##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549 Form 10-Q þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
 SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended May 31, 2004Commission File Number: 0-17932 Interland, Inc. (Exact name of registrant as specified in its charter)
 Minnesota
(State or other jurisdiction
of incorporation or organization)
    
    41-1404301
(I.R.S. Employer
Identification No.)
 303 Peachtree Center Avenue, Suite 500, Atlanta, GA 30303
(Address, including Zip Code, of principal executive offices) (404) 720-8301
(Registrants telephone number, including area code) Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $.01 per share
Registered on The Nasdaq National Market Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months, and (2) has been subject to such filing
requirements for the past 90 days. Yes [x] No [  ] Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [x] No [  ] The number of outstanding shares of the registrants Common Stock on June 30,
2004 was 16,080,805.    1




---



##### Table of Contents



PART I. Financial Information
    
    
    
    
    
    
    3Item 1. Financial Statements
    
    
    
    
    
    
    3Consolidated Statements Of Operations
    
    
    
    
    
    
    3Consolidated Balance Sheets
    
    
    
    
    
    
    4Consolidated Statements of Cash Flows
    
    
    
    
    
    
    5Notes To Consolidated Financial Statements
    
    
    
    
    
    
    6Item 2. Managements Discussion And Analysis Of Financial Condition And Results Of Operations
    
    
    
    
    
    
    12Item 3. Quantitative And Qualitative Disclosures About Market Risk
    
    
    
    
    
    
    26Item 4. Controls and Procedures
    
    
    
    
    
    
    26PART II.  OTHER INFORMATION
    
    
    
    
    
    
    27Item 1. Legal Proceedings
    
    
    
    
    
    
    27Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
    
    
    
    
    
    
    28Item 6. Exhibits And Reports On Form 8-K
    
    
    
    
    
    
    29EX-31.1 SECTION 302 CERTIFICATION OF CEOEX-31.2 SECTION 302 CERTIFICATION OF CFOEX-32.1 SECTION 906 CERTIFICATION OF CEOEX-32.2 SECTION 906 CERTIFICATION OF CFO
 2




---



##### Table of Contents



PART I. Financial Information 
 Item 1. Financial Statements 
 Interland, Inc.
Consolidated Statements Of Operations
(In thousands except per share amounts)
(Unaudited) For the three months ended
    
    For the nine months endedMay 31,
    
    May 31,
    
    May 31,
    
    May 31,2004
    
    2003
    
    2004
    
    2003Revenues
    
    $
    25,686
    
    
    $
    25,898
    
    
    $
    78,402
    
    
    $
    79,295Operating costs and expenses:Network
operating costs, exclusive of depreciation shown below
    
    
    7,423
    
    
    
    8,065
    
    
    
    21,587
    
    
    
    27,235Sales and marketing, exclusive of depreciation shown below
    
    
    4,960
    
    
    
    5,727
    
    
    
    16,701
    
    
    
    15,600Technical support, exclusive of depreciation shown below
    
    
    4,519
    
    
    
    3,998
    
    
    
    13,965
    
    
    
    11,519General and administrative, exclusive of depreciation  shown below
    
    
    7,704
    
    
    
    12,004
    
    
    
    23,681
    
    
    
    32,260Bad debt expense
    
    
    874
    
    
    
    1,975
    
    
    
    2,940
    
    
    
    5,791Depreciation and amortization
    
    
    7,331
    
    
    
    22,194
    
    
    
    23,755
    
    
    
    47,590Restructuring costs
    
    
    758
    
    
    
    2,204
    
    
    
    758
    
    
    
    5,644Merger and integration costs
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    527Goodwill impairment
    
    
    66,587
    
    
    
    89,928
    
    
    
    66,587
    
    
    
    89,928Asset impairment
    
    
    7,009
    
    
    
    13,868
    
    
    
    7,009
    
    
    
    13,868Other expense (income), net
    
    
    (110
    )
    
    
    1,558
    
    
    
    (184
    )
    
    
    1,627Total operating costs and expenses
    
    
    107,055
    
    
    
    161,521
    
    
    
    176,799
    
    
    
    251,589Operating loss
    
    
    (81,369
    )
    
    
    (135,623
    )
    
    
    (98,397
    )
    
    
    (172,294
    )Interest income (expense), net
    
    
    124
    
    
    
    (74
    )
    
    
    (180
    )
    
    
    77Loss from continuing operations before taxes
    
    
    (81,245
    )
    
    
    (135,697
    )
    
    
    (98,577
    )
    
    
    (172,217
    )Income tax benefit (expense)
    
    
    
    
    
    
    (629
    )
    
    
    
    
    
    
    (629
    )Net loss from continuing operations
    
    
    (81,245
    )
    
    
    (136,326
    )
    
    
    (98,577
    )
    
    
    (172,846
    )Loss from discontinued operations, net of tax
    
    
    (481
    )
    
    
    (167
    )
    
    
    (1,802
    )
    
    
    (482
    )Net loss
    
    $
    (81,726
    )
    
    $
    (136,493
    )
    
    $
    (100,379
    )
    
    $
    (173,328
    )Net loss per share, basic and diluted:Continuing operations
    
    $
    (5.07
    )
    
    $
    (9.41
    )
    
    $
    (6.11
    )
    
    $
    (12.16
    )Discontinued operations
    
    
    (0.03
    )
    
    
    (0.01
    )
    
    
    (0.11
    )
    
    
    (0.03
    )$
    (5.10
    )
    
    $
    (9.42
    )
    
    $
    (6.22
    )
    
    $
    (12.19
    )Number of shares used in per share calculation:Basic and diluted
    
    
    16,019
    
    
    
    14,491
    
    
    
    16,131
    
    
    
    14,217
 The accompanying notes are an integral part of these consolidated financial statements. 3




---



##### Table of Contents



Interland, Inc. Consolidated Balance
Sheets
(In thousands)
(Unaudited) As ofMay 31,
    
    
    
    
    
    August 31,2004
    
    
    
    
    
    2003AssetsCurrent assetsCash and cash equivalents
    
    $
    30,959
    
    
    
    
    
    
    $
    35,255Short term investments
    
    
    2,500
    
    
    
    
    
    
    
    16,300Trade receivables, net
    
    
    3,311
    
    
    
    
    
    
    
    3,556Other receivables, net
    
    
    712
    
    
    
    
    
    
    
    1,604Income taxes recoverable
    
    
    612
    
    
    
    
    
    
    
    612Other current assets
    
    
    2,217
    
    
    
    
    
    
    
    3,210Restricted investments
    
    
    362
    
    
    
    
    
    
    
    362Total current assets
    
    
    40,673
    
    
    
    
    
    
    
    60,899Restricted investments
    
    
    10,825
    
    
    
    
    
    
    
    18,264Property plant and equipment, net
    
    
    27,554
    
    
    
    
    
    
    
    35,935Goodwill
    
    
    
    
    
    
    
    
    
    
    66,646Intangibles, net
    
    
    13,770
    
    
    
    
    
    
    
    24,791Other assets
    
    
    438
    
    
    
    
    
    
    
    507Total assets
    
    $
    93,260
    
    
    
    
    
    
    $
    207,042Liabilities and shareholders equityCurrent liabilitiesAccounts payable
    
    $
    1,792
    
    
    
    
    
    
    $
    1,488Accrued expenses
    
    
    13,613
    
    
    
    
    
    
    
    16,526Accrued restructuring charges
    
    
    5,084
    
    
    
    
    
    
    
    7,129Current portion of long-term debt and capital lease obligations
    
    
    3,344
    
    
    
    
    
    
    
    10,845Deferred revenue
    
    
    8,442
    
    
    
    
    
    
    
    10,991Total current liabilities
    
    
    32,275
    
    
    
    
    
    
    
    46,979Long-term debt and capital lease obligations
    
    
    3,732
    
    
    
    
    
    
    
    1,654Deferred revenue, long-term
    
    
    316
    
    
    
    
    
    
    
    354Other liabilities
    
    
    3,937
    
    
    
    
    
    
    
    5,397Total liabilities
    
    
    40,260
    
    
    
    
    
    
    
    54,384Commitments and contingenciesShareholders equityCommon stock, $.01 par value, authorized 21 million shares,
issued and outstanding 16.1 and 16.3 million shares, respectively
    
    
    161
    
    
    
    
    
    
    
    164Additional capital
    
    
    320,678
    
    
    
    
    
    
    
    322,523Warrants
    
    
    4,990
    
    
    
    
    
    
    
    4,990Deferred compensation
    
    
    (477
    )
    
    
    
    
    
    
    (1,046
    )Note receivable from shareholder
    
    
    (735
    )
    
    
    
    
    
    
    (2,735
    )Accumulated deficit
    
    
    (271,617
    )
    
    
    
    
    
    
    (171,238
    )Total shareholders equity
    
    
    53,000
    
    
    
    
    
    
    
    152,658Total liabilities and shareholders equity
    
    $
    93,260
    
    
    
    
    
    
    $
    207,042
 The accompanying notes are an integral part of these consolidated financial statements. 4




---



##### Table of Contents



Interland, Inc. 
 Consolidated Statements of Cash Flows
(In thousands)
(Unaudited) For the nine months endedMay 31,
    
    May 31,2004
    
    2003CASH FLOWS FROM OPERATING ACTIVITIESNet loss
    
    $
    (100,379
    )
    
    $
    (173,328
    )Adjustments to reconcile net loss to net cash used in
operating activities from continuing operations:Loss from discontinued operations
    
    
    1,802
    
    
    
    482Depreciation and amortization
    
    
    23,755
    
    
    
    47,590Bad debt expense
    
    
    2,940
    
    
    
    5,791Loss (gain) on sale of assets
    
    
    (152
    )
    
    
    1,578Goodwill and intangible asset impairment
    
    
    
    
    
    
    Goodwill and asset impairment
    
    
    73,596
    
    
    
    103,796Other non-cash adjustments
    
    
    721
    
    
    
    1,997(Gain)/Loss on sale of connectivity accounts
    
    
    
    
    
    
    Changes in operating assets and liabilities
net of effect of acquisitions:Receivables, net
    
    
    (1,803
    )
    
    
    (3,624
    )Income tax recoverable
    
    
    
    
    
    
    778Other current assets
    
    
    1,061
    
    
    
    477Accounts payable, accrued expenses and deferred revenue
    
    
    (8,061
    )
    
    
    (12,422
    )Cash used in operating activities of continuing operations
    
    
    (6,520
    )
    
    
    (26,885
    )CASH FLOWS FROM INVESTING ACTIVITIESExpenditures for property, plant, and equipment
    
    
    (9,742
    )
    
    
    (10,024
    )Purchases of held-to-maturity investment securities
    
    
    (2,000
    )
    
    
    (30,300
    )Proceeds from held-to-maturity investment securities
    
    
    15,800
    
    
    
    61,700Net change in restricted investments
    
    
    7,438
    
    
    
    14,293Acquisitions, net of cash acquired
    
    
    242
    
    
    
    (4,590
    )Cash provided by investing activities of continuing operations
    
    
    11,738
    
    
    
    31,079CASH FLOWS FROM FINANCING ACTIVITIESRepayments of debt and capital lease obligations
    
    
    (7,674
    )
    
    
    (18,250
    )Proceeds from issuance of common stock
    
    
    
    
    
    
    433Purchase and retirement of stock
    
    
    
    
    
    
    (985
    )Financing, other
    
    
    
    
    
    
    (17
    )Cash used in financing activities of continuing operations
    
    
    (7,674
    )
    
    
    (18,819
    )Net cash used in continuing operations
    
    
    (2,456
    )
    
    
    (14,625
    )Net cash used in discontinued operations
    
    
    (1,840
    )
    
    
    (2,063
    )Net decrease in cash and cash equivalents
    
    
    (4,296
    )
    
    
    (16,688
    )Cash and cash equivalents at beginning of period
    
    
    35,255
    
    
    
    62,693Cash and cash equivalents at end of period
    
    $
    30,959
    
    
    $
    46,005
 The accompanying notes are an integral part of these consolidated financial statements 5




---



##### Table of Contents



Interland, Inc. 
 Notes To Consolidated Financial Statements 1. General Business Interland, Inc. together with its subsidiaries (collectively the
Company), is a leading Web hosting and online services company dedicated to
helping small-and-medium-sized businesses (SMB) achieve success by providing
the knowledge, services and tools to build, manage and promote businesses
online. Interland offers a wide selection of online services, including
standardized Web hosting, e-commerce, application hosting, Web site development
and marketing and optimization tools. Historically, the Company provided a
variety of computer products and related services through its PC Systems,
SpecTek, and Web hosting business segments. The Company disposed of its PC
Systems and SpecTek business segments during the third quarter of fiscal 2001.
The Companys Web hosting business remains as the Companys sole continuing
operation. History of operating lossesThe Companys Web hosting business has incurred
net losses and losses from operations for all but one quarter from inception
through the first nine-months of fiscal 2004. The Companys future success is
dependent upon its ability to achieve positive cash flow prior to the depletion
of cash resources and its ability to raise funds, if needed. Nonetheless, the
Companys current financial forecast supports managements expectation that the
Company will have adequate cash resources to fund operations for at least the
next 12 months. 2. Significant Accounting Policies Interim Unaudited Financial Information The accompanying unaudited
consolidated financial statements for the three and nine- month periods ended
May 31, 2004 and May 31, 2003, have been prepared in accordance with generally
accepted accounting principles for interim financial information. In
managements opinion, these statements include all adjustments necessary for a
fair presentation of the results of the interim periods shown. All adjustments
are of a normal recurring nature unless otherwise disclosed. Operating results
for the three and nine-month periods ended May 31, 2004 are not necessarily
indicative of the results that may be expected for the full fiscal year. Basis of Presentation This report on Form 10-Q (10-Q) for the third quarter
ended May 31, 2004 should be read in conjunction with the Companys Annual
Report on Form 10-K (10-K) for the fiscal year ended August 31, 2003. The
financial statements include the accounts of Interland, Inc. and its wholly
owned subsidiaries. All significant intercompany balances and transactions have
been eliminated. Stock-based employee compensation The Company accounts for stock-based
compensation issued to employees using the intrinsic value method as prescribed
by Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock
Issued to Employees and has adopted the disclosure requirements of SFAS No. 123
and SFAS 148. If the Company had elected to adopt the optional recognition provisions of SFAS
No. 123, which uses the fair value based method for stock-based compensation,
and amortized the fair value of the options to compensation expense on a
straight-line basis over the vesting period of the options, the following table
illustrates the effect on net loss and loss per share: 6




---



##### Table of Contents



Interland, Inc.
Notes To Consolidated Financial Statements (Continued) Three-month period ended
    
    For the nine months endedMay 31,
    
    May 31,
    
    May 31,
    
    May 31,2004
    
    2003
    
    2004
    
    2003in thousands, except per share numbersNet loss as reported
    
    $
    (81,726
    )
    
    $
    (136,493
    )
    
    $
    (100,379
    )
    
    $
    (173,328
    )Add: Stock-based employee compensation
expense included in reported net income,
net of related tax effects
    
    
    173
    
    
    
    175
    
    
    
    520
    
    
    
    300Deduct: Total stock-based employee compensation
expense determined under fair value method-
based methods for all awards, net of tax effects
    
    
    (540
    )
    
    
    (961
    )
    
    
    (1,794
    )
    
    
    (2,708
    )Proforma net loss
    
    $
    (82,093
    )
    
    $
    (137,279
    )
    
    $
    (101,653
    )
    
    $
    (175,736
    )Loss per share:Basic and diluted  as reported
    
    $
    (5.10
    )
    
    $
    (9.42
    )
    
    $
    (6.22
    )
    
    $
    (12.19
    )Basic and diluted  pro forma
    
    $
    (5.12
    )
    
    $
    (9.47
    )
    
    $
    (6.30
    )
    
    $
    (12.36
    )Weighted average shares outstanding
Basic and diluted
    
    
    16,019
    
    
    
    14,491
    
    
    
    16,131
    
    
    
    14,217
 Recently issued accounting standards In January 2003, the FASB issued FASB
Interpretation No. 46, Consolidation of Variable Interest Entities (FIN 46).
FIN 46 clarified the application of Accounting Research Bulletin No. 51,
Consolidated Financial Statements, to certain entities in which equity
investors do not have the characteristics of a controlling financial interest
or do not have sufficient equity at risk for the entity to finance its
activities without additional subordinated support from other parties. FIN 46
requires existing unconsolidated variable interest entities to be consolidated
by their primary beneficiaries if the entities do not effectively disperse
risks among parties involved. The Company has evaluated its investments and
other relationships and concluded that none meets the requirements for
consolidation under FIN 46. In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial
Instruments with Characteristics of Both Liabilities and Equity. This
statement establishes standards for how an issuer classifies and measures
certain financial instruments with characteristics of both liabilities and
equity. This statement is effective for financial instruments entered into or
modified after May 31, 2003, and otherwise is effective for the first quarter
of fiscal year 2004. The adoption of this standard on September 1, 2003 did not
have a material impact on Interlands consolidated financial statements. 3. Discontinued Operations During the third quarter and
first nine-months of fiscal 2004, the Company recorded
$0.5 million and $1.8 million, respectively, of losses on
disposal of discontinued operations primarily in connection with
litigation related to the PC Systems business. The Company has
several pending claims concerning the intellectual property rights of
its discontinued operations and is vigorously defending these claims.
The Company expects to incur additional losses from discontinued
operations due to the costs of defending these claims. As of
May 31, 2004, the Company had an aggregate amount of
$1.0 million accrued for such matters. 4. Restructuring And Facility Exit Costs In March 2004 the Company decided to change its approach to distributing its
mainstream market hosting solutions from reliance upon a direct field sales
force to an indirect channel approach. Due to this decision, the Company
implemented a restructuring program to reduce its cost structure. These
restructuring charges include costs of $0.3 million related to lease
commitments, and $0.8 million employee severance and benefits. The remaining
accruals for these restructuring charges as of May 31, 2004 were $0.3 and $0.1
million, respectively. During the second quarter of 2003, the Company approved and initiated a program
to exit certain facilities and consolidate those operations into other existing
facilities. This restructuring plan is part of managements continued plan to
streamline the Companys operations and to reduce the long-term operating
costs. In accordance with SFAS No. 146, Accounting for Costs Associated with
Exit or Disposal Activities, costs associated with these activities have been
recognized and measured at their fair value in the period in which the
liabilities are incurred. One-time termination benefits for employees required
to render services until they are terminated in order to receive termination
benefits were recognized ratably over the future service period. The plan
provided for the closure of three data center facilities, a reduction of those
related workforces of approximately 171 employees, and the termination of
bandwidth and data connectivity contracts in place at these and other
facilities. The Company exited all three data centers by June 2003. During the fourth quarter of 2001, the Company approved and implemented a
restructuring program in connection with its acquisition of Interland-Georgia.
In accordance with EITF No. 94-3, Liability Recognition for Certain Employee
Termination Benefits and Other Costs to Exit an Activity, the restructuring
costs, excluding asset impairments, were recognized as liabilities at the time
management committed to the plan. Management determined that these costs
provided no future economic benefit, were incremental to other costs incurred
by the Company prior to the restructuring, or were contractual obligations that
existed prior to the date the plan was approved and were either continued after
the exit plan was 7




---



##### Table of Contents



Interland, Inc.
Notes To Consolidated Financial Statements (Continued) completed with no economic benefit to the Company or could not be cancelled without
penalty, and they were incurred as a direct result of the plan to exit the
identified activities. The asset impairments were accounted for in accordance
with SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to be Disposed Of. The following table shows a reconciliation of the beginning and ending
liability balances from August 31, 2001 through May 31, 2004 related to all
restructuring activities recorded by the Company under the restructuring
programs described in the above paragraphs. The balance at May 31, 2004
represents the remaining liabilities to be paid in cash: Property,
    
    
    
    
    
    EmployeeLease
    
    plant, and
    
    Other exit
    
    termination
    
    Goodwill andabandonments
    
    equipment
    
    costs
    
    benefits
    
    Intangibles
    
    Total(In thousands)Balance at August 31, 2000
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    Plan charges
    
    
    9,404
    
    
    
    26,915
    
    
    
    3,528
    
    
    
    727
    
    
    
    69,704
    
    
    
    110,278Cash paid
    
    
    (683
    )
    
    
    
    
    
    
    
    
    
    
    (498
    )
    
    
    
    
    
    
    (1,181
    )Non-cash write downs
    
    
    
    
    
    
    (26,915
    )
    
    
    
    
    
    
    
    
    
    
    (69,704
    )
    
    
    (96,619
    )Balance at August 31, 2001
    
    $
    8,721
    
    
    $
    
    
    
    $
    3,528
    
    
    $
    229
    
    
    $
    
    
    
    $
    12,478Cash paid
    
    
    (1,625
    )
    
    
    
    
    
    
    (487
    )
    
    
    (229
    )
    
    
    
    
    
    
    (2,341
    )Other adjustments
    
    
    538
    
    
    
    
    
    
    
    (1,862
    )
    
    
    
    
    
    
    
    
    
    
    (1,324
    )Balance at August 31, 2002
    
    $
    7,634
    
    
    $
    
    
    
    $
    1,179
    
    
    $
    
    
    
    $
    
    
    
    $
    8,813Plan charges
    
    
    2,061
    
    
    
    1,317
    
    
    
    1,886
    
    
    
    1,317
    
    
    
    
    
    
    
    6,581Cash paid
    
    
    (3,831
    )
    
    
    (227
    )
    
    
    (625
    )
    
    
    (1,165
    )
    
    
    
    
    
    
    (5,848
    )Other adjustments
    
    
    (218
    )
    
    
    46
    
    
    
    (1,216
    )
    
    
    (121
    )
    
    
    
    
    
    
    (1,509
    )Non-cash write down
    
    
    
    
    
    
    (871
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (871
    )Balance at August 31, 2003
    
    $
    5,646
    
    
    $
    265
    
    
    $
    1,224
    
    
    $
    31
    
    
    $
    
    
    
    $
    7,166Plan charges
    
    
    273
    
    
    
    
    
    
    
    
    
    
    
    845
    
    
    
    
    
    
    
    1,118Cash paid
    
    
    (1,607
    )
    
    
    (236
    )
    
    
    (227
    )
    
    
    (749
    )
    
    
    
    
    
    
    (2,819
    )Other adjustments
    
    
    174
    
    
    
    
    
    
    
    (428
    )
    
    
    
    
    
    
    
    
    
    
    (254
    )Non-cash write down
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Balance at May 31, 2004
    
    $
    4,486
    
    
    $
    29
    
    
    $
    569
    
    
    $
    127
    
    
    $
    
    
    
    $
    5,211
 During the nine-month period ended May 31, 2004 the Company continued to pay
down the lease abandonment obligations according to the contractual monthly
liability, net of sublease payments received, which the Company believes will
continue through 2007. The Company also adjusted its reserves down related to
bandwidth contract obligations by $0.4 million as a result of continued
negotiations and expects to have complete resolution in fiscal year 2005. The
Company also increased its reserves by $0.2 million related to lease
abandonment obligations as a result of changes in the Companys sublease
expectations and landlord requirements. The employee termination benefits
associated with the termination of the mainstream market direct sales force of
$0.8 million, which $0.7 million was paid out by May 31, 2004. The remaining
$0.1 million will be paid out in the fourth quarter of this fiscal year. 5. Purchase Business Combination Liabilities In connection with the acquisitions of Interland-Georgia in fiscal 2001,
iNNERHOST in fiscal 2002, and Trellix Corporation in fiscal 2003, the Company
accrued certain liabilities representing estimated costs of exiting certain
facilities, termination of bandwidth contracts and involuntary termination of
employees in accordance with EITF No. 95-3, Recognition of Liabilities in
Connection with a Purchase Business Combination. These amounts are included in
Accrued expenses on the balance sheet and are not included in the
restructuring reserves discussed in Note 3. The following table shows the
changes in the accrual from inception to the period ending May 31, 2004: 8




---



##### Table of Contents



Interland, Inc.
Notes To Consolidated Financial Statements (Continued) EmployeeLease
    
    
    
    terminationabandonments
    
    Bandwidth
    
    benefits
    
    Total(In thousands)Balance at August 31, 2000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Liabilities accrued
    
    $
    7,098
    
    
    $
    1,440
    
    
    $
    1,362
    
    
    $
    9,900Cash paid
    
    
    (123
    )
    
    
    
    
    
    
    (83
    )
    
    
    (206
    )Balance at August 31, 2001
    
    
    6,975
    
    
    
    1,440
    
    
    
    1,279
    
    
    
    9,694Other adjustments
    
    
    2,470
    
    
    
    (1,440
    )
    
    
    
    
    
    
    1,030Cash paid
    
    
    (1,871
    )
    
    
    
    
    
    
    (1,027
    )
    
    
    (2,898
    )Balance at August 31, 2002
    
    
    7,574
    
    
    
    
    
    
    
    252
    
    
    
    7,826Liabilities accrued and adjustments
    
    
    
    
    
    
    
    
    
    
    675
    
    
    
    675Cash paid
    
    
    (6,653
    )
    
    
    
    
    
    
    (710
    )
    
    
    (7,363
    )Balance at August 31, 2003
    
    
    921
    
    
    
    
    
    
    
    217
    
    
    
    1,138Liabilities accrued and adjustments
    
    
    
    
    
    
    
    
    
    
    (89
    )
    
    
    (89
    )Cash paid
    
    
    (134
    )
    
    
    
    
    
    
    (128
    )
    
    
    (262
    )Balance at May 31, 2004
    
    $
    787
    
    
    $
    
    
    
    $
    
    
    
    $
    787
 During the nine-month period ended May 31, 2004 the Company continued to pay
down the lease abandonment obligation according to the contractual monthly
liability, net of sublease payments received, which the Company believes will
continue through July 2009. The Company made payments on specific obligations
included in the business combinations liability of $0.1 million for rent
obligations, net of sublease payments received. There were also adjustments of
$0.1 million and payments of $0.1 million for benefits paid to specific
terminated employees. 6. GOODWILL AND INTANGIBLES In accordance with the requirements of SFAS 142,Goodwill and Other Intangible
Assets, the Company tests for impairment on an annual basis and between annual
tests if an event occurs or circumstances change that would more likely than
not reduce the fair value of goodwill below its carrying amount. During the
third quarter of 2004, the Company completed the annual impairment test which
entailed comparing the aggregate market value of the Companys outstanding
securities plus its liabilities to the aggregate carrying value of the
Companys assets, including goodwill and other indefinite life intangible
assets. The Companys market price of its stock has experienced significant
volatility over the last fiscal year and closed as of May 31, 2003, with a
market value significantly less that the value at the beginning of the fiscal
year. Management retained valuation specialists to assist in the valuation of
its intangible assets for purposes of determining the implied fair value of
goodwill at May 31, 2004. Upon completion of the annual assessment, Interland
recorded a non-cash impairment charge of $66.6 million to remove the remainder
of the carrying value of goodwill. The following table discloses changes in the carrying amount of goodwill from
August 31, 2003 through May 31, 2004: For the Period endedMay 31, 2004(In thousands)Balance at August 31, 2003
    
    $
    66,646Goodwill acquired
    
    
    Impairment write-down
    
    
    (66,587
    )Other adjustments
    
    
    (59
    )Balance at May 31, 2004
    
    $
    
 9




---



##### Table of Contents



Interland, Inc.
Notes To Consolidated Financial Statements (Continued) During the third quarter of
2004, the Company performed an impairment test pursuant to the
guidance provided by SFAS 144, Accounting for the
Impairment or Disposal of Long-Lived Assets. Upon completion of
the assessment, Interland recorded a non-cash impairment charge of
$4.8 million, reducing the carrying value of certain core
technology, customer relationships, trademarks and other intangible
assets to their new estimated fair values. The following table
summarizes intangible assets by asset class and related accumulated
amortization: As of May 31, 2004
    
    As of August 31, 2003Gross carrying
    
    Accumulated
    
    Gross carrying
    
    Accumulatedamount
    
    amortization
    
    amount
    
    amortization(In thousands)Amortizable intangible assets:Core technology
    
    $
    15,505
    
    
    $
    10,383
    
    
    $
    17,900
    
    
    $
    7,784Customer account acquisitions
    
    
    16,323
    
    
    
    13,887
    
    
    
    16,323
    
    
    
    12,602Customer relationships
    
    
    9,383
    
    
    
    5,153
    
    
    
    10,129
    
    
    
    3,776Trademarks
    
    
    4,553
    
    
    
    2,571
    
    
    
    6,100
    
    
    
    1,798Other
    
    
    1,027
    
    
    
    1,027
    
    
    
    1,162
    
    
    
    863Total
    
    $
    46,791
    
    
    $
    33,021
    
    
    $
    51,614
    
    
    $
    26,823
 7. Property, plant and equipment The Company had invested in
certain software to improve its internal customer billing process.
During the third quarter 2004, the decision was made to abandon the
project and record an impairment charge of $2.2 million against
earnings and reduce the capital assets being held in assets in
progress, in accordance with the requirements of SFAS 144,
Accounting for the Impairment or Disposal of Long-Lived
Assets. 8. Contingencies In February 2003, the Company filed a lawsuit in Cobb County, Georgia against
Mr. Gabriel Murphy, one of the former principals of Interlands subsidiary,
CommuniTech.Net, Inc. (Communitech), which was acquired by Interland in
February 2002. The Companys lawsuit claims, among other things, that Mr.
Murphy breached certain covenants under his employment agreement and also
demands payment from Mr. Murphys two promissory notes (one of which was
non-recourse while the other was recourse). In March 2004, Interland
retired the 273,526 shares of stock held as collateral and wrote off the
$2,000,000 non-recourse promissory note. The other $735,000 full recourse
promissory note remains outstanding and continues to be a subject of the Cobb
County litigation noted above. In February 2003 Messrs. Heitman, also a former principal of Communitech, and
Murphy filed a lawsuit against Interland, its CEO, Mr. Joel Kocher, and
Communitech, in Jackson County, Missouri claiming, among other things, that
Interland acted unreasonably in failing to have the S-3 registration statement
declared effective by the SEC on a timely basis and claiming that Interland
and/or Mr. Kocher made inaccurate disclosures in connection with Interlands
acquisition of Communitech. The complaint asks for compensatory and punitive
damages in an unspecified amount. Interland believes that these claims are
without merit and will not have a material adverse effect on Interland and
intends to vigorously defend the claims. Interland initiated a lawsuit in the United States District Court for the
Northern District of Georgia against the representatives of the former
shareholders of Hostcentric (the Hostcentric Shareholders), seeking a
declaratory judgment that it will be entitled to reimbursement from the escrow
fund established as part of the Hostcentric acquisition for any amounts over
$180,000 that it may be required to pay to the landlord for a leased facility
in Farmingdale, New York. The representatives of the Hostcentric Shareholders
have denied Interlands claims and have attempted to assert various
counterclaims. Correspondence between the parties has also discussed the
possibility of other claims, but these claims have not yet been
asserted in litigation. Interland believes its claims in this case are
meritorious, that the counterclaims of the former 10




---



##### Table of Contents



Interland, Inc.
Notes To Consolidated Financial Statements (Continued) Hostcentric shareholders are
without merit, plans to continue to contest the matter vigorously and believes
that no material adverse effect on Interland will occur as a result of this
litigation. Interland, through its Hostcentric subsidiary, has also initiated a lawsuit in
United States District Court for Southern District of New York against the
landlord for the same Farmingdale, New York facility, seeking a declaratory
judgment that the lease for that facility has been terminated and that the
landlord has accepted that termination, thereby eliminating any further
obligation on the part of the tenant to make lease payments. The landlord has
denied the claims in the complaint and has asserted counterclaims for
approximately $200,000 that it claims is past due under the lease. The
landlord may, in the future, assert claims against Interland for the balance of
payments due under the Lease which claims, the landlord has asserted, could
amount to approximately $2 million in the aggregate. As reported above,
Interland believes any obligation found to exist to the landlord in excess of
$180,000 is the responsibility of the Hostcentric Shareholders. Interland
plans to continue to contest the matter vigorously and believes that no
material adverse effect on Interland will occur as a result of this litigation. Periodically, the Company is made aware that technology it used in its
discontinued operations may have infringed on intellectual property rights held
by others. The Company has evaluated all such claims and, if necessary and
appropriate, sought to obtain licenses for the use of such technology. If the
Company or its suppliers were unable to obtain licenses necessary to use
intellectual property in its discontinued operations products or processes, it
may be forced to defend legal actions taken against it relating to allegedly
protected technology. The Company evaluates all such claims and has accrued a
liability and charged discontinued operations for the estimated costs of
settlement or adjudication of claims for alleged infringement as of the
respective dates of the balance sheets included in this report. As of May 31,
2004, the Company had an aggregate amount of $1.0 million accrued for such
matters. The Company is also a defendant in a number of other lawsuits that the Company
regards as unlikely to result in any material payment; nonetheless, the outcome
of litigation may not be assured, and the Companys cash balances could be
materially affected by an adverse judgment. In accordance with SFAS No. 5
Accounting for Contingencies, the Company believes it has adequately reserved
for the contingencies arising from the above legal matters where an outcome was
deemed to be probable and the loss amount could be reasonably estimated. As
such, the Company does not believe that the anticipated outcome of the
aforementioned proceedings will have a materially adverse impact on its results
of operations, its financial condition or its cash flows. 11




---



##### Table of Contents



Interland, Inc. 
 Item 2. Managements Discussion And Analysis Of Financial Condition And Results
Of Operations Statements contained in this Form 10-Q that are not purely historical are
forward-looking statements and are being provided in reliance upon the safe
harbor provisions of the Private Securities Litigation Reform Act of 1995.
Words such as anticipates, expects, intends, plans, believes,
seeks, estimates, and similar expressions identify forward-looking
statements. These forward-looking statements include but are not limited to
statements regarding Interlands expectations of its future liquidity needs,
its expectations regarding its future operating results including its planned
increase in its revenue levels and the actions the Company expects to take in
order to maintain its existing customers and expand its operations and customer
base. All forward-looking statements are made as of the date hereof and are
based on current management expectations and information available to it as of
such date. The Company assumes no obligation to update any forward-looking
statement. It is important to note that actual results could differ materially
from historical results or those contemplated in the forward-looking
statements. Forward-looking statements involve a number of risks and
uncertainties, and include risks associated with our target markets and risks
pertaining to our ability to successfully integrate the operations and
personnel of the recent acquisitions. Factors that could cause actual results
to differ materially from expected results are identified in Risk Factors
below, and in the Companys annual report on Form 10-K for the year ended
August 31, 2003 and in the Companys other filings with the Securities and
Exchange Commission. All quarterly references are to the Companys fiscal
periods ended May 31, 2004, or May 31, 2003, unless otherwise indicated. All
annual references are also on a fiscal August 31st year-end basis, unless
otherwise indicated. All tabular dollar amounts are stated in thousands. OVERVIEW Interland is a leader in delivering standardized business-class Web hosting and
online solutions to small- and medium-sized businesses, and in helping them to
achieve success by providing the knowledge, services and tools to build, manage
and promote businesses online. Interland offers a broad range of products and
services, including shared and dedicated hosting services, e-commerce,
application hosting, Web site development and marketing and optimization tools.
The Company is in its third year of a three-year plan designed to create a
profitable business through the amalgamation of numerous relatively small, and
for the most part, only marginally profitable entrepreneurial companies. The
first two years of the plan were focused on acquiring appropriate businesses
and then integrating their operations into a small number of efficient data
centers. The current third year of the plan focuses on stabilizing the revenue generated
by the acquired lines of business and on laying the foundation for meaningful
growth by developing the Companys mass market or mainstream market
strategy. The customers of the acquired businesses were primarily those who
either had sufficient technical abilities to develop a website, or who could
persuade or hire someone to develop the website for them. The hosting company
merely provided power, ping and pipethe environment and connections to
electricity and telecommunications grids that a specialized computer requires
to be able to host a website on the Internet. Although individuals with modest
personal computer skills can use any one of a number of widely available
template-based programs to create a personal or consumer website, the Company
believes that the owners of small businesses on which they are dependent for
their livelihood will not be satisfied with such websites. The Company also
believes that even though most owners of small businesses recognize the
potential value to their business of having a website, only a small percentage
of such owners have been or will be willing to engage a professional web
developer given the cost, and the future dependency on the developer even for
small future changes. In order to develop an attractive alternative for business owners, the Company
acquired in early 2003 a powerful software tool that enables only modestly
trained SME business personnel to build an impressive website with great
functionality in a fraction of the time and at a fraction of the cost charged
by website development firms. Since the acquisition, the Company has been
developing a line of products and services, known as Business Solutions,
designed to help mainstream businesses attract and serve customers through
websites supplied by Interland designers using its proprietary software. The
Company has been testing and marketing products based on the use of the
software tools and believes, based on some nine months of experience, that
there is a great potential for its mass market products. Based on initial
results the Company, in several stages, increased the number of salespeople,
web designers and support personnel dedicated to this effort in order to
further test the ability of the distribution and provisioning models to perform
profitably at increasingly larger scales. The Company was prepared to accept
the expected costs of customer acquisition and provisioning so long as
performance matched expectations. At the end of February 2004, however,
management concluded that despite the fact that many of the assumptions
underlying the business plan were being proven, certain aspects of the business were not
performing to the standard required to justify 12




---



##### Table of Contents



Item 2. Managements Discussion And Analysis Of Financial Condition And Results
Of Operations continued high levels of investment. Accordingly, in early March 2004 the Company publicly announced
that it would substantially reduce its investment level and concentrate the
website and software development teams in Atlanta for greater interaction with
the rest of the company. Management continues to believe that adding website
creation and promotion applications and services is essential to expanding the
addressable market, and the Company will continue to work to perfect its
business model, but without attempting to simultaneously scale a direct sales
organization. Moreover, the Companys research and experience has shown that even those small
businesses that have a website require assistance to make their web presence
effective in attracting, tracking, and servicing customers. Many of the
functions which Interland offers in conjunction with the websites it designs
meet this need and can be offered to owners of websites previously designed by
others. The Company continues to develop this aspect of the mainstream
business, and believes it to be an increasingly important part of its business
in the future. Interland has entered into a marketing arrangement with Advanta, one of the
largest providers in the U.S. of credit cards to small businesses, under which
Advanta will market Interlands web hosting solutions to Advantas customer
base. Interland anticipates that Advanta will begin its marketing efforts
during Interlands fourth fiscal quarter. At the same time the Company is
exploring a variety of distribution channels for its mainstream market
products, it is endeavoring to stabilize the revenue derived from its acquired
businesses. Because all the acquired businesses are subscription businesses
that suffer from churn, or the regular loss of customers paying monthly fees,
the aggregation of a number of such businesses resulted in loss of customers
and their associated revenue each month. Since the Company did not wish to
continue the long-term support and development of a myriad of products, few
resources were devoted to attracting new customers for the legacy acquired
product lines. Sales of only the Interland product lines have not, in the
aggregate, been sufficient to replace the churn generated by the acquired
businesses, resulting in net churn. During the third quarter the monthly net
churn averaged $83,000, compared to $62,000 during the prior quarter. (Please refer to Risk Factors  Ours is a
recurring-revenue subscriber business and as such the effects of a net loss of
monthly recurring revenue are magnified for further important information on
this topic.) Data center performance, customer satisfaction surveys, and call
center performance are all believed by management to be good predictors of
future churn, and during the third quarter the trends in all of these measures
were favorable. In order to make all of its products as attractive to potential customers as
possible, the Company continues to make investments. Among the improvements
being made are enhancements to the security and reliability of the Companys
data center and supported networks, rebuilding the web interfaces used by
customers to place orders and to control aspects of their websites, and
improving customer care management. The Company intends to operate its data
centers to a much higher standard of professionalism than had been achieved by
any of the acquired web hosting businesses or by any of the Companys current
competitors. The Company also recognizes that it is incurring unnecessary
duplicative costs by continuing to maintain discrete hosting platforms for each
of its acquired customer bases. The Company is developing a series of platforms
and products, which are intended to be attractive both to new customers and to
acquired customers who may be expected to move their sites to a newer platform. The critical challenges faced by the Company are to stabilize the revenue
generated by the acquired businesses and to develop channels for distributing
its mass market product that are both highly productive and cost efficient, and
there can be no assurance that the Company will be successful in meeting these
challenges. DISCONTINUED OPERATIONS PC Systems In fiscal 2001 the Company discontinued the operations of its PC Systems
business segment, which was accounted for as discontinued operations in
accordance with Accounting Principles Board Opinion (APB) No. 30, Reporting
the Results of Operations  Reporting the Effects of Disposal of a Segment of a
Business, and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions. During the third quarter and first nine-months of fiscal 2004, the Company
recorded $0.5 million and $1.8 million, respectively, of losses on disposal of
discontinued operations primarily in connection with litigation related to the
PC Systems business. The Company has several pending claims concerning the
intellectual property rights of its discontinued operations and is vigorously
defending these claims. The Company expects to incur additional losses from
discontinued operations due to the costs of defending these claims. 13




---



##### Table of Contents



Item 2. Managements Discussion And Analysis Of Financial Condition And Results
Of Operations RESULTS OF CONTINUING OPERATIONS The Companys consolidated financial information presents the net effect of
discontinued operations separate from the results of the Companys continuing
operations. Comparison of the Quarters and Nine-Months Ended May 31, 2004 And May 31, 2003 The loss from continuing operations decreased $55.1 million to $81.2 million,
or 40.4% and $74.3 million to $98.6 million, or 43.0% for the quarter and for
the nine-months ended May 31, 2004, respectively, when compared to the same
periods of the prior fiscal year. The basic and diluted loss per share
decreased $4.34 per share to $ 5.07 per share, or 46.1%, and $6.05 to $ 6.11
per share, or 49.8% for the quarter and for the nine-months ended May 31, 2004,
respectively, when compared to the same periods of the prior fiscal year. Revenues Total revenues decreased $0.2 million to $25.7 million, or 0.8%, and $0.9
million to $78.4 million, or 1.1%, respectively, for the quarter and for the
nine- months ended May 31, 2004 when compared to the same periods of the prior
fiscal year. For the quarter ended
    
    For the nine months endedMay 31,
    
    May 31,
    
    May 31,
    
    May 31,2004
    
    2003
    
    2004
    
    2003in thousandsHosting revenue
    
    $
    24,337
    
    
    $
    24,927
    
    
    $
    74,500
    
    
    $
    77,096Other revenue
    
    
    1,349
    
    
    
    971
    
    
    
    3,902
    
    
    
    2,199Total revenue
    
    $
    25,686
    
    
    $
    25,898
    
    
    $
    78,402
    
    
    $
    79,295
 Hosting revenues decreased $0.6 million to $24.3 million, or 2.4%, and $2.6
million to $74.5 million, or 3.4% for the quarter and for the nine-months ended
May 31, 2004, respectively, when compared to the same periods of the prior
fiscal year. Hosting revenues for the third quarter and nine months ended May
31, 2004 include $3.1 million and $9.6 million, respectively from the
Hostcentric acquisition that occurred in June 2003. Hosting revenues are
comprised of shared, dedicated, mainstream market, application hosting services
and domain name registrations. The decrease in hosting revenues is primarily
attributable to account cancellations, net of new sales and acquisitions. These
cancellations may occur as a result of: a) customer action; b) termination by
the Company for non-payment; or c) termination by the Company as a result of a
decision to no longer provide a particular service. The Company intends to
stabilize the revenue of its acquired Web hosting business by focusing on
improving customer retention and increasing sales of hosting services. Shared average monthly revenue per account was $27.07 and $29.60 during the
three months ended May 31, 2004 and 2003, respectively. Dedicated average
monthly revenue per account was $305.91 and $440.60 during the three months
ended May 31, 2004 and 2003, respectively. These ARPU decreases were partially
offset by an increase of shared hosting accounts to approximately 181,000 from
171,000 during the three months ended May 31, 2004 and 2003 respectively, and
an increase in dedicated servers to approximately 9,800 from approximately
7,000 as of May 31, 2004 and 2003 respectively, due to the recent launch of new
products with lower price points. Other revenues increased $0.4 million to $1.3 million, or 38.9%, and $1.7
million to $3.9 million, or 77.4%, for the quarter and for the nine-months
ended May 31, 2004, respectively, when compared to the same period of the prior
fiscal year. Other revenues for the third quarter and nine months ended May 31,
2004 include $0.4 million and $1.2 million, respectively from the Hostcentric
acquisition that occurred in June 2003. Other revenues are primarily comprised
of consulting, co-location, and other fees under contract. 14




---



##### Table of Contents



Item 2. Managements Discussion And Analysis Of Financial Condition And Results
Of Operations Operating Costs and Expenses Network Operating Costs Network operating costs decreased 8.0% to $7.4 million and 20.7% to $21.6
million for the quarter and for the nine-months ended May 31, 2004,
respectively, from $8.1 million and $27.2 million in the same periods of the
prior year. The Companys network operating expenses as a percentage of
revenues were 28.9% and 27.5% for the quarter and for the nine-months ended May
31, 2004 respectively, as compared to 31.1% and 34.3% in the same periods of
the prior fiscal year. The decrease in network operating costs in these
periods was primarily related to the data center consolidation, which was a
critical part of the Companys restructuring and integration initiative and was
completed in June 2003. This initiative provided a $0.4 million reduction in
bandwidth connectivity costs when comparing the quarter ended May 31, 2004 to
the same period for the prior year. The Company reached an agreement regarding
a domain registration liability in the third quarter of 2003, which resulted in
an additional expense of $0.5 million. These decreases were partially offset
by an additional $0.7 million in labor related costs due to the companys
commitment to improving customer satisfaction. Sales and Marketing Sales and marketing expenses decreased 13.4% to $5.0 million and increased 7.1%
to $16.7 million for the quarter and for the nine-months ended May 31, 2004,
respectively, from $5.7 million and $15.6 million in the same periods of the
prior year. The Companys sales and marketing expenses as a percentage of
revenues was 19.3% and 21.3% for the quarter and for the nine-months ended May
31, 2004, respectively, as compared to 22.1% and 19.7% in the same periods of
the prior fiscal year. The 13.4% quarterly decrease is primarily due to a decrease in outside
marketing expenditures of $1.2 million partially offset by an increase in labor
related costs of $0.4 million primarily resulting from the expansion of the
Companys mainstream market initiatives earlier in fiscal year 2004. The 7.1%
year-to-date increase is primarily due to an increase in labor related costs of
$1.6 million. In March 2004, the Company reduced the expenses related to the
mainstream marketing initiative that began during the third quarter of fiscal
year 2003. Technical Support Technical support expenses increased 13.0% to $4.5 million and 21.2% to $14.0
million for the quarter and for the nine-months ended May 31, 2004,
respectively, from $4.0 million and $11.5 million in the same periods of the
prior year. The Companys technical support expenses as a percentage of net
revenues were 17.6% and 17.8% for the quarter and for the nine-months ended May
31, 2004, respectively, as compared to 15.4% and 14.5% in the same periods of
the prior fiscal year. The Company enhanced its technical support efforts to
improve customer service resulting in a $0.3 million increase in labor related
costs and a $0.2 million increase in related occupancy costs for the quarter
ended May 31, 2004 when compared to the same period of the prior year. The
comparison of the nine-months ended May 31, 2004 reflects a $1.8 million
increase in labor related costs and a $0.8 million increase in related
occupancy costs when compared to the same period in the prior year. General and Administrative General and administrative expenses decreased 35.8% to $7.7 million and 26.6%
to $23.7 million for the quarter and for the nine-months ended May 31, 2004,
respectively, from $12.0 million and $32.3 million in the same periods of the
prior year. As a percentage of revenues, the Companys general and
administrative expenses was 30.0% and 30.2% for the quarter and for the
nine-months ended May 31, 2004, respectively, as compared to 46.4% and 40.7% in
the same periods of the prior year. The primary factors causing the quarterly
decrease in general and administrative expenses were a $2.1 million decrease in
labor related costs associated with the reduction of headcount compared to
prior year, a decrease of $0.7 million in legal costs, and a decrease of $0.4
million in related occupancy costs due to the consolidation of office spaces.
The decrease in the comparative nine-month periods was primarily due to a $5.3
million decrease in labor related costs, a $1.5 million decrease in
professional and technical fees, and a $0.8 million decrease in related
occupancy costs. The Companys employee base has been reduced from 701 as of May 31, 2003 to
681 as of May 31, 2004. Bad Debt Expense Bad debt expense decreased 55.7% to $0.9 million and 49.2% to $2.9 million for
the quarter and for the nine-months ended May 31, 2004, respectively, from $2.0
million and $5.8 million in the same periods of the prior year. The decrease in
bad debt expense is due to more stringent collection and customer account
termination policies. 15




---



##### Table of Contents



Interland, Inc.Item 2.  Managements Discussion And Analysis Of Financial Condition And Results Of Operations Depreciation and Amortization Depreciation and amortization expenses decreased 67.0% to $7.3 million and
50.1% to $23.8 million, for the quarter and for the nine-months ended May 31,
2004, respectively, from $22.2 million and $47.6 million in the same periods of
the prior year. The Companys depreciation and amortization expenses as a
percentage of revenues was 28.5% and 30.3% for the quarter and for the
nine-months ended May 31, 2004, respectively, as compared to 85.7% and 60.0% in
the same periods of the prior year. During the third quarter of fiscal 2003,
management used the expected discounted present value of future cash flows to
determine the fair value of the Companys identifiable intangible assets and
determined that the carrying amount of these assets was higher than their fair
values. Upon completion of the assessment, the Company recorded a non-cash
impairment charge of $13.9 million to reduce the carrying value of identifiable
intangible assets to estimated fair values. As such, the amortization expense
of the third quarter of fiscal 2004 was substantially lower than the third
quarter of fiscal 2003. Also during the third quarter of fiscal 2003, the
Company recorded $9.8 million of accelerated depreciation on the assets
associated with closed data centers in Seattle, Los Angeles and Kansas City and
$9.6 million additional depreciation and amortization charges associated with
acquired entities and purchased assets. With the lower asset base, depreciation
expense for the third quarter ended May 31, 2004 was lower than the same period
of the prior year. Restructuring Costs Restructuring costs were $0.8 million for the quarter and for the nine-months
ended May 31, 2004 from $2.2 million and $5.6 million in the same periods of
the prior year. The restructuring costs in the third quarter relate to the
decision by the Company to change its approach to distributing its mainstream
market hosting solutions from reliance upon a direct field sales force to an
indirect channel approach. As a result of these restructuring actions
the Company is expected to generate approximately $5.2 million of
annualized savings. Merger and Integration Costs During the Companys fiscal quarter and for the nine-months ended May 31, 2004
no merger and integration expenses were incurred. During the nine months ended
May 31, 2003, the Company recorded $0.5 million for financial advisory
services, legal, accounting, relocation, employee stay bonuses and other
non-capitalizable expenses directly related to merger and integration of the
business following the Interland-Georgia acquisition and other acquisitions
occurring in fiscal 2002. Goodwill Impairment In accordance with the requirements of SFAS 142, the Company completed its
annual goodwill impairment test which entailed comparing the aggregate market
value of the companys outstanding securities plus its liabilities to the
aggregate carrying value of the Companys assets, including goodwill and other
indefinite life intangible assets. The Companys market price of its stock has
experienced significant volatility over the last fiscal year and closed as of
May 31, 2004, with a market value significantly less that the value at the
beginning of the fiscal year. Management retained valuation specialists to
assist in the valuation of its tangible and identifiable intangible assets for
purposes of determining the implied fair value of goodwill at May 31, 2004.
Upon completion of the annual assessment, Interland recorded a non-cash
impairment charge of $66.6 million to write-off the remainder of the carrying
value of goodwill. Asset Impairment During the third quarter of 2004, the Company performed an impairment
test pursuant to the guidance provided by SFAS 144, Accounting for the
Impairment or Disposal of Long-Lived Assets. Upon completion
of the assessment, Interland recorded  a non-cash impairment charge
of $4.8 million, reducing the carrying value of certain core
technology, customer relationships, trademarks and other intangible
assets to their new estimated fair values. The following table
summarizes intangible assets by asset class and related accumulated
amortization: The Company had invested in ADC software to improve its customer billing
process. The project was delayed during the first quarter of 2004 until
further research could be completed and analyzed as to the functionality and
benefits of implementing this software. The decision was made in the third
quarter of 2004 to abandon the project and record the impairment of the
capitalized costs incurred of $2.2 million. 16




---



##### Table of Contents



Interland, Inc.Item 2.  Managements Discussion And Analysis Of Financial Condition And Results Of Operations Interest Income (Expense), net Interest income (expense) increased to $0.1 million and decreased to $(0.2)
million, respectively, for the quarter and for the nine-months ended May 31,
2004 from $(0.1) and $0.1 million in the same periods of the prior year.
Interest income (expense), net consists of interest income earned on the
Companys combined cash and cash equivalents, short-term investments, and
restricted investments less interest expense on debt (primarily capital
leases). The change is primarily due to the lower levels of cash and liquid
investments that were available for investment, lower interest rates and
interest expense incurred in the early payoff of an outstanding line of credit. Net Cash Used in Operating Activities and Earnings from Continuing Operations
Before Interest, Taxes, Depreciation and Amortization (EBITDA) EBITDA is defined as net income (loss) less (i) provision for income taxes,
(ii) interest income or expense, and (iii) depreciation and amortization.
EBITDA is not an indicator of financial performance under generally accepted
accounting principles and may not be comparable to similarly captioned
information reported by other companies. In addition, it does not replace net
income (loss), operating income (loss), or cash flows from operating activities
as indicators of operating performance. The effect of taxes and interest on
Interlands net loss is not significant, but depreciation and amortization,
primarily as a result of acquisitions, is significant. The Company believes
that measuring the performance of the business without regard to non-cash
depreciation and amortization can make trends in operating results more readily
apparent, and when considered with other information, assist investors and
other users of the Companys financial statements who wish to evaluate the
Companys ability to generate future cash flows. The following table reflects the calculation of EBITDA from continuing
operations and a reconciliation to net cash provided
by (used in) operating activities: For the quarter ended
    
    For the nine months endedMay 31,
    
    May 31,
    
    May 31,
    
    May 31,2004
    
    2003
    
    2004
    
    2003in thousandsNet loss
    
    $
    (81,726
    )
    
    $
    (136,493
    )
    
    $
    (100,379
    )
    
    $
    (173,328
    )Depreciation and amortization
    
    
    7,331
    
    
    
    22,194
    
    
    
    23,755
    
    
    
    47,590Interest expense (income)
    
    
    (124
    )
    
    
    74
    
    
    
    180
    
    
    
    (77
    )Income tax
expense
    
    
    
    
    
    
    629
    
    
    
    
    
    
    
    629Discontinued operations
    
    
    481
    
    
    
    167
    
    
    
    1,802
    
    
    
    482EBITDA
    
    $
    (74,038
    )
    
    $
    (113,429
    )
    
    $
    (74,642
    )
    
    $
    (124,704
    )Interest income / (expense)
    
    
    124
    
    
    
    (74
    )
    
    
    (180
    )
    
    
    77Provision for bad debts
    
    
    874
    
    
    
    1,975
    
    
    
    2,940
    
    
    
    5,791Loss on the sale of assets
    
    
    (81
    )
    
    
    
    
    
    
    (152
    )
    
    
    Goodwill and asset impairment
    
    
    73,596
    
    
    
    103,796
    
    
    
    73,596
    
    
    
    103,796Other non-cash adjustments
    
    
    173
    
    
    
    2,477
    
    
    
    721
    
    
    
    3,575Changes in assets and liabilities:Receivables, net
    
    
    (572
    )
    
    
    (2,086
    )
    
    
    (1,803
    )
    
    
    (3,624
    )Income tax expense (benefit)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    778Income tax recoverable
    
    
    
    
    
    
    (629
    )
    
    
    
    
    
    
    (629
    )Other current assets
    
    
    521
    
    
    
    820
    
    
    
    1,061
    
    
    
    477Accounts payable, accrued expenses, and deferred revenue
    
    
    (182
    )
    
    
    (4,185
    )
    
    
    (8,061
    )
    
    
    (12,422
    )Net cash provided by (used in) operating activities
    
    $
    415
    
    
    $
    (11,335
    )
    
    $
    (6,520
    )
    
    $
    (26,885
    )
 For the quarter ended and for the nine-months ended May 31, 2004, the Companys
EBITDA increased $39.4 million and $50.1 million, respectively, resulting in an
EBITDA loss of $74.0 million and $74.6 million. This increase is primarily due
to the cost savings from the integration and restructuring efforts during
fiscal year 2003 and the decrease in bad debt expense attributed to the more
stringent collection and customer account termination policies. 17




---



##### Table of Contents



Interland, Inc.Item 2.  Managements Discussion And Analysis Of Financial Condition And Results Of Operations Liquidity and Capital Resources As of May 31, 2004, the Company had $31.0 million in cash and cash equivalents.
In addition, the Company had $2.5 million in short-term investments and $11.2
million in short and long-term restricted investments representing a total of
$44.7 million of restricted and unrestricted cash and investments. This
represents a decrease of $25.5 million compared to August 31, 2003. Of the $11.2 million in restricted investments, $4.7 million serves as
collateral for a financing agreement with U.S. Bancorp Oliver-Allen Technology
Leasing. This amount will gradually decrease until the agreement terminates in
February 2009. The remainder of the restricted investments relates to
collateral amounts for merchant services agreements and does not have a stated
maturity date. On a comparative basis cash used in operating activities of continuing
operations decreased $20.5 million or 76.4% to $6.5 million for the nine-months
ended May 31, 2004 versus the $26.9 million of cash used in operating
activities for the same period in the prior year. The reduction in cash used in
continuing operations is reflective of the Companys integration initiatives
that reduced facility, bandwidth connectivity and employee related costs. Cash
provided by investing activities
decreased $19.5 million or 62.6% to $11.7 million for the nine-months ended May
31, 2004 versus $31.1 million of cash provided by investing activities for the
same period in the prior year. The decrease in cash generated from investing
activities is primarily related to a reduction in the investments that were
liquidated in order to fund daily cash requirements. Cash used in financing
activities decreased $11.1 million or 59.0% to $7.7 million for the nine-months
ended May 31, 2004 versus the $18.8 million of cash used in financing
activities for the same period of prior year. The decrease in cash used in
financing activities is primarily due to the reduction of overall debt and
capital lease obligations. Cash used in discontinued operations decreased $0.2
million or 10.8% to $1.8 million for the nine-months ended May 31, 2004. In July 2001, the Company entered into a financing arrangement with U.S.
Bancorp Oliver-Allen Technology Leasing for a sale and leaseback of up to $14.6
million for certain equipment, primarily computer hardware. The stated interest
rate on the facility is 5.75%. In January 2002, the Company repurchased certain
of the leased assets from U.S. Bancorp Oliver-Allen Technology Leasing at a
total cost of $2.9 million. In connection with the repurchase, approximately
$3.3 million of cash and equivalents became unrestricted. On February 1, 2004,
the Company terminated the sale and leaseback agreement and repurchased the
assets. In conjunction with this lease termination the company executed a
five-year promissory note with US Bancorp Oliver-Allen Technology Leasing for
the repurchase amount. As of May 31, 2004, the principal balance on the
promissory note was $4.5 million. The Company has pledged $4.7 million as
collateral for this promissory note; this amount will gradually decrease until
the agreement terminates in February 2009. These restrictions prevent the
Company from utilizing the related cash and cash equivalents until all of its
obligations under the note are satisfied. The promissory note requires monthly
payments of $93,000 over the next five years. The Company anticipates making capital expenditures of approximately $13.5
million during fiscal 2004, generally for server equipment and related
software, hardware to improve service reliability and security, integration and
restructuring activities, and other expenditures related to new customer
growth. During the first nine-months of fiscal 2004, the Company expended $10.9
million on capital equipment purchases. The Companys continued future success is dependent upon its ability to achieve
and sustain positive cash flow prior to the depletion of cash resources and to
raise funds, thereafter, if needed. The Company assessed its overall cash flow
and cash balances for the next four quarters. Although the Company does not
believe that it can achieve meaningful positive cash flows during that period
(primarily due to payment of accrued liabilities), the Company believes it has
adequate cash and liquid resources to fund operations and planned capital
expenditures through at least the next 12 months. The Companys long-term cash
needs will be dependent upon additional factors such as pricing pressures,
level of investment on data center reliability and security improvement, our
ability to reduce net churn and unexpected costs associated with discontinued
operations and pending litigations. Recently Issued Accounting Standards In January 2003, the FASB issued FASB Interpretation No. 46, Consolidation of
Variable Interest Entities (FIN 46). FIN 46 clarified the application of
Accounting Research Bulletin No. 51, Consolidated Financial Statements, to
certain entities in which equity investors do not have the characteristics of a
controlling financial interest or do not have sufficient equity at risk for the
entity to finance its activities without additional subordinated support from
other parties. FIN 46 requires existing unconsolidated variable interest
entities to be consolidated by their primary beneficiaries if the entities do
not effectively 18




---



##### Table of Contents



Interland, Inc.Item 2.  Managements Discussion And Analysis Of Financial Condition And Results Of Operations disperse risks among parties involved. The Company has
evaluated its investments and other relationships and concluded that none meet
the requirements for consolidation under FIN 46. In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial
Instruments with Characteristics of Both Liabilities and Equity. This
statement establishes standards for how an issuer classifies and measures
certain financial instruments with characteristics of both liabilities and
equity. This statement is effective for financial instruments entered into or
modified after May 31, 2003, and otherwise is effective for the first quarter
of fiscal year 2004. The adoption of this standard on September 1, 2003 did not
have a material impact on Interlands consolidated financial statements. RISK FACTORS You should carefully consider the following factors and all other information
contained in this Form 10-Q and the Companys recently filed Form 10-K for the
fiscal year ended August 31, 2003 before you make any investment decisions with
respect to the Companys securities. The risks and uncertainties described
below are not the only risks the Company faces. Interland has incurred losses since inception and could incur losses in the
future. Interland has incurred net losses and losses from operations for all but one of
each quarterly period from its inception through the quarter ended May 31,
2004. A number of factors could increase its operating expenses, such as:  Adapting network infrastructure and administrative resources to
accommodate additional customers and future growth;  Developing products, distribution, marketing, and management for the mainstream market;  Broadening customer technical support capabilities; and  Improving network security features. In addition, the Company recently has experienced a decline in quarterly
revenues. Increases in expenses or further decreases in revenues may cause
operating losses to increase. Ours is a recurring-revenue subscriber business and as such the effects of a
net loss of monthly recurring revenue are magnified. A large majority of our revenue is derived from the monthly recurring charges
(MRC) incurred by owners of hosted websites. Accordingly, the termination of
a single account paying $30.00 per month will affect revenue every month in the
future. The loss of such a customer at the beginning of a fiscal year will
result in a twelve-fold reduction in revenue for that fiscal year, and the loss
of even one such customer each month of the fiscal year will result in a
diminution of 78 times the monthly recurring revenue, or $2,340 over the entire
fiscal year. Absent the addition of customers through acquisitions, Interland
has consistently incurred a net loss in MRC, and this situation may continue
with material negative effects on reported revenue and net income. Although
reductions in MRC may be offset for a time by increases in revenue derived from
one-time or non-recurring charges, the compounding effect of MRC losses will
almost certainly eventually result in a meaningful reduction of reported
revenue. Moreover, because of Interlands relatively low percentage of
variable costs, a concomitantly high percentage of the amount of revenue loss
results in a loss of EBITDA and of net income. There can be no assurance
that Interlands efforts to reduce the loss of MRC will be successful. Because Interlands historical financial information is not representative of
its future results, investors and analysts will have difficulty analyzing
Interlands future earnings potential. Because the Company has grown through acquisition and its past operating
results reflect the costs of integrating these acquisitions, historical results
are not representative of future expected operating results. Furthermore, the
Companys historical annual financial results reflect only the partial impacts
of recent acquisitions. In addition, because the Company will be seeking to
drive revenue growth primarily through its mainstream market initiative,
which is a new market for the Company, it will be challenging to predict future
revenues. As a result, investors and their advisors will find it challenging
to predict future operating income. Interland has a limited operating history and its business model is still
evolving, which makes it difficult to evaluate its prospects. 19




---



##### Table of Contents



Interland, Inc.Item 2.  Managements Discussion And Analysis Of Financial Condition And Results Of Operations Interlands limited operating history makes evaluating its business operations
and prospects difficult. Its range of service offerings has changed since
inception and its business model is still developing. Interland has changed
from being primarily a seller of personal computers and related accessories to
being primarily a Web hosting and Web based value added business solutions
provider to small- and medium-sized businesses company. Because some of its
services are new, the market for them is uncertain. As a result, the revenues
and income potential of its business, as well as the potential benefits of its
acquisitions, may be difficult to evaluate. Quarterly and annual operating results may fluctuate, which could cause
Interlands stock price to be volatile. Past operating results have fluctuated significantly on a quarterly and an
annual basis. Quarterly and annual operating results may continue to
significantly fluctuate due to a wide variety of factors. Because of these
fluctuations, comparing operating results from period to period is not
necessarily meaningful, and it would not be prudent to rely upon such
comparisons as an indicator of future performance. Factors that may cause its
operating results to fluctuate include, but are not limited to:  
    
    Demand for and market acceptance of the Companys services and products;  
    
    Introduction of new services or enhancements by Interland or its competitors;  
    
    Costs of implementing new network security features;  
    
    Technical difficulties or system downtime affecting the
Internet generally or its hosting operations specifically;  
    
    Customer retention;  
    
    Increased competition and consolidation within the Web hosting and applications hosting markets;  
    
    Changes in its pricing policies and the pricing policies of its competitors; and  
    
    Gains or losses of key strategic partner relationships. Interland cannot provide any assurances that it will succeed in its plans to
increase the size of its customer base, the amount of services it offers, or
its revenues during the next fiscal year and beyond. In addition, relatively
large portions of its expenses are fixed in the short term, and therefore its
results of operations are particularly sensitive to fluctuations in revenues.
Also, if it cannot continue using third-party products in its service
offerings, its service development costs could increase significantly. Interlands stock price may be volatile which could cause an investment in its
common stock to decrease significantly. The market price of Interland common stock has experienced a significant
decline. The price has been and is likely to continue to be highly volatile.
The following are examples of factors or developments that would likely cause
the Companys stock price to continue to be volatile:  
    
    Variations in operating results and analyst earnings estimates;  
    
    The volatility of stock within the sectors within which it conducts business;  
    
    Announcements by Interland or its competitors regarding introduction of new services;  
    
    General decline in economic conditions;  
    
    Reductions in the volume of trading in its common stock and;  
    
    The Companys inability to reduce the rate of account
cancellations, or to increase the rate of account additions, or both. During the 52 weeks ended May 31, 2004, the high and low closing price for
Interland common stock on NASDAQ was $12.20 and $2.67, respectively. Interland operates in a new and evolving market with uncertain prospects for
growth and may not be able to achieve and sustain growth in its customer base
or to maintain its average revenue per customer account (ARPU). The market for Web hosting and applications hosting services for small- and
medium-sized businesses, and especially the mainstream market, has only
recently begun to develop and is evolving rapidly. Interlands future growth,
if any, will depend upon the willingness of small- and medium-sized businesses
to purchase Web and applications services, Interlands ability to increase or
at least maintain its average revenues-per customer, and its ability to retain
customers. As of May 31, 2004, Interlands average monthly revenue per
customer account was $27.07 for shared hosting services and $305.91 for
dedicated hosting services, and its average monthly customer turnover was 3.6%
for shared hosting services and 5.7% for dedicated hosting services. The
corresponding average monthly revenue per customer as of May 31, 2003 was
$29.60 for shared hosting services and $440.60 for dedicated hosting services,
and the associated average monthly customer turnover rates were 4.0% for shared
hosting services and 6.1% for dedicated hosting services. The market for
Interlands services may not develop further, consumers may not widely adopt
its services and significant numbers of businesses or organizations may not use
the Internet for commerce and communication. If this market fails to develop
further or develops more slowly than 20




---



##### Table of Contents



Interland, Inc.Item 2.  Managements Discussion And Analysis Of Financial Condition And Results Of Operations expected, or if Interlands services do
not achieve broader market acceptance, Interland will not be able to grow its
customer base. In addition, Interland must be able to differentiate itself
from its competition through its service offerings and brand recognition.
These activities may be more expensive than Interland anticipates, and
Interland may not succeed in differentiating itself from its competitors,
achieving market acceptance of its services, or selling additional services to
its existing customer base. Interlands ability to significantly organically grow revenue is dependent, in
part, on successful penetration of the mainstream market of
small-and-medium-sized businesses lacking an effective Web presence. The mainstream market of small-and-medium-sized businesses lacking an
effective Web presence has only been evaluated with limited market research and
trials. In addition, the Companys potential for success is dependent upon the
successful market introduction of the Companys software-based Web site
development product offerings. Delays in seizing this market initiative and/or
in the related product introduction could slow or limit the Companys future
revenue growth. Interlands mainstream market initiative could cause losses for Interland,
particularly within the next fiscal year. The Company has initiated a product line and marketing program directed at the
mainstream market of SMBs without an effective Web presence. This initiative
is described in fuller detail in the Business section. This is a new
product line, and the products and services in this line may prove unprofitable
to the Company unless it is successful in implementing them and achieving
economies of scale in its distribution and service delivery activities.
Although the Company has announced that it is reducing its level of investment
in this initiative, such reduction may only be temporary, and financial results
during this period of retrenchment will not necessarily be indicative of future
performance if investment is resumed. Because Interlands target markets are volatile, the Company may face a loss of
customers or a high level of non-collectible accounts. The Company intends to continue to concentrate on serving the small- and
medium-sized business market. This market contains many businesses that may
not be successful, and consequently present a substantially greater risk for
non-collectible accounts receivable and for non-renewal. Moreover, a
significant portion of this target market is highly sensitive to price, and may
be lost to a competitor with a lower pricing structure. Because few businesses
in this target market employ trained technologists, they tend to generate a
high number of customer service and technical support calls. The expense of
responding to these calls is considerable, and the expense is likely to
increase in direct proportion to revenue, potentially limiting the scalability
of the business. Additionally, if the customer becomes dissatisfied with the
Companys response to such calls, cancellation, non-payment, or non-renewal
becomes more likely. Interlands strategy for minimizing the negative aspects
of its target market include:  
    
    Increased expenditures on sales and marketing programs to replace failing customers;  
    
    Capitalizing on infrastructure efficiencies to become a profitable provider at the lowest sustainable price;  
    
    Automating customer care and technical support to reduce the cost per
call, and to minimize the time spent by Company personnel; and,  
    
    Intensive training and supervision of customer care and technical
support personnel to maximize customer satisfaction. The Company can give no assurance, however, that any of these measures will be
successful, and the Companys failure to manage these risks could decrease
revenues and profitability. Interland could incur liabilities in the future relating to its PC Systems
business, which could cause additional operating losses. Interland could incur liabilities from the sale of the PC Systems business to
GTG PC Holdings, LLC, (GTG PC). According to the terms of its agreement with
GTG PC, it retained liabilities relating to the operation of the PC systems
business prior to the closing of the transaction including liabilities for
taxes, contingent liabilities and liabilities for accounts payable accrued
prior to the closing. It also agreed to indemnify GTG PC and its affiliates
for any breach of its representations and warranties contained in the agreement
for a period of two years, or for the applicable statute of limitations for
matters related to taxes. Its indemnification obligation is capped at $10.0
million. Except for claims for fraud or injunctive relief, this indemnity is
the exclusive remedy for any breach of its representations, warranties and
covenants contained in the agreement with GTG PC. Accordingly, it could be
required in the future to make payments to GTG PC and its affiliates in
accordance with the agreement, which could adversely affect its future results
of operations and cash flows. To date it has not had to satisfy any 21




---



##### Table of Contents



Interland, Inc.Item 2.  Managements Discussion And Analysis Of Financial Condition And Results Of Operations indemnification. For the nine-months ended May 31, 2004, the Company incurred
$1.8 million in litigation expenses from the PC business. The Company expects
to incur additional expense relating to defending or settling PC related
claims. Unfavorable results of existing litigation may cause Interland to have
additional expenses or operating losses. The Company is a defendant in a number of lawsuits, which the Company regards
as unlikely to result in any material payment. See Part II  Item 1 Legal
Proceedings. Nonetheless, the outcome of litigation may not be assured, and
the Companys cash balances could be materially affected by an adverse
judgment. Because Interland faces intense competition, it may not be able to operate
profitably in its markets. The Web hosting and applications hosting markets are highly competitive, which
could hinder Interlands ability to successfully market its products and
services. The Company may not have the resources, expertise or other
competitive factors to compete successfully in the future. Because there are
few substantial barriers to entry, the Company expects that it will face
additional competition from existing competitors and new market entrants in the
future. Many of Interlands current and potential competitors have greater name
recognition and more established relationships in the industry and greater
resources. As a result, these competitors may be able to:  
    
    Develop and expand their network infrastructures and service offerings more rapidly;  
    
    Adapt to new or emerging technologies and changes in customer requirements more quickly; and,  
    
    Devote greater resources to the marketing and sale of their services
and adopt more aggressive pricing policies than the Company can. Current and potential competitors in the market include Web hosting service
providers, applications hosting providers, Internet service providers,
telecommunications companies, large information technology firms and computer
hardware suppliers. These competitors may operate in one or more of these areas
and include companies such as NTT/Verio, Affinity Internet, Earthlink and
United Internet. Impairment of Interlands intellectual property rights could negatively affect
its business or could allow competitors to minimize any advantage that
Interlands proprietary technology may give it. The Company currently has no patented technology that would preclude or inhibit
competitors from entering the Web hosting market that it serves. While it is
the Companys practice to enter into agreements with all employees and with
some of its customers and suppliers to prohibit or restrict the disclosure of
proprietary information, the Company cannot be sure that these contractual
arrangements or the other steps it takes to protect its proprietary rights will
prove sufficient to prevent illegal use of its proprietary rights or to deter
independent, third-party development of similar proprietary assets. Effective copyright, trademark, trade secret and patent protection may not be
available in every country in which its products and services are offered.
Interland currently is, and in the future may be, involved in legal disputes
relating to the validity or alleged infringement of its intellectual property
rights or those of a third party. Intellectual property litigation is
typically extremely costly and can be disruptive to business operations by
diverting the attention and energies of management and key technical personnel.
In addition, any adverse decisions could subject it to significant liabilities,
require it to seek licenses from others, prevent it from using, licensing or
selling certain of its products and services, or cause severe disruptions to
operations or the markets in which it competes which could decrease
profitability. Periodically, it is made aware of claims, or potential claims, that technology
it used in its discontinued operations may have infringed on intellectual
property rights held by others. The Company has accrued a liability and
charged operations for the estimated costs of settlement or adjudication of
several asserted and unasserted claims for alleged infringement relating to its
discontinued operations prior to the balance sheet date. Resolution of these
claims could be costly and decrease profitability. If Interland is unable to attract and retain key personnel, it may not be able
to compete effectively in its market. The future success of Interland will depend, in part, on its ability to attract
and retain key management, technical, and sales and marketing personnel. The
Company attempts to enhance its management and technical expertise by
recruiting qualified individuals who possess desired skills and experience in
certain targeted areas. The Company experiences strong competition for such
personnel in the Web hosting industry. The Companys inability to retain
employees and attract and retain sufficient additional employees, information
technology, engineering, and technical support resources could adversely affect
its ability to remain competitive in its markets. The Company has and may
continue to face the loss of key personnel, which could limit the ability of
the Company to develop and market its products and services. 22




---



##### Table of Contents



Interland, Inc.Item 2.  Managements Discussion And Analysis Of Financial Condition And Results Of Operations Interland depends on its reseller sales channel to market and sell many of its
services. Interland does not control its resellers, and if it fails to develop
or maintain good relations with resellers, it may not achieve the growth in
customers and revenues that it expects. An element of the strategy for the Companys growth is to further develop the
use of third parties that resell its services. Many of these resellers are Web
development or Web consulting companies that also sell Interlands Web hosting
services, but that generally do not have established customer bases to which
they can market these services. The Company is not
currently dependent on any one reseller to generate a significant level of
business, but it has benefited and continues to significantly benefit from
business generated by the reseller channel. Although Interland attempts to
provide its resellers with incentives such as price discounts on its services
that the resellers seek to resell at a profit, the failure of its services to
be commercially accepted in some markets, whether as a result of a resellers
performance or otherwise, could cause its current resellers to discontinue
their relationships with the Company. The Company is in discussions with
Verizon regarding a potential renewal, modification or extension of its current
agreement, which otherwise expires November 1, 2004. However, the Company
cannot predict the outcome of these discussions. Verizon accounts for
2.8% of the Companys monthly revenue. We
May Require Additional Cash in the Future and May Not Be Able to
Secure Adequate Funds on a Timely Basis or on Terms Acceptable to
Us. We expect to meet our cash  requirements over the next 12 months with
existing cash, cash equivalents, short-term investments and cash
flows from sales of our services and existing credit facilities. If, however,
our cash requirements vary materially from those currently planned,
or if we fail to generate sufficient cash flow from the sales of our
services, management believes it has the ability to curtail capital
spending and reduce expenses to ensure our cash and investments will
be sufficient to meet our cash requirements for the next 12 months. We
may, however, require additional financing sooner than anticipated. In
that event, we might not be able to obtain equity or debt financing
on acceptable terms, if at all. Also, future borrowing instruments,
such as credit facilities and lease agreements, will likely contain
covenants which may restrict our ability to incur further
indebtedness, and which will likely require us to pledge assets as
security for any such borrowings. Interland is vulnerable to system failures, which could harm its reputation,
cause its customers to seek reimbursement for services, and cause its customers
to seek another provider for services. The Company must be able to operate the systems that manage its network around
the clock without interruption. Its operations will depend upon its ability to
protect its network infrastructure, equipment and customer files against damage
from human error, fire, earthquakes, hurricanes, floods, power loss,
telecommunications failures, sabotage, intentional acts of vandalism and
similar events. Although the Company has attempted to build redundancy into its
networks, its networks are currently subject to various points of failure. For
example, a problem with one of its routers (devices that move information from
one computer network to another) or switches could cause an interruption in the
services the Company provides to a portion of its customers. In the past, the
Company has experienced periodic interruptions in service. The Company has also
experienced, and in the future it may continue to experience, delays or
interruptions in service as a result of the accidental or intentional actions
of Internet users, current and former employees, or others. Any future
interruptions could:  
    
    Cause customers or end users to seek damages for losses incurred;  
    
    Require the Company to replace existing equipment or add redundant facilities;  
    
    Damage the Companys reputation for reliable service;  
    
    Cause existing customers to cancel their contracts; or  
    
    Make it more difficult for the Company to attract new customers. Interlands data centers and network vulnerability to security breaches could
cause disruptions in its service, liability to third parties, or loss of
customers. A significant barrier to electronic commerce and communications is the need for
secure transmission of confidential information over public networks. Some of
the Companys services rely on security technology licensed from third parties
that provides the encryption and authentication necessary to effect the secure
transmission of confidential information. Despite the design and implementation
of a variety of network security measures by the Company, unauthorized access,
computer viruses, accidental or intentional actions and other disruptions could
occur. In addition, inappropriate use of the network by third parties could
also potentially jeopardize the security of confidential information, such as
credit card and bank account numbers stored in the Companys computer systems.
These security problems could result in the Companys liability and could also
cause the loss of existing customers and potential customers. Although the Company continues to implement industry-standard security
measures, third parties may be able to overcome any measures that it
implements. The costs required to eliminate computer viruses and alleviate
other security problems could be prohibitively expensive and the efforts to
address such problems could result in interruptions, delays or cessation of
service to customers, and harm the Companys reputation and growth. Concerns
over the security of Internet transactions and the privacy of users may also
inhibit the growth of the Internet, especially as a means of conducting
commercial transactions. Disruption of Interlands services caused by unknown software or hardware
defects could harm its business and reputation. The Companys service offerings depend on complex software and hardware,
including proprietary software tools and software licensed from third parties.
Complex software and hardware may contain defects, particularly when first
introduced or when new versions are released. The Company may not discover
software or hardware defects that affect its new or current 23




---



##### Table of Contents



Interland, Inc.Item 2.  Managements Discussion And Analysis Of Financial Condition And Results Of Operations services or
enhancements until after they are deployed. Although Interland has not
experienced any material software or hardware defects to date, it is possible
that defects may exist or occur in the future. These defects could cause
service interruptions, which could damage its reputation or increase its
service costs, cause it to lose revenue, delay market acceptance or divert its
development resources. Providing services to customers with critical Web sites and Web-based
applications could potentially expose Interland to lawsuits for customers lost
profits or other damages. Because the Companys Web hosting and applications hosting services are
critical to many of its customers businesses, any significant interruption in
those services could result in lost profits or other indirect or consequential
damages to its customers as well as negative publicity and additional
expenditures for it to correct the problem. Although the standard terms and
conditions of the Companys customer contracts disclaim liability for any such
damages, a customer could still bring a lawsuit against it claiming lost
profits or other consequential damages as the result of a service interruption
or other Web site or application problems that the customer may ascribe to it.
A court might not enforce any limitations on its liability, and the outcome of
any lawsuit would depend on the specific facts of the case and legal and policy
considerations even if the Company believes it would have meritorious defenses
to any such claims. In such cases, it could be liable for substantial damage
awards. Such damage awards might exceed its liability insurance by unknown but
significant amounts, which would seriously harm its business. Interland could face liability for information distributed through its network. The law relating to the liability of online services companies for information
carried on or distributed through their networks is currently unsettled. Online
services companies could be subject to claims under both United States and
foreign law for defamation, negligence, copyright or trademark infringement,
violation of securities laws or other theories based on the nature and content
of the materials distributed through their networks. Several private lawsuits
seeking to impose such liability upon other entities are currently pending
against other companies. In addition, organizations and individuals have sent
unsolicited commercial e-mails from servers hosted by service providers to
massive numbers of people, typically to advertise products or services. This
practice, known as spamming, can lead to complaints against service providers
that enable such activities, particularly where recipients view the materials
received as offensive. The Company may, in the future, receive letters from
recipients of information transmitted by its customers objecting to such
transmission. Although the Company prohibits its customers by contract from
spamming, it cannot provide assurances that its customers will not engage in
this practice, which could subject it to claims for damages. In addition, the Company may become subject to proposed legislation that would
impose liability for or prohibit the transmission over the Internet of some
types of information. Other countries may also enact legislation or take action
that could impose liability on the Company or cause it not to be able to
operate in those countries. On December 16, 2003 the President signed into law
the Can SPAM Act of 2003 to prohibit Internet users from sending unsolicited
commercial e-mail. Pub. Law. No. 108-187 (the Can SPAM Act). The Can SPAM
Act prohibits Internet users from collecting or harvesting e-mail addresses
using electronic means, prohibits Internet marketers from sending unsolicited
commercial e-mails and requires the Federal Trade Commission to conduct a study
into the advisability of creating a federal do not e-mail registry along the
lines of the current do not call registry that relates to telemarketing.
Interland requires all of its customers to comply with all applicable laws,
including the Can SPAM Act. Although to date the Can SPAM Act has not had a
significant impact on the Company, there can be no assurance that compliance
with the Can SPAM Act will not cause the Companys operating expenses to
increase. The Company does not anticipate that the Can SPAM Act will have a
significant impact on the conduct of its business. The imposition upon the Company and other online services of potential
liability for information carried on or distributed through its systems could
require it to implement measures to reduce its exposure to this liability,
which may require it to expend substantial resources, or to discontinue service
offerings. The increased attention focused upon liability issues as a result of
these lawsuits and legislative proposals also could affect the rate of growth
of Internet use. Interlands business operates in an uncertain legal environment where future
government regulation and lawsuits could restrict Interlands business or cause
unexpected losses. Due to the increasing popularity and use of the Internet, laws and regulations
with respect to the Internet may be adopted at federal, state and local levels,
covering issues such as user privacy, freedom of expression, pricing,
characteristics and quality of products and services, taxation, advertising,
intellectual property rights, information security and the convergence of
traditional telecommunications services with Internet communications. The
Company cannot fully predict the nature of future 24




---



##### Table of Contents



Interland, Inc.Item 2.  Managements Discussion And Analysis Of Financial Condition And Results Of Operations legislation and the manner in
which government authorities may interpret and enforce such legislation. As a
result, Interland and its customers could be subject to potential liability
under future legislation, which in turn could have a material adverse effect on
the Companys business. The adoption of any such laws or regulations might
decrease the growth of the Internet which in turn could decrease the demand for
the Companys services, or increase the cost of doing business. In addition, applicability to the Internet of existing laws governing issues
such as property ownership, copyright and other intellectual property issues,
taxation, libel, obscenity and personal privacy is uncertain. These laws
generally pre-date the advent of the Internet and related technologies and, as
a result, do not consider or address the unique issues of the Internet and
related technologies. Substantial future sales of shares by shareholders could negatively affect
Interlands stock price. If the Companys shareholders sell substantial amounts of its common stock in
the public market, the market price of its common stock could decline. Only a
small portion of the Companys issued and outstanding shares is subject to any
restriction on resale. Interland operates a large number of acquired platforms in its data center,
some of which are less than optimal, and securing, improving, or migrating from
these platforms could adversely affect Interlands earnings and cash flows. Because the Company has grown by acquisition it continues to serve customers
that are supported by legacy hosting platforms. Some of these platforms have
experienced, or are approaching, technical obsolescence, and are difficult or
expensive to maintain, secure, or upgrade. If the Company continues to support
these platforms it will face risks of service failure or customer cancellation.
If the Company attempts to migrate the customers supported by these legacy
platforms it risks temporary disruption of the customers service that may
result in customer cancellation. The Company may offer incentives for such a
migration, which would temporarily or permanently reduce the revenue derived
from customers who accept the incentives. 25




---



##### Table of Contents



Interland, Inc. Item 3. Quantitative And Qualitative Disclosures About Market Risk Substantially all of the Companys liquid investments and a majority of its
debt are at fixed interest rates, and therefore the fair value of these
instruments is affected by changes in market interest rates. As of May 31,
2004, approximately 93.6% of the Companys liquid investments mature within
three months and 100% mature within one year. As of May 31, 2004, management
believes the reported amounts of liquid investments and debt to be reasonable
approximations of their fair values. Generally, the fair market value of fixed
interest rate investment securities will increase as interest rates fall and
decrease as interest rates rise. The Company does not use derivative financial
instruments in its investment portfolio. The portfolio has been primarily
comprised of commercial paper rated A1/P1, bank certificates rated AA or
better, and corporate medium-term notes rated AA or better. At May 31, 2004,
the Companys investment portfolio included fixed rate securities with an
estimated fair value of $37.2 million. The interest rate changes affect the
fair market values but do not impact earnings or cash flows. The fair market
value of long-term fixed interest rate debt is also subject to interest rate
risk. Generally, the fair market of fixed interest rate debt will increase as
interest rates fall and decrease as interest rates rise. The estimated fair
value of the Companys long-term debt, exclusive of current maturities, at May
31, 2004 was $3.7 million. 
 Item 4. Controls and Procedures The Companys management, including its chief executive officer, chief
financial officer and chief accounting officer evaluated the effectiveness of
the Companys disclosure controls and procedures (as defined in the Securities
Exchange Act of 1934 Rules 13(a)  14(c), and 14(d)) as of May 31, 2004. Based
on this review, the chief executive officer, chief financial officer and chief
accounting officer concluded that Interlands disclosure controls and
procedures were effective to provide reasonable assurances that such disclosure
controls and procedures satisfy their objectives and that the information
required to be disclosed by the Company in its periodic reports is accumulated
and communicated to management, including its chief executive officer, chief
financial officer and chief accounting officer, as appropriate to allow timely
decisions regarding disclosure and is recorded, processed, summarized and
reported within the time periods specified in the U.S. Securities and Exchange
Commissions rules and forms. Nevertheless, the Companys management, including its chief executive officer,
chief financial officer and chief accounting officer, do not expect that the
Companys disclosure controls and procedures will prevent all error and all
fraud. A control system, no matter how well conceived and operated, can provide
only reasonable, not absolute, assurance that the objectives of the control
system are met. The design of any system of controls is based in part upon
certain assumptions about the likelihood of future events, and there can be no
assurance that any design will succeed in achieving its stated goals under all
potential future conditions. Further, the design of a control system must
reflect the fact that there are resource constraints, and the benefits of
controls must be considered relative to their costs. Because of the inherent
limitations in all control systems, no evaluation of controls can provide
absolute assurance that all control issues and instances of fraud, if any,
within the Company have been detected. These inherent limitations include the
realities that judgments in decision-making can be faulty, and that breakdown
can occur because of simple error or mistake. In particular, many of the
Companys current processes rely upon manual reviews and processes to ensure
that neither human error nor system weakness has resulted in erroneous
reporting of financial data. As discussed in prior quarters, the Company has implemented a number of
significant improvements to its internal controls over financial reporting. While we continued to make
incremental improvements to our internal controls over financial reporting
during the quarter ended May 31, 2004, there were no changes in the Companys
internal control over financial reporting which management considered to be
material, although any improvement necessarily has the potential to avoid a material misstatement. 26




---



##### Table of Contents



Interland, Inc. PART II.  OTHER INFORMATION 
 Item 1. Legal Proceedings In February 2003, the Company filed a lawsuit in Cobb County, Georgia against
Mr. Gabriel Murphy, one of the former principals of Interlands subsidiary,
CommuniTech.Net, Inc. (Communitech), which was acquired by Interland in
February 2002. The Companys lawsuit claims, among other things, that Mr.
Murphy breached certain covenants under his employment agreement and also
demands payment from Mr. Murphys two promissory notes (one of which was
non-recourse while the other was recourse). In March 2004, Interland
retired the 273,526 shares of stock held as collateral and wrote off the
$2,000,000 non-recourse promissory note. The other $735,000 full recourse
promissory note remains outstanding and continues to be a subject of the Cobb
County litigation noted above. In February 2003 Messrs. Heitman, also a former principal of Communitech, and
Murphy filed a lawsuit against Interland, its CEO, Mr. Joel Kocher, and
Communitech, in Jackson County, Missouri claiming, among other things, that
Interland acted unreasonably in failing to have the S-3 registration statement
declared effective by the SEC on a timely basis and claiming that Interland
and/or Mr. Kocher made inaccurate disclosures in connection with Interlands
acquisition of Communitech. The complaint asks for compensatory and punitive
damages in an unspecified amount. Interland believes that these claims are
without merit and will not have a material adverse effect on Interland and
intends to vigorously defend the claims. Interland initiated a lawsuit in the United States District Court for the
Northern District of Georgia against the representatives of the former
shareholders of Hostcentric (the Hostcentric Shareholders), seeking a
declaratory judgment that it will be entitled to reimbursement from the escrow
fund established as part of the Hostcentric acquisition for any amounts over
$180,000 that it may be required to pay to the landlord for a leased facility
in Farmingdale, New York. The representatives of the Hostcentric Shareholders
have denied Interlands claims and have attempted to assert various
counterclaims. Correspondence between the parties has also discussed the
possibility of other claims, but these claims have not yet been asserted in
litigation. Interland believes its claims in this case are meritorious, that
the counterclaims of the former Hostcentric shareholders are without merit,
plans to continue to contest the matter vigorously, and believes that no
material adverse effect on Interland will occur as a result of this litigation. Interland, through its Hostcentric subsidiary, has also initiated a lawsuit in
United States District Court for Southern District of New York against the
landlord for the same Farmingdale, New York facility, seeking a declaratory
judgment that the lease for that facility has been terminated and that the
landlord has accepted that termination, thereby eliminating any further
obligation on the part of the tenant to make lease payments. The landlord has
denied the claims in the complaint and has asserted counterclaims for
approximately $200,000 that it claims is past due under the lease. The
landlord may, in the future, assert claims against Interland for the balance of
payments due under the Lease which claims, the landlord has asserted, could
amount to approximately $2 million in the aggregate. As reported above,
Interland believes any obligation found to exist to the landlord in excess of
$180,000 is the responsibility of the Hostcentric Shareholders. Interland
plans to continue to contest the matter vigorously and believes that no
material adverse effect on Interland will occur as a result of this litigation. Periodically, the Company is made aware that technology it used in its
discontinued operations may have infringed on intellectual property rights held
by others. The Company has evaluated all such claims and, if necessary and
appropriate, sought to obtain licenses for the use of such technology. If the
Company or its suppliers were unable to obtain licenses necessary to use
intellectual property in its discontinued operations products or processes, it
may be forced to defend legal actions taken against it relating to allegedly
protected technology. The Company evaluates all such claims and has accrued a
liability and charged discontinued operations for the estimated costs of
settlement or adjudication of claims for alleged infringement as of the
respective dates of the balance sheets included in this report. As of May 31,
2004, the Company had an aggregate amount of $1.0 million accrued for such
matters. The Company is also a defendant in a number of other lawsuits that the Company
regards as unlikely to result in any material payment; nonetheless, the outcome
of litigation may not be assured, and the Companys cash balances could be
materially affected by an adverse judgment. In accordance with SFAS No. 5
Accounting for Contingencies, the Company believes it has adequately reserved
for the contingencies arising from the above legal matters where an outcome was
deemed to be probable and the loss amount could be reasonably estimated. As
such, the Company does not believe that the
anticipated outcome of the aforementioned proceedings will have a materially
adverse impact on its results of operations, its financial condition or its
cash flows. 27




---



##### Table of Contents



Interland, Inc. Item 2.  Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities In March 2004, the Company executed on 273,526 shares of stock, at an average price per share of $7.31, held as collateral on a promissory note and
immediately retired them from circulation. ISSUER PURCHASES OF EQUITY SECURITIES (c) Total Number ofShares Purchased as Part
    
    (d) Maximum Number of Shares(a) Total Number of
    
    (b) Average Price Paid
    
    of Publicly Announced
    
    that May Yet Be Purchased UnderPeriod
    
    Shares Purchased
    
    per Share
    
    Plans or Programs
    
    the Plans or ProgramsMarch 2004
    
    
    273,526
    
    
    $
    7.31
    
    
    
    
    
    
    
    April 2004
    
    
    
    
    
    $
    
    
    
    
    
    
    
    
    May 2004
    
    
    
    
    
    $
    
    
    
    
    
    
    
    
    Total
    
    
    273,526
    
    
    $
    7.31
    
    
    
    
    
    
    
    
 28




---



##### Table of Contents



Item 6.  Exhibits And Reports On Form 8-K (A)      Exhibits: Exhibit
    
    Description3.01
    
    Unofficial Restated Articles of Incorporation of Registrant (as
amended through April 24, 2002) (incorporated by reference to the
Registrants Quarterly Report on Form 10-Q for the quarter ended
5/31/02).3.01(b)
    
    Articles of Amendment to Articles of Incorporation of Registrant
(incorporated by reference to the Registrants Annual Report on Form 10-K for
the year ended 8/31/02).3.02
    
    Unofficial Restated Bylaws of the Registrant (as amended through
April 24, 2002) (incorporated by reference to the Registrants Quarterly
Report on Form 10-Q for the quarter ended 5/31/02).31.1
    
    Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    Certification of Chief Executive Officer under Section 906 of the Sarbanes-Oxley Act of 2002.32.2
    
    Certification of Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of 2002.
 (B)      Reports on Form 8-K.  On April 14, 2004, the Company filed a Form 8-K regarding its
financial results for the fiscal quarter ended February 29, 2004.On April 19, 2004, the Company filed a Form 8-K with a transcript
and related material from its earnings conference call.On April 28, 2004, the Company filed a Form 8-K with its amended
Code of Conduct. 29




---



##### Table of Contents



Signatures Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. Interland, Inc.
(Registrant)Dated: July 7, 2004
    
    /s/ Allen L. Shulman
Allen L. Shulman
Senior Vice President, Chief Financial Officer,
and Executive Counsel
(Principal Financial Officer)
 30