<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 MARCH 31, 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 April 30, 2001, there were 27,120,009 shares of AppliedTheory Corporation
common stock, par value $.01, outstanding.

                   The Index of Exhibits appears on page 42.


--------------------------------------------------------------------------------
<PAGE>   2
                            APPLIEDTHEORY CORPORATION

                                TABLE OF CONTENTS

<TABLE>
<CAPTION>
PART I.  FINANCIAL INFORMATION

Item 1.  Financial Statements (Unaudited):

<S>      <C>                                                                            <C>
         Consolidated Balance Sheets as of December 31, 2000 and March 31, 2001..........3

         Consolidated Statements of Operations for the three months ended
         March 31, 2000 and March 31, 2001...............................................4

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

         Consolidated Statements of Cash Flows for the three months ended
         March 31, 2000 and March 31, 2001...............................................6

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


Item 2.  Management's Discussion and Analysis of Financial Condition
         and Results of Operations......................................................16

Item 3.  Quantitative and Qualitative Disclosures about Market Risk.....................25

PART II.  OTHER INFORMATION

Item 1.  Legal Proceedings..............................................................26

Item 2.  Changes in Securities and Use of Proceeds......................................27

Item 3.  Defaults Upon Senior Securities................................................27

Item 4.  Submission of Matters to a Vote of Security Holders............................27

Item 5.  Other Information..............................................................28

Item 6.  Exhibits and Reports on Form 8K................................................41

Signatures    ..........................................................................42

Exhibit Index...........................................................................43
</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,      March 31,
                                                                                   2000            2001
                                                                                 ---------       ---------
                                                                          (Derived from Audited  (Unaudited)
                                                                          Financial Statements)
<S>                                                                       <C>                   <C>
                                   ASSETS

Current assets

    Cash and cash equivalents                                                   $   5,733       $   7,753
    Marketable securities                                                           4,098           3,178
    Accounts receivable, net of allowance of $1,031 and $1,083, respectively       15,379          15,289
    Costs in excess of billings                                                       702           1,491
    Due from related parties                                                        1,436           1,413
    Prepaid expenses and other current assets                                       1,920           1,815
                                                                                ---------       ---------
           Total current assets                                                    29,268          30,939
Property and equipment, net                                                        30,632          28,573
Investment, at cost                                                                 5,250             760
Goodwill                                                                           61,946          58,470
Other assets                                                                        3,150           3,375
                                                                                ---------       ---------
           Total assets                                                         $ 130,246       $ 122,117
                                                                                =========       =========

                    LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities

    Accounts payable                                                            $   6,028       $  11,408
    Lines of credit                                                                   687           5,750
    Accrued payroll                                                                 3,088           3,520
    Accrued expenses                                                                4,385           4,048
    Deferred revenue                                                                4,270           4,473
    Current portion of convertible debentures                                      13,804          13,268
    Current portion of long-term debt and capital lease obligations                 4,394           5,699
                                                                                ---------       ---------
           Total current liabilities                                               36,656          48,166
Long-term debt and capital lease obligations                                       11,655           6,103
Convertible debentures                                                             13,804          13,967
Other liabilities                                                                     404             681
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 26,432,341 shares at March 31, 2001                                        260             264
    Additional paid-in capital                                                    139,900         140,910
    Accumulated deficit                                                           (82,439)        (97,614)
    Accumulated other comprehensive income (loss)                                       6            (360)
                                                                                ---------       ---------
           Total stockholders' equity                                              57,727          43,200
                                                                                ---------       ---------
           Total liabilities and stockholders' equity                           $ 130,246       $ 122,117
                                                                                =========       =========
</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
                                                                                    March 31,

                                                                               2000            2001
                                                                               ----            ----
<S>                                                                          <C>            <C>
Net revenues
     Web hosting                                                             $   1,730      $    7,441
     Internet solutions                                                          6,627           5,274
     Internet connectivity                                                       7,466           7,473
                                                                             ---------      ----------

     Total net revenues                                                         15,823          20,188
                                                                             ---------      ----------

Costs and expenses

     Cost of revenues                                                           11,043          13,790
     Sales and marketing                                                         6,711           6,095
     General and administrative                                                  4,909           5,372
     Research and development                                                      167             594
     Depreciation                                                                1,839           3,025
     Amortization                                                                2,278           3,708
     Other expenses (income)                                                       (21)            (22)
     Loss from sale of investment in PTI (see Note J)                                            1,711
                                                                             ---------      ----------

     Total costs and expenses                                                   26,926          34,273
                                                                             ---------      ----------

     Loss from operations                                                      (11,103)        (14,085)

Interest income                                                                   (393)           (101)
Interest expense                                                                   278           1,191
                                                                             ---------      ----------

     Net loss attributable to common stockholders                            $ (10,988)     $  (15,175)
                                                                             =========      ==========

Basic and diluted loss per common share                                      $   (0.48)     $    (0.58)
                                                                             =========      ==========

Shares used in computing basic and diluted loss per share                   23,105,302      26,154,357
                                                                            ==========      ==========
</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 THREE MONTHS ENDED MARCH 31, 2001 (UNAUDITED)
                        (IN THOUSANDS, EXCEPT SHARE DATA)


<TABLE>
<CAPTION>

                                                         Common stock         Additional     Accumu-
                                                      ------------------        paid-in       lated
                                                       Shares     Amount        capital      deficit
                                                       ------     ------      -------------------------
<S>              <C>                                  <C>           <C>       <C>         <C>
BALANCE, JANUARY 1, 2000                              21,413,362    $ 214     $ 84,052    $ (29,806)
                                                      ==========      ===       ======      =======

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

Comprehensive loss


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

Issuance of common stock pursuant to exercise
 of stock options                                         79,060        1           14
Issuance of common stock pursuant to conversion
 of convertible debentures, net of debt
 discount and issuance costs                             366,334        3          696
Compensation expense related to stock option plan                                  300
Unrealized gain (loss) on marketable securities
Net loss                                                                                    (15,175)
                                                    --------------- -----    ----------     -------

Comprehensive loss


BALANCE, MARCH 31, 2001                               26,432,341    $ 264    $ 140,910    $ (97,614)
                                                      ==========      ===      =======      =======
</TABLE>


<TABLE>
<CAPTION>
                                                      Accumu-
                                                       lated
                                                       other
                                                       compre-                  Compre-
                                                       hensive                  hensive
                                                      income (loss)   Total   income (loss)
                                                     --------------   -----   -------------
<S>                                                  <C>            <C>       <C>
BALANCE, JANUARY 1, 2000                               $ (251)      $ 54,209
                                                        =====        =======

Issuance of common stock for acquisitions                             48,365
Issuance of common stock pursuant to exercise
 of stock options                                                      1,009
Issuance of common stock pursuant to Employee
 Stock Purchase Plan                                                   1,192
Compensation expense related to stock option plan                      1,236
Discount on convertible debenture                                      4,092
Unrealized gain (loss) on marketable securities           257            257         257
Net loss                                                             (52,633)    (52,633)
                                                       ------        -------     -------

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

BALANCE, DECEMBER 31, 2000                                $ 6       $ 57,727
                                                            =        =======

Issuance of common stock pursuant to exercise
 of stock options                                                         15
Issuance of common stock pursuant to conversion
 of convertible debentures, net of debt discount
 and issuance costs                                                      699
Compensation expense related to stock option plan                        300
Unrealized gain (loss) on marketable securities          (366)          (366)       (366)
Net loss                                                             (15,175)    (15,175)
                                                       ------        -------     -------

Comprehensive loss                                                            $ (15,541)
                                                                                =======

BALANCE, MARCH 31, 2001                                $ (360)     $ 43,200
                                                         =====      =======
</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>
                                                                                          Three months ended
                                                                                              March 31,
                                                                                     -----------------------------
                                                                                         2000           2001
                                                                                         ----           ----
<S>                                                                                    <C>            <C>
Cash flows from operating activities
         Net loss                                                                      $ (10,988)     $ (15,175)
         Adjustments to reconcile net loss to net cash used in operating activities
              Depreciation                                                                 1,839          3,025
              Amortization of goodwill                                                     2,278          3,708
              Amortization of debt discount                                                                 321
              Provision for bad debts                                                        110             51
              Realized loss on marketable securities                                                      1,712
              Gain on sale of property and equipment                                                        (23)
              Compensation expense related to stock option plans                             309            300
              Changes in assets and liabilities, net of acquisitions
                Accounts receivable                                                       (1,796)          (721)
                Due from related parties                                                    (952)           (91)
                Prepaid expenses, other current assets and other assets                      592            (59)
                Accounts payable                                                              58          5,380
                Accrued payroll, expenses and other liabilities                             (448)           375
                Deferred revenue                                                             (41)          (587)
                                                                                       ----------     ----------
              Net cash used in operating activities                                       (9,039)        (1,784)
                                                                                       ---------      ---------

Cash flows from investing activities
         Purchases of property and equipment                                              (5,690)        (1,051)
         Proceeds from sales of marketable securities                                     15,842          4,093
         Investment in certain businesses, net of cash acquired                           (9,653)          (118)
         Payments received on notes receivable                                                 1              1
         Proceeds from sale of property and equipment                                                       219
                                                                                       ---------      ---------
              Net cash provided by investing activities                                      500          3,144
                                                                                       ---------      ---------

Cash flows from financing activities
         Issuance of common stock, net of issuance costs                                      90             15
         Convertible debenture issue costs                                                                  (62)
         Proceeds from (payments of) line of credit borrowings, net                                        (437)
         Principal payments on long-term debt and capital leases                          (1,182)        (1,187)
         Proceeds received from long-term debt and capital leases                                         2,331
                                                                                       ---------      ---------
              Net cash provided by (used in) financing activities                         (1,092)           660
                                                                                       ----------     ---------

              Net increase (decrease) in cash and cash equivalents                        (9,631)         2,020

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

Cash and cash equivalents, end of period                                               $   5,203      $   7,753
                                                                                       =========      =========

Supplemental disclosures of cash flow information
         Cash paid during the period for interest                                      $     278      $     423

Non-cash investing and financing transactions
         Fixed asset acquisitions financed through capital lease obligations           $   5,029      $     112
         Conversion of convertible debentures to equity                                                     699
         Acquired stock in exchange for cancellation of accounts receivable                                 760
         Unrealized holding (loss) gain on available for sale securities                     168           (366)
         Investment in businesses

               Fair value of assets acquired, net of cash acquired                        48,406            118
              Liabilities assumed                                                          4,792
              Issuance of common stock for investment in businesses                       23,961
              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, e-Business, 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 months ended March 31, 2000 and 2001 and the
     related footnote information are unaudited and have been prepared on a
     basis substantially consistent with the audited 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 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 month
     periods ended March 31, 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 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 through the pursuit of these initiatives. 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 a favorable 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.

NOTE B - ACQUISITIONS

     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


                                       7
<PAGE>   8
                   APPLIEDTHEORY CORPORATION AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (UNAUDITED)

     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 March 31, 2001 (see Note L).

     Under escrow provisions of the merger agreements in connection with the
     acquisitions of CRL, The Cordada Group, Inc. ("Cordada") and Team Tech
     International, Inc. ("Team Tech") in 2000, the Company has placed 285,507,
     160,000 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 March
     31, 2001, no shares had been issued since the outcome of the contingencies
     was not determinable.

NOTE C - COMPREHENSIVE LOSS

     Comprehensive loss for the three months ended March 31, 2000 and 2001, was
     as follows:

<TABLE>
<CAPTION>
                                                              2000              2001
                                                         ------------     ----------
                                                                 (in thousands)
          <S>                                              <C>             <C>
          Net loss attributable to common stockholders     $ (10,988)      $  (15,175)
          Other comprehensive income (loss):
            Unrealized gain (loss) on
               marketable securities, net of
               income tax                                        168             (366)
                                                             ---------      -----------
          Comprehensive loss                              $  (10,820)      $  (15,541)
                                                           ==========       ==========
</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 securities
     outstanding of 3,417,000 and 8,511,000 for the three months ended March 31,
     2000 and 2001, respectively.


                                       8
<PAGE>   9
                   APPLIEDTHEORY CORPORATION AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (UNAUDITED)

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 are
     expected to occur by June 2001 and $0.5 million had been charged against
     these liabilities for the three months ended March 31, 2001.

     On December 21, 1998, the Company adopted a plan, which was approved by its
     Board of Directors, to close a leased facility, which principally is used
     as a Web hosting data center. The facility had experienced operational
     difficulties which limited its usability as a Web hosting site and its
     ability to generate sufficient revenues to continue in operation. In
     connection with the plan of abandonment, the Company recorded a $900,000
     charge to other expense for the year ended December 31, 1998 consisting of
     (i) a $486,000 write-down of equipment and leasehold improvements to
     management's estimate of their fair value, based on the anticipated
     discounted future cash flows through the date of abandonment, of
     approximately $70,000, and (ii) a $414,000 accrued liability, included in
     accrued expenses at December 31, 1998, relating to equipment leases and
     facility operating leases, (net of anticipated subrental income) expiring
     in October 2001 and May 2006, respectively. This accrued liability provides
     for only those costs subsequent to exiting the facility and costs prior
     thereto will be recognized during the period they are incurred. For the
     three months ended March 31, 2000 and 2001, $0 and $43,000, respectively,
     had been charged against the aforementioned accrued liability. These costs
     were included in other income (expense) in the financial statements. As of
     March 31, 2001, management has completed a significant portion of the exit
     plan and charged aggregate costs of $245,000 against the liability.

NOTE F - LONG-TERM DEBT

     Lines 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 or a prime rate basis
     less 200 basis points (6.0% on March 31, 2001). The credit facility is
     collateralized by a maximum of $5,500,000 of cash and cash equivalents,
     government securities, corporate securities or corporate equities pledged
     by NYSERNet.net, Inc. ("NET").

     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 March 31, 2001, the Company had $5,750,000 outstanding and $550,000
     available under lines of credit. The average interest rate on outstanding
     borrowings was 6.1% at March 31, 2001.


                                       9
<PAGE>   10
                   APPLIEDTHEORY CORPORATION AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (UNAUDITED)

     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 March 31, 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 16.6%. 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 $675,000 at March 31, 2001.

     The following is a summary of future minimum lease payments under capital
     leases as of March 31, 2001.

<TABLE>
<CAPTION>
                                                            (in thousands)
         Year ending December 31,
         <S>                                                <C>
         2001                                                      $ 3,736
         2002                                                        4,438
         2003                                                        1,916
         2004                                                          317
         2005                                                          10
                                                                     ------

         Total minimum lease payments                               10,417

         Less amounts representing interest                         1,544
                                                                    ------

         Present value of minimum lease obligation               $  8,873
                                                                 ========
</TABLE>


NOTE G - CONVERTIBLE DEBENTURES

     On June 5, 2000 the Company entered into a purchase agreement (the
     "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 (the "Amended
     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. Under related agreements with these Investors, the
     Company can also receive up to an additional $13 million over the next five
     years from the


                                       10
<PAGE>   11
                   APPLIEDTHEORY CORPORATION AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (UNAUDITED)

     exercise of warrants for the purchase and sale of the Company's common
     stock. The current warrant exercise price is $6.00 per share. The maximum
     investment by the Investors in the Company under the amended agreements is
     an aggregate of $43 million, $30 million of which was invested when the
     Investors purchased the Debentures.

     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 added to principal or paid. On December 5, 2000, accrued interest of
     $750,000 was added to the principal of the Debentures. Principal and
     interest accrued on the Debentures are convertible into common stock at the
     option of the holder. These Debentures are presently convertible into
     approximately 1.8 million shares of common stock at a conversion price of
     $16.69 per share at any time until maturity. On June 5, 2001 and at six
     month intervals thereafter, ending June 5, 2003, the conversion price will
     reset downward if the average trading price during a period defined in the
     Debentures is less than the Company's stock price during the period when
     the initial conversion price was set. The Company may require the Investors
     to convert the convertible debentures into common stock if the volume
     weighted average price of the common stock exceeds $33.38 on each of 60
     consecutive trading days.

     During each calendar month, in addition to its other conversion rights,
     under the Amended Agreement the Investors may now convert up to a total of
     $15 million of convertible debentures in monthly installments equal to the
     greater of $3 million or 20% of the aggregate dollar sale volume of the
     Company's common stock for the 21 trading days preceding an investor's
     delivery of a notice to convert. The conversion price for a monthly
     conversion will be based on the volume weighted average price of the
     Company's common stock during the 4 consecutive 5 trading day periods
     during the 20 trading days beginning 3 days after the investor's delivery
     of a conversion notice. In the event a conversion notice is given, the
     Company has the right to redeem the debentures sought to be converted. The
     Investors can also convert an additional 50% of the amount submitted on
     each conversion notice if certain criteria are met. During the three months
     ended March 31, 2001, $699,000 of the convertible debentures' principal,
     net of debt discount and issuance costs, was converted into 366,334 shares
     of our common stock. Due to these conversion rights, $13,268,000 of the
     convertible debentures are included in current liabilities at March 31,
     2001.

     The Company now has the right to redeem up to $14,750,000 of the 5%
     convertible debentures, with such amount declining $1.00 for each $3.00 of
     convertible debentures the Investors elect to convert as described in the
     preceding paragraph. If the Company elects to so redeem any of the 5%
     convertible debentures, the Investors can convert such 5% convertible
     debentures into common stock at the volume weighted average price of the
     common stock for the 5 trading days preceding their receipt of the
     Company's redemption notice.

     The Amended Agreement contains certain restrictions on the Company's
     ability to redeem common shares pursuant to a certain put option agreement
     (see Note B) until July 11, 2002, unless certain liquidity criteria are
     satisfied.

     The Investors also received warrants to purchase up to $13,000,000 of the
     Company's common stock under the amended agreements. The warrants as
     amended are presently exercisable to purchase up to 2,166,667 shares of
     AppliedTheory for $6.00 per share and expire on June 5, 2005. The warrant
     exercise price will reset upon the issuance of securities at a per share
     price below the warrant exercise price or the occurrence of certain other
     events.


                                       11
<PAGE>   12
                   APPLIEDTHEORY CORPORATION AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (UNAUDITED)

     Based on an independent valuation of the Debentures and related warrants
     and options the Company 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 Investor's call
     option. The carrying value of the Debentures is being accreted to the face
     value of $30 million using the interest method over the life of the
     Debentures. The accretion was $321,000 for the three months ended March 31,
     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
     March 31, 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
                                                March 31,
                                          --------------------
                                            2000         2001
                                       -------------  --------
                                             (in thousands)
          <S>                           <C>            <C>
          Unrelated customers           $      752     $    1,138
          Member institutions                1,265          2,003
          Services to ORG                      707            824
                                         ---------     ----------
                                        $    2,724     $    3,965
                                        ==========     ==========
</TABLE>


     During the three months ended March 31, 2000, the Company charged NET and
     ORG approximately $25,000 and $75,000 in management fees, respectively.
     During the three months ended March 31, 2001, the Company charged NET and
     ORG approximately $17,000 and $53,000 in management fees, respectively.

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

     On June 22, 1999, the Company entered into a stock purchase agreement (the
     "Stock Purchase Agreement") with Planning Technologies, Inc. ("PTI"), a
     Georgia corporation, which provides consulting and network engineering
     services, along with Grumman Hill


                                       12
<PAGE>   13
                   APPLIEDTHEORY CORPORATION AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (UNAUDITED)

     Investments III, L.P., ("Grumman Hill") and certain shareholders of PTI.
     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 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 publicly
     traded company on the Nasdaq Stock Market. As a result of the merger, the
     Company converted 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. At March 31,
     2001, the fair value of $3.2 million was classified as an available for
     sale marketable security and the unrealized loss of $0.4 million, net of
     taxes, on the investment was included in stockholders' equity as a
     component of accumulated other comprehensive income (loss). The shares may
     be freely traded by the Company upon the effectiveness of a Form S-3
     registration statement and compliance with other conditions of the merger
     agreement by Red Hat, Inc.

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. Based on the 22 trading days' volume and closing prices
     of AppliedTheory common stock for the period ended April 30, 2001, the
     Company could have sold approximately $400,000 of its shares under the
     initial purchase and, assuming the trading volume and closing price of its
     common stock remained constant, an additional $300,000 per month
     thereafter. 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.


                                       13
<PAGE>   14
                   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.

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 plans to pursue claims under
     the escrow agreement against Mr. Couch. 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


                                       14
<PAGE>   15
                   APPLIEDTHEORY CORPORATION AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (UNAUDITED)

     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. 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 December 31, 2000, 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.


                                       15
<PAGE>   16
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."

WE FOCUS ON INTEGRATED INTERNET BUSINESS SOLUTIONS

         Our customers' successful Internet business strategies have become as
complicated as they are critical. As companies face this challenge, they turn to
the services offered by AppliedTheory's outsourced hosting and life cycle
approach.


                                       16
<PAGE>   17
         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 and network operation and, when appropriate, managed application
support.

         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 600 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 and Carrier Corporation.

     -    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,


                                       17
<PAGE>   18
          which we believe is the world's largest online employment database. We
          created the original site design and continue to operate and manage
          the site.

     -    We assisted Johns Hopkins University's Department of Medicine in
          developing a new Internet-based, content management application
          providing physicians with instantaneous information pulled from the
          hospital's database for treating infectious diseases. We also host and
          manage the web site that provides their doctors and health care
          professionals round-the-clock access to this life-saving data.

     -    Ingersoll-Rand, one of the world's largest industrial manufacturers,
          expanded their relationship with us through an agreement to provide
          managed hosting and applications for their Bobcat line of equipment.

     -    Snapper Mowers, the lawn and garden equipment manufacturer, contracted
          with us to redesign and re-engineer their web site and build extranet
          applications to take all levels of their dealer relations, sales and
          warranty services online.

     -    Our government work continues to expand as a result of a new General
          Services Administration ("GSA") contract. 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. We have expanded our application development for the State
          Department and added the State of Hawaii as a new customer. In
          addition, we 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.


                                       18
<PAGE>   19
     -    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.

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 quarter of 2001.
In addition, our year-over-year revenue growth has been strong, especially
considering the recent market downturn. We continue our core business focus on
fast-growing, high-margin outsourced and managed hosting and have created a more
efficient, streamlined delivery machine which allows us to produce better
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.

         Our growth strategy dictates that 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, we expect our
acquisitions during 2001 to be fewer than in the prior year as a result of the
currently existing market conditions.

CONSOLIDATED RESULTS OF OPERATIONS

THREE MONTHS ENDED MARCH 31, 2001 COMPARED TO THREE MONTHS ENDED MARCH 31, 2000

REVENUES

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

<TABLE>
<CAPTION>
                                                              Three months ended
                                                                   March 31,
                                                          2000       2001    Increase
                                                                (in millions)
          <S>                                             <C>       <C>      <C>
          Net revenues
            Web hosting                                   $  1.7    $  7.4   $  5.7
            Internet solutions                               6.6       5.3     (1.3)
            Internet connectivity                            7.5       7.5      0.0
                                                           -----     -----   ------
          Total net revenues                               $15.8     $20.2   $  4.4
                                                           =====     =====   ======

          Percent of total revenue
            Web hosting                                     11%       37%
            Internet solutions                              42        26
            Internet connectivity                           47        37
                                                          -----      ----
          Total net revenues                               100%      100%
                                                           ====      ====
</TABLE>


                                       19
<PAGE>   20
         Total net revenues increased 28%, or approximately $4.4 million, from
$15.8 million in the three months ended March 31, 2000 to $20.2 million in the
three months ended March 31, 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 330% illustrates the dramatic
expansion of these services from the three months ended March 31, 2000 to the
three months ended March 31, 2001.

         WEB HOSTING REVENUE increased by approximately $5.7 million, from $1.7
million during the three months ended March 31, 2000 to $7.4 million for the
three months ended March 31, 2001. 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 $1.8 million of the increase in comparison to the same period
in 2000. In addition, approximately $1.3 million of the increase in the three
months ended March 31, 2001 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 $2.6 million in hosting revenue during the three months ended
March 31, 2001.

         INTERNET SOLUTIONS REVENUE decreased by approximately $1.3 million,
from $6.6 million during the three months ended March 31, 2000 to $5.3 million
for the three months ended March 31, 2001. 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 $4.6 million during the three months ended March 31, 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 $3.2 million, reflecting the continued
diversification and expansion of our customer base. During the three months
ended March 31, 2001, revenue from customers other than the New York State
Department of Labor was 72% of total Internet solutions revenue, up from 9%
during the same period in 2000.

         INTERNET CONNECTIVITY REVENUE remained relatively stable during the
three months ended March 31, 2001, as compared to the same period 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;


                                       20
<PAGE>   21
     -    nationwide dial access through over 480 points-of-presence;

     -    digital subscriber line (DSL) services; and

     -    infrastructure and connectivity engineering special projects provided
          to NET.


COSTS AND EXPENSES

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

<TABLE>
<CAPTION>
                                                              Three months ended
                                                                   March 31,
                                                           2000       2001     Increase
                                                                 (in millions)

          <S>                                            <C>          <C>     <C>
          Cost of revenues                               $  11.0      $13.8   $  2.8
          Sales and marketing                                6.7        6.1     (0.6)
          General and administrative                         4.9        5.4      0.5
          Research and development                           0.2        0.6      0.4
          Depreciation                                       1.8        3.0      1.2
          Amortization                                       2.3        3.7      1.4
          Other                                              0.0        1.7      1.7
                                                         -------     ------  -------
           Total costs and expenses                        $26.9      $34.3     $7.4
                                                           =====      =====     ====
</TABLE>


     COST OF REVENUE. Cost of revenue increased approximately $2.8 million, from
$11.0 million in the three months ended March 31, 2000 to $13.8 million in the
three months ended March 31, 2001. The increase in cost of revenues was
primarily attributable to the factors below.

     -    Increased labor costs to support our revenue growth of approximately
          28% versus the same period in the prior year added $2.7 million in
          costs during the three months ended March 31, 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 revenue decreased to 68% for the
three months ended March 31, 2001 from 70% in the three months ended March 31,
2000.

         SALES AND MARKETING. For the three months ended March 31, 2000 and
2001, sales and marketing expenses were approximately $6.7 million and $6.1
million, respectively. Our sales and marketing expenses have decreased as we
have continued efforts to train and structure our sales force to target specific
types of customers. As a result of refining our sales and marketing approach,
we have been able to increase sales productivity. The largest components of the
decrease for the three months ended March 31, 2001, were:

     -    $0.5 million in decreased costs associated with our marketing program
          and product management efforts; and

     -    $0.1 million in decreased occupancy costs and other costs that support
          our sales presence.


                                       21
<PAGE>   22
         Sales and marketing expense, as a percentage of revenue, decreased to
approximately 30% for the three months ended March 31, 2001 from 42% for the
three months ended March 31, 2000.

         GENERAL AND ADMINISTRATIVE. For the three months ended March 31, 2000
and 2001, general and administrative expenses were approximately $4.9 million
and $5.4 million, respectively. The increase in general and administrative
expenses of $0.5 million during the three months ended March 31, 2001 was
primarily attributable to:

     -    $0.2 million in costs related to salaries of new personnel;

     -    $0.1 million in increased real estate occupancy costs from the
          companies we acquired during 2000;

     -    $0.2 million in additional audit, legal and other professional service
          costs; and

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

         For the quarter ended March 31, 2001, general and administrative
expense decreased as a percent of revenue to 27% from 31% for the quarter ended
March 31, 2000.

         RESEARCH AND DEVELOPMENT. Research and development costs are
principally focused in our web hosting and Internet solutions service offerings.
For the three months ended March 31, 2000 and 2001, research and development
costs were approximately $0.2 million and $0.6 million, respectively. The
increase in research and development costs of approximately $0.4 million in the
three 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 March 31, 2000 and 2001,
depreciation expense was approximately $1.8 million and $3.0 million,
respectively. The increase of $1.2 million in the three months ended March 31,
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 employee base.

         AMORTIZATION. For the three months ended March 31, 2000 and 2001,
amortization expense was approximately $2.3 million and $3.7 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 $0.9 million from $0.3
million to $1.2 million for the three months ended March 31, 2000 and 2001,
respectively. The increase is mainly the result of approximately $0.6 million in
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.




                                       22

<PAGE>   23
         INTEREST INCOME. Interest income has decreased from $0.4 million to
$0.1 million for the three months ended March 31, 2000 and 2001, respectively.
This decrease was due primarily to a decrease in the amount of assets available
to invest.

         NET LOSS. Net loss attributable to common stockholders for the quarter
ended March 31, 2001 was approximately $15.2 million or $0.58 per share,
compared with approximately $11.0 million or $0.48 per share for the quarter
ended March 31, 2000. However, the increase in our loss per share was primarily
due to the one-time, non-cash adjustment for the loss on the sale of the PTI
shares of $1.7 million in the first quarter of 2001 (see Note J to the financial
statements) which resulted in our loss per share increasing from $0.51 to $0.58.


LIQUIDITY AND CAPITAL RESOURCES

         On June 5, 2000, we entered into a purchase agreement and issued a
total of $30 million in 5% convertible debentures due June 5, 2003 to seven
institutional investors. On January 9, 2001, this agreement was amended and
restated. These debentures are convertible into shares of our common stock and
mature on June 5, 2003. See additional discussion in Note G to the financial
statements. After payment of approximately $1.0 million in fees and expenses,
net proceeds of approximately $29.0 million were received. The remaining
proceeds are being used to fund our operations, working capital requirements and
capital expenditures.

         At March 31, 2001, we had $7.8 million in cash and cash equivalents, of
which $0.7 million is restricted, $3.2 million in marketable securities and a
$17.2 million working capital deficit. Although we have utilized the available
proceeds from our IPO and a significant portion of the proceeds from the
issuance of 5% convertible debentures, we have several sources of additional
funds at our disposal. These include the liquidation of marketable securities
and other investments, the use of vendor financing and, if needed, a stock
purchase arrangement with Crescent International Ltd. that provides the company
with financing ability in a series of defined tranches of up to $30 million
subject to various limitations (see discussion below and Note K to the financial
statements).

         -        Once registered, we will have the ability to freely liquidate
                  up to 521,769 shares of Red Hat, Inc. common stock due to the
                  acquisition of Planning Technologies, Inc. ("PTI") by Red Hat,
                  Inc. on February 26, 2001. As a result of the acquisition, we
                  exchanged our interest in PTI (see Note J to the financial
                  statements for additional discussion on PTI investment) for
                  shares of Red Hat, Inc. common stock. The shares were valued
                  at approximately $3.2 million on March 31, 2001 and may be
                  freely traded by us upon the effectiveness of a Form S-3
                  registration statement and compliance with other conditions of
                  the merger agreement by Red Hat, Inc.

         -        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 March
                  31, 2001, we have used $2.3 million of our available financing
                  to acquire equipment to meet the increasing demands for our
                  network and web hosting services by our customers.

         -        On February 22, 2001, we completed a stock purchase
                  arrangement with Crescent International Ltd., an investment
                  fund managed by GreenLight (Switzerland) SA of Geneva,
                  Switzerland, that provides us 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
                  we choose to sell. Under the terms of the deal, we have the
                  right, but are not obligated, to exercise the option, in whole
                  or in part. The amount of shares that the Company can sell and
                  the value at which those shares

                                       23
<PAGE>   24
                  can be sold is contingent upon certain trading volume and
                  share price parameters. If the price of our common stock is
                  below $1.00 on any 8 trading days beginning on the day we
                  notify Crescent our intention to sell common stock or, if the
                  average of the closing price times the trading volume of our
                  common stock for the 22 trading days preceding such notice is
                  less than $150,000, we can only sell $50,000 of our common
                  stock to Crescent. Based on the 22 trading days' volume and
                  closing prices of our common stock for the period ended April
                  30, 2001, assuming that the trading volume remains constant
                  and the closing price of our common stock exceeds $1.00 for
                  the 8 days following delivery of notice, we estimate that
                  approximately $0.4 million would be available under the
                  initial purchase with an additional $0.3 million available per
                  month thereafter. See additional discussion in Note K to the
                  financial statements.

         Our principal uses of cash are to fund operations, working capital
requirements and capital expenditures. We had an accumulated deficit of $97.6
million at March 31, 2001, and have used $1.8 million in cash in the aggregate
to fund operations during the first quarter of 2001.

         -        Net cash used in operating activities for the three months
                  ended March 31, 2000 and 2001 was approximately $9.0 million
                  and $1.8 million, respectively. The decrease of $7.2 million
                  was principally a result favorable working capital changes of
                  $6.9 million, increased amortization of goodwill of $1.4
                  million, additional depreciation expense of $1.2 million and
                  realized loss on marketable securities of $1.7 million offset
                  by increased net losses from operations of $4.2 million.

         -        Net cash provided by investing activities for the three months
                  ended March 31, 2000 and 2001 was approximately $0.5 million
                  and $3.1 million, respectively. The increase in the net cash
                  provided by investing activities of approximately $2.6 million
                  was primarily associated with the decrease in the investment
                  in acquired companies of $9.5 million and the decrease in
                  purchases of property and equipment of $4.6 million offset by
                  the decrease in the proceeds from sales of marketable
                  securities of $11.7 million.

         -        For the three months ended March 31, 2000, cash of
                  approximately $1.1 million was used in financing activities.
                  For the three months ended March 31, 2001, cash of
                  approximately $0.7 million was provided by financing
                  activities. This increase of approximately $1.8 million
                  consists principally of a $2.3 million increase in proceeds
                  from long-term debt and capital leases offset by an increase
                  in payments on line of credit borrowings of $0.4 million.

         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 5% convertible
debentures contain certain restrictions on our ability to redeem common shares
pursuant to this put option agreement until July 11, 2002, unless certain
liquidity criteria are satisfied. 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.

         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 $1.2 million in the three months ended
March 31, 2001. We acquired assets under capital leases for $1.5 million in
1999, $7.7 million in 2000, and $2.4 million in the three months ended March 31,
2001.

         At March 31, 2001 we had $3.2 million in marketable securities and $7.8
in cash, of which $0.7 million is restricted. In addition to these amounts and
the aforementioned sources of funds at


                                       24
<PAGE>   25
our disposal, we will need to raise 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. There can be no
assurance that additional financing, if needed, 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. Management believes, although there can be no
assurance, that the implementation of these initiatives combined with the
financing outlined above, and assuming a favorable resolution of the litigation
with the former CRL shareholders, there will be sufficient cash flow for the
next twelve months.

COMMITMENTS

         As of March 31, 2001, our operating lease obligations will be $4.5
million, $4.1 million and $3.1 million for 2001, 2002 and 2003, respectively,
and $12.1 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: $17.4 million
in 2001, $10.6 million in 2002 and $16.5 million in 2003. A majority of the debt
maturing in 2001 represents $13.3 million in convertible debentures that will be
redeemed only upon receipt of monthly conversion notices from the investors. In
addition, we have the right to redeem the debentures through the issuance of our
common stock or in cash in accordance with the terms of the amended and restated
purchase agreement. See additional discussion in Note G to the financial
statements. As a result, the repayment of these debentures may not adversely
affect our working capital for 2001. The remaining debt maturing in 2001
includes $0.3 million in line of credit obligations and $3.8 million in capital
lease and other equipment financing obligations. Debt maturing in 2002 includes
$5.5 million in line of credit obligations and $5.1 million in capital lease and
other equipment financing obligations. Debt maturing in 2003 includes the
remaining $14.0 million in convertible debentures maturing on June 5, 2003 and
$2.5 million in capital lease and other equipment financing obligations.


ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

         At March 31, 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 March 31, 2001, the carrying value of our debt obligations
approximate the fair value due to the debt discount recorded on the convertible
debenture and the short maturity and/or variable interest rates of a majority of
the other debt. The weighted average interest rate of our debt obligations at
March 31, 2001 was 7.1%.

         Our investments are generally common stock securities. At March 31,
2001, all of our investments are classified as available for sale and are
carried at fair value of $3.2 million. 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 which
would amount


                                       25
<PAGE>   26
to $0.3 million at March 31, 2001. We actively monitor the capital and investing
markets in analyzing our capital raising and investing decisions.


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 plans to
pursue claims under an escrow agreement against Mr. Couch. 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


                                       26
<PAGE>   27
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. 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 March 31, 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 March 31, 2001, the Company has used the proceeds from its IPO on
May 5, 1999 and is currently using the remaining proceeds from the $30,000,000
in 5% convertible debentures issued on June 5, 2000 and amended on January 9,
2001 to fund its operations, working capital requirements, acquisitions and
capital expenditures.

         During the three months ended March 31, 2001, proceeds of approximately
$15,000 were generated from the exercise of options for 79,060 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 1996 Incentive Stock Option Plan and were exercised by certain employees and
directors. No issuances of common stock under our Employee Stock Purchase Plan
occurred during the three months ended March 31, 2001. 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

         During the first quarter of 2001, no matters were submitted to a vote
of security holders.


                                       27
<PAGE>   28
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 March 31, 2001 and December 31, 2000 and 1999, we
had an accumulated deficit of approximately $97.6 million, $82.4 million and
$29.8 million, respectively. We incurred net losses of $15.2 million for the
three months ended March 31, 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, for making investments or


                                       28
<PAGE>   29
acquisitions and for general corporate and working capital purposes. Our
business plan projects expansion through acquisitions funded mostly with stock
but requiring some cash expenses and consideration. 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 (see Note
L to the financial statements and Part II, Item 1 - Legal Proceedings for
further discussion), we may not have sufficient financial resources to meet that
obligation and achieve our goal of being EBITDA positive by the fourth quarter
of 2001. 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 could
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 obligations 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.

OUR RAPID 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;

         -        to develop and offer successful new products and services;

         -        to retain key employees and hire new employees; and


                                       29
<PAGE>   30
         -        to ensure that any future business we may develop or acquire
                  will perform in a satisfactory manner.

         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 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.


                                       30
<PAGE>   31
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
us. 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:


                                       31
<PAGE>   32
         -        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 three months ended March 31, 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 three months ended March 31, 2001 represented 23% 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


                                       32
<PAGE>   33
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


                                       33
<PAGE>   34
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.


                                       34
<PAGE>   35
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.


                                       35
<PAGE>   36
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
32% of our total revenue for the three months ended March 31, 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
22 months ending March 31, 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


                                       36
<PAGE>   37
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


                                       37
<PAGE>   38
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 57% 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 21.4%,
17.9% and 11.0%, respectively, of our outstanding common stock at March 31,
2001. In addition, our executive officers may be deemed to beneficially own in
the aggregate approximately 6.8% 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.


                                       38
<PAGE>   39
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 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 would particularly impact 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. 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 March 31, 2001, we had approximately $44.8 million of outstanding
debt and an accumulated deficit of $97.6 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.


                                       39
<PAGE>   40
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 and
exercise warrants to purchase common stock, up to an additional 22,333,333
shares of our common stock would be registered and freely tradable.

         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 March 31, 2001, an additional 34% 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.


                                       40
<PAGE>   41
ITEM 6. EXHIBITS AND REPORTS ON FORM 8K

         (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 March 31, 2001.

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


         (b.) REPORTS ON FORM 8K.

                  On January 26, 2001, we filed a current report on Form 8-K
         that included information relating to the amended and restated purchase
         agreement between the Company and seven institutional investors dated
         January 9, 2001. The amended and restated purchase agreement providing
         for the issuance of $30,000,000 worth of 5% convertible debentures due
         June 5, 2003 and warrants to purchase $13,000,000 of our common stock.



                                       41
<PAGE>   42
                            APPLIEDTHEORY CORPORATION
                                    FORM 10-Q
                                 MARCH 31, 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.


<TABLE>
<S>                                       <C>
                                          AppliedTheory Corporation


Date:    May 14, 2001                        by:     /s/  Danny E. Stroud
                                                   ----------------------------------------------
                                                   Danny E. Stroud
                                                   President and Chief Executive Officer
                                                   (Principal Executive Officer)


Date:    May 14, 2001                        and:    /s/  Angelo A. Gencarelli III
                                                   ----------------------------------------------
                                                   Angelo A. Gencarelli III
                                                   Sr. Vice President and Chief Financial Officer
                                                   (Principal Financial and Accounting Officer)
</TABLE>


                                       42
<PAGE>   43
                                  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 March 31, 2001.

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



                                       43