<PAGE>

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

                                   FORM 10-Q

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

               For the quarterly period ended December 31, 2000

                                      OR

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

                 For the transition period from _____ to _____

                          Commission File No. 0-27801

                            DATA RETURN CORPORATION
            (Exact name of registrant as specified in its charter)

             Texas                                          75-2725998
 (State or other jurisdiction of                         (I.R.S. Employer
  incorporation or organization)                        Identification No.)

                        222 West Las Colinas Boulevard
                                   Suite 450
                              Irving, Texas 75039
                  (Address, including zip code, of principal
                              executive offices)

                                (972) 869-0770
                  (Registrant's telephone number, including
                                  area code)

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.

                             YES  X       NO ____
                                 ---

The registrant had 35,918,581 shares of Common Stock, par value $.001 per share,
outstanding as of December 31, 2000.

                                       1
<PAGE>

PART I - FINANCIAL INFORMATION

Item 1.   Condensed Financial Statements                                   Page
                                                                           ----

          Condensed Balance Sheets at March 31, 2000 and
            December 31, 2000 (Unaudited)                                     3

          Condensed Statements of Operations for the three and nine
            months ended December 31, 1999 and 2000 (Unaudited)               4

          Condensed Statements of Cash Flows for the nine months
            ended December 31, 1999 and 2000 (Unaudited)                      5

          Notes to Condensed Financial Statements (Unaudited)                 6

Item 2.   Management's Discussion and Analysis of Financial Condition
          and Results of Operations                                           8

          Risk Factors                                                       14

Item 3.   Quantitative and Qualitative Disclosures About Market Risk         25

PART II - OTHER INFORMATION

Item 6.   Exhibits and Reports on Form 8-K                                   26

          Signatures                                                         27

                                       2
<PAGE>

                            Data Return Corporation
                           Condensed Balance Sheets
                     (in thousands, except per share data)

<TABLE>
<CAPTION>
                                                                      March 31,       December 31,
                                                                         2000             2000
                                                                     ----------------------------
                                                                                      (Unaudited)
<S>                                                                  <C>              <C>
Assets
Current assets:
   Cash                                                               $ 85,424          $  9,103
   Investment in marketable securities                                       -            23,711
   Accounts receivable, net of allowance for doubtful accounts
     of $328 and $1,539 at March 31, 2000 and December 31, 2000,
     respectively                                                        5,429             9,355
   Prepaid and other                                                     1,349             2,718
                                                                      --------          --------
Total current assets                                                    92,202            44,887

   Investment in marketable securities                                       -             9,740
   Property and equipment, net                                          22,027            46,083
   Other assets                                                            628             1,089
                                                                      --------          --------
Total assets                                                          $114,857          $101,799
                                                                      ========          ========

Liabilities and shareholders' equity
Current liabilities:
   Accounts payable                                                   $  2,021          $  3,523
   Accrued expenses and other                                            2,205             2,682
   Deferred revenue                                                      2,207             4,667
   Notes payable and capital lease obligations - current                 5,799            11,622
                                                                      --------          --------
Total current liabilities                                               12,232            22,494

Notes payable and capital lease obligations - long term                 11,324            21,275
Commitments and contingencies                                              -                 -
Shareholders' equity:
   Preferred stock, $.001 par value; 20,000 shares
     authorized, none issued or outstanding                                -                 -
   Common stock, $.001 par value; 100,000 shares
     authorized; 35,398 and 35,919 issued and outstanding
     at March 31, and December 31, 2000, respectively                       35                36
   Additional paid-in capital                                          109,718           110,353
   Pre-paid broadband services                                          (5,000)           (5,000)
   Deferred stock compensation                                            (290)             (141)
   Accumulated deficit including comprehensive earnings                (13,162)          (47,218)
                                                                      --------          --------
Total shareholders' equity                                              91,301            58,030
                                                                      --------          --------
Total liabilities and shareholders' equity                            $114,857          $101,799
                                                                      ========          ========
</TABLE>


           See accompanying notes to Condensed Financial Statements.

                                       3
<PAGE>

                            Data Return Corporation
                      Condensed Statements of Operations
                     (in thousands, except per share data)
                                   Unaudited

<TABLE>
<CAPTION>
                                                        Three Months Ended                  Nine Months Ended
                                                            December 31,                       December 31,
                                                    ---------------------------        ----------------------------
                                                       1999             2000              1999             2000
                                                    ---------        ----------        ----------        ----------
<S>                                                 <C>              <C>               <C>               <C>
Revenues                                            $   3,414        $   14,063        $    6,367        $   35,682

Costs and expenses:
   Cost of revenue                                      3,090            12,781             4,861            33,317
   General and administrative                           1,921             6,511             3,944            16,497
   Marketing and sales                                  1,854             6,292             3,306            17,939
   Product research & development                         166             1,537               232             3,422
   Stock- based compensation                            1,230                25             1,527               150
                                                    ---------        ----------        ----------        ----------
Total costs and expenses                                8,261            27,146            13,870            71,325
                                                    ---------        ----------        ----------        ----------

Loss from operations                                   (4,847)          (13,083)           (7,503)          (35,643)

Other income (expense):
   Interest income                                        892               818             1,003             3,133
   Interest expense                                       (78)             (790)              (90)           (1,776)
                                                    ---------        ----------        ----------        ----------
Net Loss                                            $  (4,033)       $  (13,055)       $   (6,590)       $  (34,286)
                                                    =========        ==========        ==========        ==========

Net loss per common share:

   Basic and diluted                                $   (0.12)       $    (0.36)       $    (0.24)       $    (0.96)
                                                    =========        ==========        ==========        ==========
</TABLE>


           See accompanying notes to Condensed Financial Statements.

                                       4
<PAGE>

                            Data Return Corporation
                      Condensed Statements of Operations
                     (in thousands, except per share data)
                                   Unaudited

<TABLE>
<CAPTION>
                                                                                Nine Months Ended December 31,
                                                                               --------------------------------
                                                                                  1999                  2000
                                                                               ----------            ----------
<S>                                                                            <C>                   <C>
Operating activities:
Net loss                                                                       $   (6,590)           $  (34,286)

Adjustments to reconcile net loss to net cash provided
     by (used in) operations:
   Noncash items included in net loss:
     Depreciation and amortization                                                    912                10,689
     Stock based compensation expense                                               1,527                   149
     Provision for bad debts                                                          234                 2,052
   Changes in assets and liabilities
     Accounts receivable                                                           (2,522)               (5,978)
     Prepaids and other assets                                                     (1,409)                 (651)
     Accounts payable and accrued expenses                                          2,330                 1,979
     Deferred revenue                                                                 867                 2,460
                                                                               ----------            ----------
Net cash provided by (used in) operating activities                                (4,651)              (23,586)

Investing Activities:
     Capital expenditures                                                          (3,311)              (12,935)
     Sale of marketable securities                                                      -               (33,451)
     Restricted cash                                                                  125                     -
                                                                               ----------            ----------
Net cash used in investing activities                                              (3,186)              (46,386)

Financing activities:
     Payments on notes payable and capital lease obligations                          (12)               (6,567)
     Net proceeds from issuance of stock                                           99,787                   218
                                                                               ----------            ----------
Net cash provided by (used in) financing activities                                99,775                (6,349)
                                                                               ----------            ----------

Net increase (decrease) in cash                                                    91,938               (76,321)

     Beginning cash                                                                   843                85,424
                                                                               ----------            ----------
     Ending cash                                                               $   92,781            $    9,103
                                                                               ==========            ==========
</TABLE>

                                       5
<PAGE>

1. Organization and Basis of Presentation

Organization

     Data Return Corporation (the "Company") was incorporated in August 1997
under the laws of the State of Texas and commenced operations on September 22,
1997 (inception). The Company primarily provides advanced Microsoft Internet
hosting services to businesses, web site developers, application service
providers, and other organizations seeking to outsource the deployment,
maintenance and support of their web sites. The Company's services include
providing, configuring, operating and maintaining the hardware, software and
network technologies necessary to implement and support these web sites.

     The Company's advanced Microsoft hosting services enable its customers to
establish and maintain e-commerce and other applications through which they can
conduct transactions and manage information on a worldwide basis over the
Internet.

     The Company's customer serving computer equipment, principally servers, is
primarily located in separate facilities owned by one of its vendors. The vendor
provides data center facilities and bandwidth connectivity to the Company on a
contractual basis.

Basis of Presentation

     The accompanying unaudited condensed financial statements have been
prepared in accordance with generally accepted accounting principles for interim
financial information and with the instructions to Form 10-Q and Article 10 of
Regulation S-X.  Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all adjustments (consisting
of normal recurring accruals) necessary to present fairly the information set
forth therein have been included. Operating results for the three- and nine-
month periods ended December 31, 2000 are not necessarily an indication of the
results that may be expected for the year ending March 31, 2001.

     The balance sheet at March 31, 2000 has been derived from the audited
financial statements at that date but does not include all of the information
and footnotes required by generally accepted accounting principles for complete
financial statements.

     The accompanying condensed financial statements should be read in
conjunction with the audited financial statements and footnotes included in the
Company's Annual Report on Form 10-K for the Year Ended March 31, 2000.

2. Net Loss Per Share

     Basic and diluted net loss per share is computed using the weighted average
number of shares of common stock outstanding during each period.  Common stock
equivalents are not considered in the calculation of diluted net loss per share
as the Company has incurred a loss for all periods presented and the effect of
common stock equivalents would be anti-dilutive.   Thus, 8,871,662 employee
stock options and 345,910 warrants to acquire shares of common stock are not
included in this calculation.

3. Recent Accounting Pronouncements

     In December 1999, the Securities and Exchange Commission (SEC) issued Staff
Accounting Bulletin No. 101 (SAB 101), Revenue Recognition, which summarizes
some of the staff's views in applying generally accepted accounting principles
to revenue recognition in financial statements. In June 2000, the SEC changed
the effective date of SAB 101 to require adoption of SAB 101 by the fourth
quarter of the first fiscal year beginning after December 15, 1999. As a result
the Company will adopt the new guidance as a change in accounting principle
beginning January 1, 2001. The Company will change its method of recognizing
revenue on set up fees to defer the revenue and recognize it over the initial
term of the contracts with its customers, generally one year. The change in
accounting method will be accounted for as a cumulative effect adjustment, which
will result in (a) the financial information for the quarters of fiscal 2001
prior to adoption of SAB 101 being restated and (b) the cumulative effect

                                       6
<PAGE>

adjustment being reflected in the first quarter of the year of adoption of SAB
101. As a result of the cumulative effect adjustment, which totals approximately
$1.7 million, revenue that has previously been recognized in the Company's
financial statements will be amortized to income in financial reporting periods
subsequent to the period of adoption of SAB 101. Had the Company adopted SAB 101
as of April 1, 2000, the effect on revenue in this quarter would not have been
material.

4. Investments

     The Company has classified all of its debt securities as available-for-
sale. Available-for-sale securities are carried at fair value, with unrealized
gains and losses reported as a separate component of shareholders' equity net of
applicable income taxes. Realized gains and losses and declines in value judged
to be other-than-temporary on available-for-sale securities are included in
other income. The cost basis for realized gains and losses on available-for-sale
securities is determined on a specific identification basis.

     As of December 31, 2000, the Company owned approximately $33.5 million of
debt securities with maturity dates in fiscal years 2001 and 2002.  As
available-for-sale securities, the $33.5 million of debt securities is carried
on the Company's books at fair value.  The Company has an unrealized gain of
$231,000, an increase of $113,000 from September 30, 2000, on its available-for-
sale securities which is recorded as other comprehensive income in shareholders'
equity.

5. Property and Equipment

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

<TABLE>
<CAPTION>
                                                     March 31, 2000   December 31, 2000
                                                     --------------   -----------------
<S>                                                  <C>              <C>
Electronics and computer equipment................       $20,910           $ 42,962
Computer software.................................         1,397              3,539
Furniture and office equipment....................           792              4,594
Leasehold improvements............................           586              5,284
Other depreciable assets..........................           520              2,122
                                                         -------           --------
                                                          24,205             58,501
Less accumulated depreciation and amortization....        (2,178)           (12,418)
                                                         -------           --------
                                                         $22,027           $ 46,083
                                                         =======           ========
</TABLE>

     Property and equipment includes assets acquired under capital leases,
principally computer equipment with a cost of $17,232,000 at March 31, 2000 and
$38,592,000 at December 31, 2000, respectively.  Related allowances for
depreciation and amortization are $1,121,000 and $8,445,000 respectively.

6. Accrued Expenses

     Accrued expenses consist of the following (in thousands):

<TABLE>
<CAPTION>
                                                  March 31, 2000   December 31, 2000
                                                  --------------   -----------------
<S>                                               <C>              <C>
Professional fees.....................                 $  157            $  152
Accrued payroll.......................                  1,013             1,487
Commissions...........................                    184               190
Other.................................                    851               853
                                                       ------            ------
                                                       $2,205            $2,682
                                                       ======            ======
</TABLE>

                                       7
<PAGE>

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

     The following discussion of the financial condition and results of
operations of Data Return should be read in conjunction with the condensed
financial statements and the related notes thereto included elsewhere in this
Form 10-Q and the Data Return Annual Report on Form 10-K for the year ended
March 31, 2000.

Forward-Looking Statements

     The statements contained in this report that are not historical facts are
"forward-looking statements" (as such term is defined in Section 27A of the
Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934).
Forward-looking statements are typically identified by the use of terms such as
"may," "will," "expect," "intend," "anticipate," "estimate" and similar words,
or by discussions of strategy that involve risks and uncertainties, although
some forward-looking statements are expressed differently. You should be aware
that our actual results could differ materially from those contained in the
forward-looking statements due to a number of factors, including without
limitation, changes in external competitive market factors, changes in our
business strategy or an inability to execute our strategy, changes in the
hosting industry, changes in the economy in general and changes in the use of
the Internet and the viability of Internet-based businesses.  We cannot
guarantee future results, levels of activity, performance or achievements. Our
actual results could differ materially from those anticipated in  forward-
looking statements as a result of certain factors, including those set forth in
the section of this report entitled "Risk Factors." Readers are cautioned not to
place undue reliance on any forward-looking statements contained in this report.
All written and oral forward-looking statements made in connection with this
report that are attributable to us or persons acting on our behalf are expressly
qualified in their entirety by the "Risk Factors" and other cautionary
statements included herein. We disclaim any obligation to update information
contained in any forward-looking statement. We undertake no obligation to
publish the results of any adjustments to these forward-looking statements that
may be made to reflect events on or after the date of this report or to reflect
the occurrence of unexpected events.

Overview

     Data Return provides advanced Internet hosting services based on Microsoft
technologies. We provide these services to businesses seeking to outsource the
deployment, maintenance and support of their complex web sites. Our services
include providing, configuring, operating and maintaining the hardware, software
and network technologies necessary to implement and support these web sites.

     Our business is rapidly evolving, and we have a limited operating history.
As a result, we believe that period-to-period comparisons of our revenue and
operating results, including our cost of revenue and other operating expenses as
a percentage of total revenue, may not be meaningful and should not be relied
upon as indicators of future performance. We do not believe that our historical
growth rates, particularly the high rates of growth we experienced in previous
quarters, are indicative of future results.

     Currently, we derive substantially all of our revenue from advanced hosting
and managed services. Historically, we have also derived a nominal amount of
revenue from technical reviews and the resale of software and other products.
Currently, most of our advanced hosting and managed services revenues are
generated from recurring monthly fees. Substantially all of the remainder is
derived from one-time set-up fees for installation and from sales of services,
such as time and materials billing and certain lab or consulting services.
Revenues are billed on a monthly basis and are recognized as the service is
performed.

     Our expenses are comprised of:

     .  cost of revenue, which consists primarily of compensation and related
        expenses for technical operations, broadband services expenses, space in
        data centers and depreciation of equipment;

     .  general and administrative, which consists primarily of compensation and
        related expenses and occupancy costs;

                                       8
<PAGE>

     .  marketing and sales, which consists primarily of compensation and
        related expenses, advertising expenses and occupancy costs;

     .  product research and development, which consists primarily of
        compensation and related expenses and facilities costs; and

     .  stock-based compensation, which relates to employee stock options
        granted at prices less than fair value.

     We have incurred significant losses since our inception and, as of December
31, 2000, had an accumulated deficit of approximately $47.2 million.  We intend
to invest heavily in marketing and sales and the continued development of our
network infrastructure and technology.  We expect to continue to expand our
operations and workforce, primarily in the sales and marketing areas.  In
particular, we intend to continue to expand our existing inside and outside
sales forces to develop new sales channels and relationships.  We will also
continue to expand our network operations, technical support, product research
and development and administrative resources.  We expect to continue to incur
substantial losses for the foreseeable future.  We may not be able to
successfully execute our expansion plans.

Results of Operations

Comparison of quarters ended December 31, 1999 and 2000

Revenues

     Our revenues increased $10,649,000 to $14,063,000 for the quarter ended
December 31, 2000 from $3,414,000 for the quarter ending December 31, 1999. The
increase was primarily due to the addition of new customers that generated
higher average monthly revenues. Growth from some existing customer accounts
also contributed.

Cost of revenue

     Our cost of revenue increased $9,691,000 to $12,781,000, or 90.9% of
revenue, for the quarter ended December 31, 2000 from $3,090,000, or 90.5% of
revenue, for the quarter ended December 31, 1999. The increase in cost of
revenue was due primarily to increases in personnel and related costs,
depreciation and communication and bandwidth expenses. Personnel and related
expenses increased approximately $3,860,000 to $5,648,000, or 40.2% of revenue,
for the quarter ended December 31, 2000 from $1,788,000, or 52.4% of revenue,
for the quarter ended December 31, 1999, as we increased our systems and
customer support personnel to 257 at December 31, 2000 from 139 at December 31,
1999. Depreciation expense increased approximately $2,960,000 to $3,479,000 for
the quarter ended December 31, 2000, as we added approximately $32.5 million in
computer and related equipment since December 31, 1999. Our communication and
bandwidth expenses increased $2,201,000 to approximately $2,614,000 for the
quarter ended December 31, 2000 from $413,000 for the quarter ended December 31,
1999 to support our increased business activities. We expect our cost of revenue
to continue to increase as our overall business grows.

General and administrative

     General and administrative expense increased $4,590,000 to $6,511,000, or
46.3% of revenue, during the quarter ended December 31, 2000 from $1,921,000, or
56.3% of revenue, during the quarter ended December 31, 1999.  The increase is
primarily due to increases in personnel and related expenses, facilities
expense, depreciation, bad debt and professional services. Personnel and related
expenses increased $1,760,000 to $2,828,000, or 20.1% of revenue, for the
quarter ended December 31, 2000 from $1,068,000, or 31.3% of revenue, for the
quarter ended December 31, 1999. We increased our number of employees in general
and administrative functions to 119 employees at December 31, 2000 from 40
employees at December 31, 1999.  Facilities expense increased $623,000 as a
result of our move into a larger facility and the growth in general and
administrative employees.  Depreciation expense increased $470,000 in the
quarter ended December 31, 2000, which is a result of increased internal
equipment necessary to support the growth of our business.  Bad debt expense
increased $1,181,000 as many of our

                                       9
<PAGE>

customers, particularly Internet-based businesses, ceased operations or reduced
or eliminated the web site operations hosted by us. We expect our financial
results, including bad debt expense, to continue to be negatively impacted by
the termination or reduction in service from these businesses. Professional
services fees increased approximately $215,000 to $324,000 for the quarter ended
December 31, 2000 from $109,000 in the comparable period in 1999.

Marketing and sales

     Marketing and sales expense increased $4,438,000 to $6,292,000, or 44.7% of
revenue, during the quarter ended December 31, 2000 from $1,854,000, or 54.3% of
revenue, during the quarter ended December 31, 1999. The increase was due
primarily to an increase in marketing and sales personnel and related expenses,
advertising costs, including agency fees, trade shows and promotional items,
travel expenses, depreciation expenses, and facilities expenses.  Personnel and
related expenses increased $2,061,000 to $3,605,000, or 25.6% of revenue, for
the quarter ended December 31, 2000 from $1,544,000, or 45.2% of revenue, for
the quarter ended December 31, 1999. Advertising costs increased $1,420,000 to
$1,561,000 for the quarter ended December 31, 2000 from $141,000 for the quarter
ended December 31, 1999. Costs in this category include expenses for
advertising, promotional items, trade shows, and fees paid to advertising,
public relations and other creative agencies.  Travel expenses increased
$366,000 for the quarter ended December 31, 2000 as a result of the growth in
marketing and sales personnel. Depreciation and facilities expenses increased
$226,000 and $183,000, respectively, for the quarter ended December 31, 2000 due
to our move into a larger facility. We increased our marketing and sales
personnel to 111 at December 31, 2000 from 40 at December 31, 1999.

Product research and development

     Product research and development expense increased $1,371,000 to
$1,537,000, or 10.9% of revenue, during the quarter ended December 31, 2000 from
$166,000, or 4.9% of revenue, during the quarter ended December 31, 1999.  The
increase was due primarily to an increase in product research and development
personnel and related expenses and facilities costs.  Personnel and related
expenses increased $1,117,000 to $1,265,000, or 9.0% of revenue for the quarter
ended December 31, 2000 from $148,000, or 4.3% of revenue, for the quarter ended
December 31, 1999.  We increased our number of employees in product research and
development to 54 at December 31, 2000 from 10 at December 31, 1999.  Facilities
costs increased $100,000 for the quarter ended December 31, 2000 as a result of
our move into a larger facility and the increase in the number of product
research and development employees.

Stock-based compensation

     Deferred stock compensation was recorded in connection with the grant of
employee stock options below fair value. Amortization of stock-based
compensation totaled $25,000 for the quarter ended December 31, 2000 and
$1,230,000 for the quarter ended December 31, 1999. The amortization of stock-
based compensation is based on the vesting schedule of stock options held by our
employees.

Other income (expense)

     Other income (expense) consists primarily of interest income on our cash
balances and investments in marketable securities and interest expense on our
outstanding notes payable and capital lease obligations. Interest earned on our
cash and cash equivalents decreased $74,000 to $818,000 for the quarter ended
December 31, 2000 from $892,000 for the quarter ended December 31, 1999. This
decrease was due primarily to having lower cash balances for investments as cash
has been used to fund operating losses. During the quarter ended December 31,
2000, interest expense and other charges increased $712,000 to $790,000 related
primarily to equipment acquired under capital leases during the last four
quarters. Without other charges, interest expense increased $724,000 to $802,000
for the quarter ended December 31, 2000.

Income taxes

     No provision for federal income taxes has been recorded as we have incurred
net operating losses since our inception. We have recorded a valuation allowance
against all of our net deferred tax asset, which is primarily attributable to
net operating loss carry forwards, due to uncertainty that we will generate
sufficient taxable income during the carry forward period to realize the benefit
of our net deferred tax asset.

                                       10
<PAGE>

Net loss

     Net loss increased $9,022,000 to $13,055,000 for the quarter ended December
31, 2000 from $4,033,000 for the quarter ended December 31, 1999. As more fully
discussed above, the increased net loss is primarily attributable to increased
costs as we continued to build our business for anticipated growth.

EBITDA

     EBITDA, as defined below, decreased $5,627,000 to negative $8,601,000 for
the quarter ended December 31, 2000 from negative $2,974,000 for the quarter
ended December 31, 1999.  The decrease is primarily attributable to costs
associated with our growth strategy. We expect to generate negative EBITDA for
fiscal 2002. Costs associated with our investments in marketing and sales, the
continued development of our network infrastructure and technology and
expansions of our operations and workforce, including our network operations,
technical support, sales, marketing, product research and development and
administrative resources, will continue to represent a large portion of our
expenses during our anticipated expansion.

     EBITDA for the quarters ended December 31, 1999 and 2000 consists of loss
from operations of $4,847,000 and $13,083,000 plus depreciation and amortization
of $643,000 and $4,457,000 and amortization of unearned stock-based compensation
of $1,230,000 and $25,000, respectively. EBITDA does not represent funds
available for management's discretionary use and is not intended to represent
cash flow from operations as measured under generally accepted accounting
principles. EBITDA should not be considered as an alternative to net loss or net
cash used in operating activities, but may be useful to investors as an
indication of operating performance. This caption excludes components that are
significant in understanding and assessing the results of operations and cash
flows. In addition, EBITDA is not a term defined by generally accepted
accounting principles and, as a result, our calculations of EBITDA may not be
consistent with calculations of EBITDA used by others. However, we believe that
EBITDA is relevant and useful information that is often reported and widely used
by analysts, investors and other interested parties in the advanced hosting
industry. Accordingly, we are disclosing this information to permit a more
comprehensive analysis of our operating performance, as an additional meaningful
measure of performance and liquidity and to provide additional information with
respect to our ability to meet future working capital requirements.

Comparison of nine-month periods ended December 31, 1999 and 2000

Revenues

     Our revenues increased $29,315,000 to $35,682,000 for the nine-month period
ended December 31, 2000 from $6,367,000 for the nine-month period ended
December 31, 1999. The increase was primarily due to the addition of new
customers that generated higher average monthly revenues. Growth from some
existing customer accounts also contributed to the increase in revenues.

Cost of revenue

     Our cost of revenue increased $28,456,000 to $33,317,000, or 93.4% of
revenue, for the nine-month period ended December 31, 2000 from $4,861,000, or
76.3% of revenue, for the nine-month period ended December 31, 1999. The
increase in cost of revenue was due primarily to increases in personnel and
related costs, depreciation, and communication and bandwidth expenses. Personnel
and related expenses increased approximately $13,050,000 to $15,697,000, or
44.0% of revenue, for the nine-month period ended December 31, 2000 from
$2,647,000, or 41.6% of revenue, for the nine-month period ended December 31,
1999, as we increased our systems and customer support personnel to 257 at
December 31, 2000 from 149 at December 31, 1999. Depreciation expense increased
approximately $7,766,000 to $8,499,000 for the nine-month period ended December
31, 2000 as we added approximately $32.5 million in computer and related
equipment since December 31, 1999. Our communication and bandwidth expenses
increased $5,144,000 to approximately $5,933,000 for the nine-month period ended
December 31, 2000 from $789,000 for the nine-month period ended December 31,
1999 to support our increased business activities.  The remainder of the
increase in cost of revenue for the nine months ended December 31, 2000 from the
nine months ended December 31, 1999 equals approximately $2,496,000 and includes
increases related to facilities

                                       11
<PAGE>

expense, equipment costs, travel, and professional services. We expect our cost
of revenue to continue to increase as our overall business grows.

General and administrative

     General and administrative expense increased $12,553,000 to $16,497,000, or
46.2% of revenue, during the nine-month period ended December 31, 2000 from
$3,944,000, or 61.9% of revenue, during the nine-month period ended December 31,
1999. The increase is primarily due to increases in personnel and related
expenses, professional services, facilities and insurance expense, depreciation,
bad debt and travel. Personnel and related expenses increased $6,122,000 to
$8,353,000, or 23.4% of revenue, for the nine-month period ended December 31,
2000 from $2,231,000, or 35.0% of revenue, for the nine-month period ended
December 31, 1999. We increased our number of employees in general and
administrative functions to 119 employees at December 31, 2000 from 40 employees
at December 31, 1999.  Professional services increased approximately $1,100,000
to $1,337,000 for the nine-month period ended December 31, 2000 from $237,000 in
the comparable period in 1999.  Facilities and insurance expense increased
$1,337,000 and $351,000, respectively, as a result of our move into a larger
facility in August 1999 and the growth in general and administrative employees.
Depreciation expense increased $1,125,000 in the nine-month period ended
December 31, 2000, which is a result of increased internal equipment necessary
to support the growth of our business.  Bad debt expense increased $1,761,000 as
many of our customers, particularly Internet-based business, ceased operations
or reduced or eliminated the web site operations hosted by us and as our
customer base and revenues continued to grow. We expect our financial results,
including bad debt expense, to continue to be negatively impacted by the
termination or reduction in service from these businesses. Travel expenses
increased approximately $114,000 to $429,000, or 1.2% of revenue, for the nine-
month period ended December 31, 2000 from $315,1000, or 4.9% of revenue, for the
nine-month period ended December 31, 1999.

Marketing and sales

     Marketing and sales expense increased $14,633,000 to $17,939,000, or 50.3%
of revenue, during the nine-month period ended December 31, 2000 from
$3,306,000, or 51.9% of revenue, during the nine-month period ended December 31,
1999. The increase was due primarily to an increase in marketing and sales
personnel and related expenses and advertising costs, including agency fees,
trade shows and promotional items and travel and facilities expenses.  Personnel
and related expenses increased $8,505,000 to $11,039,000, or 30.9% of revenue,
for the nine-month period ended December 31, 2000 from $2,534,000, or 39.8% of
revenue, for the nine-month period ended December 31, 1999. Advertising costs
increased $3,780,000 to $4,318,000 for the nine-month period ended December 31,
2000 from $538,000 for the nine-month period ended December 31, 1999.
Advertising costs include expenses for advertising, promotional items, trade
shows, and fees paid to advertising, public relations and other creative
agencies, and printing. Travel expenses increased $1,160,000 for the quarter
ended December 31, 2000 as a result of the growth in the marketing and sales
personnel. Facilities and depreciation expenses increased $524,000 and $387,000,
respectively, for the quarter ended December 31, 2000,due to our move into a
larger facility.  We increased our marketing and sales personnel to 111 at
December 31, 2000 from 40 at December 31, 1999.

Product research and development

     Product research and development expense increased $3,190,000 to
$3,422,000, or 9.6% of revenue, during the nine-month period ended December 31,
2000 from $232,000, or 3.6% of revenue, during the nine-month period ended
December 31, 1999. The increase was due primarily to an increase in product
research and development personnel and related expenses, facilities and travel
expenses. Personnel and related expenses increased $2,597,000 to $2,811,000, or
7.9% of revenue for the nine-month period ended December 31, 2000 from $214,000,
or 3.4% of revenue, for the nine-month period ended December 31, 1999. We
increased our number of employees in product research and development personnel
to 54 at December 31, 2000 from 10 at December 31, 1999. Facilities and travel
expense increased $241,000 and $78,000 respectively, for the nine-month period
ended December 31, 2000 as a result of our move into a larger facility and an
increase in the number of product research and development personnel.

Stock-based compensation

     Deferred stock compensation was recorded in connection with the grant of
employee stock options below

                                       12
<PAGE>

fair value. Amortization of stock-based compensation totaled $150,000 for the
nine-month period ended December 31, 2000 and $1,527,000 for the nine-month
period ended December 31, 1999. The amortization of stock-based compensation is
based on the vesting schedule of stock options held by our employees.

Other income (expense)

     Other income (expense) consists primarily of interest income on our cash
balances and investments in marketable securities and interest expense on our
outstanding notes payable and capital lease obligations. Interest earned on our
cash and cash equivalents increased $2,130,000 to $3,133,000 for the nine-month
period ended December 31, 2000 from $1,003,000 for the nine-month period ended
December 31, 1999. This increase was due primarily to the closing of our initial
public offering in October 1999, which resulted in larger cash balances
available for investment. During the nine-month period ended December 31, 2000,
interest expense and other charges increased $1,686,000 to $1,776,000 related
primarily to equipment acquired under capital leases during the last four
quarters. Without other charges, interest expense increased $1,701,000 to
$1,791,000 for the nine-month period ended December 31, 2000.

Income taxes

     No provision for federal income taxes has been recorded as we have incurred
net operating losses since our inception. We have recorded a valuation allowance
against all of our net deferred tax asset, which is primarily attributable to
net operating loss carry forwards, due to uncertainty that we will generate
sufficient taxable income during the carry forward period to realize the benefit
of our net deferred tax asset.

Net loss

     Net loss increased $27,696,000 to $34,286,000 for the nine-month period
ended December 31, 2000 from $6,590,000 for the nine-month period ended December
31, 1999. As more fully discussed above, the increased net loss is primarily
attributable to increased costs as we continued to build our business for
anticipated growth.

EBITDA

     EBITDA, as defined above, decreased $19,740,000 to negative $24,804,000 for
the nine-month period ended December 31, 2000 from negative $5,064,000 for the
nine-month period ended December 31, 1999. The decrease is primarily
attributable to costs associated with our growth strategy.  Costs associated
with our investments in marketing and sales, the continued development of our
network infrastructure and technology and expansions of our operations and
workforce, including our network operations, technical support, sales,
marketing, product research and development and administrative resources, will
continue to represent a large portion of our expenses during our anticipated
expansion.  EBITDA for the nine-month periods ended December 31, 1999 and 2000
consists of loss from operations of $7,503,000 and $35,643,000 plus depreciation
and amortization of $912,000 and $10,689,000 and amortization of unearned stock-
based compensation of $1,527,000 and $150,000, respectively.

Liquidity and Capital Resources

     We have historically financed our operations primarily through sales of
equity securities and capital leases. Since our inception, we have raised $15.9
million through private placements of our common stock. In November 1999, we
raised $85.9 million in net proceeds from our initial public offering. As of
December 31, 2000, we had cash and cash equivalents of $9.1 million and
investments in marketable securities of $33.5 million.

     Net cash used in our operating activities for the nine-month period ended
December 31, 2000 was $23.6 million. The net cash used in operations was
comprised primarily of working capital requirements and our net loss, net of
depreciation and amortization. Net cash used in investing activities was $46.4
million for the nine-month period ended December 31, 2000 and consisted of the
investments in marketable debt securities of  $33.5 million and purchases of
property and equipment of approximately $13.0 million. Our purchases of property
and equipment consisted primarily of leasehold improvements, equipment to
provide services to our customers and purchases of furniture and equipment for
new employees. We acquired $21.4 million in computer and related equipment under
capital leases for the nine-month period ended December 31, 2000.  Net cash used
in financing activities was approximately $6.3 million for the nine-month period
ended December 31, 2000 and consisted primarily of principal

                                       13
<PAGE>

payments on our notes payable and capital leases.

     Total borrowings under our notes payable and capital lease obligations as
of December 31, 2000 were approximately $32.9 million.

     To help manage short-term liquidity needs without disrupting our investment
strategies, in December 1999 we entered into a revolving credit facility with
Bank One, Texas, N.A. This credit facility matures on July 31, 2001 and
outstanding balances accrue interest at the bank's base rate. We may borrow up
to $2.0 million under the credit facility but have not borrowed any amounts to
date. The facility is secured by all of our equipment that was unencumbered on
the date we entered into the facility and all accounts receivable outstanding
from time to time. Under certain limited circumstances, we could be required to
deposit cash with the bank to secure the loan. The credit facility contains
standard events of default and other covenants.

     We believe that our current cash and investment balances should be
sufficient to meet our working capital and capital expenditure requirements
through December 31, 2001.  Under our agreement with Level 3 Communications,
Inc., which we entered into in July 1999, we are required to purchase at least
an additional $8.6 million of bandwidth and colocation services over the next
four years.  Our quarterly commitment is $300,000 per quarter through July 2001,
$400,000 per quarter during the next 12 months, $600,000 per quarter during the
next 12 months and $1.0 million per quarter during the final 12 months of the
agreement. We anticipate that further expansion of our operations will cause us
to continue to incur negative cash flows and, therefore, require us to use our
cash and other liquid resources to support our growth. Our operating and
investing activities on a long-term basis may require us to obtain additional
equity or debt financing. We have no present understandings, commitments or
agreements with respect to any acquisition of other businesses, products,
services or technologies. However, we may evaluate potential acquisitions of
other businesses, products and technologies from time to time. In order to
consummate potential acquisitions, we may need additional equity or debt
financings in the future.

Recent Accounting Pronouncements

     In December 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 101 (SAB 101), Revenue Recognition, which summarizes
some of the SEC staff's views in applying generally accepted accounting
principles to revenue recognition in financial statements. In June 2000, the SEC
changed the effective date of SAB 101 to require adoption of SAB 101 by the
fourth quarter of the first fiscal year beginning after December 15, 1999. As a
result, we will adopt the new guidance as a change in accounting principle
effective January 1, 2001. We will change our method of recognizing revenue on
set up fees to defer the revenue and recognize it over the initial term of the
contracts with our customers, generally one year. The change in accounting
method will be accounted for as a cumulative effect adjustment, which will
result in (a) the financial information for the quarters of fiscal 2001 prior to
adoption of SAB 101 being restated and (b) the cumulative effect adjustment
being reflected in the first quarter of the year of adoption of SAB 101. As a
result of the cumulative effect adjustment, which totals approximately $1.7
million, revenue that has previously been recognized in our financial statements
will be amortized to income in financial reporting periods subsequent to the
period of adoption of SAB 101. Had the company adopted SAB 101 as of April 1,
2000, the effect on revenue in this quarter would not have been material.

Risk Factors

     The risks and uncertainties described below are not the only risks we face.
Additional risks and uncertainties not presently known to us or that are
currently deemed immaterial may also impair our business operations. If any of
the following risks actually occur, our financial condition and operating
results could be materially adversely affected.

Our business and prospects are difficult to evaluate because we have a limited
operating history and our business model is still evolving.

     We were incorporated in August 1997 and commenced operations in September
of that year with a focus on advanced hosting services. As a result, we have a
limited operating history and our business model is evolving. We may not be able
to successfully implement our business plan or adapt it to changes in the
market. If we are not able to do so, our business, results of operations and
financial condition will be adversely affected.

                                       14
<PAGE>

We have a history of substantial losses, and we anticipate continuing and
increasing losses.

     We have experienced operating losses and negative cash flows from
operations in each quarterly and annual period since incorporating in 1997. We
experienced net losses of approximately $13.1 million, or negative 92.8% of
revenues, for the quarter ended December 31, 2000. As of December 31, 2000, we
had an accumulated deficit of approximately $47.2 million. We expect our
operating expenses to increase significantly as we attempt to expand our
business. We are required to purchase $300,000 of colocation and bandwidth
services from Level 3 during the last quarter of fiscal 2001 and an additional
$1.5 million during fiscal 2002. We anticipate increased expenses as we continue
to expand and improve our infrastructure, introduce new services, develop our
distribution channel, fund research and development, support and improve our
operational and financial systems, broaden customer service and support, enhance
our hosting and managed services capabilities, expand our sales and marketing
efforts, expand internationally and pursue additional industry relationships. As
a result, we expect to incur operating losses for at least the next fiscal year.
We cannot assure you that we will ever be profitable on a quarterly or annual
basis or that, if we achieve profitability, it will be sustainable.

Our quarterly and annual results may fluctuate, resulting in fluctuations in the
price of our common stock.

     Our operating results may fluctuate significantly in the future on a
quarterly and annual basis. Because of these fluctuations, comparisons of our
operating results from period to period are not necessarily meaningful and
should not be relied upon as an indicator of future performance. We expect to
experience significant fluctuations as a result of a variety of factors, many of
which are outside of our control. The following factors could affect our
operating results:

     .    size and timing of customer installations and related payments;

     .    fluctuations in data and voice communications costs;

     .    fluctuations in hardware and software costs;

     .    timing and magnitude of capital expenditures and other expenses;

     .    costs relating to operations;

     .    customer retention and satisfaction;

     .    termination of customer contracts, some of which can be terminated on
          30 days' notice;

     .    termination or reduction of services by customers that do not have
          sufficient funding to continue their operations, either at all or at
          the level contemplated by our agreements with them;

     .    customer discounts and credits;

     .    changes in our pricing policies or those of our competitors;

     .    timing and success of marketing efforts and service introductions by
          us;

     .    economic conditions specific to the hosting industry, as well as
          general economic conditions; and

     .    timing of our recognition of set-up fees as a result of SAB 101.

We expect that our operating expenses will continue to increase as we further
develop our business. If our revenues do not increase as quickly as our
expenses, our operating results will suffer.

     For these and other reasons, in future periods our operating results may
fall below the expectations of securities analysts or investors, which could
result in widely varying stock prices and negatively affect the market price of
our common stock.

We rely on our strategic relationship with Level 3, and if this relationship is
terminated or deteriorates our

                                       15
<PAGE>

business may suffer.

     In July 1999, we entered into a strategic relationship with Level 3. Level
3 is a communications and information services company that is building an
advanced facilities-based communications network through which it provides
colocation, Internet connectivity and other services. As part of our
relationship, we have committed to purchase a fixed amount of services and
Level 3, including, among other things, bandwidth, colocation space, and
installation and maintenance services, over the next five years. We will incur
these expenses even if anticipated increases in sales do not materialize or, in
some circumstances, if the agreement is terminated. We have also agreed that if
Level 3 is capable of providing the services we request, and if those services
are substantially similar to other services that we purchase, we will purchase
75% of these services from Level 3 from July 2000 through December 2000 and 90%
of these services from Level 3 from January 2001 through June 2004. We are
required to purchase these services from Level 3 even if these services are
available at lower prices from alternative vendors. We route the network traffic
of our customers through multiple backbone providers to increase network
performance. To enable us to do this, we obtain Internet connectivity through a
number of providers, and Level 3 may not be able to provide all of the
connectivity services that we require. As a result, we may purchase less than
the applicable percentages of these services from Level 3.

     We also currently rely on Level 3 to provide substantially all of the data
center capacity that we need to provide our hosting services, and in the future
we may be required to purchase most of our data center capacity from Level 3.
Further, Level 3 may provide personnel at these data centers to install
equipment and assist with support as necessary for us to deliver service in
these facilities. If Level 3 fails to provide this data center capacity or
perform these services in a timely or effective manner, or at all, we would be
required to make alternate arrangements. If demand for colocation space
increases, Level 3 may not be able or willing to provide the data center
capacity we require to deliver our services. If our relationship with Level 3 is
terminated or if Level 3 does not provide the data center capacity that we need,
or provide it on acceptable terms, we would be required to seek arrangements
with other data center providers or construct our own data centers. We cannot be
certain that alternate data center capacity will be available on commercially
reasonable terms or at all. We currently rely, and for the foreseeable future
will continue to rely, on Level 3 to provide a substantial part of our bandwidth
and other networking services. If we were not able to obtain these services from
Level 3, we would be required to seek arrangements with other providers of these
services, and we cannot be certain that alternate services will be available on
commercially reasonable terms or at all.

Our success depends on Microsoft's continued success, and the loss or
deterioration of our relationship with Microsoft could harm our business and
have an adverse impact on our revenues.

     We focus on advanced hosting services for Microsoft-based Internet
technologies. If these technologies are not widely used building blocks for
advanced Internet sites in the future, the demand for our services would
decrease and our business would be adversely affected. The final outcome of the
antitrust case against Microsoft is uncertain, but the outcome could cause the
acceptance of Microsoft products to decrease. Except for our relationship with
Microsoft as a customer, and under the Development, License, and Co-Marketing
Agreement, our relationship with Microsoft is generally informal. We believe
this relationship provides us with access to developments in Microsoft products
before they are generally available, which allows us to maintain and enhance our
technical expertise. If our relationship with Microsoft deteriorates or if we
lose some of the status or privileges we currently enjoy, our technical
expertise could be adversely affected. Our ability to market our services as a
provider of advanced hosting services for Microsoft-based Internet technologies
would also be adversely affected if Microsoft does not continue to confer
certifications and designations on us, or changes our current certifications and
designations or ceases to be our customer. We do not have a written agreement
with Microsoft relating to all of these certifications or designations. Some of
our competitors also have received these certifications and designations.
Microsoft generally confers these certifications unilaterally and in its sole
discretion and could change them at any time. We cannot be certain that we will
continue to enjoy them.

If we are unable to expand our network infrastructure to meet increasing demand
for reliable and secure services, we could lose customers and our operating
results could suffer.

     We must continue to expand and adapt our network infrastructure to
accommodate an increasing number of customers, the amount of information they
wish to transmit and their changing requirements. We face risks related

                                       16
<PAGE>

to our network's ability to be scaled to meet increasing customer levels while
maintaining acceptable performance levels. The continued expansion and
adaptation of our networking and hosting facility infrastructure will continue
to require substantial financial, operational and management resources as we
negotiate bandwidth capacity with existing and other network infrastructure
suppliers. If we are required to expand our network significantly and rapidly
due to increased usage, additional stress will be placed upon our network
hardware, traffic management systems and hosting facilities as well as our
financial, operational and management resources. The ability of our network to
support a substantially larger number of customers at high transmission speeds
is unknown. Furthermore, it may be difficult for us to increase quickly our
network capacity in light of current lead times to purchase circuits and other
critical items. If the network providers upon which we rely fail to provide
reliability, capacity and performance for our network, we could lose customers
and our operating results could suffer.

     Our success partly depends upon the capacity, reliability and security of
our network infrastructure, including the capacity leased from our network
suppliers. Our network currently delivers service through Level 3, InterNap,
AT&T, GTE, Netcom/Mindspring, PSINet, Qwest, Verio, MCI WorldCom, Inc.,
including UUNET Technologies, Inc., Sprint Corporation, Digex, Incorporated,
Cable & Wireless plc and SAVVIS Communications Enterprises, LLC. Some of these
suppliers are also our competitors. In the future, we will be required to
purchase most of our network capacity from Level 3 to the extent that it
provides capacity that is substantially similar to the capacity of other
providers. We depend on these companies to provide uninterrupted and error-free
service through their telecommunications networks. As our customers' usage of
telecommunications capacity increases, we will need to make additional
investments in our infrastructure to maintain adequate data transmission speeds,
the availability of which may be limited or the cost of which may be
significant. We monitor all network links to prevent their being utilized in
excess of their recommended capacity. If capacity is not available to us as our
customers' usage increases, our network may not be able to achieve or maintain
sufficiently high data transmission capacity, reliability or performance. In
addition, our business would suffer if our network suppliers increased the
prices for their services and we were unable to pass along any increased costs
to our customers. Any failure on our part or the part of our third-party
suppliers to achieve or maintain high data transmission capacity, reliability or
performance could significantly reduce customer demand for our services and
damage our business.

Increased costs associated with our private transit Internet connections could
result in the loss of customers or significant increases in operating costs.

     Our private transit Internet connections are more costly than other
arrangements commonly utilized to move Internet traffic. If providers increase
the pricing associated with utilizing their bandwidth, we may be required to
identify alternative methods to distribute our customers' digital content. We
cannot assure you that our customers will continue to be willing to pay the
higher costs associated with direct private transit or that we could effectively
move to another network approach. If we are unable to access alternative
networks to distribute our customers' digital content on a cost-effective basis
or to pass any additional costs on to our customers, our operating costs would
increase significantly.

We may not be able to deliver our services and our business may suffer if our
third-party suppliers do not provide us with key components of our network
infrastructure.

     We depend on other companies to supply key components of our network
infrastructure. Any failure to obtain needed products or services in a timely
fashion or at an acceptable cost could adversely affect our business. We buy
servers, routers and switches on an as-needed basis and therefore do not carry
significant inventories of them. We also have no guaranteed supply arrangements
with our vendors. We currently only use servers from Compaq and rely on Compaq
to provide us with access to Compaq technical personnel. In July 1999, we
entered into an agreement with Compaq under which we agreed during the
immediately following three years to purchase from Compaq the lesser of 2,000
servers or the number of servers reasonably necessary to adequately operate our
business consistent with our business plan. Through December 31, 2000, we had
purchased approximately 1,600 servers from Compaq under this agreement. Our
requirement to purchase these servers is contingent upon Compaq providing
financing for the servers on competitive terms, upon the price, performance and
quality of the Compaq servers being reasonably satisfactory to us and upon
Compaq's commitment to deliver these servers on the schedule we request. In
addition, we rely on Cisco Systems, Inc. and others to supply equipment critical
to our network, but we do not have a supply agreement with any of them. If this
equipment were to become unavailable on terms acceptable to us, we would be
forced to find alternative equipment. The inability to obtain equipment or
technical

                                       17
<PAGE>

services from Compaq, Cisco or others on terms acceptable to us would force us
to spend time and money selecting and obtaining new equipment, training our
personnel to use different equipment and deploying alternative components needed
to integrate the new equipment, and as a result our business could be adversely
affected. In addition, if our sole or limited source suppliers do not provide
products or components that comply with evolving Internet and telecommunications
standards or that interoperate with other products or components we use, our
business would be harmed. For example, we have experienced performance problems,
including previously unknown software and firmware bugs, with routers and
switches that have caused disruptions in and impairment of network performance.

Because we operate in a new and evolving market with uncertain prospects for
growth, we may be unable to sustain growth in our customer base and our
operating results may suffer.

     Our market is new and rapidly evolving. Growth in demand for and acceptance
of advanced hosting services are highly uncertain. Businesses may not be aware
of the potential benefits of outsourcing or may find it cheaper, more secure or
otherwise preferable to host their web sites internally. Internet technologies,
such as e-commerce applications, which require advanced hosting, may not grow as
rapidly as we expect. If the market for advanced hosting services fails to grow
or grows more slowly than we anticipate, our business, operating results and
financial condition will be adversely affected. Growth in the demand for our
products and services may be inhibited, and we may be unable to sustain growth
in our customer base for a number of reasons, including:

  .  our inability to market our products and services in a cost-effective
     manner to new customers;

  .  the inability of customers to differentiate the products and services we
     offer from those of our competitors;

  .  our inability to strengthen awareness of our brand; and

  .  reliability, quality or compatibility problems with our services.

Our customer base includes a significant number of businesses that currently
face increasing difficulty in obtaining funding to support their operations.

     Many of our customers are businesses; including Internet-based businesses,
that have traditionally been initially funded by venture capital firms and then
through public securities offerings. Funding alternatives for these businesses
have become more limited than in the past.  Many of these customers have ceased
or reduced their operations, and it is has become increasingly difficult for us
to collect revenues from these businesses.  If the market for technology and
Internet based businesses is not supported by the private and public investors
who have funded these customers, we face the risk that these customers may
cease, curtail or limit web site operations hosted by us. If this continues to
occur, we could experience a loss of revenue associated with these customers and
will then have to increase sales to other businesses using the Internet in order
to preserve and grow our revenue.   If we are successful in increasing sales to
other businesses, we will incur the expenses associated with these new
customers, such as sales and marketing expenses, including commissions, and
implementation costs.  As a result, to preserve and grow our revenue, we will
have to increase sales by substantially more than the amount of lost revenue.

We may not be able to adapt to evolving technologies and customer demands, which
could cause our business to suffer.

     Our market is characterized by rapidly changing technology, evolving
industry standards and frequent new product announcements. These characteristics
are magnified by the growth of the Internet and the intense competition in our
industry. We are also subject to risks from technological changes in the way
hosting solutions are marketed and delivered. To be successful, we must adapt to
our rapidly changing market by continually improving the performance, features
and reliability of our services and modifying our business strategies
accordingly. We could also incur substantial costs if we need to modify our
services or infrastructure in order to adapt to these changes. In addition, our
internal costs to provide service to our customers could be adversely affected.
Our business would suffer if we fail to respond to these changes in a timely and
cost-effective manner or at all. Our business will suffer if Internet usage does
not continue to increase or if the Internet fails to perform reliably.

                                       18
<PAGE>

Our ability to successfully market our services could be substantially impaired
if we are unable to deploy new Internet technologies or service offerings or if
new Internet technologies or service offerings deployed by us prove to be
unreliable, defective or incompatible.

     We cannot assure you that we will not experience difficulties that could
delay or prevent the successful development, introduction or marketing of
Internet technologies in the future. If any newly introduced Internet
technologies or our service offerings suffer from reliability, quality or
compatibility problems, market acceptance of our services could be greatly
hindered and our ability to attract new customers could be adversely affected.
We cannot assure you that new applications or services deployed by us will be
free from any reliability, quality or compatibility problems. If we incur
increased costs or are unable, for technical or other reasons, to offer and
deploy new Internet technologies or enhancements of existing technologies, our
ability to successfully market our services could be substantially impaired.

Our business will not grow unless Internet usage grows and Internet performance
remains adequate.

     Use of the Internet for retrieving, sharing and transferring information
among businesses, consumers, suppliers and partners has increased rapidly. Our
success depends in large part on continued growth in the use of the Internet. In
addition, our business plan anticipates significant growth in the web site
hosting and application hosting markets. The growth of the Internet, including
the web site hosting and application hosting markets, is subject to a high level
of uncertainty and Internet usage and growth may be inhibited for a number of
reasons, such as:

  .  inadequate network infrastructure;

  .  security concerns, including viruses and denial of service attacks;

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

  .  inconsistent quality of service;

  .  the inability of Internet-based businesses to develop and maintain
     successful business models;

  .  failure of Internet-based businesses;

  .  lack of availability of cost-effective, reliable, high-speed service; and

  .  failure of Internet use to expand internationally.

     If Internet usage grows, the Internet infrastructure may not be able to
support the demands placed on it by this growth, or its performance and
reliability may decline. For example, web sites have experienced interruptions
in service as a result of outages and other delays occurring throughout the
Internet network infrastructure. If these outages or delays occur frequently,
use of the Internet as a commercial or business medium could in the future grow
more slowly or decline, which would adversely affect our business.

Failure of our operating and financial systems to keep pace with the anticipated
growth in our business could result in customer dissatisfaction, operating
inefficiencies and lost revenue opportunities.

     The rapid growth of our business and our service offerings has placed, and
is likely to continue to place, a significant strain on our operating and
financial resources. Our future performance will partly depend on our ability to
manage our growth effectively, which will require that we further develop our
operating and financial system capabilities and controls. If our information
systems and other infrastructure, including customer service and support, are
unable to support the demands placed on them by the rapid growth in our
business, we may be forced to implement new systems. If we fail to improve our
operational systems or to expand our customer service capabilities to keep pace
with the growth of our business, we could experience customer dissatisfaction,
cost inefficiencies and lost revenue opportunities, which could harm our
operating results. We may not be able to successfully implement

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<PAGE>

these systems when needed or they may not perform reliably.

We may not be able to successfully sustain our growth if we are unable to retain
and attract highly skilled personnel.

     We have experienced rapid growth and intend to continue to expand our
operations. Since incorporating in August 1997, we have grown to 541 employees
at December 31, 2000. If we do not succeed in retaining and attracting qualified
personnel, including our current personnel, our business could suffer. We must
expand our direct and indirect sales operations to increase market awareness of
our products and generate increased revenues. We cannot be certain that we will
be successful in these efforts. Newly-hired employees will require training and
it will take time for them to achieve full productivity. Our business requires
individuals with significant levels of Internet expertise, in particular to win
consumer confidence in outsourcing the hosting and management of mission-
critical applications. Competition for such personnel is intense, and qualified
technical personnel are likely to remain a limited resource for the foreseeable
future. Locating candidates with the appropriate qualifications, particularly in
the desired geographic location, can be costly and difficult. We may not be able
to hire enough qualified individuals in the future, newly-hired employees may
not achieve necessary levels of productivity and we may need to provide higher
compensation to such personnel than we currently anticipate. If any of these
events occurs, our operations and financial results could be adversely affected.

We may need additional capital to fund our operations and finance our growth,
and we may not be able to obtain it on terms acceptable to us or at all.

     We believe that our existing capital resources, including the remaining
proceeds from our initial public offering in October 1999 and the amounts
available under our capital lease facilities, will enable us to maintain our
current operations through December 31, 2001.  However, we may require
additional funds during or after that period. In particular, if we expand our
existing business plan to focus on growth in international markets or in other
ways, we would likely require additional funding. If adequate funds were not
available or were not available on acceptable terms, our ability to respond to
competitive pressures would be significantly limited. Any required financing may
not be available or may be available only on terms that are not favorable to us.
Further, if additional funds are raised through the issuance of additional
equity securities, the percentage ownership of our shareholders would be
diluted. Any new equity securities may have rights, preferences or privileges
senior to those of our common stock.

We could experience system failures that could harm our business and reputation.

     To succeed, we must be able to operate our network management
infrastructure without interruption. Our operations depend upon our ability to
protect our network infrastructure, equipment and customer files against damage
from human error, fire, earthquakes, hurricanes, floods, power loss,
telecommunications failures, intrusion (including hackers), sabotage,
intentional acts of vandalism and similar events. Our servers and network
infrastructure are located primarily in the Dallas/Ft. Worth, Texas metropolitan
area. We are continuing to develop a comprehensive disaster recovery plan and
the occurrence of a natural disaster or other unanticipated problems at any of
the our data centers from which we provide services could result in
interruptions in the services we provide to our customers.

     Although we have attempted to build redundancy into our network and hosting
infrastructure, we have experienced interruptions in service in the past. We
have experienced partial system failures due to routing problems, hard drive
failures, database corruption and other computer failures. Our network is
subject to various points of failure, and a problem with our routers, switches
or other equipment could cause an interruption in the services we provide to
some or all of our customers. Any future interruptions could:

  .  cause customers or end users to seek damages or service credits for losses
     incurred;

  .  require us to replace existing equipment or add redundant facilities;

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<PAGE>

  .  damage our reputation for reliable service;

  .  cause existing customers to cancel their contracts; or

  .  make it more difficult for us to attract new customers.

Any of these results could damage our business.

     We also often provide our customers with service level agreements. If we do
not meet the required service levels, we may have to provide credits to our
customers, which could significantly reduce our revenues. Additionally, in the
event of any resulting harm to customers, we could be held liable for damages.
Awards for such damages might exceed our liability insurance by an unknown but
significant amount and could seriously harm our business.

Disruption of our services caused by unknown software defects could harm our
business and reputation.

     Our service offerings depend on complex software, including software
licensed from third parties and our proprietary software tools. Complex software
often contains defects, particularly when first introduced or when new versions
are released. We may not discover software defects that affect our new or
current services or enhancements until after they are deployed. These defects
could cause service interruptions or performance issues, which could damage our
reputation or increase our service costs, cause us to lose revenue, delay market
acceptance or divert our development resources.

Our business and reputation will suffer if we do not prevent security breaches.

     Unauthorized access, computer viruses, denial of service attacks,
accidents, misconduct resulting in disruptions and other disruptions could
occur. In addition, we may incur significant costs to prevent breaches in
security or to alleviate problems caused by breaches. We work with Level 3 and
other colocation vendors to protect our equipment and hardware against breaches
in physical security and with other vendors of software and hardware to protect
other breaches in security. We cannot be certain that they will provide adequate
security. We have experienced and may in the future experience delays or
interruptions in service as a result of the accidental or intentional actions of
Internet users, current and former employees of Data Return or others.
Furthermore, inappropriate use of the network by third parties could also
jeopardize the security of confidential information, such as customer and Data
Return passwords as well as credit card and bank account numbers, stored in our
computer systems or those of our customers. As a result, we could become liable
to others and lose existing or potential customers. The costs required to
eliminate computer viruses and alleviate other security problems could be
prohibitively expensive. In addition, the efforts to address these problems
could result in interruptions, delays or cessation of service to our customers.

Providing services to customers with mission-critical web sites and web-based
applications could potentially expose us to lawsuits for customers' lost profits
or other damages.

     Because our hosting services are critical to many of our customers'
businesses, any significant interruption in our services could result in lost
profits or other indirect or consequential damages to our customers. Although
many of our contracts disclaim our liability for any such damages, a customer
could still bring a lawsuit against us 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 us. There can be no
assurance a court would enforce any limitations on our liability, and the
outcome of any lawsuit would depend on the specific facts of the case and legal
and policy considerations. We could also have meritorious defenses to any such
claims, but there can be no assurance we would prevail. In such cases, we could
be liable for substantial damage awards. Such damage awards might exceed our
liability insurance by unknown but significant amounts, which would seriously
harm our business.

Our limited ability or failure to protect our intellectual property may
adversely affect our ability to compete.

     Third parties may infringe or misappropriate our technology or proprietary
rights, which could have an adverse effect on our business, results of
operations or financial condition. In addition, our competitors or potential

                                       21
<PAGE>

competitors may independently develop technologies that are equivalent or
superior to our technology. We rely on a combination of copyright, trademark,
service mark and trade secret laws to protect our intellectual property. We have
filed federal registrations for the mark "Data Return" and other marks. We also
have internally developed software and other tools that are important to our
business for which we rely on copyright protection. We have entered into
contractual arrangements with some of our employees and contractors as well as
suppliers, distributors and some of our customers in order to limit access to,
and any disclosure of, our proprietary information. The steps we have taken to
protect our intellectual property may be insufficient. We may need to take legal
action to protect our intellectual property rights, which could be costly and
divert the attention of our technical and management personnel.

We may be accused of infringing the proprietary rights of others, which could
subject us to costly and time-consuming litigation.

     In addition to the technologies we develop or have developed, we license
certain technologies from third parties and may license additional technologies
in the future. We could become subject to infringement actions based upon our
internally developed technologies or technologies licensed from third parties.
Any of these claims, with or without merit, could subject us to costly
litigation and divert the attention of our technical and management personnel.
In addition, third parties may change the terms of their license agreements in
ways that would prevent us from using technologies licensed from them on
commercially reasonable terms or that would prevent us from using them at all.
We may not be able to replace those technologies with technologies that have the
same features or functionality on commercially reasonable terms or at all.

Regulatory and legal uncertainties could result in significant costs or
otherwise harm our business.

     The success of our business depends on the growth of the Internet. Laws and
regulations directly applicable to commerce or communications over the Internet
are becoming increasingly prevalent. However, the law of the Internet remains
largely unsettled. The adoption or modification of laws or regulations relating
to the Internet could adversely affect our business if they impose a direct cost
on us or if they curtail the growth of the Internet. If liability for materials
carried on or disseminated through their systems is imposed on service
providers, we would make efforts to implement measures to reduce our exposure to
such liability. Such measures could require us to expend substantial resources
or discontinue certain product or service offerings. In addition, increased
attention to liability issues, as a result of lawsuits, legislation and
legislative proposals, could divert management attention, result in
unanticipated expenses and harm our business. If legislation is adopted in the
U.S. or internationally that makes transacting business over the Internet, such
as e-commerce, less favorable or otherwise curtails the growth of the Internet,
our business would suffer.

We may be subject to legal claims in connection with the information
disseminated through our network which could have the effect of diverting
management's attention and require us to expend significant financial resources.

     We may face potential direct and indirect liability for claims of
defamation, negligence, copyright, patent or trademark infringement, violation
of securities laws and other claims based on the nature and content of the
materials disseminated through our network. For example, lawsuits may be brought
against us claiming that content distributed by some of our current or future
customers may be regulated or banned. In these and other instances, we may be
required to engage in protracted and expensive litigation which could have the
effect of diverting management's attention and require us to expend significant
financial resources. Our liability insurance may not cover any of these claims
or may not be adequate to protect us against all liability that may be imposed
or claimed.

     In addition, on a limited number of occasions in the past, businesses,
organizations and individuals have sent unsolicited commercial e-mails from
servers hosted at our facilities 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. We have in the past
received, and may in the future receive, letters from recipients of information
transmitted by our customers objecting to such transmission. Although we
prohibit our customers by contract from spamming, we cannot assure you that our
customers will not engage in this practice, which could subject us to claims for
damages.

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<PAGE>

The loss of key personnel including our Chairman and Chief Executive Officer or
our President and Chief Operating Officer could harm our business.

     We depend on the continued service of our key technical, sales and senior
management personnel, including Sunny C. Vanderbeck, our Chairman and Chief
Executive Officer, and Michelle R. Chambers, our President and Chief Operating
Officer. We have entered into employment agreements with Mr. Vanderbeck and Ms.
Chambers expiring in June 2002, but any of our officers or employees can quit at
any time. Losing one or more of our key employees could harm our business.

We operate in an extremely competitive market, and our business would suffer if
we are unable to compete effectively.

     The market for hosting and Internet services is highly competitive.  There
are few substantial barriers to entry to keep new competitors from entering this
market. We expect that we will face additional competition from existing
competitors and new market entrants in the future. Many of our competitors have
substantially greater financial, technical and marketing resources, larger
customer bases, longer operating histories, greater name recognition and more
established relationships in the industry than we do. As a result, some of 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;

  .  take advantage of acquisition and other opportunities more readily;

  .  devote greater resources to the marketing and sales of their services; and

  .  adopt more aggressive pricing policies.

  In addition, some of our competitors have entered and will likely continue to
enter into joint ventures or other arrangements to provide additional services
competitive with those provided by us. We believe that the market in which we
compete is likely to experience consolidation in the near future, which could
result in increased competition on price and other factors that could adversely
affect our business.

  Some of our competitors may be able to provide their customers with additional
benefits in connection with their Internet system and network management
solutions, including reduced communications costs, which could reduce the
overall costs of their services relative to ours. We may not be able to offset
the effects of any price reductions. In addition, we believe our market is
likely to consolidate in the near future, which could result in increased
competition, including price competition.

  In an effort to gain market share, some of our competitors have offered
incentives not matched by us. In addition, some of our competitors may be able
to provide customers with additional benefits that could reduce the overall
costs of their services relative to ours. We may not be able to reduce the
pricing of our services or offer incentives in response to the actions of our
competitors without an adverse impact on our business.

The market for our services in international territories is unproven, and as a
result, the revenue generated by any future international operations may not be
adequate to offset the expense of establishing and maintaining those operations.

     One component of our strategy is to expand into international markets. We
cannot assure you that we will be able to market, sell and provide our services
successfully outside the United States. We could suffer significant operating
losses if the revenue generated by any current or future operations adequate to
offset the expense of establishing and maintaining those international
operations. Our present international strategy is based upon the creation of
alliances with companies that own or operate data centers into which we intend
to place our infrastructure and to service customers. In the event that are
unable to negotiate favorable agreements with such companies, our international
strategy will be significantly impaired, curtailed or eliminated.

Because we have international customers and are beginning to operate in foreign
markets, our business may be adversely affected by foreign political and
economic conditions.

     In fiscal 2000, approximately 4.1% of our revenues were derived from our
customers located in Europe and Asia. In addition, we are beginning to operate
in London, England.  We expect that we will expand our operations in

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<PAGE>

London during 2001. Our success depends in part on expanding our customer base
internationally and our ability to successfully operate from data centers in
foreign markets. Because our international sales are denominated in U.S.
dollars, currency fluctuations may deter foreign customers from purchasing our
services. In addition, we face risks in operating and servicing customers in
foreign markets, such as:

  .  different Internet access fees;

  .  different technology standards;

  .  different privacy, censorship and service provider liability standards and
     regulations; and

  .  less protective intellectual property laws.

Any of these risks could adversely affect our ability to operate or expand
internationally, which would limit the growth of our business.

Our management will have significant flexibility in applying the proceeds from
our initial public offering and our use of proceeds may not yield a favorable
return.

     We have used and intend generally to continue to use the net proceeds from
our October 1999 initial public offering to fund our capital expenditures and
for working capital and other general corporate purposes. We may also acquire or
make investments in other businesses, products, services or technologies and, if
we do, we may not be able to make those acquisitions or investments on
commercially acceptable terms or we could have difficulty assimilating and
integrating any acquired businesses, technologies, services or products. We have
not yet determined all expected expenditures and thus cannot estimate the
amounts to be used for each specified purpose. Our management has significant
flexibility in applying the net proceeds of our initial public offering. We
cannot be certain that our use of the proceeds will yield a favorable return.

Our principal shareholders, directors and executive officers currently own
approximately 64.9% of our common stock, which may allow them to exert influence
over us or to prevent a change of control.

     Our directors and executive officers and shareholders who currently own
over 5% of our common stock collectively beneficially own approximately 64.9% of
our outstanding common stock. These shareholders would be able to exercise
significant influence over all matters requiring shareholder approval, including
the election of directors and approval of significant corporate transactions.
This concentration of ownership could also delay or prevent a change in control
of Data Return even if beneficial to our shareholders.

Some provisions of our articles, bylaws and rights plan and of Texas law could
delay or prevent a change of control, which could adversely affect our stock
price.

     Our articles of incorporation and bylaws contain provisions that could make
it more difficult for a third party to acquire us, even if doing so would be
beneficial to our shareholders. These provisions could limit the price that
investors might be willing to pay in the future for shares of our common stock.
Some of these provisions:

  .  authorize the issuance of preferred stock which can be created and issued
     by our board of directors without prior shareholder approval, commonly
     referred to as "blank check" preferred stock, with rights senior to those
     of common stock;

  .  prohibit certain shareholder actions by written consent;

  .  establish advance notice requirements for submitting nominations for
     election to our board of directors and for proposing matters that can be
     acted upon by shareholders at a meeting; and

  .  provide for a board of directors with staggered three-year terms.

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<PAGE>

We have also adopted a shareholders' rights plan that could delay, deter or
prevent a change in control of us.

     In September 1999, we adopted a shareholder rights plan. This plan entitles
our shareholders to rights to acquire additional shares of our common stock when
a third party acquires 15% of our common stock or commences or announces its
intent to commence a tender offer for at least 15% of our common stock. This
plan could delay, deter or prevent a change in control of us.

Future sales of our common stock could cause our stock price to decline.

     At December 31, 2000, 35,918,581 shares of our common stock were issued and
outstanding. We cannot be sure what effect, if any, future sales of our common
stock or the availability of shares for future sale will have on the market
price of our common stock. The market price of our common stock could drop due
to sales of a large number of shares of our common stock in the market or the
perception that these sales could occur. These factors could also make it more
difficult to raise funds through future offerings of our common stock.

Item 3.  Quantitative and Qualitative Disclosures About Market Risk.

     All our customer contracts are currently denominated in United States
dollars, and we do not currently invest in derivative financial instruments.
However, we invest our excess cash balances in cash equivalents and other
investment securities and are therefore subject to market risk related to
changes in interest rates. We believe, but cannot be certain, that the effect on
our financial position, results of operation and cash flows of any reasonably
likely changes in interest rates would not be material.

                                       25
<PAGE>

                          PART II - OTHER INFORMATION


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

(a)  Exhibits:

     None

(b)  Reports on Form 8-K:

     None


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<PAGE>

                                  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.


                                     Data Return Corporation



Dated: February 13, 2000             By: /s/ Stuart A. Walker
                                         ---------------------------------------
                                             Stuart A. Walker, Vice President
                                             Chief Financial Officer
                                             (Principal Financial & Accounting
                                             Officer & Authorized Officer)

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