In the event of a change of control
     transaction, the Investors are entitled to convert their Debentures into
     common stock and receive the same consideration as the common stock
     holders. Also, in the event that the Company enters into a sale of the
     Company (as defined in the Amendment Agreement), the Company is obligated
     to pay to the Investors a percentage of the consideration paid by the
     acquirer in such a transaction. Such payments shall be applied, as to
     each Investor, first, to redeem the Debentures. The consideration from
     such a sale of the Company shall be paid to the Investors as follows:
     100% of the first $10,000,000; 60% of the next $20,000,000; 20% of the
     next $20,000,000; and 10% of amounts above $50,000,000. After the
     Debentures have been redeemed and/or converted in full, the Investors may
     continue to be entitled to receive part of the consideration resulting
     from each sale of the Company based on the terms set forth in the
     Amendment Agreement.


                                      12

<PAGE>   13

                  APPLIEDTHEORY CORPORATION AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 (UNAUDITED)

     Additionally, the Amendment Agreement terminated the Investors' warrants to
     purchase up to $13,000,000 of the Company's common stock under the prior
     agreements. Based on an independent valuation of the Debentures and related
     warrants and options, the Company had originally recorded a $3.9 million
     debt discount and corresponding increase in additional paid in capital
     representing the allocation of proceeds to the detachable warrants and
     Investors' call option. The carrying value of the Debentures was being
     accreted to the face value of $30 million using the interest method over
     the life of the Debentures. The accretion was $316,000 and $637,000 for the
     three and six months ended June 30, 2001. Due to the termination of the
     warrants and call option the Company wrote off the unamortized portion of
     $2.4 million as of June 30, 2001. In addition, the Company assigned a value
     of $250,000 to certain features in the Amendment Agreement. The net of
     these two amounts of approximately $2.2 million was included in
     non-recurring charges on the consolidated statements of operations for the
     three and six months ended June 30, 2001.


NOTE H - STOCK OPTIONS

     Certain options and stock appreciation rights were granted in 1998 and
     1999 at exercise prices below the fair market value of the Company's
     stock. The Company recorded $309,000 and $300,000 of compensation expense
     associated with these options and stock appreciation rights for the three
     months ended June 30, 2000 and 2001 and a total of $618,000 and $600,000
     for the six months ended June 30, 2000 and 2001, respectively.


NOTE I - RELATED PARTY TRANSACTIONS

     Transactions with NET and ORG

     The Company has a resale agreement with NYSERNet.org, Inc. ("ORG") to
     serve as ORG's provider for Internet services and network management
     solutions to ORG's customer base under contractual arrangements. ORG's
     customers consist of (i) unrelated customers for which ORG serves as a
     conduit to the sales transactions between the Company and these customers
     and (ii) member institutions of ORG. In addition, the Company provides
     services to ORG principally related to network operations and
     development. The Company's revenues from ORG's customer base and services
     to ORG for the following periods are:

<TABLE>
<CAPTION>
                                     Three Months Ended               Six Months Ended
                                            June 30,                      June 30,
                                   -------------------------      -----------------------
                                      2000            2001           2000         2001
                                   ----------      ---------      ---------     ---------
                                        (in thousands)                 (in thousands)
<S>                                <C>             <C>            <C>           <C>
          Unrelated customers      $      729      $     961      $   1,481     $   2,100
          Member institutions           1,287          2,341          2,552         4,344
          Services to ORG                 747            644          1,454         1,467
                                   ----------      ---------      ---------     ---------
                                   $    2,763      $   3,946      $   5,487     $   7,911
                                   ==========      =========      =========     =========
</TABLE>

     During the three months ended June 30, 2000 and 2001, the Company charged
     NET and ORG approximately $100,000 and $0, respectively, in management
     fees. During the six months ended June 30, 2000 and 2001, the Company
     charged NET and ORG approximately $200,000 and $50,000, respectively, in
     management fees.


                                      13

<PAGE>   14


                  APPLIEDTHEORY CORPORATION AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 (UNAUDITED)

NOTE J - INVESTMENT IN PLANNING TECHNOLOGIES, INC. AND RED HAT, INC.

     On June 22, 1999, the Company and certain other shareholders of PTI
     entered into a stock purchase agreement (the "Stock Purchase Agreement")
     with Planning Technologies, Inc. ("PTI"), a Georgia corporation, which
     provided consulting and network engineering services. Pursuant to the
     Stock Purchase Agreement, the Company acquired approximately 10% of the
     capital stock of PTI on a fully diluted basis, as defined in the Stock
     Purchase Agreement, for $5 million. At December 31, 1999, the Company's
     10% ownership interest in PTI was represented by 2,976,190 shares of
     PTI's Convertible Preferred Stock.

     On April 4, 2000, the Company converted its 2,976,190 shares of PTI's
     Convertible Preferred Stock into common shares and received 1,816,173
     additional shares of common stock in exchange for the termination of the
     Stock Purchase Agreement. This increased the Company's ownership
     percentage to 16% of PTI's common stock on a fully diluted basis. The
     Company also invested an additional $250,000 in PTI in connection with
     the reorganization of PTI in exchange for 564,498 shares of common stock.
     After the reorganization the Company owned approximately 8.5% of PTI's
     outstanding common stock. The Company accounted for the investment under
     the cost method.

     On February 26, 2001, PTI merged with Red Hat, Inc. ("RHAT"), a company
     publicly traded on the Nasdaq Stock Market. As a result of the merger,
     the Company converted its 5,356,861 shares of PTI into 521,769 shares of
     common stock of RHAT and recorded a realized loss of $1.7 million based
     on the investment's fair value of $3.6 million on February 26, 2001. On
     June 28 and June 29, 2001, the Company sold a total of 467,497 shares of
     RHAT resulting in proceeds of $2.0 million and a realized loss of $1.3
     million. The proceeds were classified as due from broker on the
     consolidated balance sheet and the realized loss was included in
     non-recurring charges on the consolidated statements of operations as of
     June 30, 2001. The fair value of the remaining shares of $0.2 million was
     classified as an available for sale marketable security and the
     unrealized loss of $0.1 million, net of taxes, on the investment was
     included in stockholders' equity as a component of accumulated other
     comprehensive income (loss) at June 30, 2001.

NOTE K - STOCK PURCHASE AGREEMENT

     On February 22, 2001, the Company completed a stock purchase arrangement
     with Crescent International Ltd., an investment fund managed by
     GreenLight (Switzerland) SA of Geneva, Switzerland, that provides the
     Company with financing ability of up to $30 million to fund operations
     and infrastructure requirements. The arrangement provides that Crescent
     will buy up to $30 million worth of AppliedTheory common stock, should
     the Company choose to sell. Under the terms of the transaction, the
     Company has the right, but is not obligated, to exercise the option, in
     whole or in part. The amount of shares that the Company can sell is
     contingent upon certain trading volume and share price parameters. The
     Company can sell the shares at a price equal to 93% of the average price
     of its common stock during the lowest three consecutive trading days
     during the 22 trading days preceding the sale. However, if the price of
     the Company's common stock is below $1.00 on any of the eight trading
     days beginning on the day it notifies Crescent of its intention to sell
     common stock or, if the average of the closing price times the trading
     volume of its common stock for the 22 trading days preceding such notice
     is less than $150,000, the Company can only sell $50,000 of its common
     stock to Crescent.

                                      14

<PAGE>   15


                  APPLIEDTHEORY CORPORATION AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 (UNAUDITED)

     If the Company chooses to sell its common stock under the agreement, the
     Company must issue warrants to Crescent entitling it to purchase, in the
     aggregate, up to $3,000,000 of AppliedTheory common stock at an exercise
     price equal to 150% of the purchase price in effect at the first sale,
     subject to certain adjustments. In connection with this agreement, the
     Company also undertook to register for public resale under the Securities
     Act of 1933, as amended, all the shares of AppliedTheory common stock
     issuable, should the Company elect to sell its common stock under the
     agreement, or upon exercise of the warrants.

     Given the current market value of the Company's common stock and the
     existence of certain restrictions, the Company does not anticipate
     selling its common stock under this agreement, and therefore, wrote-off
     its financing costs pursuant to the agreement of $0.3 million. This
     amount was included in non-recurring charges on the consolidated
     statements of operations for the three and six months ended June 30,
     2001.


NOTE L - LEGAL PROCEEDINGS AND CONTINGENCIES

     In June 2000, the Company was notified by the U.S. Attorney for the
     Western District of New York that a relator had filed a qui tam action
     under seal against the Company and Net. The complaint alleged that the
     National Science Foundation was fraudulently induced to provide a grant
     of $2.45 million to Net, a portion of which was paid by Net to the
     Company for services rendered. The complaint seeks treble damages related
     to the alleged overpayment for services provided by the Company to Net,
     as well as certain other penalties and forfeitures under the False Claims
     Act. On January 19, 2001, the Company received a redacted copy of the
     amended complaint in this action. In addition to the original
     allegations, this amended complaint alleged that Net and the Company
     failed to disclose the transfer of alleged program income in violation of
     the False Claims Act. Furthermore, the amended complaint alleged that the
     Company conspired with Net to engage in the fraudulent conduct described
     above and seeks unspecified millions of dollars in treble damages as a
     result. Although the Department of Justice has not yet determined whether
     or not it will join in this action, the Company believes that these
     allegations are without merit and intends to contest them.


     On December 13, 2000, James G. Couch filed a complaint in New York state
     court seeking approximately $9,650,000 in damages against the Company due
     to an alleged anticipatory breach of a put option agreement between the
     Company, Mr. Couch and others dated January 5, 2000, pursuant to which
     Mr. Couch, as part of the consideration for his sale to the Company of
     the capital stock of CRL Network Services, Inc., was granted two put
     options, exercisable on January 5, 2001 and January 5, 2002,
     respectively, pursuant to which Mr. Couch may require the Company to
     purchase shares of its common stock from Mr. Couch at specified times and
     in specified circumstances. On January 2, 2001, the Company answered the
     complaint and asserted affirmative defenses and counterclaims for fraud,
     indemnification and breach of contract for which the Company seeks
     compensatory and punitive damages. Mr. Couch served an amended complaint
     on January 8, 2001 asserting claims of actual and anticipatory breach of
     the Put Option Agreement, and a reply to the Company's answer and
     counterclaims. On January 29, 2001, the Company answered the amended
     complaint and asserted affirmative defenses and counterclaims for fraud,
     violations of the California Corporation Code, indemnification and breach
     of contract which the Company seeks compensatory and punitive damages. In
     addition, the Company is pursuing indemnification

                                      15

<PAGE>   16


                  APPLIEDTHEORY CORPORATION AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 (UNAUDITED)

     claims under the escrow agreement against Mr. Couch in an arbitration
     proceeding. On February 15, 2001, Mr. Couch filed a motion to dismiss the
     Company's counterclaim for violations of the California Corporations Code
     and to stay the Company's counterclaims for indemnification and breach of
     contract pending the completion of an arbitration between the parties
     concerning the Company's claims against Mr. Couch under the escrow
     agreement. The Company cross-moved to stay the entire litigation,
     including Mr. Couch's claims, pending completion of this arbitration. On
     March 9, 2001, Mr. Couch filed a motion for partial summary judgment
     seeking entry of judgment in his favor on all of his claims, striking the
     Company's fraud defense to the extent it seeks a rescission remedy, and
     striking the Company's claim for punitive damages. Oral argument for Mr.
     Couch's motion filed on February 15, 2001, the Company's cross-motion
     thereto, and Mr. Couch's motion filed on March 9, 2001 took place on
     April 5, 2001. On July 23, 2001, the court ruled on the parties' motions.
     The court granted Mr. Couch's motion to dismiss the Company's
     counterclaim for violations of the California Corporations Code. The
     court granted Mr. Couch's motion to stay the Company's counterclaims for
     indemnification and breach of contract and the Company's cross-motion to
     stay the entire litigation pending the completion of an arbitration
     between the parties concerning the Company's claims against Mr. Couch
     under the escrow agreement. The court held in abeyance Mr. Couch's motion
     for partial summary judgment on his breach of contract claim pending the
     determination of the arbitration, denied Mr. Couch's motion to strike the
     Company's fraud defense to the extent it seeks a rescission remedy, and
     granted Mr. Couch's motion to strike the Company's claim for punitive
     damages. The Company is considering whether to appeal from the adverse
     aspects of the ruling. This litigation is in the preliminary stage, and
     therefore, no opinion as to likelihood of an unfavorable outcome can be
     made. However, if an unfavorable outcome does occur requiring the Company
     to pay cash to redeem the shares owned by the former CRL shareholders,
     the Company may not have sufficient financial resources to meet the
     obligation. At June30, 2001, the Company has $10 million recorded as
     temporary equity in connection with these put options.

     There can be no assurance whether these matters will be determined in a
     manner that is favorable to the Company or, if adversely determined, that
     such determination would not have a material adverse effect upon the
     Company's business, financial condition or results of operations.

     The Company is not involved in any other legal proceedings which it
     believes would, if adversely determined, have a material adverse effect
     upon its business, financial condition or results of operations.

                                      16

<PAGE>   17




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

         You should read and consider the following discussion in conjunction
with our audited financial statements and notes thereto and the "Management's
Discussion and Analysis of Financial Condition and Results of Operations" as
of and for the year ended December 31, 2000 which is included in Form 10-K
(File No. 000-25759), as filed with the SEC .

         Certain statements in this Form 10-Q constitute "forward-looking
statements" within the meaning of the Private Securities Litigation Reform Act
of 1995. These forward-looking statements involve known and unknown risks,
uncertainties and other factors which may cause our actual results,
performance or achievements, or those of the industry in which we operate, to
be materially different from any expected future results, performance or
achievements expressed or implied by these forward-looking statements. Factors
that could cause or contribute to such differences include, but are not
limited to, those discussed below, as well as those discussed in Part II, Item
5 of this Form 10-Q and in the Registration Statement of our initial public
offering of common stock.

         Unless the context otherwise requires, references in this Form 10-Q
to "AppliedTheory", the "Company, "we", "our" and "us" refer to AppliedTheory
Corporation.

OUR COMPANY

         Industry veteran AppliedTheory combines its knowledge base with the
ability to build, integrate and manage Internet business solutions for
corporations wanting to remain competitive in an increasingly complex economy.
We offer a comprehensive and fully integrated suite of managed web hosting,
Internet solutions and connectivity and security services, which enable us to
provide a variety of outsourced managed hosting services options for large
enterprise business needs.

         We help businesses use the Internet to increase profit, decrease
costs and meet business objectives.

MANAGED HOSTING SERVICES AND THE LIFE-CYCLE SUPPORT MODEL

         Today, companies are looking beyond their own resources to meet their
Internet solutions objectives and to fulfill their web hosting requirements.
These companies need to ensure the long-term success of their critical, hosted
applications, such as e-commerce, benefits management, process management, or
any other traditional information technology function that is being migrated
to the Internet environment. Each of these areas makes an important
contribution to the success of an organization's business plan. We believe -
and our experience has shown - that companies often want the cost savings and
flexibility of managed hosting and outsourcing these applications.

         The more critical and more complex the application, the more these
companies might require full support for the life cycle of that application.
Thus, fully integrated Internet solutions become the pathway to a hosting
solution and vice versa. We call this self-perpetuating process our "life
cycle support."


                                      17

<PAGE>   18
WE FOCUS ON INTEGRATED INTERNET BUSINESS SOLUTIONS

         Our customers' successful Internet business strategies have become as
complicated as they are critical. We have found that our business, organization
and government customers view the Internet as a tool to achieve a business
strategy. We believe our intensely customer-focused, life-cycle support approach
helps support established business models.

         We believe the high percentage of customers that are buying complex
solutions from us, and the high degree of retention of our customers, along
with repeat business validates our integrated, web-centric, life-cycle
customer service model. An increasing number of our new proposals are quoting
a complex mix of services, including managed web hosting.

         We use a phased approach designed to develop and implement
comprehensive Internet solutions for our customers. Our core expertise is
derived from our experience in developing business-to-business and
business-to-consumer web-centric solutions.

         We believe that no business-critical Internet solution is viable
without a completely integrated hosting solution; therefore, we offer parallel
lines of hosting services to our customers. Our web hosting solutions include
web site development, managed application support, security and network
operations.

         Each of our managed hosting service offerings is available as a fully
outsourced, upgradeable solution. The managed application hosting solution is
designed to allow its user to save time and greatly reduce capital
expenditures, risk of obsolescence and internal management responsibilities.

         In addition, we provide dedicated server and co-location hosting
services, security consulting services, virtual private networks (VPNs) and
managed firewalls for network security. We also provide direct connectivity to
the global Internet via a redundant, rigorously engineered, high-speed network
backbone.

WE PARTNER WITH OUR CUSTOMERS

         We have found that enterprise customers are increasingly less likely
to consider facilities-based hosting and knowledge-based development,
integration and management services to be mutually exclusive. As large-scale,
web-based business applications become more complex, companies and
organizations are requiring that their Internet outsourcing company be a
partner that has both the technology and the knowledge to scale and grow with
their needs.

OUR EXPERTISE IS EVIDENT IN OUR HANDS-ON EXPERIENCE

         AppliedTheory deploys Internet solutions to more than 1,500
customers. Our customer satisfaction is reflected in our low churn rate of
less than 1/2% per month and reflects the dedication of our more than 500
employees nationwide.

         We have developed business-to-business networks, web sites, portals
and e-business strategies; built internal corporate networks; migrated
existing or legacy software and data processing and storage systems to the
Internet; designed web site user interfaces; and constructed e-commerce sites
from the ground up for major businesses and mid-sized companies nationwide.

     -   We provide Internet solutions to some of America's leading companies,
         including AOL Time Warner, Eddie Bauer, United Parcel Service and
         Ingersoll-Rand..

     -   The New York State Department of Labor awarded AppliedTheory a
         five-year $82 million contract extension in November 2000 to continue
         to manage and host America's Job Bank, which we believe is the
         world's largest online employment database. We created the original

                                      18

<PAGE>   19

         site design and continue to operate and manage the site. We have also
         received additional work orders from this customer in 2001 that has
         resulted in an increase of $5 million in our expected first year
         revenue on this contract.

     -   We have also expanded contracts with other top-tier customers
         including Carrier Corporation, the U.S. Department of State and the
         Denver Broncos.

     -   In addition to the NYS Department of Labor and U.S Department of
         State, our government work has further expanded as a result of a
         General Services Administration ("GSA") contract that was entered
         into during 2001. This contract qualifies the Company to sell
         e-business services directly to Federal agencies. The GSA is one of
         three central management agencies of the Federal Government. In
         addition, we have added the State of Hawaii as a customer and are
         working with the U.S. Forest Service on the redesign of their web
         operations.

OUR EXPERTISE SPANS MANY INDUSTRIES

         AppliedTheory's concentration on providing mission-critical
applications to key industries makes us highly knowledgeable in numerous
vertical markets, including:

     -   EDUCATION - We provide Internet solutions to many of the nation's
         colleges and universities.

     -   HEALTHCARE - We develop healthcare applications for medical
         professionals, supplying technology to address and meet the demand
         for online healthcare delivery systems.

     -   GOVERNMENT - We have worked to develop teams of software engineers
         and consultants with the experience and expertise to efficiently
         fulfill the special requirements that governmental institutions face.

STRONG ALLIANCES EXPAND OUR CAPABILITIES

         To ensure our customers have access to today's leading technology, we
have developed various business relationships with major Internet technology
companies, including:

     -   AT&T - We utilize AT&T's national IP network, peering and co-location
         services to supply the majority of our network infrastructure.

     -   Cisco - Their high-end routers and switches serve as the core of our
         network backbone and web hosting infrastructure.

     -   Compaq - Their development, web and file servers are the foundation
         for our NT and Linux hosting product line.

     -   EDS - They supply high-end and large scale technology project
         management support.

     -   IDS Scheer - They assist us in business process reengineering.

     -   Microsoft - We are a Microsoft Certified Solutions provider.

     -   Pivot Technologies - They provide our customers with network security
         integration expertise and firewall support.

     -   Sprint - We utilize Sprint's national IP infrastructure to provide
         certain peering relationships.

     -   Sun Microsystems - Their development, web and file servers are the
         foundation for our UNIX hosting product line.

                                      19

<PAGE>   20

WE CONTINUE TO EXECUTE OUR BUSINESS PLAN

         We believe that the recurring revenue realized from our managed
hosting services offering is an important element of our business strategy.

         We continue to grow our business. We have been able to increase our
repeat business and add valuable new customers during the first half of 2001. We
continue to focus our core business on fast-growing, high-margin outsourced and
managed hosting and have created a more efficient, streamlined delivery machine
which allows us to produce long-term recurring revenue.

         We have developed certain standard managed hosting configurations.
This streamlines our service delivery and shortens the time to implement the
service. We are continuing to mine certain vertical market segments and build
upon our experience base. By continuing to leverage our success, we maximize
the opportunity to re-use solutions or parts of solutions. Our library of
experienced software code and solutions models is rapidly expanding.

         We will continue to look for targeted, strategic acquisitions, with a
view towards make-versus-buy. We find that these strategic acquisitions resonate
with our business model, and their teams bring new ideas, new skills and, of
course, new customers. However, although we continue to have long-term
aspirations for expansion through acquisitions, we don't expect to complete any
acquisitions during 2001 as a result of the currently existing market
conditions.

RESULTS OF OPERATIONS

THREE AND SIX MONTHS ENDED JUNE 30, 2001 COMPARED TO THREE AND SIX MONTHS
ENDED JUNE 30, 2000

         REVENUES

         The following table and discussion highlights the revenues of the
Company:

<TABLE>
<CAPTION>
                                  Three months ended                Six months ended
                                         June 30,                       June 30,
                              ---------------------------   -----------------------------
                               2000      2001     Change     2000        2001     Change
                              ------    ------    ------    ------      ------  ---------
                                      (in millions)                 (in millions)
<S>                           <C>       <C>       <C>       <C>       <C>       <C>
    Net revenues
      Web hosting              $   2.0    $  6.8   $  4.8    $   3.8    $ 14.2   $   10.4
      Internet solutions           8.1       4.7     (3.4)      14.7      10.0       (4.7)
      Internet connectivity        7.9       7.4     (0.5)      15.3      14.9       (0.4)
                               -------    ------  --------   -------    ------   ---------
    Total net revenues         $  18.0    $ 18.9   $  0.9    $  33.8    $ 39.1   $    5.3
                               =======    ======   ======    =======    ======   =========

    Percent of total revenue

      Web hosting                 11%       36%                 11%       36%
      Internet solutions          45        25                  44        26
      Internet connectivity       44        39                  45        38
                               -----      ----               -----      ----
    Total net revenues           100%      100%                100%      100%
                               ======     =====              ======     =====
</TABLE>

         Total net revenues increased 5%, or approximately $0.9 million, from
$18.0 million in the three months ended June 30, 2000 to $18.9 million in the
three months ended June 30, 2001. Total net revenues increased 16%, or
approximately $5.3 million, from $33.8 million in the six months ended June
30, 2000 to $39.1 million in the six months ended June 30, 2001.

         As the table above illustrates, revenue from web hosting has become a
more significant component of our total revenue as we continue to place more
of a business emphasis on the higher-margin outsourced and managed web hosting
services. Our web hosting revenue growth of 274% illustrates the dramatic
expansion of these services from the six months ended June 30, 2000 to the six
months ended June 30, 2001.

                                      20

<PAGE>   21

         WEB HOSTING REVENUE increased by approximately $4.8 million and $10.4
million, from $2.0 million and $3.8 million for the three and six months ended
June 30, 2000, respectively, to $6.8 million and $14.2 million for the three
and six months ended June 30, 2001, respectively. These services include:

     -   fully managed application hosting including equipment, monitoring and
         maintenance services;

     -   co-located and shared web hosting services in our state of the art
         web hosting centers; and

     -   event solutions consisting of managed hosting, integration services,
         and a software suite of web-based event tools known as
         CyberCentral(TM).

         The continued expansion of our web hosting customer base and product
line accounted for $3.0 million of the increase for the six months ended June
30, 2001 in comparison to the same period in 2000. In addition, approximately
$2.2 million of the increase was the result of revenue from our event
solutions, CyberCentral(TM). An increase in the managed web hosting services
provided to the New York Department of Labor in connection with America's Job
Bank provided an additional $5.2 million in hosting revenue during the six
months ended June 30, 2001.

         INTERNET SOLUTIONS REVENUE decreased by approximately $3.4 million
and $4.7 million, from $8.1 million and $14.7 million for the three and six
months ended June 30, 2000, respectively, to $4.7 million and $10.0 million
for the three and six months ended June 30, 2001, respectively. These services
include:

      -  linking existing databases and legacy systems with the web;

      -  creating open, universal interfaces to business-critical information
         and standards-based software used to link with the systems of
         suppliers, partners and customers; and

      -  developing business-to-business and business-to-consumer web sites.

         The Internet solutions revenue related to the services provided to
the New York State Department of Labor in connection with America's Job Bank
decreased $8.0 million during the six months ended June 30, 2001 in comparison
to the same period in 2000. This decrease was primarily due to a shift in
focus to more managed web hosting services provided to America's Job Bank as
discussed above. However, offsetting the decrease, was an increase in revenue
from our other Internet solutions customers obtained organically and through
acquisitions which increased by $3.3 million, reflecting the continued
diversification and expansion of our customer base. During the six months
ended June 30, 2001, revenue from customers other than the New York State
Department of Labor was 76% of total Internet solutions revenue, up from 63%
during the same period in 2000.

         INTERNET CONNECTIVITY REVENUE remained relatively stable during the
three and six months ended June 30, 2001, as compared to the same periods in
2000. These services include:

     -   providing high-speed broadband internet connections to businesses and
         institutions at speeds ranging from OC-3 to fractional T-1;

     -   nationwide dial access through over 480 points-of-presence;

     -   digital subscriber line (DSL) services; and

     -   infrastructure and connectivity engineering special projects provided
         to NET.

                                      21

<PAGE>   22


         COSTS AND EXPENSES

         The following table and discussion highlights the costs and expenses
of the Company:


<TABLE>
<CAPTION>
                                    Three months ended                    Six months ended
                                           June 30,                           June 30,
                                 ---------------------------      -----------------------------
                                   2000       2001    Change        2000        2001     Change
                                  ------     ------   ------      -------      ------    ------
                                         (in millions)                    (in millions)
<S>                            <C>        <C>       <C>           <C>       <C>        <C>
   Cost of revenues              $  12.7     $ 12.2   $ (0.5)      $  23.8    $ 26.0     $  2.2
   Sales and marketing               7.5        5.6     (1.9)         14.2      11.8       (2.4)
   General and  administrative       4.9        4.7     (0.2)          9.8      10.0        0.2
   Research and development          0.2        0.7      0.5           0.3       1.2        0.9
   Depreciation                      2.6        3.2      0.6           4.4       6.2        1.8
   Amortization                      2.5        3.7      1.2           4.8       7.4        2.6
   Other                            (0.2)       4.5      4.7          (0.2)      6.2        6.4
                                 -------     ------  -------      ---------   ------     ------
    Total costs and expenses     $  30.2     $ 34.6   $  4.4       $  57.1    $ 68.8     $ 11.7
                                 =======     ======   ======       =======    ======     ======
</TABLE>


         COST OF REVENUES. Cost of revenue decreased approximately $0.5
million from $12.7 million in the three months ended June 30, 2000 to $12.2
million in the three months ended June 30, 2001. Total cost of revenues
increased approximately $2.2 million from $23.8 million in the six months
ended June 30, 2000 to $26.0 million in the six months ended June 30, 2001.
The increase in cost of revenues of $2.2 million was primarily attributable to
the factors below.

     -   Increased labor costs to support our revenue growth of approximately
         16% versus the same period in the prior year added $1.9 million in
         costs during the six months ended June 30, 2001. These costs are a
         result of the expansion of web hosting services, additional Internet
         solutions contracts, and labor to integrate our two networks and
         staff our new and expanded web hosting centers.

     -   The remaining increases are a result of other costs to support our
         revenue and customer growth.

         As a percentage of revenue, cost of revenues decreased to 65% in the
three months ended June 30, 2001 from 71% in the three months ended June 30,
2000. During the six months ended June 30, 2001, cost of revenues decreased to
66% of revenue from 70% of revenue in the six months ended June 30, 2000. These
improved gross margins for the three and six months ended June 30, 2001 can be
attributed to our revenue strategy that focuses on high-end, integrated managed
hosting services as well as our continuing ongoing initiatives to reduce the
cost of delivery.

         SALES AND MARKETING. For the three months ended June 30, 2000 and
2001, sales and marketing expense was approximately $7.5 million and $5.6
million, respectively. For the six months ended June 30, 2000 and 2001, sales
and marketing expense was approximately $14.2 million and $11.8 million,
respectively. The $2.4 million decrease in the six months ended June 30, 2001
was primarily attributable to the factors below.

     -   $2.6 million in decreased costs associated with our marketing program
         and product management efforts; and

     -   $0.2 million in decreased occupancy costs and other costs that
         support our sales presence.

                                      22

<PAGE>   23

     -   $0.4 million in increased training costs due to our continued efforts
         to train and structure our sales force to target specific types of
         customers and sell high margin managed application hosting services.

         As a percentage of revenue, sales and marketing expense decreased to
30% in the three months ended June 30, 2001 from 42% in the three months ended
June 30, 2000. During the six months ended June 30, 2001, sales and marketing
expense decreased to 30% of revenue from 42% of revenue in the six months
ended June 30, 2000. The reduction in these percentages for the three and six
months ended June 30, 2001 reflects our better use of marketing resources, an
improved expense management and an increase in sales force productivity.

         GENERAL AND ADMINISTRATIVE. For the three months ended June 30, 2000
and 2001, general and administrative expenses were approximately $4.9 million
and $4.7 million, respectively. For the six months ended June 30, 2000 and
2001, general and administrative expenses were approximately $9.8 million and
$10.0 million, respectively. The increase in general and administrative
expenses of approximately $0.2 million in the six month period was primarily
attributable to:

     -   $0.6 million increase in costs related to salaries of new personnel;

     -   $0.4 million in increased bad debt expense;

     -   $0.8 million decrease in recruiting costs; and

     -   other changes necessary to manage the financial, legal and
         administrative aspects of our business.

         For the quarter ended June 30, 2001, general and administrative
expense decreased as a percent of revenue to 25% from 27% for the quarter
ended June 30, 2000. For the six months ended June 30, 2001, general and
administrative expense decreased as a percent of revenue to 26% from 29% for
the quarter ended June 30, 2000. The improvement in these percentages for the
three and six months ended June 30, 2001 represents a concerted and continued
effort by the entire Company to reduce costs.

         RESEARCH AND DEVELOPMENT. Research and development costs are
principally focused in our web hosting and Internet solutions service
offerings. For the three months ended June 30, 2000 and 2001, research and
development costs were approximately $0.2 million and $0.7 million,
respectively. For the six months ended June 30, 2000 and 2001, research and
development costs were approximately $0.3 million and $1.2 million,
respectively. The increase in research and development costs of approximately
$0.9 million in the six month period was primarily attributable to salaries
and related costs to develop and design web hosting and Internet solutions
products, such as Delta Edge(TM), which we believe is the first content
distribution technology to accelerate Internet delivery of dynamic data with
real-time changes.

         DEPRECIATION. For the three months ended June 30, 2000 and 2001,
depreciation expense was approximately $2.6 million and $3.2 million,
respectively. For the six months ended June 30, 2000 and 2001, depreciation
expense was approximately $4.4 million and $6.2 million, respectively. The
increase of $1.8 million in the six months ended June 30, 2001 is primarily
attributable to the acquisition of equipment and leasehold improvements to
support our web hosting customer base and equipment used to support the
expansion of our network infrastructure. A portion of the depreciation expense
increase also resulted from additional office furniture and equipment
necessary to support our expanded office space.

         AMORTIZATION. For the three months ended June 30, 2000 and 2001,
amortization expense was approximately $2.5 million and $3.7 million,
respectively. For the six months ended June 30,

                                      23

<PAGE>   24

2000 and 2001, amortization expense was approximately $4.8 million and $7.4
million, respectively Amortization expense relates to goodwill from businesses
acquired during 2000 and is being amortized generally over five years.

         INTEREST EXPENSE. Interest expense has increased $0.3 million from
$1.0 million for the three months ended June 30, 2000 to $1.3 million for the
three months ended June 30, 2001. Interest expense has increased $1.2 million
from $1.3 million for the six months ended June 30, 2000 to $2.5 million for
the six months ended June 30, 2001. The increase of $1.2 million for the six
months ended June 30, 2001 is mainly the result of the debt discount
amortization and interest expense charges on the $30 million 5% convertible
debentures issued on June 5, 2000. Interest expense from new equipment leases
and loans account for the remainder of the increases.

         NET LOSS. Net loss attributable to common stockholders for the
quarter ended June 30, 2000 was approximately $12.9 million, or $0.54 per
share, compared with approximately $16.9 million or $0.62 per share for the
quarter ended June 30, 2001. Net loss attributable to common stockholders for
the six months ended June 30, 2000 was approximately $23.9 million, or $1.02
per share, compared with approximately $32.0 million or $1.20 per share for
the six months ended June 30, 2001. However, the increase in our loss per
share was primarily due to the following non-recurring, non-cash adjustments
which resulted in our loss per share increasing from $0.97 to $1.20 for the
six months ended June 30, 2001:

     -   A realized loss of $1.7 million for the conversion of the PTI shares
         to Red Hat, Inc. shares in the first quarter of 2001.

     -   A realized loss of $1.3 million on the sale of the Red Hat, Inc.
         shares in the second quarter of 2001.

     -   A write-off of $1.0 million for the financing costs incurred pursuant
         to the Crescent stock purchase agreement and other potential
         financing arrangements in the second quarter of 2001.

     -   A net write-off of $2.2 million for the unamortized portion of the debt
         discount with respect to the convertible debentures which resulted
         from the termination of the stock purchase warrants pursuant to an
         amendment agreement on July 10, 2001.



LIQUIDITY AND CAPITAL RESOURCES

         On June 28 and June 29, 2001, the Company sold a total of 467,497
shares of Red Hat Inc. common stock which provided proceeds of $2.0 million to
be used to fund our operations and working capital requirements. These
proceeds were classified as due from broker on the balance sheet at June 30,
2001 and were received on July 18, 2001.

         At June 30, 2001, we had $2.9 million in cash and cash equivalents,
of which $0.7 million is restricted, $2.0 million in proceeds due from broker
as described above, $0.2 million in marketable securities and an $11.9 million
working capital deficit. Although we have utilized the available proceeds from
our IPO and the issuance of 5% convertible debentures, we have several sources
of additional funds at our disposal. These include a $6 million revolving
credit agreement and the use of vendor financing as discussed below.

     -   On July 10, 2001, we entered into a one-year revolving credit agreement
         with seven lenders for a principal amount of up to $6,000,000. The
         total amount that we may borrow is limited by our borrowing base, which
         is measured at any time of borrowing by multiplying the total value of
         our eligible account receivables by 44.44%. Amounts borrowed will be
         evidenced by a note, which will be secured by the Company's assets.
         Amounts borrowed under the

                                      24

<PAGE>   25

         credit agreement bear interest for the first 60 days outstanding at
         the prime rate plus two hundred basis points and thereafter at the
         prime rate plus four hundred basis points.

     -   In the first quarter of 2001, we received commitments for a combined
         total, ranging from $8.6 million to $13.0 million dependent upon
         meeting certain financial conditions, in vendor financing from two
         leading technology companies. As of June 30, 2001, we have used $2.4
         million of our available financing to acquire equipment to meet the
         demands for our network and web hosting services by our customers.

         Our principal uses of cash are to fund operations, working capital
requirements and capital expenditures. We had an accumulated deficit of $114.5
million at June 30, 2001, and have used $7.3 million in cash in the aggregate
to fund operations during the first two quarters of 2001.

     -   Net cash used in operating activities for the six months ended June
         30, 2000 and 2001 was approximately $19.0 million and $7.3 million,
         respectively. The decrease in cash used of $11.7 million was
         principally a result favorable working capital changes of $9.9
         million, increased amortization of goodwill of $2.6 million,
         additional depreciation expense of $1.7 million, write-off of debt
         discount of $2.1 million and realized loss on marketable securities
         of $3.0 million offset by increased net losses from operations of
         $8.1 million.

     -   For the six months ended June 30, 2000, cash of approximately $18.5
         million was used in investing activities. For the six months ended
         June 30, 2001, cash of approximately $4.6 million was provided by
         investing activities. The increase in the net cash provided by
         investing activities of approximately $23.1 million was primarily
         associated with the decrease in the investments in acquired companies
         of $10.9 million and the decrease in purchases of property and
         equipment of $11.8 million.

     -   For the six months ended June 30, 2000, cash of approximately $30.6
         million was provided by financing activities. For the six months
         ended June 30, 2001, cash of approximately $0.1 million was used in
         financing activities. This decrease in cash provided of approximately
         $30.7 million consists principally of the issuance of convertible
         debentures of $30.0 million that took place in June 2000.

         We may need up to $10 million during the next year to satisfy
obligations under a put option agreement in connection with our acquisition of
CRL Network Services, Inc. Payment of these obligations is subject to the
resolution of certain legal proceedings described in Part II, Item 1 - "Legal
proceedings" of this quarterly report. In addition, the agreements relating to
the 5% convertible debentures contain certain restrictions on our ability to
redeem common shares pursuant to this put option agreement. If an unfavorable
outcome does occur requiring us to pay cash to redeem the shares owned by the
former CRL shareholders, we may not have sufficient financial resources to
meet the obligation and may be in default under the terms of the convertible
debenture and revolving credit agreements.

         We have made capital investments in our web hosting centers, network
and other capital assets totaling $11.6 million and $16.8 million in the years
ended December 31, 1999 and 2000 and $1.9 million in the six months ended June
30, 2001. We acquired assets under capital leases for $1.5 million in 1999,
$7.7 million in 2000, and $0.5 million in the six months ended June 30, 2001.

         At June 30, 2001 we had $2.0 million in proceeds due from broker,
$0.2 million in marketable securities and $2.9 in cash, of which $0.7 million
is restricted. In addition to these amounts and the aforementioned sources of
funds at our disposal, we will need to renew our $7.5 million bank line of
credit and our $6.0 million revolving credit agreement in 2002 and raise

                                      25

<PAGE>   26

additional funds through public or private financing, strategic relationships,
the sale of non-strategic assets or other arrangements to complete the
execution of our business plan. Additional financing is subject to certain
restrictions within the convertible debenture agreements and there can be no
assurance that additional financing will be available on terms acceptable to
us, or at all. Furthermore, any additional equity financing may be dilutive to
stockholders, and debt financing, if available may involve restrictive
covenants and significant interest expense. Strategic arrangements, if
necessary to raise additional funds, may require us to relinquish rights to
some of our technologies and sell certain non-core assets. In response to
current market conditions and as part of our ongoing corporate strategy, we
are pursuing several initiatives intended to increase liquidity and better
position ourselves under current market conditions. We have completed the
consolidation of duplicate network operations facilities and are continuing the
ongoing initiatives to reduce non-essential personnel and controllable costs
such as travel and capital expenditures. These initiatives continue to reduce
our working capital requirements and move us closer to our goal of being EBITDA
positive in the fourth quarter of 2001. Management believes, although there can
be no assurance, that the implementation of these initiatives combined with
obtaining and renewing the financing outlined above, and assuming no unfavorable
resolution of the litigation with the former CRL shareholders, there will be
sufficient cash flow for the next twelve months.

COMMITMENTS

         As of June 30, 2001, our operating lease obligations will be $3.0
million, $4.1 million and $3.1 million for 2001, 2002 and 2003, respectively,
and $12.0 million thereafter. Our purchase commitments under various
telecommunication agreements will be $5.0 million, $5.5 million and $5.0
million for 2001, 2002 and 2003, respectively, and $9.5 million thereafter.

         Annual maturities of our debt obligations are as follows: $2.6
million in 2001, $11.3 million in 2002 and $32.9 million in 2003. The debt
maturing in 2001 represents capital lease and other equipment financing
obligations. The debt maturing in 2002 includes $6.0 million in bank line of
credit obligations and $5.3 million in capital lease and other equipment
financing obligations. The debt maturing in 2003 includes $30.3 million in
convertible debentures maturing on June 5, 2003 and $2.6 million in capital
lease and other equipment financing obligations. The convertible debentures
can be redeemed for stock at any time until maturity pursuant to conversion
notices from the investors. As a result, the repayment of these debentures
will not have an effect on our working capital until 2003.


ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

         At June 30, 2001, we had various financial instruments consisting of
variable rate debt, short-term investments and convertible debentures entered
into for purposes other than trading. The substantial majority of our
outstanding debt obligations excluding the convertible debentures have
variable interest rates of LIBOR plus 40 basis points or prime rate less 200
basis points. At June 30, 2001, the carrying value of our debt obligations
approximate the fair value due to the short maturity and/or variable interest
rates of a majority of the debt. The weighted average interest rate of our
debt obligations at June 30, 2001 was 6.8%.

         Our investments are generally common stock securities. At June 30,
2001, all of our investments are classified as available for sale and are
carried at fair value of $217,000. These investments are subject to market
risk which is estimated as the potential loss in fair value resulting from a
hypothetical 10% adverse change in the securities' quoted market prices. A
change of this nature would not have a material impact on our financial
position at June 30, 2001. We actively monitor the capital and investing
markets in analyzing our capital raising and investing decisions.

                                      26

<PAGE>   27


PART II. OTHER INFORMATION

ITEM 1.    LEGAL PROCEEDINGS

         The Company is periodically involved in certain disputes, claims and
threatened with or named as a defendant in lawsuits. Some of these disputes,
lawsuits and threatened litigation include claims asserting alleged breach of
agreements and some of them relate to unresolved issues of law arising out of
or relating to the developing nature of the Internet and on-line services
industries. See, for example, "Risk Factors--Legal liability for distributing
or publishing content over the Internet " in Item 5 of this Form 10-Q.

         In June 2000, the Company was notified by the U.S. Attorney for the
Western District of New York that a relator had filed a qui tam action under
seal against the Company and NYSERNet.net ("NYSERNet"). The complaint alleged
that the National Science Foundation was fraudulently induced to provide a
grant of $2.45 million to NYSERNet, a portion of which was paid by NYSERNet to
the Company for services rendered. The complaint seeks treble damages related
to the alleged overpayment for services provided by the Company to NYSERNet,
as well as certain other penalties and forfeitures under the False Claims Act.
On January 19, 2001, the Company received a redacted copy of the amended
complaint in this action. In addition to the original allegations, this
amended complaint alleged that NYSERNet and the Company failed to disclose the
transfer of alleged program income in violation of the False Claims Act.
Furthermore, the amended complaint alleged that the Company conspired with
NYSERNet to engage in the fraudulent conduct described above and seeks
unspecified millions of dollars in treble damages as a result. Although the
Department of Justice has not yet determined whether or not it will join in
this action, the Company believes that these allegations are without merit and
intends to contest them.

         On December 13, 2000, James G. Couch filed a complaint in New York
State court seeking approximately $9,650,000 in damages against the Company
due to an alleged anticipatory breach of a put option agreement between the
Company, Mr. Couch and others dated January 5, 2000 pursuant to which Mr.
Couch, as part of the consideration for his sale to the Company of the capital
stock of CRL Network Services, Inc., was granted two put options, exercisable
on January 5, 2001 and January 5, 2002, respectively, pursuant to which Mr.
Couch may require the Company to re-purchase shares of its common stock from
Mr. Couch at specified times and in specified circumstances. On January 2,
2001, the Company answered the complaint and asserted affirmative defenses and
counterclaims for fraud, indemnification and breach of contract for which the
Company seeks compensatory and punitive damages. Mr. Couch served an amended
complaint on January 8, 2001 asserting claims of actual and anticipatory
breach of the Put Option Agreement, and a reply to the Company's answer and
counterclaims. On January 29, 2001, the Company answered the amended complaint
and asserted affirmative defenses and counterclaims for fraud, violations of
the California Corporation Code, indemnification and breach of contract for
which the Company seeks compensatory and punitive damages. In addition, the
Company is pursuing indemnification claims under an escrow agreement against
Mr. Couch in an arbitration proceeding. On February 15, 2001, Mr. Couch filed
a motion to dismiss the Company's counterclaim for violations of the
California Corporations Code and to stay the Company's counterclaims for
indemnification and breach of contract pending the completion of an
arbitration between the parties concerning the Company's claims against Mr.
Couch under the escrow agreement. The Company cross-moved to stay the entire
litigation, including Mr. Couch's claims, pending completion of this
arbitration. On March 9, 2001, Mr. Couch filed a motion for partial summary
judgment seeking entry of judgment in his favor on all his claims, striking
the Company's fraud defense to the extent it seeks a rescission remedy, and
striking the Company's claim for punitive damages. Oral argument for Mr.
Couch's motion filed on February 15, 2001, the Company's cross-motion thereto,
and Mr. Couch's motion filed on March 9, 2001 took place on April 5, 2001. On
July 23, 2001, the court ruled on the parties' motions. The

                                      27

<PAGE>   28

court granted Mr. Couch's motion to dismiss the Company's counterclaim for
violations of the California Corporations Code. The court granted Mr. Couch's
motion to stay the Company's counterclaims for indemnification and breach of
contract and the Company's cross-motion to stay the entire litigation pending
the completion of an arbitration between the parties concerning the Company's
claims against Mr. Couch under the escrow agreement. The court held in
abeyance Mr. Couch's motion for partial summary judgment on his breach of
contract claim pending the determination of the arbitration, denied Mr.
Couch's motion to strike the Company's fraud defense to the extent it seeks a
rescission remedy, and granted Mr. Couch's motion to strike the Company's
claim for punitive damages. The Company is considering whether to appeal from
the adverse aspects of the ruling. This litigation is in the preliminary
stage, and therefore, no opinion as to likelihood of an unfavorable outcome
can be made. However, if an unfavorable outcome does occur requiring the
Company to pay cash to redeem the shares owned by the former CRL shareholders,
the Company may not have sufficient financial resources to meet the
obligation. At June 30, 2001, the Company has $10 million recorded as
temporary equity in connection with these put options.

         There can be no assurance whether these matters will be determined in
a manner that is favorable to the Company or, if adversely determined, that
such determination would not have a material adverse effect upon the Company's
business, financial condition or results of operations.

         The Company is not involved in any other legal proceedings which it
believes would, if adversely determined, have a material adverse effect upon
its business, financial condition or results of operations.


ITEM 2.    CHANGES IN SECURITIES AND USE OF PROCEEDS

         As of June 30, 2001, the Company has used the proceeds from its IPO
on May 5, 1999 and convertible debentures issued on June 5, 2000 to fund its
operations, working capital requirements, acquisitions and capital
expenditures.

         During the three months ended June 30, 2001, proceeds of
approximately $33,000 were generated from the exercise of options for 216,767
shares of our common stock. There were no significant expenses, underwriting
discounts or commissions attributable to these proceeds. These options had
been granted under our Incentive Stock Option Plans and were exercised by
certain employees and directors. During the three months ended June 30, 2001,
proceeds of approximately $337,839 were generated from the issuance of 537,105
shares of our common stock under our Employee Stock Purchase Plan. The shares
issued pursuant to our 1996 and 1999 Option Plans and our Employee Stock
Purchase Plan were registered through our registration statement on Form S-8
(File No. 333-83177), which we filed with the SEC on July 19, 1999.


ITEM 3.    DEFAULTS UPON SENIOR SECURITIES

         Not applicable.


ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

         On May 31, 2001, the annual meeting of the stockholders of
AppliedTheory Corporation was held pursuant to a notice dated May 4, 2001,
which was mailed to all stockholders. The meeting was called in order to: (i)
elect two Class II directors to the Company's Board of Directors for a three
year term; (ii) approve the issuance of shares of the Company's common stock
in excess of

                                      28

<PAGE>   29

20% of its total shares outstanding to the 5% convertible debenture holders,
if and when such debentures are converted into, and/or warrants held by such
holders are exercised for, common stock; (iii) approve the issuance of shares
of the Company's common stock in excess of 20% of its total shares outstanding
to Crescent International Ltd; (iv) approve an increase in the number of
shares available to be granted under the Company's 1999 Stock Option Plan; and
(v) ratify the appointment of Grant Thornton LLP as independent certified
public accountants for the Company.

          The above proposals received stockholder approval at the annual
meeting. Holders of the following shares were present in person or by proxy at
this meeting and votes were cast in the following manner:

     Election of Class II Directors: 21,620,508 shares present and voting in
     favor of the election of Danny E. Stroud and David Groelinger as
     directors, representing 79% of the common stock outstanding and 95% of
     the total shares voted.

     Approval of the issuance of shares of the Company's common stock in
     excess of 20% of its total shares outstanding to the 5% convertible
     debenture holders: 16,140,281 shares present and voting in favor of the
     proposal representing 59% of the common stock outstanding and 69% of the
     total shares voted.

     Approval of the issuance of shares of the Company's common stock in
     excess of 20% of its total shares outstanding to Crescent International
     Ltd.: 16,145,449 shares present and voting in favor of the proposal
     representing 59% of the common stock outstanding and 69% of the total
     shares voted.

     Approval of an increase in the number of shares available to be granted
     under the Company's 1999 Stock Option Plan: 16,129,721 shares present and
     voting in favor of the proposal representing 59% of the common stock
     outstanding and 69% of the total shares voted.

     Ratification of Grant Thornton LLP as independent certified public
     accountants: 23,044,934 shares present and voting in favor of the
     ratification, representing 85% of the common stock outstanding and 99% of
     the total shares voted.

                                      29


<PAGE>   30




ITEM 5.    OTHER INFORMATION

RISK FACTORS

         From time to time, in both written and in oral statements by our
senior management, we express expectations and other statements regarding
future performance. These forward-looking statements are inherently uncertain
and you must recognize that events could turn out to be different than such
expectations and statements. We discuss key factors impacting current and
future performance in our annual report on Form 10-K (Commission File No.
000-25759) filed with the SEC and in our other filings and reports. In
addition, you should consider the following risk factors, as well as any other
information in this Quarterly Report in evaluating our business and us. Any
investment in our common stock involves a high degree of risk.


WE HAVE A LIMITED OPERATING HISTORY AND MAY NOT SUCCESSFULLY IMPLEMENT OUR
BUSINESS PLAN.

         We have a limited operating history, and our business model is still
in development. We were incorporated in 1995 and commenced operations in late
1996. As an early stage Internet company we are subject to expenses and
difficulties associated with implementing our business plan that are not
typically encountered by more mature companies. The risks associated with
implementing our business plan relate to:

     -   building out our web hosting and network infrastructure;

     -   expanding our sales structure and marketing programs;

     -   increasing awareness of our brand;

     -   providing services to our customers that are reliable and
         cost-effective;

     -   responding to technological development or service offerings by
         competitors; and

     -   attracting and retaining qualified personnel.

         If we are not successful in implementing our business plan, our
business or future financial or operating results could suffer.

WE HAVE A HISTORY OF NET LOSSES AND EXPECT THESE LOSSES TO CONTINUE IN THE
FORESEEABLE FUTURE.

         We have incurred net losses and have experienced negative cash flows
in each quarterly and annual period since inception and expect to continue to
do so for the foreseeable future. At June 30, 2001 and December 31, 2000 and
1999, we had an accumulated deficit of approximately $114.5 million, $82.4
million and $29.8 million, respectively. We incurred net losses of $32.0
million for the six months ended June 30, 2001 and $52.6 million, $14.1
million and $7.1 million for the years ended December 31, 2000, 1999 and 1998,
respectively. In connection with our business plan, we anticipate making
investments in sales and marketing, customer support and personnel. As a
result of executing our business plan, we expect our net losses and negative
cash flows on a quarterly and annual basis to continue in the foreseeable
future. Our ability to achieve profitability is dependent in large part upon
the successful implementation of our business plan. We cannot assure you that
we will achieve or sustain revenue growth or profitability on either a
quarterly or annual basis.

WE WILL NEED ADDITIONAL FUNDS WHICH, IF AVAILABLE, COULD RESULT IN DILUTION OF
YOUR SHAREHOLDINGS OR AN INCREASE IN OUR INTEREST EXPENSE. IF THESE FUNDS ARE
NOT AVAILABLE, OUR BUSINESS COULD BE HURT.

         We intend to use our available cash and existing financing
arrangements to fund our sales and marketing efforts, to enhance our customer
support services and for general corporate and

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<PAGE>   31

working capital purposes. We believe that our remaining cash, marketable
securities and existing financing arrangements will be sufficient for the
implementation of our business plan to achieve our goal of being EBITDA
positive by the fourth quarter of 2001. However, if we are required to pay
cash to redeem the shares owned by the former CRL shareholders, we may not
have sufficient financial resources to meet that obligation and/or achieve our
goal. In addition, we will need to raise additional funds through public or
private debt or equity financing in order to:

     -        take advantage of anticipated opportunities or acquisitions of
              complementary assets, technologies or businesses;

     -        develop new products;

     -        respond to unanticipated competitive pressures; or

     -        achieve profitability.

         When additional funds become necessary, additional financing may not
be available on terms favorable to us or available at all. If adequate funds
are not available or are not available on acceptable terms when needed, our
business could be hurt.

         If additional funds are raised through the issuance of equity
securities, the percentage ownership of our then current stockholders may be
reduced, and the new equity securities may have rights, preferences or
privileges senior to those of the holders of our common stock. If additional
funds are raised through the issuance of debt securities, these securities
would have some rights, preferences and privileges senior to those of the
holders of our common stock, and the terms of this debt could impose
restrictions on our operations and result in significant interest expense to
us.

WE MAY NOT BE ABLE TO GENERATE THE NECESSARY AMOUNT OF CASH TO SERVICE OUR
EXISTING FINANCIAL OBLIGATIONS.

         In addition to the 5% convertible debentures due June 5, 2003, we
also have other financial obligations, including a contested obligation to
certain former shareholders of CRL Network Services, Inc., pursuant to a put
option agreement entered into between the Company and those shareholders as
part of the consideration for the Company's acquisition of CRL Network
Services, Inc. We cannot assure you that our business will generate sufficient
cash flow from operations or that additional equity or debt financing will be
available on commercially reasonable terms or at all to enable us to fulfill
our financial obligations or fund our other liquidity needs. If we are unable
to generate sufficient cash flow for those needs, we may be unable to meet our
obligations and may need to renegotiate or refinance all or a portion of our
obligations under those agreements. We cannot assure you that we would be able
to renegotiate or refinance our obligations under those agreements on
commercially reasonable terms or at all, which could cause us to default on
our obligations and impair our liquidity and our business.

OUR GROWTH STRATEGY IS LIKELY TO PLACE A SIGNIFICANT STRAIN ON OUR RESOURCES.

         Our future success depends in large part on our ability to manage any
achieved growth in our business. For our business plan to succeed, we will
need to:

     -   expand our business with new and current customers;

     -   develop and offer successful new products and services;

     -   retain key employees and hire new employees; and

     -   ensure that any future business we may develop or acquire will
         perform in a satisfactory manner.

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<PAGE>   32

         These activities are expected to place a significant strain on our
resources. Also, we cannot guarantee that any of these will occur or that we
will succeed in managing the results of any success in our business plan.

OUR ANNUAL AND QUARTERLY OPERATING RESULTS ARE SUBJECT TO SIGNIFICANT
FLUCTUATIONS. AS A RESULT, PERIOD-TO-PERIOD COMPARISONS OF OUR RESULTS OF
OPERATIONS ARE NOT NECESSARILY MEANINGFUL AND SHOULD NOT BE RELIED UPON AS
INDICATIONS OF FUTURE PERFORMANCE.

         We have experienced significant fluctuations in our results of
operations on a quarterly and annual basis. We expect to continue to
experience significant fluctuations in our future quarterly and annual results
of operations due to a variety of factors, many of which are outside of our
control, including:

     -   demand for and market acceptance of our services;

     -   customer retention;

     -   the timing and success of our marketing efforts;

     -   the timing and magnitude of capital expenditures, including costs
         relating to the expansion of operations;

     -   the timely expansion of existing facilities and completion of new
         facilities;

     -   the ability to increase bandwidth as necessary;

     -   fluctuations in bandwidth used by customers;

     -   introductions of new services or enhancements by us and our
         competitors;

     -   increased competition in our markets;

     -   economic conditions including those in the technology sector;

     -   potential unfavorable legislative and regulatory developments;

     -   growth of Internet use and establishment of Internet operations,
         including the providing of Internet solutions, managed hosting and
         related services by mainstream enterprises; and

     -   changes in our pricing policies and our competitors' pricing
         policies.

A RELATIVELY LARGE PORTION OF OUR EXPENSES ARE FIXED IN THE SHORT-TERM. AS A
RESULT, OUR RESULTS OF OPERATIONS WILL BE PARTICULARLY SENSITIVE TO
FLUCTUATIONS IN REVENUE.

         A relatively large portion of our expenses are fixed in the
short-term, particularly in respect of data and telecommunications costs,
depreciation, amortization, real estate occupancy costs, interest expense and
personnel. Because we will be required to incur these fixed expenses,
irrespective of our revenue, our future results of operations are particularly
sensitive to fluctuations in revenue.

THE EXPECTED CONTINUED GROWTH IN THE MARKET FOR OUR PRODUCTS AND SERVICES MAY
NOT MATERIALIZE OR MAY MATERIALIZE IN A MANNER WE HAVE NOT ANTICIPATED.

         Our market is new and rapidly evolving. Whether, and the manner in
which, the market for our products and services will continue to grow is
uncertain. The market for our products and services may be inhibited for a
number of reasons, including:

     -   the reluctance of businesses to outsource their Internet solutions
         and Web hosting needs;

     -   our failure to successfully market our products and services to new
         customers; and

     -   the inability to maintain and strengthen our brand awareness.


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<PAGE>   33

OUR SUCCESS DEPENDS IN LARGE PART ON THE CONTINUED GROWTH OF THE INTERNET
MARKET.

         Our business will be hurt if demand for Internet and related services
does not continue to grow. This demand may be inhibited for a number of
reasons, including:

     -   general economic conditions;

     -   access costs;

     -   inadequate network infrastructure;

     -   security concerns;

     -   uncertainty of legal and regulatory issues concerning use of the
         Internet;

     -   inconsistent quality of service; and

     -   lack of availability of cost-effective, high-speed service.

         The Internet infrastructure may not be able to support the demands
placed on it or the Internet's performance and reliability may decline.
Similarly, Web sites have experienced interruptions in their service as a
result of outages and other delays occurring throughout the Internet network
infrastructure. This could hurt our business.

A PORTION OF OUR GROWTH DEPENDS ON OUR ABILITY TO EXPAND WEB HOSTING CAPACITY
TO MEET ANTICIPATED DEMAND.

         Continuing to expand web hosting center capacity is critical to
achieving the goals of our business plan. This expansion is likely to include
the need to add new hardware and software, and may include the opening of
additional web hosting centers. We intend to add web hosting center capacity
in the future as justified by customer demand. Our ability to do so
successfully depends on:

     -   anticipating and planning for future demand levels;

     -   having access to sufficient capital; and

     -   locating and securing satisfactory web hosting center sites and
         implementing the build-out of these and existing sites, all of which
         may require significant lead time.

         If we are unable to expand our capacity effectively, our growth may
suffer and we may not be able to adequately meet the demands of existing
customers.

WE OPERATE IN AN EXTREMELY COMPETITIVE MARKET AND MAY NOT BE ABLE TO COMPETE
EFFECTIVELY.

         The Internet-based services market is extremely competitive and many
of our competitors are more established and have greater financial resources
than we do. In addition, there are no substantial barriers to entry in this
market. We also expect that competition will intensify in the future. Many of
our competitors have greater market presence, engineering and marketing
capabilities and financial, technological and personnel resources than we do.
As a result, as compared to us our competitors may:

     -   develop and expand their network and web hosting infrastructures and
         service offerings more efficiently or more quickly;

     -   adapt more swiftly to new or emerging technologies and changes in
         customer requirements;

     -   take advantage of acquisitions and other opportunities more
         effectively; and

     -   more effectively leverage existing relationships with customers or
         exploit a more recognized brand name to market and sell their
         services.

         Our current and prospective competitors generally may be divided into
the following three groups:

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<PAGE>   34

     -   Web hosting companies including Digex, Inc., Verio, Inc., Genuity,
         Globix Corporation, PSINet Inc., Exodus Communications, Inc. and
         other companies;

     -   Internet solution companies including Razorfish Inc., IBM Global
         Services, Accenture, US Internetworking Inc., Scient Corp., Cambridge
         Technology Partners, Inc., Whittman-Hart Inc., Oracle Corporation,
         the Big 5 accounting firms, EDS Corporation and other companies; and

     -   Internet connectivity, VPNs and security providers including Genuity,
         Verio Inc., Qwest Communications International Inc., Sprint
         Corporation, AT&T Corp., UUNET Technologies, Inc., XO Communications,
         Cable & Wireless plc, WorldCom, Inc. and other national and regional
         providers.

         We believe that we may also face competition from other large
computer hardware and software companies and other media, technology and
telecommunications companies.

         The number of businesses providing Internet-related services is
rapidly growing. We are aware of other companies, in addition to those named
above, that have entered into or are forming joint ventures or consortia to
provide services similar to those provided by us. Others may acquire the
capabilities necessary to compete with us through acquisitions.

WE COULD ENCOUNTER SIGNIFICANT PRICING PRESSURE AS A RESULT OF INCREASED
COMPETITION AND INDUSTRY CONSOLIDATION.

         As a result of increased competition and consolidation in the
industry, we could encounter significant pricing pressure, which in turn could
result in significant reductions in the average selling price of our services.
We may not be able to offset such price reductions even if we obtain an
increase in the number of our customers, derive higher revenue from enhanced
services or manage to reduce our costs. Increased price or other competition
could erode our market share and could significantly hurt our business. We
cannot assure you that we will have the financial resources, technical
expertise or marketing and support capabilities to continue to compete
successfully in that environment.

OUR REVENUES ARE HEAVILY DEPENDENT ON TWO CONTRACTS. IF WE LOSE EITHER OF
THESE CONTRACTS, IF THERE IS A REDUCTION IN THE AMOUNT OF WORK GENERATED FROM
EITHER OF THEM, OR IF WE FAIL TO DIVERSIFY OUR CUSTOMER BASE, OUR BUSINESS
WILL SUFFER.

         We currently derive a substantial portion of our total revenue from
contracts with two customers; NYSERNet.org, Inc. ("NYSERNet"), a
not-for-profit corporation that is affiliated with one of our major
stockholders, and the New York State Department of Labor. The loss of either
of these contracts could significantly hurt our business. For the six months
ended June 30, 2001, revenue from NYSERNet.org, Inc. represented approximately
20% of our total revenue. For the years ended December 31, 2000, 1999 and 1998
revenue from NYSERNet.org, Inc. represented approximately 18%, 27% and 37% of
our total revenue, respectively. Revenue under the agreement with the New York
State Department of Labor for the six months ended June 30, 2001 represented
24% of our total revenue. Revenue under the agreement with the New York State
Department of Labor for the years ended December 31, 2000, 1999 and 1998
represented 28%, 39% and 28% of our total revenue, respectively.

         We have an agreement with NYSERNet to provide NYSERNet and its
customers with services. Under this agreement we provide services to
approximately 140 different customers affiliated with NYSERNet. Each of these
customers makes individual buying decisions resulting in separate agreements.
In March 2000 we extended and expanded these services through an agreement
with NYSERNet to upgrade and maintain a minimum of 10 full OC-3 connections
for NYSERNet and its customers. This agreement extends until October 2005 and
it is estimated that

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<PAGE>   35

we will receive approximately $40 million for our services over the term of
the agreement. While these agreements only allow termination by either party
under special circumstances, it is still possible that NYSERNet could
terminate the agreement or cease working with us.

         On June 14, 1999, we signed a contract with NYSERNet to enhance,
operate and maintain NYSERNet2000, NYSERNet's next generation Internet
backbone network. We completed construction of the network in April 1999.
Under the terms of the contract, which extends until March 2002, we will
operate and maintain the first OC-12 research network backbone in New York
State. We expect to receive approximately $5.2 million for our services over
the term of the contract.

         On November 30, 2000, we executed a five year $82 million contract
with the New York State Department of Labor for the development and
maintenance of the America's Job Bank Web site. Although this contract is
initiated by the New York State Department of Labor, the contract includes
separate maintenance of America's Job Bank Web sites for 50 different states
and territories. Each of these states and territories makes an individual
buying decision and may terminate its affiliation with America's Job Bank
annually. The America's Job Bank agreement is subject to cancellation upon 15
days notice by the New York State Department of Labor.

         We cannot assure you that revenue from these two customers, or from
other customers that have accounted for significant revenue in past periods,
individually or as a group, will continue, or if continued, will reach or
exceed historical levels in any future period. In addition, we may not succeed
in diversifying our customer base in future periods.

WE COULD EXPERIENCE SYSTEM FAILURES AND CAPACITY CONSTRAINTS, WHICH WOULD
AFFECT OUR ABILITY TO COMPETE.

         Interruptions in service to our customers could hurt our business. To
succeed, we must be able to operate our network and web hosting management
infrastructure 24 hours per day, seven days per week, without interruption.
Our operations depend upon our ability to protect our network and web hosting
infrastructure, our equipment and customer data against damage from human
error or "acts of God." Even if we take precautions, the occurrence of a
natural disaster or other unanticipated problems could result in interruptions
in the services we provide to our customers.

         Although we have attempted to build redundancy into our network and
hosting facilities by establishing a redundant, rigorously engineered backbone
connected to our four web hosting centers, our network is currently subject to
various single points of failure. For example, a problem with one of our
routers or switches could cause an interruption in the services we provide to
some of our customers. Any interruptions in service could:

     -   cause end users to seek damages for losses incurred;

     -   require us to spend more money and dedicate more resources to
         replacing existing equipment, expanding facilities or adding
         redundant facilities;

     -   cause us to spend money on existing or new equipment and
         infrastructure earlier than we plan;

     -   damage our reputation for reliable service;

     -   cause existing end-users and resellers to cancel our contracts; or

     -   make it more difficult for us to attract new end-users and partners.

         Any of these results could hurt our business.

         Failure of the national telecommunications network and Internet
infrastructure to continue to grow in an orderly manner could result in
service interruptions. While the national

                                      35

<PAGE>   36


telecommunications network and Internet infrastructure have historically
developed in an orderly manner, there is no guarantee that this will continue
as the network expands and more services, users and equipment connect to the
network. Failure by our telecommunications providers to provide us with the
data communications capacity we require could cause service interruptions,
which could hurt our business.

WE ARE DEPENDENT ON NETWORKS BUILT AND OPERATED BY OTHERS. IF WE DO NOT HAVE
CONTINUED ACCESS TO A RELIABLE NETWORK, OUR BUSINESS WILL SUFFER.

         In delivering our services, we rely on networks which are built and
operated by others. We do not have control over these networks, nor can we
guarantee that we will continue to have access on terms that fit our business
needs.

         Our use of the infrastructure of other communications carriers
presents risks. Our success partly depends upon the coverage, capacity,
scalability, reliability and security of the network infrastructure provided
to us by telecommunications network suppliers, including AT&T Corp., Sprint
Corporation, Verizon Communications, Pacific Bell, Worldcom, Inc. and
Broadwing, Inc. Our expansion plans require additional network resources.
Without these resources, our ability to execute our business strategy could be
hurt. In addition, future expansion and adaptation of our network and web
hosting infrastructure may require substantial financial, operational and
management resources. We may not be able to expand or adapt our network or web
hosting infrastructure on a timely basis and at a commercially reasonable cost
to meet additional demand, changing customer requirements or evolving industry
standards. In addition, if demand for usage of our network and web hosting
facilities were to increase faster than projected or were to exceed our
current forecasts, the network could experience capacity constraints which
would hurt its performance.

         The consolidation of network providers could adversely affect our
peering and transit arrangements if peering criteria becomes more restrictive
or cost prohibitive. We also depend on our telecommunications suppliers to
provide uninterrupted and error-free service through their telecommunications
networks. If these suppliers greatly increase the price for their services or
if the telecommunications capacity available to us is insufficient for our
business purposes, and we are unable to use alternative networks or pass along
any increased costs to our customers, our business could suffer.

OUR NETWORK AND SOFTWARE ARE VULNERABLE TO SECURITY BREACHES AND SIMILAR
THREATS WHICH COULD RESULT IN OUR BEING LIABLE FOR DAMAGES AND HARM OUR
REPUTATION.

         Despite the implementation of network security measures, the core of
our network infrastructure is vulnerable to computer viruses, break-ins and
similar disruptive problems caused by Internet users. This could result in our
being liable for damages, and our reputation could suffer, thereby deterring
potential customers from working with us. Security problems caused by third
parties could lead to interruptions and delays or to the cessation of service
to our customers. Furthermore, inappropriate use of the network by third
parties could also jeopardize the security of confidential information stored
in our computer systems and in those of our customers.

         We rely upon encryption and authentication technology purchased from
third parties to provide the security and authentication necessary to effect
secure transmission of confidential information. Although we intend to
continue to implement industry-standard security measures, in the past some of
these standards have occasionally been circumvented by third parties.
Therefore, we cannot assure you that the measures we implement will not be
circumvented. The costs and resources required to eliminate computer viruses
and alleviate other security problems may result in interruptions, delays or
cessation of service to our customers, which could hurt our business.

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<PAGE>   37

OUR BRAND IS NOT AS WELL KNOWN AS SOME OF OUR COMPETITORS, AND FAILURE TO
DEVELOP BRAND RECOGNITION COULD HURT OUR BUSINESS.

         To successfully execute our strategy, we must strengthen our brand
awareness. While many of our competitors have well-established brands, prior
to 2000, our market presence was limited principally to New York State. In
order to build our brand awareness, our marketing efforts must succeed, and we
must provide high quality services. We cannot assure you that these
investments will succeed as planned. If we do not build our brand awareness,
our ability to realize our strategic and financial objectives could be hurt.

IF WE DO NOT RESPOND EFFECTIVELY AND ON A TIMELY BASIS TO RAPID TECHNOLOGICAL
CHANGE, OUR BUSINESS COULD SUFFER.

         If we do not successfully use or develop new technologies, introduce
new services or enhance our existing services on a timely basis, or new
technologies or enhancements used or developed by us do not gain market
acceptance, our business could be hurt. Our industry is characterized by
rapidly changing technology, industry standards, customer needs and
competition, as well as by frequent new product and service introductions. Our
future success will depend, in part, on our ability to accomplish all of the
following in a timely and cost-effective manner, all while continuing to
develop our business model and rolling-out our services on a national level:

     -   effectively use and integrate leading technologies;

     -   continue to develop our technical expertise;

     -   enhance our products and current networking services;

     -   develop new products and services that meet changing customer needs;

     -   have the market accept our services;

     -   advertise and market our products and services; and

     -   influence and respond to emerging industry standards and other
         changes.

         We cannot assure you that we will successfully use or develop new
technologies, introduce new services or enhance our existing services on a
timely basis, or that new technologies or enhancements used or developed by us
will achieve market acceptance. Our pursuit of necessary technological
advances may require substantial time and expense. In addition, we cannot
assure you that, if required, we will successfully adapt our services to
alternate devices and conduits.

         If our services do not continue to be compatible and interoperable
with products and architectures offered by other industry members, our ability
to compete could be impaired. Our ability to compete successfully is
dependent, in part, upon the continued compatibility and interoperability of
our services with products and architectures offered by various other members
of the industry. Although we intend to support emerging standards in the
market for Internet solutions, we cannot assure you that we will be able to
conform to new standards in a timely fashion and maintain a competitive
position in the market. Our services rely on the continued widespread
commercial use of Transmission Control Protocol/Internet Protocol, commonly
known as TCP/IP, which is an industry standard to facilitate the transfer of
data. Alternative open protocol and proprietary protocol standards could
emerge and become widely adopted. A resulting reduction in the use of TCP/IP
could render our services obsolete and unmarketable. Our failure to anticipate
the prevailing standard or the failure of a common standard to emerge could
hurt our business.


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<PAGE>   38



WE DERIVE SIGNIFICANT REVENUE FROM CONTRACTS WITH GOVERNMENT AGENCIES. THESE
CONTRACTS OFTEN ARE SUBJECT TO A COMPLEX PROCUREMENT PROCESS, REQUIRE
COMPLIANCE WITH VARIOUS GOVERNMENT REGULATIONS AND POLICIES AND MAY BE SUBJECT
TO UNILATERAL TERMINATION OR MODIFICATION BY THE GOVERNMENT. IN ADDITION,
CHANGES IN GOVERNMENT FUNDING AND OTHER POLICY DECISIONS COULD JEOPARDIZE OUR
CONTRACTS WITH GOVERNMENT AGENCIES.

         Contracts with various government agencies accounted for
approximately 35% of our total revenue for the six months ended June 30, 2001,
and 36% and 53% of our total revenue for years ended December 31, 2000 and
1999, respectively. Government contracts are often subject to a competitive
bidding process, which is governed by applicable federal and state statutes
and regulations. The procurement process for government contracts is complex
and can be very time consuming.

         Because of our contracts with governmental agencies, we are required
to comply with various government regulations and policies. For instance, we
are required to maintain employment policies relating to equal employment
opportunities, and we are subject to audit by the government to confirm our
compliance with these policies. If we fail to comply with regulations which
apply to government contractors, we may face sanctions, including substantial
fines and disqualification from being awarded government contracts in the
future.

         Contracts with governmental agencies are subject to the risk of
unilateral termination by the government for its convenience and reductions in
services, or modifications in contractual terms, due to changes in the
government's requirements or to budgetary restraints.

         In addition, the government may not continue to fund the projects and
programs with which we work. Even if funding continues, we may not obtain this
funding. We cannot assure you that we will be able to procure additional
government contracts, that we will be able to retain our existing government
contracts or, if retained, that these contracts will be fully funded.

WE MAY BE EXPOSED TO RISKS ASSOCIATED WITH ACQUISITIONS, INCLUDING INTEGRATION
RISKS AND RISKS ASSOCIATED WITH METHODS OF FINANCING AND THE IMPACT OF
ACCOUNTING TREATMENT. ALSO, COMPLETED ACQUISITIONS MAY NOT ENHANCE OUR
BUSINESS.

         A component of our strategy is to acquire web hosting and Internet
solutions companies and other businesses complementary to our operations. In
the 25 months ending June 30, 2001 we have acquired or invested in several
companies. In the future, we intend to acquire additional companies that
complement our existing business model and growth strategies. Any future
acquisitions would be accompanied by the risks commonly encountered in
acquisitions, including:

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

     -   the potential disruption of our business;

     -   our management's inability to maximize our financial and strategic
         position through the incorporation of an acquired technology or
         business into our service offerings;

     -   the difficulty of maintaining uniform standards, controls, procedures
         and policies;

     -   the potential loss of key employees from acquired businesses, and the
         impairment of relationships with the employees and customers of an
         acquired business as a result of changes in management; and

     -   the inaccuracy of financial data of acquired companies.

         We cannot assure you that any completed acquisition will enhance our
business. If we consummate additional acquisitions in which any significant
portion of the consideration consists of cash, a significant portion of our
available cash could be used to consummate the acquisitions. If we consummate
one or more acquisitions in which any significant portion of the consideration
consists

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<PAGE>   39

of stock, our stockholders could suffer significant dilution of their interest
in us. In addition, we could incur or assume significant amounts of
indebtedness in connection with acquisitions. The purchase price of future
acquisitions will most likely be significantly greater than the fair value of
the acquired net assets. Acquisitions required to be accounted for under the
purchase method could result in significant goodwill and/or amortization
charges for acquired technology.

WE ARE DEPENDENT ON OUR HARDWARE AND SOFTWARE SUPPLIERS TO PROVIDE US WITH THE
PRODUCTS AND SERVICES WE NEED TO SERVE OUR CUSTOMERS.

         We rely on outside vendors to supply us with computer hardware,
software and networking equipment. These products are available from only a
few sources. We purchase a significant portion of these products from Sun
Microsystems, Inc., Compaq Computer Corporation, Cisco Systems, Inc.,
Microsoft Corporation and Oracle Corporation. We cannot assure you that we
will be able to obtain the products and services that we need on a timely
basis and at affordable prices.

         We have in the past experienced delays in receiving shipments of
equipment purchased for resale. To date, these delays have not adversely
affected us, but we cannot guarantee that we will not be adversely affected by
delays in the future. We may not be able to obtain computer equipment on the
scale and at the times required by us at an affordable cost. Our suppliers may
enter into exclusive arrangements with our competitors or stop selling us
their products or services at commercially reasonable prices. If our sole or
limited source suppliers do not provide us with products or services, our
business, financial condition and results of operations may be significantly
hurt.

WE OPERATE IN AN UNCERTAIN REGULATORY AND LEGAL ENVIRONMENT. NEW LAWS AND
REGULATIONS COULD HARM OUR BUSINESS.

         We are not currently subject to direct regulation by the Federal
Communications Commission ("FCC") or any other governmental agency, other than
regulations applicable to businesses in general. However, in the future, we
may become subject to regulation by the FCC or another regulatory agency. Our
business could suffer depending on the extent to which our activities are
regulated or proposed to be regulated.

         While there are currently few laws or regulations that specifically
regulate Internet communications, laws and regulations directly applicable to
online commerce or Internet communications are becoming more prevalent. There
is much uncertainty regarding the market-place impact of these laws. In
addition, various jurisdictions already have enacted laws covering
intellectual property, privacy, libel and taxation that could affect our
business by virtue of their impact on online commerce. Further, the growth of
the Internet, coupled with publicity regarding Internet fraud, may lead to the
enactment of more stringent consumer protection laws. If we become subject to
claims that we have violated any laws, even if we successfully defend against
these claims, our business could suffer. Moreover, new laws that impose
restrictions on our ability to follow current business practices or increase
our costs of doing business could hurt our business.

WE MAY BE SUBJECT TO LEGAL LIABILITY FOR DISTRIBUTING OR PUBLISHING CONTENT
OVER THE INTERNET, WHICH COULD BE COSTLY FOR US TO DEFEND.

         It is possible that claims will be made against online service
companies and Internet access providers in connection with the nature and
content of the materials disseminated through their networks. Several private
lawsuits are pending which seek to impose liability upon online services
companies and Internet access providers as a result of the nature and content
of materials disseminated over the Internet. If any of these actions succeed,
we might be required to respond by investing substantial resources in
connection with this increased liability or by discontinuing some of

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<PAGE>   40

our service or product offerings. Also, any increased attention focused upon
liability issues relating to the Internet could also have a negative impact on
the growth of Internet use. Although we carry general liability insurance, it
may not be adequate to compensate us or it 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 that we incur as a result of liability or
asserted liability for information carried on or disseminated through our
networks could hurt our business.

WE MAY BE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS OR TO CONTINUE
USING INTELLECTUAL PROPERTY THAT WE LICENSE FROM OTHERS.

         We rely on a combination of copyright, trademark, service mark and
trade secret laws and contractual restrictions to establish and protect
certain of our proprietary rights. We have no patented technology that would
bar competitors from our market. Despite our efforts to protect our
proprietary rights, unauthorized parties may attempt to copy or otherwise
obtain and use our data or technology.

         We also rely on certain technologies licensed from third parties. We
cannot be sure these licenses will remain available to us on commercially
reasonable terms or at all. The loss of such technology may require us to
obtain substitute technology of lesser quality or performance standards or at
greater cost which could harm our business.

SIGNIFICANT STOCKHOLDERS AND CURRENT MANAGEMENT CONTROL APPROXIMATELY 50% OF
OUR COMMON STOCK, AND THESE PARTIES MAY HAVE CONFLICTS OF INTEREST.

         Broadwing Communications, Inc. ("Broadwing"), NYSERNet.net, Inc. and
Grumman Hill Investments III, L.P. ("Grumman Hill") control approximately
18.2%, 17.1% and 10.6%, respectively, of our outstanding common stock at June
30, 2001. In addition, our executive officers may be deemed to beneficially
own in the aggregate approximately 3.6% of our outstanding common stock.
Accordingly, Broadwing, NYSERNet.net, Grumman Hill and our officers and
directors, whether acting alone or together, are able to exert considerable
influence over any stockholder vote, including any vote on the election or
removal of directors and any merger, consolidation or sale of all or
substantially all of our assets, and control our management and affairs. Such
control could discourage others from initiating potential merger, takeover or
other change in control transactions. As a consequence, our business could be
hurt. In addition, Grumman Hill has a representative on our board of
directors. NYSERNet.net, Broadwing, Grumman Hill and our officers and
directors may have conflicts of interest among themselves, and their interests
could conflict with the interests of our other stockholders.

WE ARE DEPENDENT ON KEY PERSONNEL AND OPERATE IN AN INDUSTRY WHERE IT IS
DIFFICULT TO ATTRACT AND RETAIN QUALIFIED PERSONNEL.

         We expect that we will need to hire additional personnel in all areas
of our business. The competition for personnel throughout our industry is
intense. At times, we have experienced difficulty in attracting qualified new
personnel. If we do not succeed in attracting new, qualified personnel or
retaining and motivating our current personnel, our business could suffer. We
are also dependent on the continued services of our key personnel, including
our senior management. We have entered into employment agreements with certain
executive officers. We have also secured key man insurance policies on the
lives of Messrs. Mandelbaum and Martin.

OUR STOCK PRICE MAY BE VOLATILE.

         Stock prices of technology companies, especially Internet-related
companies, have been highly volatile. The current trading price of our common
stock may not be indicative of prices that

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<PAGE>   41

will prevail in the trading market. Various factors could cause the market
price of our common stock to fluctuate substantially. These factors may
include:

     -   variations in our revenue, earnings and cash flow;

     -   announcements of new service offerings, technological innovations or
         price reductions by us, our competitors or providers of alternative
         services;

     -   changes in analysts' recommendations or projections; and

     -   changes in general economic and market conditions.

         In addition, the U.S. equity markets in general have periodically had
significant price corrections, trading volume fluctuations and prolonged periods
of decline. These events have impacted the stock prices for Internet-related,
technology and telecommunications companies. Specifically, recent events have
adversely affected the market price of our common stock in a significant manner
that potentially could result in the delisting of our common stock from the
Nasdaq Stock Market. In the past, following periods of volatility in the market
price of a company's securities, securities class action litigation has often
been instituted against the company in question. If we become subject to
securities litigation, we could incur substantial costs and experience a
diversion of management's attention and resources.

INDUSTRY CONSOLIDATION COULD MAKE IT MORE DIFFICULT TO COMPETE.

         Companies offering Internet, data and communications services are
increasingly consolidating. As a company with a limited operating history, we
may not be able to successfully compete with businesses that have combined, or
will combine, to produce companies with substantially greater financial, sales
and marketing resources, larger customer bases, extended networks and
infrastructures and more established relationships with vendors, distributors
and partners than we have. In addition, this consolidation trend could prevent
or hinder our ability to further grow our operations through acquisitions.
With these heightened competitive pressures, there is a significant risk that
the value of our common stock will decline.

WE HAVE A SIGNIFICANT AMOUNT OF DEBT.

         We are leveraged, and we may seek additional debt funding in the
future. As of June 30, 2001, we had approximately $46.9 million of outstanding
debt and an accumulated deficit of $114.5 million. We may not be able to
generate sufficient revenue to fund our operations or to repay our debt. Our
existing substantial leverage poses, and any future leverage would pose, the
risk that:

     -   we may be unable to repay our debt;

     -   we may be unable to obtain additional financing; and

     -   we may be more vulnerable during economic downturns, less able to
         withstand competitive pressures and less flexible in responding to
         changing business and economic conditions.

         Additionally, our outstanding debt may impose significant
restrictions on how we can conduct our business. The debt may prohibit or
limit our ability to incur additional debt and may materially and adversely
affect our ability to finance future operations or capital needs or conduct
additional business activities. Any future debt that we may incur would also
likely impose restrictions on us. If we fail to comply with any of these
restrictions, we would be in default and, as a result, the holders of the
applicable debt could demand that we pay the debt, including interest,
immediately. This would create a significant risk that the value of our common
stock will decline.

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<PAGE>   42
DELISTING OF OUR SHARES ON THE NASDAQ NATIONAL MARKET MAY LIMIT YOUR ABILITY TO
DISPOSE OF YOUR SHARES.

On May 23, 2001, Nasdaq formally notified us of our failure, for more than 30
consecutive business days, to maintain the $1.00 minimum bid price required by
Nasdaq Marketplace Rule 4310(c)(4). Pursuant to Nasdaq Marketplace Rule
4310(c)(8)(b), Nasdaq has given the Company 90 calendar days, or until August
21, 2001 to regain compliance with Rule 4310(c)(4).

Nasdaq has notified us that, if we are unable to demonstrate compliance with
Rule 4310(c)(4) on or before August 21, 2001, Nasdaq will provide us with
written notification that our common stock will be delisted. If we do not
regain compliance with Rule 4310(c)(4), we intend to request a hearing and
request a stay of the delisting of our common stock.

If our common stock is delisted from the Nasdaq National Market, trading in our
common stock, if any, would have to be conducted in the over-the-counter market
(also known as the pink sheet market). In such an event, an investor could find
it more difficult to dispose of, or to obtain accurate quotations as to the
market value of our common stock.

In addition, if our common stock were to become delisted from trading on the
Nasdaq National Market and the trading price were to remain below $5.00 per
share, trading in our common stock may also be subject to the requirements of
certain rules promulgated under the Securities Exchange Act of 1934, as amended,
which require additional disclosures by broker-dealers in connection with any
trades involving a stock defined as a "penny stock." The additional burdens
imposed upon broker-dealers by these requirements could discourage
broker-dealers from facilitating trades in our common stock, which could
severely limit the market liquidity of our common stock and the ability of our
shareholders to trade our common stock.

OUR STOCK PRICE MAY BE AFFECTED BY THE AVAILABILITY OF SHARES FOR FUTURE SALE.
THE FUTURE SALE OF A LARGE AMOUNT OF OUR STOCK, OR THE PERCEPTION THAT THESE
SALES COULD OCCUR, COULD NEGATIVELY AFFECT OUR STOCK PRICE.

         On May 5, 1999, we completed our initial public offering, or IPO, of
5,175,000 shares of our common stock pursuant to a registration statement on
Form S-1 (File No. 333-72133). In addition to our IPO as a result of our
re-offer prospectus filed on Form S-8 with the Securities and Exchange
Commission ("SEC") on July 19, 1999 (File No. 333-83177), approximately
4,500,000 shares of our outstanding common stock no longer qualify as
"restricted securities" under Rule 144 of the Securities Act of 1933 and,
under the Securities Act, these shares may be freely re-offered and re-sold.
However, affiliates who sell shares of our common stock under this re-offer
prospectus must comply with the volume of sale limitations imposed under Rule
144(e) of the Securities Act. Also, a substantial number of shares of common
stock issuable upon exercise of outstanding stock options are available for
resale in the public market as a result of our filing a registration statement
on Form S-8 with the SEC on July 19, 1999 (File No. 333-83177) in order to
register the shares issued and issuable upon the exercise of options granted
under our 1996 Incentive Stock Option Plan and our 1999 Stock Option Plan as
well as shares issued under our 1999 Employee Stock Purchase Plan.

         As a result of filing of a registration statement on Form S-3 with
the SEC on October 24, 2000 (File No. 333-48518), 211,000 shares of our common
stock were issued and these shares may be freely re-offered and re-sold. Also,
as a result of filing of a registration statement on Form S-3 with the SEC on
October 25, 2000 (File No. 333-48578), approximately 839,881 shares of our
outstanding common stock will no longer qualified as "restricted securities"
under Rule 144 of the Securities Act and, under the Securities Act, these
shares may be freely re-offered and re-sold. Furthermore, due to the
registration statement on Form S-3 with the SEC that was filed on April 4,
2001 (File No. 333-54420), if certain parties convert the 5% convertible
debentures into common stock up to an additional 22,333,333 shares of our
common stock would be registered and freely tradable. As a result of filing a
registration statement on Form S-3 with the SEC on May 18, 2001 (File No.
333-61254), approximately 280,759 shares of our common stock may be freely
re-offered and re-sold.

         Therefore, through the S-8 re-offer prospectus, a separate S-8
registration statement and the S-3 registration statements, as a result of
registration rights and under Rule 144, a large number of shares of our common
stock may become freely tradable and affect the market for our stock.

         As of June 30, 2001, an additional 30% of the shares of our common
stock continue to be restricted securities. Certain of the holders of these
restricted securities have registration rights with respected to these
restricted shares and with respect to any after-acquired shares. Also, under
Rule 144 these shares are or may become freely tradable in the future.




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<PAGE>   43


ITEM 6.    EXHIBITS AND REPORTS ON FORM 8-K

         (a.)     EXHIBITS.

         The following exhibits are filed or incorporated by reference herewith:

         Exhibit 11.1      Calculation of Basic and diluted loss per share and
                           weighted average shares used in calculation for the
                           three months ended June 30, 2001.

         Exhibit 11.2      Calculation of Basic and diluted loss per share and
                           weighted average shares used in calculation for the
                           six months ended June 30, 2001.

         Exhibit 99.1      Press release issued by AppliedTheory Corporation
                           on August 2, 2001.

         (b.)     REPORTS ON FORM 8-K.

                  On July 26, 2001, we filed a current report on Form 8-K that
         included information relating to an amendment agreement, a revolving
         credit agreement and a security agreement between the Company and
         seven institutional investors dated July 10, 2001. The amendment
         agreement modified certain provisions of the $30,000,000 in 5%
         convertible debentures under the January 9, 2001 amended and restated
         purchase agreement and related documents. Based on the revolving
         credit agreement, the investors agreed to loan the Company and its
         subsidiaries up to $6,000,000. Under the security agreement, the
         investors received a security interest in the assets of the Company
         to secure the Company's obligations to them, including their
         obligations under the revolving credit loans and the convertible
         debentures.

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<PAGE>   44


                          APPLIEDTHEORY CORPORATION
                                  FORM 10-Q
                                JUNE 30, 2001




                                  SIGNATURES

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

                          AppliedTheory Corporation



Date:  August 10, 2001     by:    /s/  Danny E. Stroud
                                -----------------------------------------------
                                Danny E. Stroud
                                President and Chief Executive Officer
                                (Principal Executive Officer)


Date:  August 10, 2001     and:   /s/  Angelo A. Gencarelli III
                                -----------------------------------------------
                                Angelo A. Gencarelli III
                                Sr. Vice President and Chief Financial Officer
                                (Principal Financial and Accounting Officer)


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<PAGE>   45


                                EXHIBIT INDEX


         The following exhibits are filed or incorporated by reference
    herewith:

    Exhibit 11.1  Calculation of Basic and diluted loss per share and
                  weighted average shares used in calculation for the
                  three months ended June 30, 2001.

    Exhibit 11.2  Calculation of Basic and diluted loss per share and
                  weighted average shares used in calculation for the six
                  months ended June 30, 2001.

    Exhibit 99.1  Press release issued by AppliedTheory Corporation on
                  August 2, 2001.



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