Attached files
file | filename |
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EX-32 - EXHIBIT 32 - PAETEC Holding Corp. | dex32.htm |
EX-31.1 - EXHIBIT 31.1 - PAETEC Holding Corp. | dex311.htm |
EX-31.2 - EXHIBIT 31.2 - PAETEC Holding Corp. | dex312.htm |
Table of Contents
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the quarterly period ended September 30, 2009
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 number: 000-52486
PAETEC HOLDING CORP.
(Exact name of registrant as specified in its charter)
Delaware | 20-5339741 | |
(State or other jurisdiction of incorporation or organization) |
(I.R.S. Employer Identification No.) |
One PAETEC Plaza 600 Willowbrook Office Park Fairport, New York |
14450 | |
(Address of principal executive offices) | (Zip Code) |
Registrants telephone number, including area code: (585) 340-2500
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 ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨ No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act:
Large accelerated filer | ¨ | Accelerated filer | x | |||
Non-accelerated filer | ¨ (Do not check if a smaller reporting company) | Smaller reporting company | ¨ |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
The number of shares of the registrants common stock outstanding on November 2, 2009 was 145,642,230.
Table of Contents
Page | ||||
Part I. Financial Information | ||||
Item 1. | Financial Statements (unaudited) | |||
Condensed Consolidated Balance Sheets as of September 30, 2009 and December 31, 2008 | 1 | |||
Condensed Consolidated Statements of Operations and Comprehensive Loss for the three and nine months ended September 30, 2009 and 2008 | 2 | |||
Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2009 and 2008 | 3 | |||
Notes to Condensed Consolidated Financial Statements | 4 | |||
Item 2. | Managements Discussion and Analysis of Financial Condition and Results of Operations | 18 | ||
Item 3. | Quantitative and Qualitative Disclosures About Market Risk | 28 | ||
Item 4. | Controls and Procedures | 29 | ||
Part II. Other Information | ||||
Item 1. | Legal Proceedings | 30 | ||
Item 1A. | Risk Factors | 30 | ||
Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds | 30 | ||
Item 6. | Exhibits | 31 |
Table of Contents
PART I
FINANCIAL INFORMATION
Item I. | Financial Statements |
PAETEC Holding Corp. and Subsidiaries
Condensed Consolidated Balance Sheets
September 30, 2009 and December 31, 2008
(Amounts in thousands, except share and per share amounts)
(Unaudited)
September 30, 2009 |
December 31, 2008 |
|||||||
ASSETS |
||||||||
Current assets: |
||||||||
Cash and cash equivalents |
$ | 141,529 | $ | 164,528 | ||||
Accounts receivable, net of allowance for doubtful accounts of $13,668 and $12,241, respectively |
204,251 | 202,843 | ||||||
Prepaid expenses and other current assets |
26,204 | 13,749 | ||||||
Total current assets |
371,984 | 381,120 | ||||||
Property and equipment, net |
608,831 | 638,941 | ||||||
Goodwill |
300,597 | 300,597 | ||||||
Intangible assets, net |
142,092 | 159,738 | ||||||
Other assets, net |
18,654 | 16,124 | ||||||
Total assets |
$ | 1,442,158 | $ | 1,496,520 | ||||
LIABILITIES AND STOCKHOLDERS EQUITY |
||||||||
Current liabilities: |
||||||||
Accounts payable |
$ | 58,904 | $ | 89,465 | ||||
Accrued expenses |
28,628 | 39,732 | ||||||
Accrued payroll and related liabilities |
29,334 | 28,183 | ||||||
Accrued taxes |
30,196 | 29,352 | ||||||
Accrued commissions |
18,173 | 17,005 | ||||||
Accrued capital expenditures |
5,872 | 12,831 | ||||||
Accrued interest |
14,089 | 13,321 | ||||||
Deferred revenue |
62,604 | 61,155 | ||||||
Current portion of long-term debt and capital lease obligations |
6,527 | 14,258 | ||||||
Total current liabilities |
254,327 | 305,302 | ||||||
Long-term debt and capital lease obligations |
921,852 | 916,575 | ||||||
Other long-term liabilities |
74,925 | 76,216 | ||||||
Total liabilities |
1,251,104 | 1,298,093 | ||||||
Commitments and contingencies (Note 9) |
||||||||
Stockholders equity: |
||||||||
Common stock, $.01 par value; 300,000,000 authorized shares at September 30, 2009 and December 31, 2008, 145,336,532 shares issued and outstanding at September 30, 2009; 140,936,868 shares issued and outstanding at December 31, 2008 |
1,453 | 1,409 | ||||||
Additional paid-in capital |
769,414 | 761,113 | ||||||
Accumulated other comprehensive loss |
(8,422 | ) | (19,022 | ) | ||||
Accumulated deficit |
(571,391 | ) | (545,073 | ) | ||||
Total stockholders equity |
191,054 | 198,427 | ||||||
Total liabilities and stockholders equity |
$ | 1,442,158 | $ | 1,496,520 | ||||
See notes to condensed consolidated financial statements.
1
Table of Contents
PAETEC Holding Corp. and Subsidiaries
Condensed Consolidated Statements of Operations and Comprehensive Loss
Three and Nine Months Ended September 30, 2009 and 2008
(Amounts in thousands, except share and per share amounts)
(Unaudited)
Three Months Ended September 30, | Nine Months Ended September 30, | |||||||||||||||
2009 | 2008 | 2009 | 2008 | |||||||||||||
Revenue: |
||||||||||||||||
Network services revenue |
$ | 315,859 | $ | 319,668 | $ | 945,881 | $ | 922,853 | ||||||||
Carrier services revenue |
63,536 | 70,305 | 199,066 | 199,928 | ||||||||||||
Integrated solutions revenue |
16,257 | 16,100 | 45,116 | 47,360 | ||||||||||||
Total revenue |
395,652 | 406,073 | 1,190,063 | 1,170,141 | ||||||||||||
Cost of sales (exclusive of operating items shown separately below) |
194,532 | 203,352 | 590,374 | 581,443 | ||||||||||||
Selling, general and administrative expenses (exclusive of operating items shown separately below and inclusive of stock-based compensation) |
140,894 | 149,703 | 422,471 | 428,337 | ||||||||||||
Sales and use tax settlement |
| | (1,200 | ) | | |||||||||||
Impairment charge |
| 340,000 | | 340,000 | ||||||||||||
Integration and separation costs |
| 3,800 | | 7,225 | ||||||||||||
Depreciation and amortization |
46,374 | 53,357 | 138,746 | 145,543 | ||||||||||||
Income (loss) from operations |
13,852 | (344,139 | ) | 39,672 | (332,407 | ) | ||||||||||
Debt extinguishment and related costs |
| | 10,348 | | ||||||||||||
Other (income) expense, net |
(156 | ) | 259 | (928 | ) | (265 | ) | |||||||||
Interest expense |
19,776 | 18,243 | 54,300 | 54,783 | ||||||||||||
Loss before income taxes |
(5,768 | ) | (362,641 | ) | (24,048 | ) | (386,925 | ) | ||||||||
Provision for (benefit from) income taxes |
757 | (6,853 | ) | 2,270 | (13,463 | ) | ||||||||||
Net loss |
(6,525 | ) | (355,788 | ) | (26,318 | ) | (373,462 | ) | ||||||||
Other comprehensive income (loss): |
||||||||||||||||
Change in fair value of hedge instruments, net of income taxes |
(584 | ) | 2,149 | 6,069 | 2,107 | |||||||||||
Change in unrealized losses on marketable securities, net of income taxes |
| (2 | ) | | (115 | ) | ||||||||||
Comprehensive loss |
$ | (7,109 | ) | $ | (353,641 | ) | $ | (20,249 | ) | $ | (371,470 | ) | ||||
Basic and diluted net loss per common share |
$ | (0.04 | ) | $ | (2.44 | ) | $ | (0.18 | ) | $ | (2.69 | ) | ||||
Basic and diluted weighted average common shares outstanding |
145,150,055 | 145,713,961 | 142,571,703 | 139,033,479 | ||||||||||||
See notes to condensed consolidated financial statements.
2
Table of Contents
PAETEC Holding Corp. and Subsidiaries
Condensed Consolidated Statements of Cash Flows
Nine Months Ended September 30, 2009 and 2008
(Amounts in thousands)
(Unaudited)
Nine Months Ended September 30, | ||||||||
2009 | 2008 | |||||||
OPERATING ACTIVITIES: |
||||||||
Net loss |
$ | (26,318 | ) | $ | (373,462 | ) | ||
Adjustments to reconcile net loss to net cash provided by operating activities: |
||||||||
Depreciation and amortization |
138,746 | 145,543 | ||||||
Amortization of debt issuance costs |
1,610 | 1,548 | ||||||
Amortization of debt discount |
1,043 | 732 | ||||||
Stock-based compensation expense |
14,583 | 17,838 | ||||||
Sales and use tax settlement |
(1,200 | ) | | |||||
Gain on non-monetary transaction |
(242 | ) | | |||||
Loss on disposal of property and equipment |
36 | 216 | ||||||
Deferred income taxes |
| (13,164 | ) | |||||
Debt extinguishment and related costs |
5,817 | | ||||||
Impairment charge |
| 340,000 | ||||||
Change in assets and liabilities which provided (used) cash, excluding effects of acquisitions: |
||||||||
Accounts receivable |
(1,408 | ) | (8,937 | ) | ||||
Prepaid expenses and other current assets |
(12,455 | ) | (52 | ) | ||||
Other assets |
(274 | ) | 5,237 | |||||
Accounts payable |
(29,324 | ) | (20,086 | ) | ||||
Accrued expenses |
(10,942 | ) | (15,017 | ) | ||||
Accrued payroll and related liabilities |
1,148 | (3,439 | ) | |||||
Accrued taxes |
844 | (1,892 | ) | |||||
Accrued commissions |
1,168 | 946 | ||||||
Accrued interest |
768 | (7,474 | ) | |||||
Deferred revenue |
6,542 | 2,992 | ||||||
Net cash provided by operating activities |
90,142 | 71,529 | ||||||
INVESTING ACTIVITIES: |
||||||||
Purchases of property and equipment |
(84,914 | ) | (87,425 | ) | ||||
Acquisitions, net of cash received McLeodUSA |
(197 | ) | (115,403 | ) | ||||
Acquisitions, net of cash received other acquisitions |
(125 | ) | (2,086 | ) | ||||
Proceeds from sale of short-term investments |
| 3,017 | ||||||
Proceeds from settlement of restricted cash |
1,890 | 4,876 | ||||||
Proceeds from disposal of property and equipment |
209 | 1,755 | ||||||
Software development costs |
(1,081 | ) | (728 | ) | ||||
Net cash used in investing activities |
(84,218 | ) | (195,994 | ) | ||||
FINANCING ACTIVITIES: |
||||||||
Repayments of long-term debt |
(350,986 | ) | (15,521 | ) | ||||
Payment for debt issuance costs |
(9,623 | ) | (1,395 | ) | ||||
Proceeds from long-term borrowings |
337,921 | 94,400 | ||||||
Repurchase of common stock/stock options |
(1,545 | ) | (8,514 | ) | ||||
Payment for registering securities |
(80 | ) | (292 | ) | ||||
Proceeds from exercise of stock options, warrants, and purchase plans |
1,954 | 15,354 | ||||||
Payment of tax withholding on vested stock units |
(6,564 | ) | | |||||
Net cash (used in) provided by financing activities |
(28,923 | ) | 84,032 | |||||
NET DECREASE IN CASH AND CASH EQUIVALENTS |
(22,999 | ) | (40,433 | ) | ||||
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD |
164,528 | 112,601 | ||||||
CASH AND CASH EQUIVALENTS, END OF PERIOD |
$ | 141,529 | $ | 72,168 | ||||
SUPPLEMENTAL CASH FLOW INFORMATION: |
||||||||
Cash paid for interest, net of amount capitalized |
$ | 51,402 | $ | 60,352 | ||||
Cash paid for income taxes |
$ | 2,032 | $ | 2,273 | ||||
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING TRANSACTIONS: |
||||||||
Accrued property and equipment expenditures |
$ | 10,957 | $ | 6,092 | ||||
Treasury stock retirement |
$ | | $ | 1,121 | ||||
Tenant incentive leasehold improvements |
$ | 1,448 | $ | 738 | ||||
Fair value of assets acquired in business acquisition |
$ | | $ | 670,536 | ||||
Liabilities assumed in business acquisition |
$ | | $ | 149,288 | ||||
Equity consideration issued in business acquisition |
$ | | $ | 521,248 | ||||
Accrued business acquisition costs |
$ | 345 | $ | 235 | ||||
Equipment purchased under capital leases |
$ | 7,233 | $ | 5,789 | ||||
See notes to condensed consolidated financial statements.
3
Table of Contents
PAETEC Holding Corp. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
1. NATURE OF BUSINESS AND BASIS OF PRESENTATION
Nature of Business
PAETEC Holding Corp. (PAETEC Holding) is a Delaware corporation that, through its subsidiaries, provides integrated communications services, including local and long distance voice, data, and broadband Internet access services, primarily to business and institutional customers.
The accompanying historical condensed consolidated financial statements and notes reflect the financial results of PAETEC Holding and PAETEC Holdings wholly-owned subsidiaries. On February 8, 2008, PAETEC Holding completed its combination by merger with McLeodUSA Incorporated (McLeodUSA), which became a wholly-owned subsidiary of PAETEC Holding upon completion of the merger. For the period beginning February 9, 2008, the accompanying historical condensed consolidated financial statements and notes include the financial results of McLeodUSA and McLeodUSAs wholly-owned subsidiaries.
References to the Company in these Notes to Condensed Consolidated Financial Statements are to PAETEC Holding and PAETEC Holdings wholly-owned subsidiaries.
Segment Disclosure
The Company operates in one segment.
Basis of Presentation
The accompanying condensed consolidated financial statements are unaudited and have been prepared by the Companys management in accordance with generally accepted accounting principles in the United States for interim financial information and the rules and regulations of the Securities and Exchange Commission (the SEC) for interim financial statements and accounting policies consistent, in all material respects, with those applied in preparing the Companys audited consolidated financial statements included in its Annual Report on Form 10-K for the year ended December 31, 2008 (the 2008 Form 10-K), as filed with the SEC. In the opinion of management, these interim financial statements reflect all adjustments, including normal recurring adjustments, management considers necessary for the fair presentation of the Companys financial position, operating results and cash flows for the interim periods presented. The condensed consolidated balance sheet as of December 31, 2008 has been derived from the audited consolidated balance sheet as of that date. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes included in the 2008 Form 10-K.
The accompanying condensed consolidated financial statements present results for the three and nine months ended September 30, 2009. These results are not necessarily indicative of the results that may be achieved for the year ending December 31, 2009 or any other period.
Basis of Consolidation
The accompanying condensed consolidated financial statements include the accounts of PAETEC Holding and PAETEC Holdings wholly-owned subsidiaries. All intercompany transactions and balances have been eliminated.
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Table of Contents
PAETEC Holding Corp. and Subsidiaries
Notes to Condensed Consolidated Financial Statements(Continued)
2. PROPERTY AND EQUIPMENT, NET
Property and equipment as of September 30, 2009 and December 31, 2008 consisted of the following:
September 30, 2009 |
December 31, 2008 |
|||||||
(in thousands) | ||||||||
Communications networks |
$ | 770,741 | $ | 713,758 | ||||
Computer hardware and purchased software |
129,165 | 106,303 | ||||||
Equipment |
38,986 | 37,237 | ||||||
Office equipment, furniture and fixtures |
73,912 | 63,826 | ||||||
Construction-in-progress |
10,668 | 20,361 | ||||||
Land and buildings |
41,630 | 41,395 | ||||||
1,065,102 | 982,880 | |||||||
Accumulated depreciation |
(456,271 | ) | (343,939 | ) | ||||
Property and equipment, net |
$ | 608,831 | $ | 638,941 | ||||
Construction-in-progress as of September 30, 2009 and December 31, 2008 consisted primarily of costs associated with the build-out of the Companys communications network. Depreciation expense totaled $114.6 million and $126.9 million for the nine months ended September 30, 2009 and 2008, respectively. Depreciation expense totaled $38.3 million and $46.5 million for the three months ended September 30, 2009 and 2008, respectively.
3. GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill
There was no change in goodwill during the nine months ended September 30, 2009. Goodwill is assessed for impairment at least annually using a two-step impairment test in accordance with the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 350, Goodwill and Other Intangibles. PAETEC assesses the carrying value of its goodwill as of July 1 of each fiscal year. The annual assessment of the carrying value of PAETECs reporting units determined that goodwill was not impaired as of July 1, 2009.
Other Intangible Assets
The gross carrying amount and accumulated amortization by major intangible asset category as of September 30, 2009 and December 31, 2008 were as follows:
September 30, 2009 | Weighted- Average Amortization Period | |||||||||||
(in thousands) | ||||||||||||
Gross Carrying Amount |
Accumulated Amortization |
Net | ||||||||||
Amortized intangible assets: |
||||||||||||
Customer-related |
$ | 205,603 | $ | (75,188 | ) | $ | 130,415 | 10 years | ||||
Technology-based |
1,953 | (1,115 | ) | 838 | 5 years | |||||||
Capitalized software development costs |
5,432 | (1,820 | ) | 3,612 | 4 years | |||||||
Technology license |
5,164 | (430 | ) | 4,734 | 5 years | |||||||
Trade name |
200 | (107 | ) | 93 | 5 years | |||||||
Total |
218,352 | (78,660 | ) | 139,692 | 10 years | |||||||
Unamortized intangible assets: |
||||||||||||
Trade name |
2,400 | | 2,400 | |||||||||
Total |
$ | 220,752 | $ | (78,660 | ) | $ | 142,092 | |||||
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PAETEC Holding Corp. and Subsidiaries
Notes to Condensed Consolidated Financial Statements(Continued)
December 31, 2008 | Weighted- Average Amortization Period | |||||||||||
(in thousands) | ||||||||||||
Gross Carrying Amount |
Accumulated Amortization |
Net | ||||||||||
Amortized intangible assets: |
||||||||||||
Customer-related |
$ | 205,603 | $ | (52,712 | ) | $ | 152,891 | 10 years | ||||
Technology-based |
1,953 | (899 | ) | 1,054 | 5 years | |||||||
Capitalized software development costs |
4,351 | (1,090 | ) | 3,261 | 5 years | |||||||
Trade name |
200 | (68 | ) | 132 | 5 years | |||||||
Total |
212,107 | (54,769 | ) | 157,338 | 10 years | |||||||
Unamortized intangible assets: |
||||||||||||
Trade name |
2,400 | | 2,400 | |||||||||
Total |
$ | 214,507 | $ | (54,769 | ) | $ | 159,738 | |||||
Intangible asset amortization expense for the nine months ended September 30, 2009 and 2008 was $23.9 million and $17.5 million, respectively. Intangible asset amortization expense for the three months ended September 30, 2009 and 2008 was $8.0 million and $6.4 million, respectively. The Company estimates that future aggregate amortization expense related to intangible assets as of September 30, 2009 will be as follows for the periods presented:
Year Ending December 31, (in thousands) |
|||
2009 (remaining three months) |
$ | 7,850 | |
2010 |
29,894 | ||
2011 |
26,536 | ||
2012 |
22,474 | ||
2013 |
16,747 | ||
Thereafter |
36,191 | ||
Total |
$ | 139,692 | |
Allocation of Cost of McLeod Acquisition
On February 8, 2008, the Company completed its acquisition by merger of McLeodUSA. The merger was accounted for as an acquisition of McLeodUSA by the Company using the purchase method in accordance with Statement of Financial Accounting Standards (SFAS) No. 141, Business Combinations. The aggregate transaction value, net of cash acquired, was $636.4 million and was preliminarily allocated to the assets acquired and liabilities assumed based on their fair values as of the closing date of the merger, with amounts exceeding the fair value being recorded as goodwill.
In the three months ended March 31, 2009, the Company finalized its purchase accounting allocations based upon the completion of the valuation of the acquired property and equipment and intangible assets. No adjustments to the fair values of the assets acquired and liabilities assumed estimated as of December 31, 2008 were required.
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PAETEC Holding Corp. and Subsidiaries
Notes to Condensed Consolidated Financial Statements(Continued)
4. LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS
Long-term debt and capital lease obligations as of September 30, 2009 and December 31, 2008 consisted of the following:
September 30, 2009 |
December 31, 2008 |
|||||||
(in thousands) | ||||||||
Senior secured credit facilities |
$ | 280,860 | $ | 629,700 | ||||
Unamortized discount on senior credit facilities |
(1,594 | ) | (4,594 | ) | ||||
8 7/8% Senior Secured Notes due 2017 |
350,000 | | ||||||
Unamortized discount on 8 7/8% Senior Secured Notes due 2017 |
(11,701 | ) | | |||||
9.5% Senior Notes due 2015 |
300,000 | 300,000 | ||||||
Capital lease obligations and other debt |
10,814 | 5,727 | ||||||
Total debt |
928,379 | 930,833 | ||||||
Less: current portion |
(6,527 | ) | (14,258 | ) | ||||
Long-term debt |
$ | 921,852 | $ | 916,575 | ||||
Early Payment of Revolving Debt
On September 30, 2009, the Company paid down $10.0 million in aggregate principal amount of loans outstanding under its revolving credit facility. As of September 30, 2009, loans in an aggregate principal amount of approximately $40.0 million were outstanding under the revolving credit facility.
Senior Secured Notes Offering
On June 29, 2009, the Company entered into an Indenture, dated as of June 29, 2009 (the Indenture), by and among PAETEC Holding, the subsidiary guarantors named therein, and The Bank of New York Mellon, as trustee (the Trustee), pursuant to which the Company issued $350 million in aggregate principal amount of its 8 7/8 % Senior Secured Notes due 2017 (the Notes).
The Company sold the Notes at an offering price of 96.549% of the principal amount of the Notes in an offering exempt from the registration requirements of the Securities Act of 1933. The closing of the sale took place on June 29, 2009. The Company applied the proceeds of the offering, together with cash on hand, to repay approximately $330.5 million principal amount of outstanding term loans under the Companys existing senior secured credit facilities and to pay related fees and expenses. Immediately following the application of the offering proceeds, term loans in an aggregate principal amount of approximately $242.1 million remained outstanding under the senior secured credit facilities, and revolving loans in an aggregate principal amount of $50 million were outstanding under the Companys $50 million revolving credit facility.
The Notes accrue interest at a rate of 8.875% per year from June 29, 2009. Interest is payable semi-annually in cash in arrears on June 30 and December 31 of each year, commencing on December 31, 2009. The Notes will mature on June 30, 2017.
The Company may redeem some or all of the Notes, at any time before June 30, 2013, at a redemption price equal to 100% of their principal amount plus a make-whole premium. The Company may redeem some or all of the Notes, at any time on or after June 30, 2013, at specified redemption prices declining from 104.438% to 100% of their principal amount. In addition, before June 30, 2012, the Company may redeem up to 35% of the aggregate principal amount of the Notes at a redemption price of 108.875% of their principal amount with the net cash proceeds of certain equity offerings. If the Company undergoes certain kinds of changes of control, or sells certain of its assets and does not either (1) apply the net sale proceeds to repay indebtedness under the Companys senior secured credit facilities, the Notes or other indebtedness secured on a first-priority basis or (2) reinvest the net sale proceeds in its business, the Company may be required to offer to purchase Notes from holders at 101% of their principal amount, in the case of a change of control, or 100% of their principal amount, in the case of a sale of assets. Accrued and unpaid interest on the Notes would also be payable in each of the foregoing events of redemption or purchase.
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Table of Contents
PAETEC Holding Corp. and Subsidiaries
Notes to Condensed Consolidated Financial Statements(Continued)
The Notes are PAETEC Holdings general senior obligations and rank equally in right of payment with all of PAETEC Holdings existing and future senior indebtedness, including amounts outstanding from time to time under PAETEC Holdings existing senior secured credit facilities and PAETEC Holdings outstanding 9.5% Senior Notes due 2015. The Notes are secured on a first-priority basis, equally and ratably with the Companys senior secured credit facilities and any future pari passu secured obligations, subject to permitted liens, by substantially all of the Companys assets.
The Notes are guaranteed on a senior secured basis by PAETEC Holdings subsidiaries. The guarantees of the Notes rank equally in right of payment with the guarantees of the Companys existing senior secured credit facilities and its outstanding 9.5% Senior Notes due 2015 and are effectively senior to the guarantors existing and future senior unsecured indebtedness to the extent of the collateral securing the guarantees. PAETEC Holding has no independent assets or operations, the guarantees are full and unconditional and joint and several, and there are no material restrictions on the ability of consolidated subsidiaries to transfer funds to PAETEC Holding in the form of cash dividends, loans or advances. PAETEC Holdings assets are composed solely of investments it has made in its consolidated subsidiaries and its operations are composed solely of changes in its investment in subsidiaries and interest payments associated with the senior indebtedness incurred by it. Based on these facts, PAETEC Holding is not required to provide condensed consolidating financial information for the subsidiary guarantors.
The Indenture contains customary restrictive covenants, all of which are subject to a number of important qualifications and exceptions.
In connection with the Companys entry into the Indenture as described above in this Note 4, the Company recognized $10.3 million of debt extinguishment and related costs in the accompanying consolidated statements of operations and comprehensive loss. This amount represents the elimination of $5.8 million of debt issuance costs and unamortized debt discount related to the repayment, from the proceeds of the offering of the Notes and cash on hand, of approximately $330.5 million of outstanding term loans under the Companys existing senior secured credit facilities and $4.5 million of costs incurred related to the reduction of the notional amount of its swap agreement in effect as of June 30, 2009 from $400.0 million to $265.0 million.
Amendment to Credit Facilities Agreement
Effective on June 1, 2009, the Company entered into a Second Amendment and Waiver to its Credit Agreement (the Amendment) with its lenders which amends the Credit Agreement, dated as of February 28, 2007 and amended as of June 27, 2007, pursuant to which the Company has obtained its senior secured term loan and revolving credit facilities. The Amendment grants the Company the right, at its option and subject to specified conditions, voluntarily to prepay term loans outstanding under its term loan facilities at any time and from time to time during a period beginning on the effective date of the Amendment and ending 18 months after such effective date. The total cash payments to be made by the Company in connection with such voluntary prepayments may not exceed $100 million, excluding amounts applied to the payment of accrued and unpaid interest and fees. The Company must make any such voluntary prepayments in accordance with specified procedures at a discount to the par value of the principal amount of the prepaid term loans. To make voluntary prepayments under the Amendment, the Company must satisfy specified liquidity requirements, maintain minimum specified corporate or corporate family ratings by designated rating agencies, and satisfy other conditions contained in the Amendment.
The Amendment also modifies some of the restrictive covenants in the Credit Agreement primarily to permit the Company to issue senior secured notes and to allow the Company and its subsidiaries to incur indebtedness and related obligations under such notes if specified conditions are satisfied. The Company issued the Notes described above in this Note 4 pursuant to the authorization provided under the Amendment.
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Notes to Condensed Consolidated Financial Statements(Continued)
Financial Covenant
Under the terms of the total leverage ratio covenant contained in the Companys credit agreement for its senior credit facilities, the Companys ratio of consolidated debt (defined for purposes of the credit agreement as total consolidated debt less cash and cash equivalents in excess of $20.0 million) to consolidated adjusted EBITDA (as defined for purposes of the credit agreement) as of any measurement date will not be permitted to be greater than 5.00: 1.00. The Company was in compliance with this financial covenant as of September 30, 2009.
Excess Cash Flow Payment
In April 2009, the Company paid an additional $5.6 million principal amount of its credit facility term loans as a result of excess cash flows generated during the year ended December 31, 2008, as calculated under the terms of the credit agreement.
Fair Value of Financial Instruments
The carrying value of the Companys financial instruments does not materially differ from the estimated fair values as of September 30, 2009 except for debt. As of September 30, 2009, the $280.9 million principal amount of borrowings outstanding under the Companys senior credit facilities had an estimated fair market value of approximately $268.2 million, the $300.0 million principal amount of the Companys 9.5% Senior Notes due 2015 had an estimated fair market value of approximately $272.3 million, and the $350.0 million principal amount of the Companys 8 7/8% Senior Secured Notes due 2017 had an estimated fair market value of approximately $348.3 million. The estimated market values as of September 30, 2009 are based on quarter-end closing market prices published by securities firms. While the Company believes these approximations to be reasonably accurate at the time published, quarter-end closing market prices can vary widely depending on volume traded by any given security firm and other factors.
Interest Rate Swap Agreements
In order to reduce the Companys exposure to fluctuations in interest rates, the Company periodically enters into interest rate swap agreements. These agreements effectively convert a portion of the Companys floating-rate debt to fixed-rate debt. Such agreements involve the exchange of fixed-rate and floating-rate payments over the life of the agreement without the exchange of the underlying principal amounts. The Companys swap agreements qualify for cash flow hedge accounting. The Companys policy is to enter into swap agreements only with counterparties it considers to be creditworthy. Swap agreements in effect as of September 30, 2009 were as follows:
Notional (in thousands) |
Maturities | Strategy | Weighted Average LIBOR Rate |
Fixed Rate | |||||||
$ | 265,000 | 06/30/2011 | Cash Flow Hedge | 0.29 | % | 2.85 | % |
Weighted-average variable rates are subject to change over time as the London interbank offered rate (LIBOR) fluctuates. Notional amounts do not represent amounts exchanged by the parties and, thus, are not a measure of the Companys interest rate exposure.
Neither the Company nor the counterparty is required to collateralize its obligations under the swap agreements. The Company is exposed to loss if the counterparty defaults. Management does not anticipate any non-performance by counterparties to the Companys swap agreements, because all counterparties have investment grade credit ratings. Risk management strategies, such as interest rate swaps, are reviewed by the Companys board of directors. The Companys policy is to limit the maximum amount of positions that can be taken in any given instrument.
The fair value, on a gross basis, of the Companys derivative financial instruments included in the accompanying consolidated balance sheet as of September 30, 2009 is presented as follows:
Balance Sheet Location |
Fair Value (in thousands) | ||||
Derivatives Designated as Hedging Instruments: |
|||||
Interest rate swap agreements |
Other long-term liabilities | 8,422 | |||
Total derivatives |
$ | 8,422 | |||
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Notes to Condensed Consolidated Financial Statements(Continued)
The activity for the three months ended September 30, 2009 related to the Companys derivative financial instruments designated as hedging instruments is presented as follows:
Amount of Loss Recognized in Other Comprehensive Loss on Derivatives (in thousands) |
Location of Loss Reclassified from Accumulated Other Comprehensive Income into Earnings (effective portion) |
Amount of Loss Reclassified from Accumulated Other Comprehensive Income into Earnings (effective portion) | |||||||
Derivatives in Cash Flow Hedging Relationships: |
|||||||||
Interest rate swap agreements |
$ | (584 | ) | Not applicable | $ | | |||
Total derivatives |
$ | (584 | ) | $ | | ||||
The activity for the nine months ended September 30, 2009 related to the Companys derivative financial instruments designated as hedging instruments is presented as follows:
Amount of Gain Recognized in Other Comprehensive Loss on Derivatives (effective portion) (in thousands) |
Location of Gain Reclassified from Accumulated Other Comprehensive Loss into Earnings (effective portion) |
Amount of Gain Reclassified from Accumulated Other Comprehensive Loss into Earnings (effective portion) |
Loss Recognized in Income on Derivative (Ineffective Portion and Amount Excluded from Effectiveness Testing) | ||||||||
Derivatives in Cash Flow Hedging Relationships: |
|||||||||||
Interest rate swap agreements |
$ | 6,069 | Not applicable | $ | | $ | | ||||
Total derivatives |
$ | 6,069 | $ | | $ | | |||||
The Company discontinues hedge accounting prospectively when it determines that the derivative is no longer effective in offsetting changes in cash flows of a hedged item, the derivative or hedged item expires or is sold, terminated, or exercised, or management determines that it is no longer appropriate to designate the derivative as a hedge instrument. The discontinuation of hedge accounting would result in a reclassification into earnings of any gains or losses that are currently being reported in accumulated other comprehensive loss. The Company does not expect to reclassify any amounts from accumulated other comprehensive loss into earnings within the next 12 months. In June 2009, the Company reduced the notional amount of its swap agreement in effect as of June 30, 2009 from $400.0 million to $265.0 million in connection with its debt refinancing transaction in June 2009 as described above in this Note 4. As a result, the Company reclassified $4.5 million from accumulated other comprehensive income to debt extinguishment and related costs in the accompanying condensed consolidated statements of operations.
5. INCOME TAXES
The Company accounts for income taxes in accordance with the provisions of ASC 740, Income Taxes. ASC 740 requires an asset and liability approach to financial accounting and reporting for income taxes. Accordingly, deferred tax assets and liabilities arise from the difference between the tax basis of an asset or liability and its reported amount in the consolidated financial statements. Deferred tax amounts are determined using the tax rates expected to be in effect when the taxes will actually be paid or refunds received, as provided under currently enacted tax law. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. The Company has recorded a full valuation allowance for its net deferred tax assets because of uncertainties that exist relative to its ability to utilize the net deferred assets. The valuation allowance was determined in accordance with the provisions of ASC 740, which requires an assessment of both positive and negative evidence when determining whether it is more likely than not that deferred tax assets are recoverable. The Company intends to maintain a full valuation allowance on the U.S. deferred tax assets until sufficient positive evidence exists to support reversal of the valuation allowance.
The provisions for income taxes for the three and nine months ended September 30, 2009 were for certain current state taxes and income taxes in selected jurisdictions where net operating losses are not available. ASC 740 requires the recognition of a financial statement benefit of a tax position only after a determination that the relevant tax authority would more likely than not sustain the position following an audit. For tax positions meeting the more-likely-than-not threshold, the amount recognized in the financial statements is the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement with the relevant tax authority. The amount of unrecognized tax benefits from uncertain tax positions as of September 30, 2009 was $0.7 million, the majority of which, if recognized, would affect the effective tax rate.
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Notes to Condensed Consolidated Financial Statements(Continued)
The Company recognizes interest and penalties accrued on unrecognized tax benefits as a component of the provision for income taxes. As of September 30, 2009, the Company had less than $0.1 million of accrued interest related to unrecognized tax benefits.
The Company files U.S. federal income tax returns and income tax returns in various state jurisdictions. The Company is no longer subject to U.S. federal, state, and local tax examinations in major tax jurisdictions for periods before the year ended December 31, 2004.
6. STOCKHOLDERS EQUITY
During the three months ended September 30, 2009, PAETEC Holdings board of directors authorized the repurchase of up to $25.0 million of PAETEC Holdings outstanding common stock through December 31, 2010, subject to conditions. PAETEC Holding may repurchase shares from time to time, at its discretion, on the open market or in private transactions. The repurchase program does not obligate PAETEC Holding to repurchase any specific number of shares and may be modified or discontinued at any time. The board of directors has fixed the size of the program at approximately the maximum amount currently permitted under PAETEC Holdings debt agreements for the period indicated assuming future compliance with applicable covenants. PAETEC Holdings previous stock repurchase program expired in August 2009.
During the three months ended September 30, 2009, PAETEC Holding repurchased, at fair value and on the open market, a total of 299,900 shares of its common stock at a total cost of approximately $0.8 million under its previous stock repurchase program. For the nine months ended September 30, 2009, PAETEC Holding repurchased, at fair value and on the open market, a total of 923,100 shares of its common stock at a total cost of approximately $1.6 million under that program. In connection with the repurchases, PAETEC Holding paid commissions totaling less than $0.1 million. The repurchased shares were retired and resumed the status of authorized and unissued shares.
7. SHARE-BASED TRANSACTIONS
Employee Stock Purchase Plan
For the three month purchase period ended September 30, 2009, PAETEC Holding issued 133,981 shares of common stock pursuant to its Employee Stock Purchase Plan (ESPP) at a purchase price of approximately $3.48 per share, which represented 90% of the closing price of the common stock on September 30, 2009, as reported on the NASDAQ Global Select Market. Compensation expense attributable to the ESPP for the three and nine months ended September 30, 2009, totaled approximately $0.1 million. As of September 30, 2009, 2,832,773 shares of common stock remained available for issuance under the ESPP.
Stock Option Activity
The following table summarizes stock option activity for the nine months ended September 30, 2009:
Shares of Common Stock Underlying Options |
Weighted Average Exercise Price |
Weighted Average Remaining Contractual Life (years) |
Aggregate Intrinsic Value (in thousands) | ||||||||
Outstanding at January 1, 2009 |
12,859,100 | $ | 4.40 | ||||||||
Granted |
774,840 | $ | 1.47 | ||||||||
Exercised |
(337,220 | ) | $ | 1.99 | |||||||
Canceled |
(743,513 | ) | $ | 3.51 | |||||||
Forfeited |
(178,492 | ) | $ | 5.49 | |||||||
Outstanding at September 30, 2009 |
12,374,715 | $ | 4.32 | 5.2 | $ | 11,200 | |||||
Exercisable at September 30, 2009 |
9,996,927 | $ | 4.19 | 4.5 | $ | 8,477 | |||||
The aggregate intrinsic value in the table above represents the total pretax intrinsic value (the difference between the closing sale price of PAETEC Holdings common stock as reported on the NASDAQ Global Select Market on September 30, 2009 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders if all option holders had exercised their options on September 30, 2009. This amount changes based on the fair market value of PAETEC Holdings common stock. The total intrinsic value of options exercised during the nine months ended September 30, 2009 was approximately $0.4 million.
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Notes to Condensed Consolidated Financial Statements(Continued)
For options granted during the nine months ended September 30, 2009 and 2008, the weighted average fair value of the stock options granted, estimated on the date of grant using the Black-Scholes option-pricing model, was $0.98 and $3.80, respectively, using the following assumptions:
Nine Months Ended September 30, | ||||
2009 | 2008 | |||
Expected option life (in years) |
6.0 | 5.06.0 | ||
Risk free interest rate |
2.0% 2.9% | 2.7% 3.6% | ||
Expected volatility |
73.8% 75.8% | 56.6% 69.2% | ||
Expected dividend yield |
| |
Total compensation expense related to stock options granted was approximately $3.4 million for the nine months ended September 30, 2009 and approximately $9.8 million for the nine months ended September 30, 2008. Total compensation expense related to stock options granted was approximately $0.7 million for the three months ended September 30, 2009 and approximately $2.3 million for the three months ended September 30, 2008. These amounts are recorded as part of selling, general and administrative expenses in the accompanying condensed consolidated statements of operations and comprehensive loss.
The following table summarizes stock option information as of September 30, 2009:
Options Outstanding | Options Exercisable | |||||||||
Range of Exercise Prices |
Number of Options |
Weighted- Average Exercise Price |
Number of Options |
Weighted- Average Exercise Price | ||||||
$0.00 - $2.10 |
3,482,073 | $ | 1.69 | 2,584,700 | $ | 1.82 | ||||
$2.11 - $3.15 |
1,835,596 | $ | 2.34 | 1,610,187 | $ | 2.33 | ||||
$3.16 - $7.35 |
4,742,356 | $ | 4.40 | 4,379,442 | $ | 4.42 | ||||
$7.36 - $23.50 |
2,314,690 | $ | 9.71 | 1,422,598 | $ | 9.86 | ||||
12,374,715 | $ | 4.32 | 9,996,927 | $ | 4.19 | |||||
As of September 30, 2009, there was approximately $4.6 million of total unrecognized stock-based compensation expense related to unvested stock options. The Company expects to recognize the expense over a weighted-average period of approximately 1.5 years.
Stock Unit Activity
The following table summarizes stock unit activity for the nine months ended September 30, 2009:
Shares of Common Stock Underlying Stock Units |
Weighted Average Grant Date Fair Value | |||||
Outstanding at January 1, 2009 |
11,158,561 | $ | 4.99 | |||
Granted |
745,940 | $ | 1.17 | |||
Vested |
(6,466,160 | ) | $ | 2.65 | ||
Forfeited |
(642,246 | ) | $ | 4.33 | ||
Outstanding at September 30, 2009 |
4,796,095 | $ | 5.57 | |||
The total intrinsic value of stock units that vested during the nine months ended September 30, 2009 was approximately $20.0 million. In connection with the vesting of stock units during the nine months ended September 30, 2009, the Company withheld 2,099,368 shares of PAETEC Holding common stock, having a total value of approximately $6.6 million, to satisfy income tax withholding requirements.
Total compensation expense related to stock units granted was approximately $9.5 million for the nine months ended September 30, 2009 and approximately $7.9 million for the nine months ended September 30, 2008. Total compensation expense related to stock units granted was approximately $1.8 million for the three months ended September 30, 2009 and approximately $2.8 million for the three months ended September 30, 2008. These amounts are recorded as part of selling, general and administrative expenses in the accompanying condensed consolidated statements of operations and comprehensive loss.
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Notes to Condensed Consolidated Financial Statements(Continued)
As of September 30, 2009, there was unrecognized stock-based compensation expense related to unvested stock unit awards of approximately $14.9 million. The Company expects to recognize the expense over a weighted-average period of approximately 1.8 years.
Warrant Activity
The following table summarizes warrant activity for the nine months ended September 30, 2009:
Shares of Common Stock Underlying Warrants |
Weighted Average Exercise Price |
Weighted Average Remaining Contractual Life (years) |
Aggregate Intrinsic Value (in thousands) | ||||||||
Outstanding at January 1, 2009 |
2,034,180 | $ | 2.28 | ||||||||
Granted |
600,000 | $ | 2.89 | ||||||||
Exercised |
| | |||||||||
Canceled |
(32,460 | ) | $ | 3.09 | |||||||
Forfeited |
(6,490 | ) | $ | 3.08 | |||||||
Outstanding at September 30, 2009 |
2,595,230 | $ | 2.41 | 4.8 | $ | 3,914 | |||||
Exercisable at September 30, 2009 |
1,987,927 | $ | 2.26 | 3.2 | $ | 3,324 | |||||
During the three months ended September 30, 2009, PAETEC Holding adopted the PAETEC Holding Corp. 2009 Agent Incentive Plan (the 2009 Warrant Plan). The 2009 Warrant Plan provides for the issuance of up to 600,000 shares of common stock upon the exercise of warrants granted under the plan to independent sales agents of the Company. Vesting of the warrants is conditioned upon the warrant holders achievement and maintenance of specified revenue levels. The 2009 Warrant Plan is designed to create an incentive for the sales agents and is administered by the Companys senior management.
During the three months ended September 30, 2009, the Company granted warrants to purchase 600,000 shares under the 2009 Warrant Plan. The warrants are accounted for under the provisions of ASC 718, Compensation-Stock Compensation (ASC 718) and ASC 505-50, Equity-Based Payments to Non-Employees (ASC 505-50). In accordance with ASC 505-50, the measurement date will be the date at which the agents performance is complete. At the measurement date, the Company will estimate the fair value of each warrant using the Black-Scholes option pricing model.
The aggregate intrinsic value in the table above represents the total pretax intrinsic value (the difference between the closing sale price of PAETEC Holdings common stock as reported on the NASDAQ Global Select Market on September 30, 2009 and the warrant exercise price, multiplied by the number of in-the-money warrants) that would have been received by the warrant holders if all warrant holders had exercised their warrants on September 30, 2009. This amount changes based on the fair market value of PAETEC Holdings common stock.
During the three months ended September 30, 2009 the Company recognized approximately $1.5 million of stock-based compensation expense in connection with an amendment to the outstanding US LEC warrants in order to extend the expiration dates of the warrants. These warrants were originally assumed by the Company pursuant to the US LEC merger on February 28, 2007, at which time they were fully vested.
Total stock-based compensation expense related to the warrants was approximately $1.5 million for the three and nine months ended September 30, 2009 and less than $0.1 million for the three and nine months ended September 30, 2008. These amounts are recorded as part of selling, general and administrative expenses in the accompanying condensed consolidated statements of operations and comprehensive loss.
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Notes to Condensed Consolidated Financial Statements(Continued)
The following table summarizes information relating to outstanding warrants as of September 30, 2009:
Warrants Outstanding | Warrants Exercisable | |||||||||
Range of Exercise Prices |
Shares of Common Stock Underlying Warrants |
Weighted- Average Exercise Price |
Shares of Common Stock Underlying Warrants |
Weighted- Average Exercise Price | ||||||
$0.00 - $2.78 |
1,737,996 | $ | 1.98 | 1,737,185 | $ | 1.98 | ||||
$2.79 - $4.00 |
710,359 | $ | 2.98 | 103,867 | $ | 3.43 | ||||
$4.01 - $5.00 |
146,875 | $ | 4.70 | 146,875 | $ | 4.70 | ||||
2,595,230 | $ | 2.41 | 1,987,927 | $ | 2.26 | |||||
8. LOSS PER COMMON SHARE
The computation of basic and diluted loss per common share for the three and nine months ended September 30, 2009 and 2008, was as follows:
Three Months Ended September 30, | Nine Months Ended September 30, | |||||||||||||||
(in thousands, except share and per share data) | ||||||||||||||||
2009 | 2008 | 2009 | 2008 | |||||||||||||
Net loss |
$ | (6,525 | ) | $ | (355,788 | ) | $ | (26,318 | ) | $ | (373,462 | ) | ||||
Weighted average common shares outstanding basic and diluted |
145,150,055 | 145,713,961 | 142,571,703 | 139,033,479 | ||||||||||||
Net loss per common share basic and diluted |
$ | (0.04 | ) | $ | (2.44 | ) | $ | (0.18 | ) | $ | (2.69 | ) | ||||
For the three and nine months ended September 30, 2009 and 2008, the Company had outstanding options, warrants and restricted stock units for 19,766,040 and 26,604,363 shares, respectively, which were convertible into or exercisable for common shares that were not included in the calculation of diluted loss per common share because the effect would have been anti-dilutive.
9. COMMITMENTS AND CONTINGENCIES
Purchase Commitments
As of September 30, 2009, the Company had entered into agreements with vendors to purchase approximately $17.4 million of equipment and services, of which the Company expects $10.4 million to be delivered and payable in the year ending December 31, 2009, $2.4 million in the year ending December 31, 2010, $1.7 million in the year ending December 31, 2011, $1.2 million in the year ending December 31, 2012, and $1.7 million in the year ending December 31, 2013 and thereafter.
Data and Voice Services
The Company has various agreements with certain carriers for data and voice services. As of September 30, 2009, the Companys minimum commitments under these agreements totaled $310.3 million, of which $33.2 million expire in the year ending December 31, 2009, $124.9 million expire in the year ending December 31, 2010, $123.1 million expire in the year ending December 31, 2011, $14.3 million expire in the year ending December 31, 2012, and the remaining $14.8 million expire in the year ending December 31, 2013 and thereafter. Related expenses, when incurred, are included in cost of sales in the accompanying condensed consolidated statements of operations and comprehensive loss.
Regulation
The Companys services are subject to varying degrees of federal, state and local regulation. These regulations are subject to ongoing proceedings at federal and state administrative agencies or within state and federal judicial systems. Results of these proceedings could change, in varying degrees, the manner in which the Company operates. The Company cannot predict the outcome of these proceedings or their effect on the Companys industry generally or on the Company specifically.
Interconnection and Network Access Agreements
The Company is dependent on the use of incumbent local exchange carriers local and transport networks and access services to provide telecommunications services to its customers. Charges for leasing local and transport network components and purchasing special access services historically have made up a significant percentage of the Companys overall cost of providing the services.
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Notes to Condensed Consolidated Financial Statements(Continued)
These network components and services are purchased in each of the Companys markets through interconnection agreements, special access contracts, commercial agreements or a combination of such agreements from the incumbent local exchange carrier, or, where available, from other wholesale network service providers. These costs are recognized in the period in which the services are delivered and are included as a component of the Companys cost of sales in the accompanying condensed consolidated statements of operations and comprehensive loss.
Letters of Credit
The Company is party to letters of credit totaling $7.8 million as of September 30, 2009. The Company does not expect any material losses from these financial instruments since performance under these letters of credit is not likely to be required.
Legal Proceedings
The Company is party to various legal proceedings, most of which relate to routine matters incidental to the Companys business. The result of any current or future litigation or other legal proceedings is inherently unpredictable. The Companys management, however, believes that there is no litigation or other legal proceedings asserted or pending against the Company that could have, individually or in the aggregate, a material adverse effect on its financial position, results of operations or cash flows, except as indicated below.
Certain operating subsidiaries of McLeodUSA have protested and appealed various sales and use tax assessments levied by the Iowa Department of Revenue (IDOR) with respect to the purchase of certain equipment from 1996 through 2005. These assessments, including estimated interest and penalties, originally amounted to approximately $16.5 million. In April 2009, the Company settled a portion of these disputes with the IDOR. The Companys commitments under the settlement did not have a material impact on the Companys consolidated financial statements. As of September 30, 2009, the protested assessments levied by the IDOR still in dispute, including interest and penalties, amount to approximately $10.4 million. The Company believes that it has meritorious defenses against a significant portion of these assessments and intends to pursue vigorously its defenses during the appeal process. If the Company were to be unsuccessful in its defense against the assessments, it may face additional assessments for the fiscal years 2006 through 2008. These additional assessments, including estimated interest and penalties, are estimated at $2.1 million.
On January 24, 2008, Sprint Communications Company L.P. (Sprint) filed a patent infringement action in the U.S. District Court for the District of Kansas (the Sprint Lawsuit) against PAETEC Holding and two of its subsidiaries, including one operating subsidiary, PaeTec Communications, Inc. (PAETEC Communications). Sprint alleged that PAETEC Communications infringed patents which Sprint characterized as constituting part of Sprints Voice over Packet patent portfolio. In May 2009, the Company entered into a confidential agreement with Sprint which included the dismissal of the Sprint Lawsuit, a release of Sprints claims against the Company, and a technology license of Sprint patents covering certain of the Companys activities. The Companys commitments under the agreement did not have a material impact on the Companys consolidated financial statements.
10. FAIR VALUE MEASUREMENTS
The provisions of ASC 820, Fair Value Measurements and Disclosures, establishes a framework for measuring the fair value of financial assets and financial liabilities by establishing a hierarchy that categorizes and prioritizes the sources to be used to estimate fair value as follows:
Level 1 defined as observable inputs such as quoted prices in active markets;
Level 2 inputs include quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (interest rates, yield curves, etc.), and inputs that are derived principally from or corroborated by observable market data by correlation or other means (market corroborated inputs); and
Level 3 unobservable inputs that reflect the Companys determination of assumptions that market participants would use in pricing the asset or liability. These inputs are developed based on the best information available, including the Companys own data.
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Notes to Condensed Consolidated Financial Statements(Continued)
The following table summarizes the valuation of the Companys financial instruments by the foregoing fair value hierarchy levels as of September 30, 2009 and December 31, 2008, respectively:
Fair Value Measurements as of September 30, 2009 Using: | |||||||
(in thousands) | |||||||
Quoted Prices in Active Markets for Identical Assets (Level 1) |
Significant Other Observable Inputs (Level 2) |
Significant Unobservable Inputs (Level 3) | |||||
Assets |
|||||||
Cash and cash equivalents |
| $ | 27,501 | | |||
Liabilities |
|||||||
Interest rate swaps |
| $ | 8,422 | | |||
Fair Value Measurements as of December 31, 2008 Using: | |||||||
(in thousands) | |||||||
Quoted Prices in Active Markets for Identical Assets (Level 1) |
Significant Other Observable Inputs (Level 2) |
Significant Unobservable Inputs (Level 3) | |||||
Assets |
|||||||
Cash and cash equivalents |
| $ | 122,368 | | |||
Liabilities |
|||||||
Interest rate swaps |
| $ | 19,022 | |
The fair value of cash and cash equivalents presented in the table above are primarily composed of the Companys investments in money market instruments. The Companys cash and cash equivalent balances excluded from the table above are composed of cash, certificates of deposits with original maturities of one month or less and overnight investments.
11. INTEGRATION AND SEPARATION COSTS
In connection with the McLeodUSA merger, the Company recorded contract termination costs in the preliminary allocation of the purchase price in accordance with Emerging Issues Task Force Issue No. 95-3, Recognition of Liabilities in Connection with a Purchase Business Combination. During the three and nine months ended September 30, 2009, the Company paid $0.3 million and $1.0 million, respectively, of contract termination costs and expects to pay the balance of the recorded costs over the remaining contract periods through December 2014.
The following table summarizes the obligations recognized by the Company in connection with the McLeodUSA merger and related activity through September 30, 2009:
Beginning Balance January 1, 2009 |
Additions | Payments | Ending Balance September 30, 2009 | ||||||||
(in thousands) | |||||||||||
Contract termination costs |
$ | 3,097 | | $ | 972 | $ | 2,125 |
In the year ended December 31, 2008, the Company recorded integration costs in connection with the McLeodUSA merger, primarily related to employee separations, and additional separation costs associated with certain involuntary employee separations. During the three and nine months ended September 30, 2009, the Company paid $1.0 million and $6.0 million, respectively, of severance costs associated with these integration and separation transactions and expects to pay the balance of the recorded costs through December 2012.
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Notes to Condensed Consolidated Financial Statements(Continued)
The following table summarizes the obligations recognized by the Company in connection with the integration and separation costs and related activity through September 30, 2009:
Beginning Balance January 1, 2009 |
Additions | Payments | Ending Balance September 30, 2009 | ||||||||
(in thousands) | |||||||||||
Severance costs |
$ | 8,701 | | $ | 6,033 | $ | 2,668 |
12. RECENT ACCOUNTING PRONOUNCEMENTS
In June 2009, the FASB issued SFAS No. 167, Amendments to FASB Interpretation No. 46(R) (SFAS No. 167). This statement is a revision to FASB Interpretation No. 46(R), Consolidation of Variable Interest Entities, and changes how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a company is required to consolidate an entity is based on, among other things, an entitys purpose and design and a companys ability to direct the activities of the entity that most significantly impact the entitys economic performance. The statement is effective on January 1, 2010 for companies reporting on a calendar year basis. The Company is currently evaluating the impact of SFAS No. 167 on its financial statements.
In August 2009, the FASB issued Accounting Standard Update (ASU) 2009-05, Fair Value Measurements and Disclosures (Topic 820). The purpose of this ASU is to clarify that in circumstances in which a quoted price in an active market for the identical liability is not available, a reporting entity is required to measure fair value using a valuation technique that uses either the quoted price of the identical liability when traded as an asset or quoted prices for similar liabilities or similar liabilities when traded as assets. This guidance is effective upon issuance. The adoption of this standard did not have a material impact on the Companys financial statements.
In October 2009, the FASB issued ASU 2009-13, Revenue Recognition (Topic 605). This ASU provides amendments to the criteria in Subtopic 605-24 for separating consideration in multiple-deliverable revenue arrangements. It establishes a hierarchy of selling prices to determine the selling price of each specific deliverable which includes vendor-specific objective evidence (if available), third-party evidence (if vendor-specific evidence is not available), or estimated selling price if neither of the first two are available. This ASU also eliminates the residual method for allocating revenue between the elements of an arrangement and requires that arrangement consideration be allocated at the inception of the arrangement. Finally, this ASU expands the disclosure requirements regarding a vendors multiple-deliverable revenue arrangements. This ASU is effective for fiscal years beginning on or after June 15, 2010. The Company is currently evaluating the impact of this ASU on its financial statements.
13. SUBSEQUENT EVENTS
In accordance with the provisions of ASC 855, Subsequent Events, the Company has evaluated all subsequent events through November 6, 2009, which represents the filing date of this Form 10-Q with the Securities and Exchange Commission, to ensure that this Form 10-Q includes appropriate disclosure of events both recognized in the financial statements as of September 30, 2009, and events which occurred subsequent to September 30, 2009 but were not recognized in the financial statements. As of November 6, 2009, there were no subsequent events which required recognition or disclosure, except as discussed below.
Registered Exchange Offer for Notes
On November 3, 2009, in accordance with registration rights granted to the purchasers of the Notes sold on June 29, 2009 (Note 4), the Company completed an exchange offer of all such Notes for notes with substantially identical terms that were registered under the Securities Act of 1933.
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Item 2. | Managements Discussion and Analysis of Financial Condition and Results of Operations |
Except for statements that present historical facts, this managements discussion and analysis contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. In some cases, you can identify these statements by such forward-looking words as anticipate, believe, could, estimate, expect, intend, may, plan, potential, should, will and would, or similar expressions. These statements involve known and unknown risks, uncertainties and other factors that may cause our actual operating results, financial position, levels of activity or performance to be materially different from those expressed or implied by such forward-looking statements. Some of these risks, uncertainties and factors are discussed under the caption Item 1A. Risk Factors in our Annual Report on Form 10-K for our 2008 fiscal year and in our subsequently filed SEC reports.
You should read the following managements discussion and analysis in conjunction with our Annual Report on Form 10-K for our 2008 fiscal year and together with the condensed consolidated financial statements and related notes and the other financial information that appear elsewhere in this report.
Unless the context indicates otherwise, references in this managements discussion and analysis to we, us, our, PAETEC Holding and PAETEC mean PAETEC Holding Corp. and its subsidiaries.
Overview
PAETEC is a competitive communications services and solutions provider guided by the principle that delivering superior customer service is the key to competing successfully with other communications services providers. PAETECs primary business is providing large, medium-sized and, to a lesser extent, small business end-user customers in metropolitan areas with a package of integrated communications services that includes local and long distance voice, data, and broadband Internet access services. PAETEC had approximately 3,663 employees as of September 30, 2009. As of September 30, 2009, PAETEC Holding had in service 225,675 digital T1 transmission lines, which represented the equivalent of 5,416,200 access lines, for over 46,000 business customers in a service area encompassing 84 of the countrys top 100 metropolitan statistical areas.
Revenue. PAETEC derives revenue from sales of its network services, carrier services and integrated solutions services. PAETEC derives most of its revenue from monthly recurring fees and usage-based fees that are generated principally by sales of its network services.
Monthly recurring fees include the fees paid by PAETECs customers for lines in service and additional features on those lines. PAETEC primarily bills monthly recurring fees in advance.
Usage-based fees consist of fees paid by PAETECs network services customers for each call made, fees paid by the incumbent carriers in PAETECs markets as reciprocal compensation when PAETEC terminates local calls made by their customers, and access fees paid by other carriers for long distance calls PAETEC originates or terminates for those carriers.
The monthly recurring fees and usage-based fees generated by sales of PAETECs network services to end users and carrier services to any customer tend to be relatively consistent from month to month, subject to changes in the calling patterns of the customers business. These fees generally are based on the number of digital T1 transmission lines used by the customer. Because PAETEC believes that the cumulative number of digital T1 transmission lines in service provides accurate information with respect to its future revenue, the company uses data with respect to the cumulative number of digital T1 transmission lines PAETEC has in service from period to period to assist it in evaluating revenue trends related to its network services and carrier services businesses.
Network Services. PAETEC delivers integrated communications services, including local services, long distance services and data and Internet services, to end users on a retail basis, which the company refers to as its network services. PAETECs core network services are those that generate revenue from retail enterprise customers to which PAETEC delivers such integrated communications services on primarily T1 or larger access lines, which excludes access fee and reciprocal compensation fee revenue related to network services and revenue from the companys non-core plain old telephone service, or POTS, operations involving the provision basic telephone services supplying standard single line telephones, telephone lines and access to the public switched network.
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PAETECs network services revenue consists primarily of monthly recurring fees and usage-based fees. In addition to usage-based fees invoiced directly to the end-user customers, usage-based fees for PAETECs network services include the interstate and intrastate access fees the company receives from other communications providers when it originates or terminates long-distance calls for those other providers to or from PAETECs network services customers, and the reciprocal compensation fees PAETEC receives from some other local carriers when it terminates local calls made by the customers of the other local carriers. PAETEC recognizes revenue during the period in which the revenue is earned. PAETECs network services also generate non-recurring service activation and installation fee revenues, which it receives upon initiation of service. PAETEC defers recognition of these revenues and amortizes them over the average contractual life, primarily three years.
Carrier Services. PAETEC generates revenue from wholesale sales of communications services to other communications businesses, which the company refers to as its carrier services. PAETECs core carrier services are those that generate revenue from other communications providers, which excludes access fee revenue related to carrier services and revenue from the companys non-core POTS operations.
PAETECs carrier services revenue consists primarily of monthly recurring fees and usage-based fees. Usage-based fees for PAETECs carrier services consist primarily of the interstate and intrastate access fees the company receives from other communications providers when it originates or terminates long distance calls for those other providers to or from PAETECs carrier services customers, and the reciprocal compensation fees PAETEC receives from some other local carriers when it terminates to its carrier services customers local calls made by customers of other local carriers.
Integrated Solutions. PAETEC derives revenue from sales to retail end-user customers of telecommunications equipment and software and related services, which the company refers to as its integrated solutions.
A portion of PAETECs integrated solutions revenue consists of fees its customers pay for equipment and for PAETECs system design and installation services. PAETEC recognizes revenue for equipment sales and system design and installation services upon delivery and acceptance of the underlying equipment.
PAETEC derives an additional component of its integrated solutions revenue by selling and supporting its proprietary telecommunications software. PAETEC recognizes revenue related to software sales upon delivery of the software. Support fees include fees for maintenance of PAETECs telecommunications software and fees for training the end user in the proper use of that software. PAETEC recognizes maintenance fees on a pro rata basis over the length of the underlying maintenance contract and training fees after it fulfills the training obligation.
Cost of Sales. PAETEC provides its network services and carrier services by using electronic network components that it owns and telephone and data transmission lines that it leases from other telecommunications carriers. PAETECs cost of sales for these services consists primarily of leased transport charges and usage costs for local and long distance calls. PAETECs leased transport charges are the payments it makes to lease the telephone and data transmission lines, which the company uses to connect its customers to its network and to connect its network to the networks of other carriers. Usage costs for local and long distance are the costs that PAETEC incurs for calls made by its customers. Cost of sales for PAETECs integrated solutions includes the costs it incurs in designing systems and purchasing and installing equipment.
Selling, General and Administrative Expenses. PAETECs selling, general and administrative expenses include selling and marketing, customer service, billing, corporate administration, engineering personnel and other personnel costs.
Depreciation and Amortization. Depreciation and amortization include depreciation of PAETECs telecommunications network and equipment, computer hardware and purchased software, office equipment, furniture and fixtures, and buildings, as well as amortization of intangible assets.
Debt Extinguishment and Related Costs. PAETECs debt extinguishment and related costs include expenses related to the repayment of outstanding term loans under PAETECs senior secured credit facilities and costs incurred related to the reduction of the notional amount of its swap agreement in effect as of June 30, 2009.
Interest Expense. Interest expense includes interest due on borrowings under PAETECs senior secured credit facilities, senior notes and senior secured notes, amortization of debt issuance costs, debt discounts, and interest due on PAETECs capital lease obligations and other debt.
Other Income, Net. Other income, net includes non-monetary gains on the sale of reciprocal indefeasible rights of use, or IRUs, investment income, and other financing income.
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Accounting for Income Taxes. PAETEC recognizes deferred income tax assets and liabilities for the expected future tax consequences of transactions and events. Under this method, PAETEC determines deferred income tax assets and liabilities based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which it expects the differences to reverse. If necessary, PAETEC reduces deferred income tax assets by a valuation allowance to an amount that it determines is more likely than not to be recoverable. PAETEC makes significant estimates and assumptions about future taxable income and future tax consequences to determine the amount of the valuation allowance.
Stock-Based Compensation. PAETECs employees participate in a variety of equity incentive plans. Stock-based compensation expense for all stock-based compensation awards is based on the grant date fair value estimated in accordance with the Financial Accounting Standards Board, or FASB, Accounting Standards Codification, or ASC, Topic 718, Compensation. PAETEC recognizes these compensation costs, net of an estimated forfeiture rate, ratably over the requisite service period of the award.
Impairment Charge. PAETEC assesses the carrying value of its goodwill annually or as events or circumstances change. In accordance with its impairment assessment process, PAETEC recorded a non-cash impairment charge of $340.0 million in the third quarter of 2008 based on a preliminary assessment in that quarter, and recorded an additional non-cash charge of $15.0 million in the fourth quarter of 2008 based on the finalization of that preliminary assessment. The goodwill impairment charges were attributable to weaker economic conditions in PAETECs markets. For more information about PAETECs impairment review policies and its 2008 impairment charges, see Managements Discussion and Analysis of Financial Condition and Results of OperationsCritical Accounting Policies in PAETECs Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2009. There was no change in goodwill during the nine months ended September 30, 2009.
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Results of Operations
The following table presents selected operating data for the three and nine months ended September 30, 2009 and September 30, 2008. The comparison of PAETECs operating results for the nine months ended September 30, 2009, which we refer to as our 2009 nine-month period, to our operating results for the nine months ended September 30, 2008, which we refer to as our 2008 nine-month period, is materially affected by the acquisition of McLeodUSA Incorporated, or McLeodUSA, on February 8, 2008. McLeodUSAs operating results are included in PAETECs operating results beginning on February 9, 2008. Because of the significance of this transaction, PAETECs operating results for the 2009 nine-month period and 2008 nine-month period are not directly comparable. PAETECs operating results for the three and nine months ended September 30, 2009 and 2008 were as follows:
Three Months Ended September 30, 2009 |
Three Months Ended September 30, 2008 |
Nine Months Ended September 30, 2009 |
Nine Months Ended September 30, 2008 (1) |
|||||||||||||||||||||||||
(dollars in thousands) | ||||||||||||||||||||||||||||
$ | % of Revenue |
$ | % of Revenue |
$ | % of Revenue |
$ | % of Revenue |
|||||||||||||||||||||
Revenue: |
||||||||||||||||||||||||||||
Network services revenue |
$ | 315,859 | 80 | % | $ | 319,668 | 79 | % | $ | 945,881 | 79 | % | $ | 922,853 | 79 | % | ||||||||||||
Carrier services revenue |
63,536 | 16 | % | 70,305 | 17 | % | 199,066 | 17 | % | 199,928 | 17 | % | ||||||||||||||||
Integrated solutions revenue |
16,257 | 4 | % | 16,100 | 4 | % | 45,116 | 4 | % | 47,360 | 4 | % | ||||||||||||||||
Total revenue |
395,652 | 100 | % | 406,073 | 100 | % | 1,190,063 | 100 | % | 1,170,141 | 100 | % | ||||||||||||||||
Cost of sales (2) |
194,532 | 49 | % | 203,352 | 50 | % | 590,374 | 50 | % | 581,443 | 50 | % | ||||||||||||||||
Selling, general and administrative expenses (3) |
140,894 | 36 | % | 149,703 | 37 | % | 422,471 | 35 | % | 428,337 | 37 | % | ||||||||||||||||
Sales and use tax settlement |
| * | | * | (1,200 | ) | * | | * | |||||||||||||||||||
Impairment charge |
| * | 340,000 | 84 | % | | * | 340,000 | 29 | % | ||||||||||||||||||
Integration and separation costs |
| * | 3,800 | 1 | % | | * | 7,225 | 1 | % | ||||||||||||||||||
Depreciation and amortization |
46,374 | 12 | % | 53,357 | 13 | % | 138,746 | 12 | % | 145,543 | 12 | % | ||||||||||||||||
Income (loss) from operations |
13,852 | 4 | % | (344,139 | ) | (85 | )% | 39,672 | 3 | % | (332,407 | ) | (28 | )% | ||||||||||||||
Debt extinguishment and related costs |
| * | | * | 10,348 | 1 | % | | * | |||||||||||||||||||
Other (income) expense, net |
(156 | ) | * | 259 | * | (928 | ) | * | (265 | ) | * | |||||||||||||||||
Interest expense |
19,776 | 5 | % | 18,243 | 4 | % | 54,300 | 5 | % | 54,783 | 5 | % | ||||||||||||||||
Loss before income taxes |
(5,768 | ) | (2 | )% | (362,641 | ) | (89 | )% | (24,048 | ) | (2 | )% | (386,925 | ) | (33 | )% | ||||||||||||
Provision for (benefit from) income taxes |
757 | * | (6,853 | ) | (2 | )% | 2,270 | * | (13,463 | ) | (1 | )% | ||||||||||||||||
Net loss |
$ | (6,525 | ) | (2 | )% | $ | (355,788 | ) | (88 | )% | $ | (26,318 | ) | (2 | )% | $ | (373,462 | ) | (32 | )% | ||||||||
Adjusted EBITDA (4) |
$ | 64,238 | $ | 57,788 | $ | 191,686 | $ | 177,432 | ||||||||||||||||||||
* | Less than one percent |
(1) | Includes results of McLeodUSA subsequent to the McLeodUSA merger closing date of February 8, 2008. |
(2) | Exclusive of operating items shown separately below. |
(3) | Exclusive of operating items shown separately below and inclusive of stock-based compensation. |
(4) | Adjusted EBITDA, as defined by PAETEC for the periods presented, represents net loss before depreciation and amortization, interest expense, provision for (benefit from) income taxes, stock-based compensation, debt extinguishment and related costs, impairment charge, sales and use tax settlement, integration and separation costs, and gain on non-monetary transaction. Adjusted EBITDA is not a financial measurement prepared in accordance with GAAP. See Managements Discussion and Analysis of Financial Condition and Results of OperationsOverviewAdjusted EBITDA Presentation in our Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2009 for our reasons for including adjusted EBITDA data in this report and for material limitations with respect to the usefulness of this measurement. The following table sets forth, for the periods indicated, a reconciliation of adjusted EBITDA to net loss, as net loss is calculated in accordance with GAAP (in thousands): |
Three Months Ended September 30, 2009 |
Three Months Ended September 30, 2008 |
Nine Months Ended September 30, 2009 |
Nine Months Ended September 30, 2008 (1) |
|||||||||||||
(dollars in thousands) | ||||||||||||||||
Net loss |
$ | (6,525 | ) | $ | (355,788 | ) | $ | (26,318 | ) | $ | (373,462 | ) | ||||
Add back non-EBITDA items included in net loss: |
||||||||||||||||
Depreciation and amortization |
46,374 | 53,357 | 138,746 | 145,543 | ||||||||||||
Interest expense, net of interest income |
19,628 | 18,147 | 53,499 | 53,751 | ||||||||||||
Provision for (benefit from) income taxes |
757 | (6,853 | ) | 2,270 | (13,463 | ) | ||||||||||
EBITDA |
60,234 | (291,137 | ) | 168,197 | (187,631 | ) | ||||||||||
Stock-based compensation |
4,022 | 5,125 | 14,583 | 17,838 | ||||||||||||
Debt extinguishment and related costs |
| | 10,348 | | ||||||||||||
Impairment charge |
| 340,000 | | 340,000 | ||||||||||||
Sales and use tax settlement |
| | (1,200 | ) | | |||||||||||
Integration and separation costs |
| 3,800 | | 7,225 | ||||||||||||
Gain on non-monetary transaction |
(18 | ) | | (242 | ) | | ||||||||||
Adjusted EBITDA |
$ | 64,238 | $ | 57,788 | $ | 191,686 | $ | 177,432 | ||||||||
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Three Months Ended September 30, 2009 Compared With Three Months Ended September 30, 2008
Revenue. Total revenue decreased $10.4 million, or 2.6%, to $395.7 million for the 2009 quarter from $406.1 million for the 2008 quarter. The decrease in total revenue was primarily attributable to customer attrition in the non-strategic POTS portion of the business obtained as part of the McLeodUSA acquisition, which attrition accounted for approximately $5.6 million of the decrease, and to a decline in access fee revenue and reciprocal compensation of approximately $4.8 million. Of total revenue for the 2009 quarter, revenue from network services, carrier services and integrated solutions accounted for 79.8%, 16.1% and 4.1%, respectively, compared to 78.7%, 17.3% and 4.0%, respectively, for the 2008 quarter.
Revenue from network services decreased $3.8 million, or 1.2%, to $315.9 million for the 2009 quarter from $319.7 million for the 2008 quarter. The decrease in network services revenue primarily resulted from customer attrition in the non-strategic POTS portion of the business, which accounted for approximately $4.2 million of the decrease, and a decrease in access fee revenue and reciprocal compensation of approximately $0.9 million. For the 2009 quarter, revenue from monthly recurring fees and usage-based fees accounted for 72.3% and 26.6%, respectively, of revenue from network services, compared to 71.6% and 28.0%, respectively, of such revenue for the 2008 quarter. Revenue from core network services accounted for 72.6% of total revenue for the 2009 quarter, compared to 70.4% for the 2008 quarter. Revenue from core network services increased $1.3 million, or 0.5%, to $287.1 million for the 2009 quarter from $285.8 million for the 2008 quarter. The increase in core network services revenue primarily resulted from an increase in the number of digital T1 transmission lines in service and from increased revenue from dynamic internet protocol and multi-site virtual private network sales. Results of the network services business were affected by lower billable minutes of use, increased pricing pressure, and continued customer attrition, particularly in the non-strategic POTS portion of the business. PAETEC anticipates that these factors will adversely affect the performance of its network services business for the remainder of 2009.
Revenue from carrier services decreased $6.8 million, or 9.6%, to $63.5 million for the 2009 quarter from $70.3 million for the 2008 quarter. The decrease in carrier services revenue primarily resulted from a decrease in access fee revenue and reciprocal compensation of approximately $3.9 million and customer attrition in the non-strategic POTS portion of the business obtained as part of the McLeodUSA acquisition, which accounted for approximately $1.4 million of the decrease. Revenue from core carrier services accounted for 11.5% of total revenue for the 2009 and 2008 quarter. Revenue from core carrier services decreased $1.5 million, or 3.1%, to $45.3 million for the 2009 quarter from $46.8 million for the 2008 quarter. The decrease in core carrier services revenue primarily resulted from lower long distance usage. For the 2009 quarter, these operating trends affected the relative contribution to revenue of monthly recurring fees and usage-based fees, which accounted for 48.5% and 41.9%, respectively, of revenue from carrier services for the 2009 quarter, compared to 43.1% and 49.8%, respectively, of such revenue for the 2008 quarter.
Access fee revenue and reciprocal compensation included in network services revenue and access fee revenue and reciprocal compensation included in carrier services revenue together accounted for 8.1% of total revenue for the 2009 quarter, compared to 9.1% for the 2008 quarter. Reciprocal compensation revenue included in network services revenue and reciprocal compensation
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revenue included in carrier services revenue together accounted for 1.3% of total revenue for the 2009 quarter, compared to 1.7% for the 2008 quarter. Access fee revenue as a percentage of network services usage-based fees increased to 19.4% for the 2009 quarter from 19.1% and for the 2008 quarter, while reciprocal compensation as a percentage of network services usage-based fees remained constant at 2.2% for the 2009 and 2008 quarters. Network access fee revenue as a percentage of network services usage-based fees increased primarily due to a lesser decline in minutes of use. Access fee revenue as a percentage of carrier services usage-based fees increased to 39.8% for the 2009 quarter from 37.5% for the 2008 quarter. Reciprocal compensation as a percentage of carrier services usage-based fees decreased to 12.6% for the 2009 quarter from 13.5% for the 2008 quarter. The decrease in reciprocal compensation as a percentage of carrier services usage-based fees was principally attributable to a shift in product mix toward Internet protocol-based services and other services that do not generate as much or any reciprocal compensation for PAETEC. PAETEC believes that the decrease in reciprocal compensation also reflected in part adverse economic conditions in PAETECs markets that have contributed to usage-related pressure experienced by the carrier services business. The carrier services business also experienced a loss of some wireless customers, which PAETEC believes is primarily due to continuing consolidation in the wireless communications industry.
Revenue from integrated solutions services increased $0.2 million, or 1.0%, to $16.3 million for the 2009 quarter from $16.1 million for the 2008 quarter. The increase in revenue generated by the integrated solutions business was a result of modest growth in both telecommunications equipment and software sales.
Cost of Sales. Cost of sales decreased to $194.5 million for the 2009 quarter from $203.4 million for the 2008 quarter, in part because of a decline in minutes of use as the companys product mix continues to evolve away from more usage-sensitive products.
Leased transport charges increased to $153.5 million, or 78.9% of cost of sales, for the 2009 quarter from $153.0 million, or 75.2% of cost of sales, for the 2008 quarter. The increase of leased transport charges as a percentage of cost of sales was primarily attributable to the cost associated with the increased number of digital T1 transmission lines in service and to a decline in minutes of use.
Usage costs for local and long distance calls decreased to $30.7 million, or 15.8% of cost of sales, for the 2009 quarter from $39.6 million, or 19.5% of cost of sales, for the 2008 quarter. The decrease was attributable in part to a decline in the average usage rates PAETEC is charged by network providers, as well as to a decline in minutes of use.
Cost of sales as a percentage of total revenue decreased to 49.2% for the 2009 quarter from 50.1% for the 2008 quarter. The decrease was primarily attributable to continued network optimization and network cost control efforts.
Selling, General and Administrative Expenses. Selling, general and administrative expenses decreased to $140.9 million for the 2009 quarter from $149.7 million for the 2008 quarter. Salaries, wages and benefits decreased by $6.7 million, primarily due to a decrease in the number of employees from approximately 3,914 at September 30, 2008 to approximately 3,663 at September 30, 2009. A decrease in sales and marketing expenses also contributed to the decline in selling, general and administrative expenses. Selling, general and administrative expenses as a percentage of total revenue decreased to 35.6% for the 2009 quarter from 36.9% for the 2008 quarter.
Depreciation and Amortization. Depreciation and amortization expense decreased to $46.4 million for the 2009 quarter from $53.4 million for the 2008 quarter. The decrease was largely attributable to the completion of purchase accounting valuations, which resulted in a decrease to the fair values assigned to property and equipment obtained in our acquisition of McLeodUSA.
Interest Expense. PAETECs average outstanding debt balances increased to $941.4 million for the 2009 quarter from $882.7 million for the 2008 quarter, primarily as a result of the $50.0 million principal amount of loans PAETEC obtained in October 2008 under its revolving credit facility and also as a result of PAETECs issuance in June 2009 of its 8 7 /8% Senior Secured Notes due 2017, or senior secured notes, and application of the note proceeds to repay outstanding credit facility term loans. Interest expense increased to $19.8 million for the 2009 quarter from $18.2 million for the 2008 quarter, as the weighted average annual borrowing rates under PAETECs credit facilities and its notes increased to 7.9% as of September 30, 2009 from 7.7% as of September 30, 2008, primarily due to PAETECs issuance of the senior secured notes and application of the note proceeds to repay outstanding credit facility term loans.
Income Taxes. The provision for income taxes for the 2009 quarter was for certain current state taxes and income taxes in selected jurisdictions where net operating losses are not available. The difference between the statutory rate and the effective tax rate for the 2009 nine-month period was primarily attributable to the existence of a valuation allowance on PAETECs net deferred tax assets. PAETEC recorded a full valuation allowance initially as of December 31, 2008 for its net deferred tax assets because of uncertainties that exist relative to its ability to utilize the net deferred assets. The valuation allowance was determined in accordance with the provisions of ASC 740, Income Taxes, which requires an assessment of both positive and negative evidence when determining whether it is more likely than not that deferred tax assets are recoverable. PAETEC intends to maintain a full valuation allowance on the U.S. deferred tax assets until sufficient positive evidence exists to support reversal of the valuation allowance.
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ASC 740 requires the recognition of a financial statement benefit of a tax position only after a determination that the relevant tax authority would more likely than not sustain the position following an audit. For tax positions meeting the more-likely-than-not threshold, the amount recognized in the financial statements is the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement with the relevant tax authority. The amount of unrecognized tax benefits from uncertain tax positions as of September 30, 2009 was $0.7 million, the majority of which, if recognized, would affect the effective tax rate. PAETEC recognizes interest and penalties accrued on unrecognized tax benefits as a component of the provision for income taxes. As of September 30, 2009, PAETEC had less than $0.1 million of accrued interest related to unrecognized tax benefits.
PAETEC files U.S. federal income tax returns and income tax returns in various state jurisdictions. PAETEC is no longer subject to U.S. federal, state, and local tax examinations in major tax jurisdictions for periods before 2004.
Nine Months Ended September 30, 2009 Compared With Nine Months Ended September 30, 2008
Revenue. Total revenue increased $19.9 million, or 1.7%, to $1,190.1 million for the 2009 nine-month period from $1,170.1 million for the 2008 nine-month period, principally because of the inclusion of McLeodUSAs results for the full 2009 nine-month period. Of total revenue for the 2009 nine-month period, revenue from network services, carrier services and integrated solutions accounted for 79.5%, 16.7% and 3.8%, respectively, compared to 78.9%, 17.1% and 4.0%, respectively, for the 2008 nine-month period.
Revenue from network services increased $23.0 million, or 2.5%, to $945.9 million for the 2009 nine-month period from $922.9 million for the 2008 nine-month period. For the 2009 nine-month period, revenue from monthly recurring fees and usage-based fees accounted for 72.1% and 26.9%, respectively, of revenue from network services, compared to 71.2% and 28.2%, respectively, of such revenue for the 2008 nine-month period. Revenue from core network services accounted for 72.1% of total revenue for the 2009 nine-month period, compared to 70.4% for the 2008 nine-month period. Revenue from core network services increased $34.6 million, or 4.2%, to $857.9 million for the 2009 nine-month period from $823.3 million for the 2008 nine-month period. The increase in core network services revenue primarily resulted from the inclusion of McLeodUSAs results for the full 2009 nine-month period, from an increase in the number of digital T1 transmission lines in service and from increased revenue from dynamic internet protocol and multi-site virtual private network sales. Growth of the network services business were affected by lower billable minutes of use, increased pricing pressure, and continued customer attrition, particularly in the non-strategic POTS portion of the business obtained as part of the McLeodUSA acquisition.
Revenue from carrier services decreased $0.9 million, or 0.4%, to $199.1 million for the 2009 nine-month period from $199.9 million for the 2008 nine-month period. Revenue from core carrier services accounted for 12.0% of total revenue for the 2009 nine-month period, compared to 11.3% for the 2008 nine-month period. The decrease in carrier services revenue primarily resulted from a decrease in access fee revenue and reciprocal compensation. For the 2009 nine-month period, revenue from monthly recurring fees and usage-based fees accounted for 46.4% and 44.4%, respectively, of revenue from carrier services, compared to 41.9% and 50.5%, respectively, of such revenue for the 2008 nine-month period. The increase in monthly recurring fees as a percentage of total carrier services revenue was primarily attributable to the inclusion of McLeodUSAs results for the full 2009 nine-month period, as monthly recurring fees historically have represented a higher percentage of total carrier services revenue of McLeodUSAs business than of PAETECs business.
Access fee revenue and reciprocal compensation included in network services revenue and access fee revenue and reciprocal compensation included in carrier services revenue together accounted for 8.0% of total revenue for the 2009 nine-month period, compared to 8.8% for the 2008 nine-month period. Reciprocal compensation revenue included in network services revenue and reciprocal compensation revenue included in carrier services revenue together accounted for 1.3% of total revenue for the 2009 nine-month period, compared to 1.6% for the 2008 nine-month period. Access fee revenue as a percentage of network services usage-based fees increased to 18.6% for the 2009 nine-month period from 17.5% for the 2008 nine-month period, while reciprocal compensation as a percentage of network services usage-based fees increased to 2.1% for the 2009 nine-month period from 1.9% for the 2008 nine-month period. Network access fee revenue grew primarily due to the inclusion of McLeodUSAs results for the full 2009 nine-month period. Access fee revenue as a percentage of carrier services usage-based fees decreased to 36.6% for the 2009 nine-month period from 38.3% for the 2008 nine-month period. Reciprocal compensation as a percentage of carrier services usage-based fees decreased to 11.6% for the 2009 nine-month period from 13.7% for the 2008 nine-month period. The decrease in access fees and reciprocal compensation as a percentage of carrier services usage-based fees was principally attributable to a shift in product mix toward Internet protocol-based services and other services that do not generate as much or any access fee revenue or reciprocal compensation for PAETEC. PAETEC believes that the decrease also reflected in part adverse economic conditions in PAETECs markets that have contributed to usage-related pressure experienced by the carrier services business. The carrier services business also experienced a loss of some wireless customers, which PAETEC believes is primarily due to continuing consolidation in the wireless communications industry.
Revenue from integrated solutions services decreased $2.2 million, or 4.7%, to $45.1 million for the 2009 nine-month period from $47.4 million for the 2008 nine-month period. The decrease in revenue generated by the integrated solutions business, which has a longer revenue cycle causing irregular trends on a quarterly basis, was partly attributable to the effects of adverse economic conditions, primarily decreased demand for customer premise hardware.
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Cost of Sales. Cost of sales increased to $590.4 million for the 2009 nine-month period from $581.4 million for the 2008 nine-month period, primarily due to the inclusion of McLeodUSAs results for the full 2009 nine-month period.
Leased transport charges increased to $458.4 million, or 77.7% of cost of sales, for the 2009 nine-month period from $433.3 million, or 74.5% of cost of sales, for the 2008 nine-month period. The increase of leased transport charges as a percentage of cost of sales was primarily attributable to the inclusion of McLeodUSAs results for the full 2009 nine-month period.
Usage costs for local and long distance calls decreased to $102.3 million, or 17.3% of cost of sales, for the 2009 nine-month period from $114.0 million, or 19.6% of cost of sales, for the 2008 nine-month period. The decrease was attributable in part to a decline in the average usage rates PAETEC is charged by network providers, as well as to a decline in minutes of use.
Cost of sales as a percentage of total revenue decreased slightly from 49.7% for the 2008 nine-month period to 49.6% for the 2009 nine-month period.
Selling, General and Administrative Expenses. Selling, general and administrative expenses decreased to $422.5 million for the 2009 nine-month period from $428.3 million for the 2008 nine-month period. The decrease was primarily due to a decline in salaries, wages and benefits and a decrease in sales and marketing expenses. The decrease was partially offset by the inclusion of McLeodUSAs results for the full 2009 nine-month period, which resulted in an increase in facilities expense to support the companys more extensive network infrastructure after the McLeodUSA acquisition. Selling, general and administrative expenses as a percentage of total revenue decreased to 35.5% for the 2009 nine-month period from 36.6% for the 2008 nine-month period.
Depreciation and Amortization. Depreciation and amortization expense decreased to $138.7 million for the 2009 nine-month period from $145.5 million for the 2008 nine-month period. The decrease was largely attributable to the completion of purchase accounting valuations, which resulted in a decrease to the initial values assigned to property and equipment obtained in our acquisition of McLeodUSA. This decrease was partially offset by an increase in depreciation and amortization expense as a result of the inclusion of McLeodUSAs results for the entire 2009 nine-month period.
Debt Extinguishment and Related Costs. In the 2009 nine-month period, PAETEC recognized $10.3 million of debt extinguishment and related costs, which represented the elimination of $5.8 million of debt issuance costs and unamortized debt discount related to the repayment of approximately $330.5 million of outstanding term loans under PAETECs credit facilities with the proceeds from its issuance and sale of its senior secured notes on June 29, 2009 and $4.5 million of costs incurred related to the reduction of the notional amount of its swap agreement in effect as of June 30, 2009 from $400.0 million to $265.0 million.
Interest Expense. PAETECs average outstanding debt balances increased to $931.4 million for the 2009 nine-month period from $877.2 million for the 2008 nine-month period, primarily as a result of the $50.0 million principal amount of loans PAETEC obtained in October 2008 under its revolving credit facility and also as a result of PAETECs issuance in June 2009 of its senior secured notes and application of the note proceeds to repay outstanding credit facility term loans. Interest expense decreased slightly to $54.3 million for the 2009 nine-month period from $54.8 million for the 2008 nine-month period, as the effect of higher debt levels and PAETECs issuance in June 2009 of its senior secured notes was offset by a decline in the weighted average annual borrowing rates under PAETECs credit facilities and its notes to 7.5% for the nine-month period ended September 30, 2009 from 7.9% for the nine-month period ended September 30, 2008.
Income Taxes. The provision for income taxes for the 2009 nine-month period was for certain current state taxes and income taxes in selected jurisdictions where net operating losses are not available. The difference between the statutory rate and the effective tax rate for the 2009 nine-month period was primarily attributable to the existence of a valuation allowance on PAETECs net deferred tax assets.
The benefit for income taxes for the 2008 nine-month period includes a benefit from federal and state taxes and was based on the estimated annual effective tax rate applicable to PAETEC for 2008. The difference between the statutory rate and the effective tax rate for the 2008 nine-month period was primarily due to the impact of non-deductible stock based compensation.
Liquidity and Capital Resources
PAETEC finances its operations and growth primarily with cash flow from operations, borrowings under credit facilities, issuances of debt securities, operating leases and normal trade credit terms.
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Sources and Uses of Cash. PAETECs cash flows for the nine months ended September 30, 2009 and 2008, respectively, were as follows:
Nine Months Ended September 30, | ||||||||
2009 | 2008 | |||||||
(in thousands) | ||||||||
Net cash provided by operating activities |
$ | 90,142 | $ | 71,529 | ||||
Net cash used in investing activities |
$ | (84,218 | ) | $ | (195,994 | ) | ||
Net cash (used in) provided by financing activities |
$ | (28,923 | ) | $ | 84,032 |
The $18.6 million increase in cash flows from operating activities for the 2009 nine-month period over the 2008 nine-month period was primarily attributable to a $14.8 million increase in net income adjusted for non-cash items and a $3.8 million increase in working capital.
PAETECs investing activities during the 2009 nine-month period related primarily to the purchase and installation of property and equipment, while its investing activities during the 2008 nine-month period related primarily to the McLeodUSA acquisition. PAETEC also made expenditures related to the purchase and installation of property and equipment during the 2008 nine-month period.
Net cash used in financing activities of $28.9 million for the 2009 nine-month period was primarily related to the repayment of $10.0 million in aggregate principal amount of loans outstanding under PAETECs revolving credit facility, the payment of debt issuance costs incurred in connection with PAETECs issuance and sale of its senior secured notes on June 29, 2009, and payments of tax withholding amounts on stock units that vested during the period in lieu of issuing shares of common stock of equal value. Net cash provided by financing activities in the 2008 nine-month period of $84.0 million was primarily related to the $100 million of borrowings under PAETECs incremental term loan facility, a portion of which was applied toward the redemption of McLeodUSAs outstanding senior secured notes in connection with the McLeodUSA acquisition.
Contractual Obligations. PAETEC has various contractual obligations and commercial commitments. PAETEC does not have off-balance sheet financing arrangements other than its letters of credit and operating leases.
During the 2009 quarter, there were no material changes in PAETECs contractual obligations as set forth in PAETECs Annual Report on Form 10-K for its 2008 fiscal year and as updated in PAETECs Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2009.
Indebtedness. At September 30, 2009, PAETEC had approximately $928.4 million of total indebtedness, net of unamortized discount of $13.3 million, which had an overall weighted average annual interest rate of 7.6%, including debt discount and excluding deferred financing costs. Of this total indebtedness, an aggregate principal amount of $240.9 million was outstanding under the companys senior secured credit facility term loans, an aggregate principal amount of $40.0 million was outstanding under the companys revolving credit facility, an aggregate principal amount of $350.0 million was outstanding under the companys senior secured notes, and an aggregate principal amount of $300.0 million was outstanding under the companys 9.5% Senior Notes due 2015, or senior notes.
In April 2009, PAETEC paid an additional $5.6 million of principal on its credit facility term loans as a result of excess cash flows generated during its 2008 fiscal year as calculated under the terms of its credit agreement.
On June 29, 2009, PAETEC issued and sold $350 million in aggregate principal amount of its senior secured notes. PAETEC sold the senior secured notes at an offering price of 96.549% of their principal amount in an offering exempt from the registration requirements of the Securities Act of 1933. PAETEC applied the proceeds of the offering, together with cash on hand, to repay approximately $330.5 million principal amount of outstanding term loans under PAETECs existing senior secured credit facilities and to pay related fees and expenses. The senior secured notes accrue interest at a rate of 8.875% per year from June 29, 2009. Interest is payable semi-annually in cash in arrears on June 30 and December 31 of each year, commencing on December 31, 2009. The senior secured notes will mature on June 30, 2017.
On September 30, 2009, the Company paid down $10.0 million in aggregate principal amount of loans outstanding under its revolving credit facility.
Under the terms of the total leverage ratio covenant contained in PAETECs credit agreement, PAETECs ratio of consolidated debt (defined for purposes of the credit agreement as total consolidated debt less cash and cash equivalents in excess of $20.0 million) to consolidated adjusted EBITDA (as defined for purposes of the credit agreement) as of any measurement date may not exceed 5.00: 1.00. PAETEC was in compliance with this financial covenant as of September 30, 2009.
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See Note 4 to PAETECs condensed consolidated financial statements appearing elsewhere in this report for additional information regarding the companys indebtedness.
Stock Repurchase Program. During the 2009 quarter, PAETEC Holdings board of directors authorized the repurchase of up to $25.0 million of PAETEC Holdings outstanding common stock through December 31, 2010, subject to conditions. PAETEC may repurchase shares from time to time, at its discretion, on the open market or in private transactions. The repurchase program does not obligate PAETEC to repurchase any specific number of shares and may be modified or discontinued at any time. The board of directors has fixed the size of the program at approximately the maximum amount currently permitted under PAETECs debt agreements for the period indicated assuming future compliance with applicable covenants. PAETECs previous stock repurchase program expired in August 2009.
During the 2009 quarter, PAETEC Holding repurchased, at fair value and on the open market, a total of 299,900 shares of its common stock at a total cost of approximately $0.8 million under PAETECs previous stock repurchase program. For the 2009 nine-month period, PAETEC Holding repurchased, at fair value and on the open market, a total of 923,100 shares of its common stock at a total cost of approximately $1.6 million under that program. In connection with the repurchases, PAETEC Holding paid commissions totaling less than $0.1 million.
Capital and Cash Requirements. PAETEC expects that it will continue to require significant capital expenditures to maintain and enhance its network and services and to generate planned revenue growth. PAETEC made capital expenditures, principally for the purchase of communications equipment, of approximately $27.7 million in the 2009 quarter and approximately $84.9 in the 2009 nine-month period. PAETEC expects to fund all of its 2009 capital expenditures from cash on hand and cash flow from operations. PAETEC plans to make such capital expenditures primarily for the following purposes:
| to continue to acquire and install equipment to enhance and maintain its network; |
| to increase penetration of its existing markets; |
| to expand its operations into additional geographic markets; and |
| to make infrastructure enhancements, principally for its back office systems. |
The actual amount and timing of PAETECs capital requirements may differ materially from its estimates as a result of regulatory, technological and competitive developments in the companys industry. As of September 30, 2009, PAETEC had entered into agreements with vendors to purchase approximately $17.4 million of equipment and services, of which PAETEC expects $10.4 million to be delivered and payable in the fourth quarter of 2009, $2.4 million in 2010, $1.7 million in 2011, $1.2 million in 2012, and $1.7 million in 2013 and thereafter.
PAETEC believes that cash on hand and cash flow from operations will provide sufficient cash to enable the company to fund its planned capital expenditures, make scheduled principal and interest payments on its debt, meet its other cash requirements, and maintain compliance with the terms of its financing agreements for at least the next 12 months. After the foregoing period, PAETEC may require additional capital for network enhancements to provide increased capacity to meet expected increased demand for its services. The amount and timing of these additional network enhancements, if any, will depend on the anticipated demand for services, the availability of funds and other factors. The actual amount and timing of PAETECs future capital requirements may differ materially from the companys estimates depending on the demand for its services and new market developments and opportunities, and on other factors, including those described in Part I, Item 1A. Risk Factors in its Annual Report on Form 10-K for its 2008 fiscal year. If PAETECs plans or assumptions change or prove to be inaccurate, the foregoing sources of funds may prove to be insufficient. In addition, if PAETEC seeks to acquire other businesses or to accelerate the expansion of its business, it may be required to seek additional capital. Additional sources may include equity and debt financing and other financing arrangements, such as vendor financing. In addition, if PAETEC believes it can obtain additional debt financing on advantageous terms, PAETEC may seek such financing at any time, to the extent that market conditions and other factors permit it to do so. The debt financing PAETEC may seek could be in the form of additional term loans under its senior secured credit facilities or additional debt securities having substantially the same terms as, or different terms from, PAETECs outstanding senior notes and senior secured notes. Any inability of PAETEC to generate the sufficient funds that it may require or to obtain such funds under reasonable terms could limit its ability to increase its revenue or to operate profitably. PAETECs ability to raise any required funds is subject to restrictions imposed by covenants contained in its existing debt agreements and could be negatively affected by a continuation of adverse conditions in the credit and capital markets.
Recent Accounting Pronouncements
In June 2009, the FASB issued SFAS No. 167, Amendments to FASB Interpretation No. 46(R), or SFAS No. 167. This statement is a revision to FASB Interpretation No. 46(R), Consolidation of Variable Interest Entities, and changes how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a company is required to consolidate an entity is based on, among other things, an entitys purpose and design and a companys ability to direct the activities of the entity that most significantly impact the entitys economic performance. The statement is effective on January 1, 2010 for companies reporting on a calendar year basis. PAETEC is currently evaluating the impact of SFAS No. 167 on its financial statements.
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In August 2009, the FASB issued Accounting Standard Update, or ASU, 2009-05, Fair Value Measurements and Disclosures (Topic 820). The purpose of this ASU is to clarify that in circumstances in which a quoted price in an active market for the identical liability is not available, a reporting entity is required to measure fair value using a valuation technique that uses either the quoted price of the identical liability when traded as an asset or quoted prices for similar liabilities or similar liabilities when traded as assets. This guidance is effective upon issuance. The adoption of this standard did not have a material impact on PAETECs financial statements.
In October 2009, the FASB issued ASU 2009-13, Revenue Recognition (Topic 605). This ASU provides amendments to the criteria in Subtopic 605-24 for separating consideration in multiple-deliverable revenue arrangements. It establishes a hierarchy of selling prices to determine the selling price of each specific deliverable which includes vendor-specific objective evidence (if available), third-party evidence (if vendor-specific evidence is not available), or estimated selling price if neither of the first two are available. This ASU also eliminates the residual method for allocating revenue between the elements of an arrangement and requires that arrangement consideration be allocated at the inception of the arrangement. Finally, this ASU expands the disclosure requirements regarding a vendors multiple-deliverable revenue arrangements. This ASU is effective for fiscal years beginning on or after June 15, 2010. PAETEC is currently evaluating the impact of this ASU on its financial statements.
Item 3. | Quantitative and Qualitative Disclosures About Market Risk |
PAETEC is exposed to market risks in the normal course of business. PAETEC manages the sensitivity of its results of operations to these risks by maintaining an investment portfolio consisting primarily of short-term, interest-bearing securities and by entering into long-term debt obligations with appropriate pricing and terms. PAETEC does not hold or issue derivative, derivative commodity or other financial instruments for trading purposes, although the company holds some derivative financial instruments to manage its exposure to fluctuations in interest rates. PAETEC does not have any material foreign currency exposure.
PAETECs major market risk exposure is to changing interest rates associated with borrowings the company used to fund the expansion of its business and to support its acquisition activities. The interest rates that PAETEC is able to obtain on this debt financing depend on market conditions. PAETECs policy is to manage interest rates through a combination of fixed-rate debt and the use of interest rate swap contracts to manage the companys exposure to fluctuations in interest rates on its variable-rate debt. As of September 30, 2009, $280.9 million of PAETECs long-term debt consisted of variable-rate instruments that accrue interest at floating rates. As of the same date, through an interest rate swap contract, PAETEC had capped its interest rate exposure through June 30, 2011 at a rate of 2.85% on $265.0 million of floating-rate debt. A change of one percentage point in the interest rates applicable to PAETECs $265.0 million of variable-rate debt subject to an interest rate swap contract as of September 30, 2009 would result in a fluctuation of approximately $2.7 million in the companys annual interest expense in the absence of the interest rate swap contracts.
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Item 4. | Controls and Procedures |
Evaluation of Disclosure Controls and Procedures
Our management, with the participation of our Chairman, President and Chief Executive Officer, who is our principal executive officer, and our Executive Vice President and Chief Financial Officer, who is our principal financial officer, has evaluated the effectiveness of our disclosure controls and procedures, as defined in Rule 13a-15 under the Securities Exchange Act of 1934, as of September 30, 2009. Based upon that evaluation, our Chairman, President and Chief Executive Officer and our Executive Vice President and Chief Financial Officer have concluded that our disclosure controls and procedures were effective as of September 30, 2009.
Changes in Internal Control Over Financial Reporting
During the fiscal period covered by this report, there were no changes in our internal control over financial reporting that materially affected, or that are reasonably likely to materially affect, our internal control over financial reporting.
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PART II
OTHER INFORMATION
Item 1. | Legal Proceedings |
PAETEC is a party or otherwise subject to various legal proceedings. A description of these proceedings is set forth in the companys Annual Report on Form 10-K for the year ended December 31, 2008 under the caption Legal Proceedings in Part I of that report and under the caption Litigation in Note 13 to the consolidated financial statements included in that report, and in the notes to the condensed consolidated financial statements included in our subsequently filed SEC reports. For updated information about some of these proceedings, see Note 9 to the condensed consolidated financial statements appearing under Item 1 of Part I of this report. This information, which appears in Note 9 under the caption Legal Proceedings, is incorporated by reference into this Item 1 of Part II of this report and is made a part hereof.
Item 1A. | Risk Factors |
In addition to the other information set forth in this report, the factors discussed in Part I, Item 1A. Risk Factors in our Annual Report on Form 10-K for our 2008 fiscal year could materially affect PAETECs business, financial condition or operating results. The risks described in our Annual Report on Form 10-K are not the only risks facing us. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition or operating results.
Item. 2. | Unregistered Sales of Equity Securities and Use of Proceeds |
(c) The following table provides information about our purchases of common stock during the quarter ended September 30, 2009.
Period |
(a) Total Number of Shares (or Units) Purchased(1) |
(b) Average Price Paid per Share (or Unit)(2) |
(c) Total Number of Shares (or Units) Purchased as Part of Publicly Announced Plans or Programs(1) |
(d) Approximate Dollar Value of Shares that May Yet Be Purchased Under the Plans or Programs (in thousands) (3) | ||||||
July 1, 2009 July 31, 2009 |
| $ | | | $ | 16,242 | ||||
Aug. 1, 2009 Aug. 31, 2009 |
299,900 | $ | 2.58 | 299,900 | $ | 0 | ||||
Sept. 1, 2009 Sept. 30, 2009 |
| $ | | | $ | 25,000 | ||||
Quarter ended Sept. 30, 2009 |
299,900 | $ | 2.58 | 299,900 | $ | 25,000 | ||||
(1) | Represents shares of common stock purchased by PAETEC in open-market transactions pursuant to the repurchase program announced on August 13, 2008, providing for the repurchase from time to time of up to $30 million of PAETECs common stock, at the companys discretion, through August 2009. |
(2) | The dollar values listed in this column include commissions to be paid to brokers to execute the transactions. |
(3) | The repurchase program announced on August 13, 2008 expired in August 2009. On September 9, 2009, PAETEC announced the approval of a new repurchase program, providing for the repurchase from time to time of up to $25 million of PAETECs common stock, at the companys discretion, through December 2010. No repurchases were made under the new program through September 30, 2009. |
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Item 6. | Exhibits |
The following exhibits are either filed with this Quarterly Report on Form 10-Q or are incorporated herein by reference. Our Securities Exchange Act file number is 000-52486.
Exhibit |
Description | |
10.1 | PAETEC Holding Corp. 2009 Agent Incentive Plan. Filed as Exhibit 4.7 to PAETEC Holding Corp.s Registration Statement on Form S-3 (SEC File No. 333-159344) and incorporated herein by reference. | |
10.2 | Form of PAETEC Holding Corp. Common Stock Purchase Warrant (including form of Exercise Notice) under the PAETEC Holding Corp. 2009 Agent Incentive Plan. Filed as Exhibit 4.6 to PAETEC Holding Corp.s Registration Statement on Form S-3 (SEC File No. 333-159344) and incorporated herein by reference. | |
*31.1 | Certification of Chief Executive Officer of PAETEC Holding pursuant to Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934. | |
*31.2 | Certification of Executive Vice President and Chief Financial Officer of PAETEC Holding pursuant to Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934. | |
*32 | Certifications pursuant to Rule 13a-14(b) or Rule 15d-14(b) under the Securities Exchange Act of 1934 and 18 U.S.C. 1350. |
* | Filed herewith. |
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
PAETEC Holding Corp. | ||||
(Registrant) | ||||
Dated: November 6, 2009 | By: | /S/ KEITH M. WILSON | ||
Keith M. Wilson | ||||
Executive Vice President and Chief Financial Officer | ||||
(Duly Authorized Officer and Principal Financial Officer) |
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Exhibit Index
Exhibit |
Description | |
10.1 | PAETEC Holding Corp. 2009 Agent Incentive Plan. Filed as Exhibit 4.7 to PAETEC Holding Corp.s Registration Statement on Form S-3 (SEC File No. 333-159344) and incorporated herein by reference. | |
10.2 | Form of PAETEC Holding Corp. Common Stock Purchase Warrant (including form of Exercise Notice) under the PAETEC Holding Corp. 2009 Agent Incentive Plan. Filed as Exhibit 4.6 to PAETEC Holding Corp.s Registration Statement on Form S-3 (SEC File No. 333-159344) and incorporated herein by reference. | |
*31.1 | Certification of Chief Executive Officer of PAETEC Holding pursuant to Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934. | |
*31.2 | Certification of Executive Vice President and Chief Financial Officer of PAETEC Holding pursuant to Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934. | |
*32 | Certifications pursuant to Rule 13a-14(b) or Rule 15d-14(b) under the Securities Exchange Act of 1934 and 18 U.S.C. 1350. |
* | Filed herewith. |
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