##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 Form 10-Q [X] QUARTERLY
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934  Commission File Number: 0-17932
 Interland, Inc. (Exact name of
registrant as specified in its charter)
 Minnesota
    
    41-1404301(State or other jurisdiction
of incorporation or organization)
    
    (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 þ No o Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes þ No o The number of outstanding shares of the registrants Common Stock on March 31,
2004 was 16,080,805.




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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
    
    28ITEM 1. LEGAL PROCEEDINGS
    
    28ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
    
    29EX-10.117 PROMISSORY NOTEEX-10.118 HOSTING PROVIDER PROGRAM AGREEMENTEX-31.1 302 CERTIFICATION OF CEOEX-31.2 302 CERTIFICATION OF CFOEX-32.1 906 CERTIFICATION OF CEOEX-32.2 906 CERTIFICATION OF CFO




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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 six months endedFebruary 29,
    
    February 28,
    
    February 29,
    
    February 28,2004
    
    2003
    
    2004
    
    2003Revenues
    
    $
    26,029
    
    
    $
    26,114
    
    
    $
    52,716
    
    
    $
    53,397Operating costs and expenses:Network operating costs, exclusive of depreciation shown below
    
    
    7,066
    
    
    
    9,830
    
    
    
    14,164
    
    
    
    19,170Sales and marketing, exclusive of depreciation shown below
    
    
    6,535
    
    
    
    5,033
    
    
    
    11,741
    
    
    
    9,872Technical support, exclusive of depreciation shown below
    
    
    4,641
    
    
    
    3,777
    
    
    
    9,446
    
    
    
    7,521General and administrative, exclusive of depreciation shown below
    
    
    7,854
    
    
    
    10,452
    
    
    
    15,977
    
    
    
    20,256Bad debt expense
    
    
    935
    
    
    
    1,770
    
    
    
    2,066
    
    
    
    3,816Depreciation and amortization
    
    
    8,241
    
    
    
    13,215
    
    
    
    16,422
    
    
    
    25,395Restructuring costs
    
    
    
    
    
    
    3,675
    
    
    
    
    
    
    
    3,440Merger and integration costs
    
    
    
    
    
    
    433
    
    
    
    
    
    
    
    527Other expense (income), net
    
    
    (48
    )
    
    
    21
    
    
    
    (73
    )
    
    
    71Total operating costs and expenses
    
    
    35,224
    
    
    
    48,206
    
    
    
    69,743
    
    
    
    90,068Operating loss
    
    
    (9,195
    )
    
    
    (22,092
    )
    
    
    (17,027
    )
    
    
    (36,671
    )Interest income (expense), net
    
    
    (166
    )
    
    
    (50
    )
    
    
    (304
    )
    
    
    151Loss from continuing operations before taxes
    
    
    (9,361
    )
    
    
    (22,142
    )
    
    
    (17,331
    )
    
    
    (36,520
    )Income tax benefit (expense)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net loss from continuing operations
    
    
    (9,361
    )
    
    
    (22,142
    )
    
    
    (17,331
    )
    
    
    (36,520
    )Loss from discontinued operations, net of tax
    
    
    (739
    )
    
    
    (281
    )
    
    
    (1,321
    )
    
    
    (315
    )Net loss
    
    $
    (10,100
    )
    
    $
    (22,423
    )
    
    $
    (18,652
    )
    
    $
    (36,835
    )Net loss per share, basic and diluted:Continuing operations
    
    $
    (0.58
    )
    
    $
    (1.56
    )
    
    $
    (1.07
    )
    
    $
    (2.59
    )Discontinued operations
    
    
    (0.04
    )
    
    
    (0.02
    )
    
    
    (0.08
    )
    
    
    (0.02
    )$
    (0.62
    )
    
    $
    (1.58
    )
    
    $
    (1.15
    )
    
    $
    (2.61
    )Number of shares used in per share calculation:Basic and diluted
    
    
    16,213
    
    
    
    14,196
    
    
    
    16,188
    
    
    
    14,099
 The accompanying notes are an integral part of these consolidated financial statements. 3




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INTERLAND, INC. 
 CONSOLIDATED BALANCE SHEETS
(In thousands)
(Unaudited) As ofFebruary 29,
    
    August 31,2004
    
    2003AssetsCash and cash equivalents
    
    $
    36,924
    
    
    $
    35,255Short term investments
    
    
    2,000
    
    
    
    16,300Receivables, net
    
    
    4,325
    
    
    
    5,160Income taxes recoverable
    
    
    612
    
    
    
    612Other current assets
    
    
    2,700
    
    
    
    3,210Restricted investments
    
    
    387
    
    
    
    362Total current assets
    
    
    46,948
    
    
    
    60,899Restricted investments
    
    
    11,037
    
    
    
    18,264Property plant and equipment, net
    
    
    30,736
    
    
    
    35,935Goodwill
    
    
    66,526
    
    
    
    66,646Intangibles, net
    
    
    20,650
    
    
    
    24,791Other assets
    
    
    478
    
    
    
    507Total assets
    
    $
    176,375
    
    
    $
    207,042Liabilities and shareholders equityAccounts payable
    
    $
    1,474
    
    
    $
    1,488Accrued expenses
    
    
    18,403
    
    
    
    23,655Current portion of long-term debt and capital lease obligations
    
    
    4,673
    
    
    
    10,845Deferred revenue
    
    
    8,738
    
    
    
    10,991Total current liabilities
    
    
    33,288
    
    
    
    46,979Long-term debt and capital lease obligations
    
    
    4,182
    
    
    
    1,654Deferred revenue, long-term
    
    
    334
    
    
    
    354Other liabilities
    
    
    4,018
    
    
    
    5,397Total liabilities
    
    
    41,822
    
    
    
    54,384Commitments and contingenciesShareholders equityCommon stock, $.01 par value, authorized 21 million
shares,
issued and outstanding 16.3 and 16.3 million shares, respectively
    
    
    164
    
    
    
    164Additional capital
    
    
    322,724
    
    
    
    322,523Warrants
    
    
    4,990
    
    
    
    4,990Deferred compensation
    
    
    (699
    )
    
    
    (1,046
    )Note receivable from shareholder
    
    
    (2,735
    )
    
    
    (2,735
    )Accumulated deficit
    
    
    (189,891
    )
    
    
    (171,238
    )Total shareholders equity
    
    
    134,553
    
    
    
    152,658Total liabilities and shareholders equity
    
    $
    176,375
    
    
    $
    207,042
 The accompanying notes
are an integral part of these consolidated financial statements. 4




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INTERLAND, INC. 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited) For the six months endedFebruary 29,
    
    February 28,2004
    
    2003CASH FLOWS FROM OPERATING ACTIVITIESNet loss
    
    $
    (18,652
    )
    
    $
    (36,835
    )Adjustments to reconcile net loss to net cash used in
operating activities from continuing operations:Loss from discontinued operations
    
    
    1,321
    
    
    
    315Depreciation and amortization
    
    
    16,422
    
    
    
    25,395Bad debt expense
    
    
    2,066
    
    
    
    3,816Gain on sale of assets
    
    
    (71
    )
    
    
    Other non-cash adjustments
    
    
    548
    
    
    
    1,099Changes in operating assets and liabilities
net of effect of acquisitions:Receivables, net
    
    
    (1,231
    )
    
    
    (1,538
    )Other current and non current assets
    
    
    540
    
    
    
    435Accounts payable, accrued expenses, other liabilities and deferred revenue
    
    
    (7,879
    )
    
    
    (8,237
    )Cash used in operating activities of continuing operations
    
    
    (6,936
    )
    
    
    (15,550
    )CASH FLOWS FROM INVESTING ACTIVITIESExpenditures for property, plant, and equipment
    
    
    (5,545
    )
    
    
    (6,524
    )Purchases of held-to-maturity investment securities
    
    
    (1,500
    )
    
    
    (24,308
    )Proceeds from held-to-maturity investment securities
    
    
    15,800
    
    
    
    41,600Net change in restricted investments
    
    
    7,201
    
    
    
    13,059Acquisitions, net of cash acquired
    
    
    120
    
    
    
    (4,459
    )Cash provided by investing activities of continuing operations
    
    
    16,076
    
    
    
    19,368CASH FLOWS FROM FINANCING ACTIVITIESRepayments of debt and capital lease obligations
    
    
    (6,112
    )
    
    
    (14,790
    )Proceeds from issuance of common stock
    
    
    
    
    
    
    433Other
    
    
    
    
    
    
    (17
    )Cash used in financing activities of continuing operations
    
    
    (6,112
    )
    
    
    (14,374
    )Net cash provided by continuing operations
    
    
    3,028
    
    
    
    (10,556
    )Net cash used in discontinued operations
    
    
    (1,359
    )
    
    
    (1,366
    )Net increases in cash and cash equivalents
    
    
    1,669
    
    
    
    (11,922
    )Cash and cash equivalents at beginning of period
    
    
    35,255
    
    
    
    62,693Cash and cash equivalents at end of period
    
    $
    36,924
    
    
    $
    50,771
 The accompanying notes
are an integral part of these consolidated financial statements. 5




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INTERLAND, INC. 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. GENERAL Business Interland, Inc. (known as Micron Electronics, Inc. prior to August
6, 2001), 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 six 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 six-month periods ended
February 29, 2004 and February 28, 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 six-month periods ended February 29, 2004 are not necessarily
indicative of the results that may be expected for the full fiscal year. Effective with the Companys filing of Form 10-Q for the quarterly period ended
February 28, 2003, the Company has revised the presentation of its consolidated
statements of operations for all periods presented to conform to presentations
used by others in the Web hosting industry. As the Company has migrated from a
manufacturing entity to a Web hosting company, it believes its revised
presentation reflects more appropriately its results of operations and allows
for more comparability to its peers. The revised presentation removes the
gross margin sub-total and instead classifies all operating expenses and costs
in their respective line item. Additionally, depreciation and amortization
expense, previously presented as components of network operating costs, general
and administrative costs, sales and marketing costs and technical support costs
is now presented separately. These reclassifications, none of which
affects net
loss, have been made to all periods presented to present the financial
statements on a consistent basis. Basis of Presentation This report on Form 10-Q (10-Q) for the second
quarter ended February 29, 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. Use of estimates The preparation of financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the amounts reported in the financial statements.
The amounts that the Company will ultimately incur or recover could differ
materially from its current estimates. The underlying estimates and facts
supporting these estimates could change in 2004 and thereafter.
        . Revenue recognition Revenues are primarily generated from shared and
dedicated hosting, managed services, e-commerce services, applications hosting
and domain name registrations. Revenues are recognized as the services are
provided. Hosting contracts generally are for service periods ranging from one
to twenty-four months and typically require up-front fees. These fees,
including set-up fees for hosting services, are deferred and recognized ratably
over the customers first year of service. Deferred revenues represent the
liability for advance billings to customers for services not yet provided. Reverse stock split In June 2003, the Company announced that its board of
directors had approved a 1-for10 reverse stock split. The reverse stock split
was made effective as of the close of the market on August 1, 2003, and the
Companys common stock began trading on a reverse split basis on August 4, 2003
and effectively reduced the number of shares of common stock 6




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INTERLAND, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) issued and
outstanding from approximately 162.6 million to approximately 16.3 million. All
per share and number of shares outstanding in this report have been revised for
the stock split. Basic and diluted income (loss) per share Basic loss per share is computed
using the weighted average number of common shares outstanding. Diluted loss
per share is computed using the weighted average number of common shares
outstanding and potential common shares outstanding when their effect is
dilutive. Potential common shares result from the assumed exercise of
outstanding stock options and warrants. Because the Company has reported a loss
from continuing operations during the first two quarters of fiscal 2004 and
fiscal year 2003, the effect of potential common shares is excluded from the
calculation of per share amounts for those periods as their effect would be
anti-dilutive. In addition to net income (loss) per share, the Company has also reported per
share amounts on the separate income statement components required by
Accounting Principles Board (APB) Opinion 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,  as
the disposal activities of the Companys discontinued operations were initiated
prior to the Companys adoption of SFAS 144, Accounting for the Impairment or
Disposal of Long-Lived Assets on September 1, 2002. Comprehensive income The Company reports comprehensive income in accordance
with Statement of Financial Accounting Standards (SFAS) No. 130, Reporting
Comprehensive Income. This statement requires the disclosure of accumulated
other comprehensive income or loss (excluding net income or loss) as a separate
component of shareholders equity. For all periods presented, comprehensive
income is the same as net income. Income taxes The Company accounts for income taxes under the provisions of
SFAS No. 109, Accounting for Income Taxes. SFAS 109 requires recognition of
deferred tax liabilities and assets for the expected future tax consequences of
events that have been included in the financial statements or tax returns.
Under this method, deferred tax liabilities and assets are determined based on
the difference between the financial statement and tax basis of assets and
liabilities using enacted tax rates in effect for the year in which the
difference is expected to reverse. 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: Three-month period ended
    
    For the six months endedFebruary 29,
    
    February 28,
    
    February 29,
    
    February 28,2004
    
    2003
    
    2004
    
    2003in thousands, except per share numbersNet loss as reported
    
    $
    (10,100
    )
    
    $
    (22,423
    )
    
    $
    (18,652
    )
    
    $
    (36,835
    )Add: Stock-based employee compensation
expense included in reported net income,
net of related tax effects
    
    
    174
    
    
    
    (33
    )
    
    
    347
    
    
    
    207Deduct: Total stock-based employee
compensation
expense determined under fair value method-
based methods for all awards, net of tax effects
    
    
    (1,147
    )
    
    
    (734
    )
    
    
    (1,723
    )
    
    
    (1,601
    )Proforma net loss
    
    $
    (11,073
    )
    
    $
    (23,190
    )
    
    $
    (20,028
    )
    
    $
    (38,229
    )Loss per share:Basic and diluted  as reported
    
    $
    (0.62
    )
    
    $
    (1.58
    )
    
    $
    (1.15
    )
    
    $
    (2.61
    )Basic and diluted  pro forma
    
    $
    (0.68
    )
    
    $
    (1.63
    )
    
    $
    (1.24
    )
    
    $
    (2.71
    )Weighted average shares outstanding
Basic and diluted
    
    
    16,213
    
    
    
    14,196
    
    
    
    16,188
    
    
    
    14,099
 7




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INTERLAND, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 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
consideration 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. LONG-TERM DEBT AND CAPITALIZED LEASE OBLIGATION On February 1, 2004, the
Company terminated its sale and leaseback agreement
with US Bankcorp Oliver-Allen Technology (UBOAT) Leasing
and repurchased the assets. In conjunction with this lease termination the
Company executed a five-year promissory note with UBOAT for the repurchase amount. As of February 29, 2004, the
principal balance on the promissory note was $4.8 million. The Company has
pledged $5.0 million as collateral for this promissory note; this amount will
gradually decrease until the agreement terminates in February 2009. 4. RESTRUCTURING AND FACILITY EXIT COSTS 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 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. 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. The following table shows a reconciliation of the beginning and ending
liability balances from August 31, 2003 through February 29, 2004 related to
all restructuring activities recorded by the Company under both of the
restructuring programs described in the above two paragraphs. The balance at
February 29, 2004 represents the remaining liabilities to be paid in cash: 8




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INTERLAND, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Property
    
    Bandwdith
    
    EmployeeLease
    
    Plant and
    
    Termination
    
    TerminationAbandonment
    
    Equipment
    
    Costs
    
    Benenfits
    
    Total(in thousands)Balance at August 31, 2003
    
    $
    5,646
    
    
    $
    265
    
    
    $
    1,224
    
    
    $
    31
    
    
    $
    7,166Cash Paid
    
    
    (524
    )
    
    
    (209
    )
    
    
    (233
    )
    
    
    (31
    )
    
    
    (997
    )Other Adjustments
    
    
    (5
    )
    
    
    
    
    
    
    24
    
    
    
    
    
    
    
    19Balance at November 30, 2003
    
    $
    5,117
    
    
    $
    56
    
    
    $
    1,015
    
    
    $
    
    
    
    $
    6,188Cash Paid
    
    
    (517
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (517
    )Balance at February 29, 2004
    
    $
    4,600
    
    
    $
    56
    
    
    $
    1,015
    
    
    $
    
    
    
    $
    5,671
 During the quarter ended February 29, 2004, the Company paid on specific
obligations included in the restructuring reserves of $0.5 million for monthly
rent, net of sublease payments received. The changes in the restructuring accruals from August 31, 2002 through February
28, 2003 are as follows: Property
    
    Bandwdith
    
    EmployeeLease
    
    Plant and
    
    Termination
    
    TerminationAbandonment
    
    Equipment
    
    Costs
    
    Benenfits
    
    Total(in thousands)Balance at August 31, 2002
    
    $
    7,634
    
    
    $
    
    
    
    $
    1,179
    
    
    $
    
    
    
    $
    8,813Cash Paid
    
    
    (395
    )
    
    
    
    
    
    
    (63
    )
    
    
    
    
    
    
    (458
    )Other Adjustments
    
    
    
    
    
    
    
    
    
    
    (235
    )
    
    
    
    
    
    
    (235
    )Balance at November 30, 2002
    
    $
    7,239
    
    
    $
    
    
    
    $
    881
    
    
    $
    
    
    
    $
    8,120Plan Charges
    
    
    1,349
    
    
    
    871
    
    
    
    1,625
    
    
    
    271
    
    
    
    4,116Cash Paid
    
    
    (1,855
    )
    
    
    
    
    
    
    (118
    )
    
    
    (100
    )
    
    
    (2,073
    )Other Adjustments
    
    
    (216
    )
    
    
    
    
    
    
    (225
    )
    
    
    
    
    
    
    (441
    )Non-cash Write Downs
    
    
    
    
    
    
    (871
    )
    
    
    
    
    
    
    
    
    
    
    (871
    )Balance at February 28, 2003
    
    $
    6,517
    
    
    $
    
    
    
    $
    2,163
    
    
    $
    171
    
    
    $
    8,851
 The lease abandonment charge represents future lease payments for exited data
centers and office facilities. The other exit costs represent termination
penalties for bandwidth and data connectivity contracts. These accrued
restructuring charges are reflected in the consolidated balance sheet in
Accrued expenses. During the six-month period ended February 28, 2003, the Company settled
certain data connectivity contracts obligations for amounts less than original
estimates. In connection with the settlements, the bandwidth termination costs
was reduced by $0.5 million and one of the Companys lease abandonment
liabilities was reduced by $0.2 million in connection with the reduction of the
Companys obligation due to a sublease arrangement for the facility. 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 9




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INTERLAND, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) sheet and are not included in the
restructuring reserves discussed in Note 3. The following table shows the
changes in the accrual for the six months ended February 29, 2004: EmployeeLease
    
    TerminationAbandonment
    
    Benenfits
    
    Total(in thousands)Balance at August 31, 2003
    
    $
    921
    
    
    $
    217
    
    
    $
    1,138Cash Paid
    
    
    (52
    )
    
    
    (88
    )
    
    
    (140
    )Other Adjustments
    
    
    
    
    
    
    
    
    
    
    Balance at November 30, 2003
    
    $
    869
    
    
    $
    129
    
    
    $
    998Cash Paid
    
    
    (46
    )
    
    
    (40
    )
    
    
    (86
    )Other Adjustments
    
    
    
    
    
    
    (89
    )
    
    
    (89
    )Balance at February 29, 2004
    
    $
    823
    
    
    $
    
    
    
    $
    823
 In the quarter ended February 29, 2004, the Company made payments on specific
obligations included in the business combinations liability of less than $0.1
million for rent obligations, net of sublease payments received. There was also
an adjustment of $0.1 million and a payment of less than $0.1 million for
benefits paid to specific employees. 6. CONTINGENCIES In February of 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 employee agreement and
also demands payment from Mr. Murphy under his delinquent $2.7 million
promissory notes. 273,526 shares of the Companys common stock collateralized
these notes and the receivable balance is shown on the balance sheet as a
reduction of equity. Messrs. Heitman 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. On March 14, 2003, Halo Management, LLC, filed a suit against Interland in the
U.S. District Court for the Northern District of California. The suit alleges
that Interlands use of blueHALO (U.S. Patent and Trademark Office Serial
No. 78/135,621) to describe its proprietary Web hosting architecture infringes
on the plaintiffs registered trademark Halo (U.S. Patent and Trademark Office
Serial No. 75/870,390; Registration No. 2,586,017). The suit seeks a
permanent injunction against Interlands use of its blueHALO mark and money
damages. Interland believes it has meritorious defenses, plans to continue to
defend 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 10




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INTERLAND, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 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 February 29, 2004, the Company had an aggregate amount of $1.1
million accrued for such matters. Interland has received notice from SCO Group alleging that it owns a copyright
interest in certain portions of certain versions of the Linux open-source
operating system. Media reports indicate that SCO Group has sent similar
letters to thousands of businesses and the notice Interland received contains
no allegations that are specific to Interland. Media reports also indicate
that SCO Group has claimed that portions of its Unix operating system were
incorporated into Linux by IBM. SCO Group has sued IBM and others in
connection with these claims. Interland continues to monitor the litigation
and press reports surrounding SCOs claims, and notes that many observers have
expressed skepticism over SCOs claims. Interland has made no determination as
to whether it operates any computers that utilize the versions of the Linux
operating system that contain the code in which SCO Group claims an interest.
Interland does not believe that SCOs claims will have a materially adverse
impact on the company. 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. 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. 7. SUBSEQUENT EVENTS In connection with the acquisition of CommuniTech.Net, the Company loaned
approximately $2.7 million to Mr. Gabriel Murphy, one of the two shareholders of
CommuniTech.Net, and Mr. Murphys obligation to repay the Company was
documented in two promissory notes: (a) a non-recourse promissory note in the
original principal amount of $2 million and (b) a full recourse promissory note
in the original principal amount of approximately $735,000. Both notes were to
bear interest at the rate of 5% per annum and were scheduled to mature on
February 8, 2004. Prior to maturity, Mr. Murphy was to make quarterly interest
payments on the notes. The notes were collateralized by approximately 273,500
shares of the Companys common stock. These notes were shown on the Companys
balance sheet as a reduction in shareholders equity as of February 29, 2004.
Mr. Murphy did not repay the notes upon their maturity. In March 2004, the
Company foreclosed on the collateral, and cancelled the $2.0 million
non-recourse note and the approximately 273,500 shares of common stock. The
Company continues to hold the full recourse $735,000 note. Mr. Murphys
obligations under the notes are among the amounts sought by Interland in its
lawsuit against Mr. Murphy in the Superior Court of Cobb County, Georgia
described in footnote 5 Contingencies. The accounting for this transaction is
expected to have no impact on the Companys Consolidated Statement of
Operations nor the Companys financial position. In March 2004 the Company announced a change in its approach to its mainstream
market initiative. As a result of this decision the Company has substantially
reduced the size of its Business Solutions field sales force and will be
concentrating its website and software development teams in Atlanta for greater
interaction with the rest of the Company. These actions are expected to lower
the Companys recurring operating expenses and result in
estimated severance charges recorded in the Companys third
fiscal quarter results of operations of at least $1.0 million. 11




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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 February 29, 2004, or February 28, 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 12




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INTERLAND, INC.ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS the business plan were being proven, certain aspects
of the business were not performing to the standard required to justify
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. 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. The net churn was
exacerbated during the second and third quarters of FY03 when the servers
supporting acquired customers were moved, or their content moved, to the
consolidating data centers in Atlanta and Miami. Since that time the Company
has taken and is continuing to take measures designed to reduce the amount of
gross churn, as well as to replace lost customers with new ones, and an
important measure of the Companys success is the amount of monthly net churn.
The Company has been making steady progress in reducing the amount of
net churn. During November 2003, the last month of the first fiscal quarter,
net churn was $55,000 and the three-month trailing average net churn was
$62,000. By the month of February, net churn had been reduced to $20,000, with
a three-month trailing average of $47,000. In the month of March this positive
trend continued, ending with a three-month trailing average net churn of
$26,000. (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 on page 21 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 second 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 is making substantial 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,
improving customer care management, and improving the billing process. 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. On the other hand, mastering these challenges presents the Company
with an opportunity to become the preeminent provider of websites to a
significant portion of American small businesses, a position the Company
believes would provide significant opportunity for profits. DISCONTINUED OPERATIONSPC 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 2nd quarter and first six months of fiscal 2004, the Company
recorded $0.7 million and $1.3 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 13




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INTERLAND, INC.ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS vigorously defending these claims. The Company expects to incur additional
losses from discontinued operations due to the costs of defending these claims. 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 Six-Months Ended February 29, 2004 And February 28, 2003 The loss from continuing operations decreased $12.8 million, or 57.7% and
$19.2 million, or 52.5% for the quarter and for the six months ended February
29, 2004, respectively, when compared to the same periods of the prior fiscal
year. The basic and diluted loss per share decreased $0.96 per share, or
60.8%,and $1.46, or 55.9% for the quarter and for the six months ended
February 29, 2004, respectively, when compared to the same periods of the prior
fiscal year. Revenues Total revenues decreased $0.1 million, or .3%, and $0.7 million, or 1.3%,
respectively, for the quarter and for the six months ended February 29, 2004
when compared to the same periods of the prior fiscal year. For the quarter ended
    
    For the six months endedFebruary 29,
    
    February 28,
    
    February 29,
    
    February 28,2004
    
    2003
    
    2004
    
    2003in thousandsHosting revenue
    
    $
    24,718
    
    
    $
    25,345
    
    
    $
    50,163
    
    
    $
    52,169Other revenue
    
    
    1,311
    
    
    
    769
    
    
    
    2,553
    
    
    
    1,228Total revenue
    
    $
    26,029
    
    
    $
    26,114
    
    
    $
    52,716
    
    
    $
    53,397
 Hosting revenues decreased $0.6 million, or 2.5%, and $2.0 million, or 3.9% for
the quarter and for the six months ended February 29, 2004, respectively, when
compared to the same periods of the prior fiscal year. Hosting revenues for
the six months ending February 29, 2004 include $6.5 million from the
Hostcentric acquisition that occurred in June 2004. 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. Other revenues increased $0.5 million, or 70.5%, and $1.3 million or 107.9%,
for the quarter and for the six months ended February 29, 2004, respectively,
when compared to the same period of the prior fiscal year. Other revenues are
primarily comprised of consulting, co-location, and other fees under contract.
The increase is due to the inclusion of revenues from royalty, licensing and
other fees under contracts acquired as part of the Trellix merger. As of February 29, 2004, the Company had approximately 188,000 paid shared
hosting customer accounts and managed approximately 9,900 dedicated servers,
many of which host multiple web sites, compared to approximately 181,000 paid
shared hosting customer accounts and 7,000 dedicated servers as of February 28,
2003. The slight increase in shared hosting customer accounts is primarily due
to the acquisition of Hostcentric in June 2003, offset by net customer churn
during the year. The increase in dedicated servers is attributable to the
Companys acquisition of Hostcentric and improved sales and customer churn
performance. OPERATING COSTS AND EXPENSES 14




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INTERLAND, INC.ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Network Operating Costs Network operating costs decreased 28.1% from $9.8 million to $7.1 million for
the quarter ended and 26.1% from $19.2 million to $14.2 million for the
six months ended February 29, 2004. The decrease in network operating costs in
these periods is primarily related to the data center consolidation, which was
a critical part of the Companys restructuring and integration initiative in
fiscal 2003, which were completed in June 2003. This initiative accounted for
a $2.6 million reduction in bandwidth connectivity costs when comparing the
quarter ended February 29, 2004 to the same period for the prior year. Sales and Marketing Sales and marketing expenses increased 29.8% to $6.5 million and 18.9% to $11.7
million for the quarter and for the six months ended February 29, 2004,
respectively, from $5.0 million and $9.9 million in the same periods of the
prior year. The Companys sales and marketing expenses as a percentage of
revenues was 25.1% and 22.3% for the quarter and for the six months ended
February 29, 2004, respectively, as compared to 19.3% and 18.5% in the same
periods of the prior fiscal year. The increase in sales and marketing expenses
in the quarter ended February 29, 2004 when compared to the same period in the
prior year is primarily due to an increase in marketing expenditures of $0.5
million and an increase in salaries and contract labor of $0.7 million
primarily resulting from the expansion of the Companys mainstream market
initiatives. The increase in the six months ended February 29, 2004 when
compared to the same period of the prior year is primarily due to an increase
in marketing expenditures of $0.6 million and an increase in salaries and
contract labor of $0.9 million. The Company is scaling back on the incremental
expenses related to the mainstream marketing initiative that began the third
quarter of fiscal year 2003. For the remainder of fiscal year 2004, the
Companys expects to have a lower level of marketing expenditures and reduced
payroll expenses related to a reduction in force primarily focused on the scale
back of the mainstream initiative. Technical Support Technical support expenses increased 22.9% to $4.6 million for the quarter
ended February 29, 2004 and 25.6% to $9.4 million from $3.8 million and $7.5
million in the same periods of the prior year. The Companys technical support
expenses as a percentage of net revenues was 17.8% and 17.9% for the quarter
and for the six months ended February 29, 2004, respectively, as compared to
14.5% and 14.1% in the same periods of the prior fiscal year. The Company
enhanced its technical support efforts to improve customer services resulting
in a $0.6 million increase in contract labor and salaries and a $0.3 million
increase in allocated occupancy costs for the quarter ended February 29, 2004
when compared to the same period of the prior year. The comparison of the
six months ended February 29, 2004 reflects a $1.2 million increase in contract
labor and salaries and a $0.5 million increase in allocated occupancy costs
when compared to the same period in the prior year. General and Administrative General and administrative expenses decreased 24.9% to $7.9 million and 21.1%
to $16.0 million for the quarter and for the six months ended February 29,
2004, respectively, from $10.5 million and $20.3 million in the same periods of
the prior year. As a percentage of revenues, the Companys general and
administrative expenses was 30.2% and 30.3% for the quarter and for the
six months ended February 29, 2004, respectively, as compared to 40.0% and
37.9% in the same periods of the prior year. The primary factors causing the
quarterly decrease in general and administrative expenses were a $2.2 million
decrease in salaries and benefits associated with the reduction of headcount
compared to prior year, a decrease of $0.3 million in legal fees, and a
decrease of $0.3 million in allocated occupancy costs due to the consolidation
of office spaces. The decrease in the comparative six month periods was
primarily due to a $3.3 million decrease in salaries and benefits, a $1.2
million decrease in professional and technical fees, and a $0.3 million
decrease in allocated occupancy costs. Bad Debt Expense Bad debt expense decreased 47.2% to $.9 million and 45.8% to $2.1 million for
the quarter and for the six months ended February 29, 2004, respectively, from
$1.8 million and $3.8 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. Depreciation and Amortization 15




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INTERLAND, INC.ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Depreciation and amortization expenses decreased 37.6% to $8.2 million and
35.3% to $16.4 million, for the quarter and for the six months ended February
29, 2004, respectively, from $13.2 million and $25.4 million in the same
periods of the prior year. The Companys depreciation and amortization
expenses as a percentage of revenues was 31.7% and 31.2% for the quarter and
for the six months ended February 29, 2004, respectively, as compared to 50.6%
and 47.6% in the same periods of the prior year. During the third quarter of
fiscal 2003, management used the expected 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 second quarter of fiscal 2004 was substantially lower than the second
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 second quarter ended February 29, 2004 was lower
than the same period of the prior year. Restructuring Costs Restructuring costs were zero for the quarter and for the six months ended
February 29, 2004 from $3.7 million and $3.4 million in the same periods of the
prior year. There have been no additional restructuring activities during this
fiscal year. Merger and Integration Costs During the Companys fiscal quarter and for the six months ended February 29,
2004 no merger and integration expenses were incurred. During the quarter
ended February 28, 2003, the Company recorded $0.4 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. Interest Income (Expense), net Interest income (expense), net decreased to $(0.2) million and to $(0.3)
million, respectively, for the quarter and for the six months ended February
29, 2004 from $(0.1) and $0.2 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: 16




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INTERLAND, INC.ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS For the three months ended
    
    For the six months endedFebruary 29,
    
    February 28,
    
    February 29,
    
    February 28,2004
    
    2003
    
    2004
    
    2003in thousands
    
    in thousandsNet loss
    
    $
    (10,100
    )
    
    $
    (22,423
    )
    
    $
    (18,652
    )
    
    $
    (36,835
    )Depreciation and amortization
    
    
    8,241
    
    
    
    13,215
    
    
    
    16,422
    
    
    
    25,395Interest expense (income)
    
    
    166
    
    
    
    50
    
    
    
    304
    
    
    
    (151
    )Discontinued operations
    
    
    739
    
    
    
    281
    
    
    
    1,321
    
    
    
    315EBITDA from continuing operations
    
    $
    (954
    )
    
    $
    (8,877
    )
    
    $
    (605
    )
    
    $
    (11,276
    )Interest income / (expense)
    
    
    (166
    )
    
    
    (50
    )
    
    
    (304
    )
    
    
    151Provision for bad debts
    
    
    935
    
    
    
    1,770
    
    
    
    2,066
    
    
    
    3,816Loss on the sale of assets
    
    
    (48
    )
    
    
    
    
    
    
    (70
    )
    
    
    Other non-cash adjustments
    
    
    375
    
    
    
    859
    
    
    
    548
    
    
    
    1,099Changes in assets and liabilities:Income tax recoverable
    
    
    
    
    
    
    778
    
    
    
    
    
    
    
    778Receivables, net
    
    
    (633
    )
    
    
    1,152
    
    
    
    (1,231
    )
    
    
    (1,538
    )Other current assets
    
    
    176
    
    
    
    (682
    )
    
    
    540
    
    
    
    (343
    )Accounts payable, accrued expenses, and deferred revenue
    
    
    (4,421
    )
    
    
    (5,475
    )
    
    
    (7,880
    )
    
    
    (8,237
    )Net cash provided by (used in) operating activities
    
    $
    (4,736
    )
    
    $
    (10,525
    )
    
    $
    (6,936
    )
    
    $
    (15,550
    )
 For the quarter ended and for
the six months ended February 29, 2004, the
Companys EBITDA increased $7.9 million and $10.7 million, respectively,
resulting in an EBITDA loss of $1.0 million and $0.6 million compared to the
same periods of the prior fiscal year. 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. Liquidity and Capital Resources As of February 29, 2004, the Company had $36.9 million in cash and cash
equivalents as noted on the Companys consolidated balance sheet and statement
of cash flows. In addition, the Company had $2.0 million in short-term
investments and $11.4 million in short and long-term restricted investments
representing a total of $50.3 million of restricted and unrestricted cash and
investments. This represents a decrease of $19.9 million compared to August
31, 2003. Of the $11.4 million in restricted investments, $5.0 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 $8.6 million or 55.4% to $6.9 million
for the six months
ended February 29, 2004 versus the $15.5 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 $3.3 million or 17.2% to $16.0
million for the six months ended February 29, 2004 versus $19.4 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 $8.3 million or
57.5% to $6.1 million for the six months ended February 29, 2004 versus the
$14.4 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 less than $0.1 million or 0.5% for the
six months ended February 29, 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 17




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INTERLAND, INC.ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Bancorp Oliver-Allen Technology Leasing for the repurchase amount. As of February 29,
2004, the principal balance on the promissory note was $4.8 million. The
Company has pledged $5.0 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 original sale-leaseback agreement required payments of $361,000 each month
with an end-of-lease buyout amount in July 2004 of approximately $2.9 million.
The new promissory note requires monthly payments of $93,000 over the next five
years. The Company anticipates making capital expenditures of approximately $12.7
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 six months of fiscal 2004, the Company expended $5.5
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. Although we expect our overall
cash flow, including cash payments of accrued liabilities, to remain negative
for at least the next three quarters 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. Stock Repurchase Program In March 2003, the board of directors authorized a stock repurchase program to
acquire outstanding common stock. Under the program, up to $10.0 million of
common stock could be reacquired over the next year. Since its announcement of
the authorization of a share purchase program by its board of directors, the
Company utilized $1.0 million to buy back shares of its outstanding stock.
There were no stock repurchases in the quarter ended February 29, 2004. 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 meet
the requirements for consideration 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 February 29,
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; 18




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INTERLAND, INC.ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS  
    
    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. 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, CRM systems, and billing modules;
    
    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 19




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INTERLAND, INC.ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 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 February 29, 2004, the high and low closing price for
Interland common stock on NASDAQ was $12.50 and $3.88, 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. For the quarter ended February 29, 2004, Interlands average
monthly revenue per customer account was $26.66 for shared hosting services and
$313.23 for dedicated hosting services, and its average monthly customer
turnover was 3.7% for shared hosting services and 5.3% for dedicated hosting
services. The corresponding average monthly revenue per customer for the
quarter ended February 28, 2003 was $27.24 for shared hosting services and
$421.15 for dedicated hosting services, and the associated average monthly
customer turnover rates were 6.0% for shared hosting services and 5.6% 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 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. The Company has been
committing substantial resources to this initiative. 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. Even if the Company
is successful in these efforts, the Company anticipates that the continued
testing and future introduction of the new line will contribute net losses and
negative cash flow from continuing operations through at least the fiscal year 2004 while the Company
completes the implementation of the new services and achieves a sufficient
volume of business to cover the additional fixed costs. Although the Company
has announced that it is 20




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INTERLAND, INC. ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS reducing its level of investment in this initiative, such reduction is expected
to be only temporary, and financial results during this period of retrenchment
will not necessarily be indicative of future performance when 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 presents 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
indemnification. For the six months ended February 29, 2004, the Company
incurred $1.3 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, 21




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INTERLAND, INC. ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS  
    
    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. 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. 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 22




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INTERLAND, INC. ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS 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 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. 23




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INTERLAND, INC. ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS 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 the Company has not fully evaluated the
effects of the Can SPAM Act, and 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 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. Resolving remaining weaknesses in disclosure and internal controls could
require more time than anticipated, distract managements attention from
Interlands ongoing operations, or prove to be more costly than expected. Interland disclosed in its Form 10-K for the fiscal year ending August 31, 2002
that it had material weaknesses in its internal and disclosure controls and
procedures. In Part I  Item 4 of this Form 10-Q, the Company reports
significant progress in most areas. In addition, management believes that its
use of alternative mitigating disclosure and reporting processes have
been sufficient to provide it with a good faith belief that there are no
material inaccuracies or omissions from its most recent SEC filings. However,
management recognizes that further improvements in its disclosure and internal
controls and procedures are appropriate. The implementation of these remaining
improvements will be time consuming and expensive. In this regard management
is unable to estimate the financial impact of:  
    
    A delay in the implementation of remaining necessary internal and disclosure control improvements; 24




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INTERLAND, INC. ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS  
    
    The effects of managements distraction caused by the implementation of the procedural improvements; and,  
    
    The ongoing cost inefficiencies caused by employment of mitigating controls and procedures necessary to address the
remaining existing weaknesses in disclosure and internal controls pending completion of the requisite improvements. Furthermore, uncertainty over these factors and the delay in
implementation may cause additional volatility in Interlands stock price. 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. Interland carries substantial intangible assets on its Balance Sheet that could
result in a significant impairment charge. As of February 29, 2004, the Company has goodwill and intangible assets of
$66.5 million and $20.6 million respectively on the balance sheet. In
accordance with the requirements of SFAS 142 Goodwill and Other Intangible
Assets, the Company tests for goodwill 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.
Any impairment will affect the financial results in the future.
Interland does its annual assessment on May 31. The market price of the
Companys stock has experienced significant volatility during the last fiscal
year. If the price of the Companys stock stays at its current levels such that
the market capitalization is less than the recorded book value, the annual
goodwill impairment test will result in a significant impairment loss. 25




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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 February 29,
2004, approximately 97.0% of the Companys liquid investments mature within
three months and 100% mature within one year. As of February 29, 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
February 29, 2004, the Companys investment portfolio included fixed rate
securities with an estimated fair value of $40.9 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 at February 29, 2004 was
$0.8 million. 
 ITEM 4. CONTROLS AND PROCEDURES The Companys 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 15(d), which became effective August 29, 2002) as of
February 29, 2004. Based on this review, the chief executive officer, chief
financial officer, and chief accounting officer concluded that Interlands
disclosure controls and procedures concerning the Companys revenue cycle
continue to require further improvement. Internal and Disclosure Controls The Companys internal and disclosure controls and procedures are necessarily
interdependent. During the course of the fiscal 2002 year-end close and
subsequent audit, the Companys management and its auditors identified several
matters related to internal controls that needed to be addressed. Several of
these matters were classified by the auditors as material weaknesses or
reportable conditions in accordance with the standards of the American
Institute of Certified Public Accountants then in effect. During fiscal 2003
management addressed the identified issues with emphasis on the Companys
revenue cycle, including associated revenue recognition policies and
receivables valuation. As a result of these efforts the Company has eliminated
the material weaknesses previously identified, and the current state of
internal and disclosure controls are sufficient to give reasonable assurance
that the financial statements are correct in all material respects.
Nonetheless, the Company recognizes that its current processes continue to rely
upon manual reviews and processes to ensure that neither human error nor system
weakness has resulted in erroneous reporting of financial data. Discussed below are the remaining specific disclosures and internal control
weaknesses existing in the revenue cycle as identified by management, and the
Companys corresponding mitigating procedures and corrective actions as
implemented through April 14, 2004. The Company does not have an efficient system for monitoring accounts
receivable and related credit memo and write-off activity. The Companys
internally developed billing system (MAARS/OASIS) is not integrated into the
Companys general ledger system. Accordingly, discrepancies can arise between
the accounts receivable sub-ledger (per the billing system) and the general
ledger. In order to promptly identify and reconcile these discrepancies, the
Company has designed and programmed a number of database exception reports.
Each entry on an exception report must be manually investigated to identify,
understand, and correct as necessary specific anomalies. Designated personnel
from both the Accounting and Information Technology departments review the
reconciliations in order to design and implement changes to processes with a
view to correcting the root cause of the discrepancies. Further procedural actions that have been employed to properly report
receivable balances and corresponding revenue recognition include:  
    
    All unresolved balances that were older than 90 days were written off
(except in a few specific instances where the balance was deemed
collectible); 26




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
    
    Virtually all shared hosting accounts that age past 60 days and
dedicated accounts past 75 days have their service de-provisioned and
are put into a write-off queue; (the Company pursues collection of all
past-due accounts, even after the balance is written off).  
    
    Generally the Company ceases future revenue recognition for customers
from whom there exists unpaid invoices more than 30 days past due.
Hosting services are also suspended until the invoices are paid at which
point revenue recognition is resumed.  
    
    The Company also maintains a balance in the allowance for doubtful
accounts to cover the following specific percentages of the accounts
receivable aging categories: 7.4% of the 0-60 day balance (which is
periodically adjusted to reflect actual historical experience), and 100%
of all balances more than 60 days old. The Company has continued to modify the programming of the billing system to
provide additional functionality and reporting capabilities. Central to the
correction of previously identified material weaknesses was the creation and
use of a detailed transaction log which may be queried on an ad-hoc basis as a
check on system output. Interland is committed to ongoing periodic reviews of its controls and their
effectiveness. Controls are improving and management has no reason to believe
that the financial statements included in this report are not fairly stated in
all material respects. However, additional problems could be identified in the
future. Management expects to continue to improve controls with each passing
quarter. Management believes its practices and procedures, although not as mature or as
formal as management intends them to be in the future, are adequate under the
circumstances, and that there are no material inaccuracies or omissions in this
Form 10-Q. In connection with the evaluation pursuant to Exchange Act Rule 13a-15(d) of
the companys internal controls over financial reporting (as defined in
Exchange Act Rule 13a-15(f)) by the companys management, including its chief
executive officer and chief financial officer, no changes during the quarter
ended February 29, 2004 were identified that have materially affected, or are
reasonably likely to materially affect, the companys internal controls over
financial reporting. 27




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INTERLAND, INC. 
 PART II.  OTHER INFORMATION 
 ITEM 1. LEGAL PROCEEDINGS In February of 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 employee agreement and
also demands payment from Mr. Murphy under his delinquent $2.7 million
promissory notes. 273,526 shares of the Companys common stock collateralized
these notes and the receivable balance is shown on the balance sheet as a
reduction of equity. Messrs. Heitman 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. On March 14, 2003, Halo Management, LLC, filed a suit against Interland in the
U.S. District Court for the Northern District of California. The suit alleges
that Interlands use of blueHALO (U.S. Patent and Trademark Office Serial No.
78/135,621) to describe its proprietary Web hosting architecture infringes on
the plaintiffs registered trademark Halo (U.S. Patent and Trademark Office
Serial No. 75/870,390; Registration No. 2,586,017). The suit seeks a
permanent injunction against Interlands use of its blueHALO mark and money
damages. Interland believes it has meritorious defenses, plans to continue to
defend 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 February
29, 2004, the Company had an aggregate amount of $1.1 million accrued for such
matters. Interland has received notice from SCO Group alleging that it owns a copyright
interest in certain portions of certain versions of the Linux open-source
operating system. Media reports indicate that SCO Group has sent similar
letters to thousands of businesses and the notice Interland received contains
no allegations that are specific to Interland. Media reports also indicate
that SCO Group has claimed that portions of its Unix operating system were
incorporated into Linux by IBM. SCO Group has sued IBM and others in
connection with these claims. Interland continues to monitor the litigation
and press surrounding SCOs claims, and notes that many observers have
expressed skepticism over SCOs claims. Interland has made no determination as
to whether it operates any computers that utilize the versions of the Linux
operating system that contain the code in which SCO Group claims an interest.
As such, Interland does not believe that SCOs claims will have a materially
adverse impact on the company. 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. 28




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INTERLAND, INC. 
 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).10.117
    
    Promissory Note in the principal amount of $4,780,475 dated February
11, 2004 in favor or U.S. Bancorp Oliver-Allen Technology Leasing.10.118 (1)
    
    Hosting Provider Program Agreement dated February 24, 2004 between
INTERLAND, INC. and Red Hat, Inc.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 December 22, 2003, the Company filed a Form 8-K regarding its
financial results for the fiscal quarter ended November 30, 2003.   (1)
    
    The Company has requested confidential treatment for portions of this
exhibit pursuant to Rule 24b-2 of the Securities Exchange Act of 1934. 29




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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: April 14, 2004
    
    /s / Allen L. ShulmanAllen L. ShulmanSenior Vice President, Chief Financial
Officer,and Executive Counsel(Principal Financial Officer)
 30