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EX-3.1(A) - EX-3.1(A) - ABOVENET INCv192369_ex3-1a.htm
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EX-32.2 - EX-32.2 - ABOVENET INCv192369_ex32-2.htm
EX-32.1 - EX-32.1 - ABOVENET INCv192369_ex32-1.htm
EX-31.2 - EX-31.2 - ABOVENET INCv192369_ex31-2.htm
EX-3.1(B) - EX-3.1(B) - ABOVENET INCv192369_ex3-1b.htm


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

FORM 10-Q

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

For the quarterly period ended June 30, 2010

OR

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

Commission File Number: 000-23269

AboveNet, Inc.

(Exact Name of Registrant as Specified in Its Charter)

DELAWARE
 
11-3168327
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer Identification No.)

360 HAMILTON AVENUE
WHITE PLAINS, NY 10601
(Address of Principal Executive Offices)

(914) 421-6700
(Registrant’s Telephone Number, Including Area Code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  x   No  ¨

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 (§232.405 of this chapter) 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 small 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 registrant’s common stock, par value $0.01 per share, outstanding as of August 2, 2010, was 25,170,404.

 

 

Table of Contents

ABOVENET, INC.

INDEX
 
 
  
 
  
Page
Part I.
  
 FINANCIAL INFORMATION
  
 
     
Item 1.
  
Financial Statements
  
 
 
  
 
  
 
 
  
Consolidated Balance Sheets
  
 
   
  As of June 30, 2010 (Unaudited) and December 31, 2009
 
1
         
   
Consolidated Statements of Operations (Unaudited)
   
   
  Three and Six month periods ended June 30, 2010 and 2009
  
2
         
   
Consolidated Statement of Shareholders’ Equity (Unaudited)
   
   
  Six month period ended June 30, 2010
 
3
         
   
Consolidated Statements of Cash Flows (Unaudited)
   
   
  Six month periods ended June 30, 2010 and 2009
 
4
         
   
Consolidated Statements of Comprehensive Income (Unaudited)
   
   
  Three and Six month periods ended June 30, 2010 and 2009
  
5
         
 
  
Notes to Unaudited Consolidated Financial Statements
  
6
         
Item 2.
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
34
         
Item 3.
 
Quantitative and Qualitative Disclosures about Market Risk
 
61
         
Item 4.
 
Controls and Procedures
 
62
     
Part II.
  
 OTHER INFORMATION
  
 
     
Item 1.
  
Legal Proceedings
  
63
     
  
 
Item 1A.
  
Risk Factors
  
63
     
  
 
Item 6.
  
Exhibits
  
64
   
Signatures
  
65
   
Exhibit Index
   

 

 

PART I.  FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS

ABOVENET, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
(in millions, except share and per share information)

   
June 30,
2010
   
December 31, 2009
 
   
(Unaudited)
       
ASSETS:
           
Current assets:
           
Cash and cash equivalents
  $ 173.0     $ 165.3  
Restricted cash and cash equivalents
    3.7       3.7  
Accounts receivable, net of allowances of $1.6 and $2.0 at June 30, 2010 and December 31, 2009, respectively
    19.6       20.1  
Prepaid costs and other current assets
    18.8       13.5  
Total current assets
    215.1       202.6  
                 
Property and equipment, net of accumulated depreciation and amortization of $263.9 and $236.5 at June 30, 2010 and December 31, 2009, respectively
    491.5       469.1  
Deferred tax assets
    162.4       183.0  
Other assets
    9.6       7.3  
Total assets
  $ 878.6     $ 862.0  
                 
LIABILITIES:
               
Current liabilities:
               
Accounts payable
  $ 6.1     $ 10.7  
Accrued expenses
    64.6       68.4  
Deferred revenue - current portion
    24.1       27.3  
Note payable - current portion
    7.6       7.6  
Total current liabilities
    102.4       114.0  
                 
Note payable
    46.0       49.7  
Deferred revenue
    90.3       93.8  
Other long-term liabilities
    10.5       10.3  
Total liabilities
    249.2       267.8  
                 
Commitments and contingencies
               
                 
SHAREHOLDERS’ EQUITY:
               
Preferred stock, 9,500,000 shares authorized, $0.01 par value, none issued or outstanding
           
Junior preferred stock, 500,000 shares authorized, $0.01 par value, none issued or outstanding
           
Common stock, 200,000,000 shares authorized, $0.01 par value, 25,754,019 issued and 25,165,638 outstanding at June 30, 2010 and 30,000,000 shares authorized, $0.01 par value, 25,271,788 issued and 24,750,560 outstanding at December 31, 2009
    0.3       0.3  
Additional paid-in capital
    318.0       308.2  
Treasury stock at cost, 588,381  and 521,228 shares at June 30, 2010 and December 31, 2009, respectively
    (20.9 )     (16.7 )
Accumulated other comprehensive loss
    (9.3 )     (9.0 )
Retained earnings
    341.3       311.4  
Total shareholders’ equity
    629.4       594.2  
Total liabilities and shareholders’ equity
  $ 878.6     $ 862.0  

The accompanying notes are an integral part of these consolidated financial statements.

 
1

 

ABOVENET, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS
(in millions, except share and per share information)

(Unaudited)

   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
   
2010
   
2009
   
2010
   
2009
 
                         
Revenue
  $ 100.7     $ 88.0     $ 197.9     $ 173.4  
                                 
Costs of revenue (excluding depreciation and amortization, shown separately below)
    34.1       32.3       67.2       61.7  
Selling, general and administrative expenses
    23.0       20.1       46.6       40.8  
Depreciation and amortization
    15.2       12.3       30.7       24.2  
                                 
Operating income
    28.4       23.3       53.4       46.7  
                                 
Other income (expense):
                               
Interest income
          0.1             0.3  
Interest expense
    (1.2 )     (1.1 )     (2.4 )     (2.3 )
Other income (expense), net
    0.2       2.5       (0.4 )     2.4  
                                 
Income before income taxes
    27.4       24.8       50.6       47.1  
                                 
Provision for (benefit from) income taxes
    11.1       0.2       20.7       (4.9 )
                                 
Net income
  $ 16.3     $ 24.6     $ 29.9     $ 52.0  
                                 
Income per share, basic:
                               
Basic income per share
  $ 0.64     $ 1.07     $ 1.19     $ 2.26  
                                 
Weighted average number of common shares
    25,145,224       23,026,298       25,045,423       22,974,578  
                                 
Income per share, diluted:
                               
Diluted income per share
  $ 0.62     $ 0.97     $ 1.14     $ 2.08  
                                 
Weighted average number of common shares
    26,194,883       25,227,006       26,205,457       24,968,436  

The accompanying notes are an integral part of these consolidated financial statements.

 
2

 

ABOVENET, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY
(in millions, except share information)

(Unaudited)

   
Common Stock
   
Treasury Stock
   
Other Shareholders’ Equity
       
   
Shares
   
Amount
   
Shares
   
Amount
   
Additional
Paid-in
Capital
   
Accumulated
Other
Comprehensive
Loss
   
Retained
Earnings
   
Total
Shareholders’
Equity
 
                                                 
Balance at January 1, 2010
    25,271,788     $ 0.3       521,228     $ (16.7 )   $ 308.2     $ (9.0 )   $ 311.4     $ 594.2  
Issuance of common stock from exercise of warrants
    437,634                         5.2                   5.2  
Issuance of common stock from vested restricted stock
    14,000                                            
Issuance of common stock from exercise of options to purchase shares of common stock
    30,597                         0.4                   0.4  
Purchase of treasury stock
                5,459       (0.3 )                       (0.3 )
Deemed purchase of treasury stock in cashless exercises of stock warrants
                61,694       (3.9 )                       (3.9 )
Foreign currency translation adjustments
                                  (0.5 )           (0.5 )
Change in fair value of interest rate swap contracts
                                  0.2             0.2  
Amortization of stock-based compensation expense for restricted stock units
                            4.2                   4.2  
Net income
                                        29.9       29.9  
Balance at June 30, 2010
    25,754,019     $ 0.3       588,381     $ (20.9 )   $ 318.0     $ (9.3 )   $ 341.3     $ 629.4  

The accompanying notes are an integral part of these consolidated financial statements.
 
3

 
ABOVENET, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
(in millions)

(Unaudited)

   
Six Months Ended June 30,
 
   
2010
   
2009
 
Cash flows provided by operating activities:
           
Net income
  $ 29.9     $ 52.0  
Adjustments to reconcile net income to net cash provided by operations:
               
Depreciation and amortization
    30.7       24.2  
Provision for equipment impairment
    0.2       0.5  
Provision for bad debts
    0.3       0.2  
Non-cash stock-based compensation expense
    4.2       5.8  
Loss on sale or disposition of property and equipment, net
          0.9  
Change in deferred tax assets
    20.5        
Changes in operating working capital:
               
Accounts receivable
    (0.1 )     (0.6 )
Prepaid costs and other current assets
    (5.2 )     (1.2 )
Accounts payable
    (4.5 )     (5.0 )
Accrued expenses
    (0.3 )     (10.6 )
Other assets
    (2.4 )     (1.1 )
Deferred revenue and other long-term liabilities
    (5.6 )     9.4  
Net cash provided by operating activities
    67.7       74.5  
Cash flows used in investing activities:
               
Proceeds from sales of property and equipment
    0.2        
Purchases of property and equipment
    (57.5 )     (53.5 )
Net cash used in investing activities
    (57.3 )     (53.5 )
Cash flows (used in) provided by financing activities:
               
Proceeds from exercise of warrants
    1.4       0.1  
Proceeds from exercise of options to purchase shares of common stock
    0.4       2.8  
Change in restricted cash and cash equivalents
          (0.2 )
Principal payment - note payable
    (3.7 )     (1.1 )
Principal payment - capital lease obligation
          (0.2 )
Purchase of treasury stock
    (0.3 )     (0.3 )
Net cash (used in) provided by financing activities
    (2.2 )     1.1  
Effect of exchange rates on cash
    (0.5 )     0.8  
Net increase in cash and cash equivalents
    7.7       22.9  
Cash and cash equivalents, beginning of period
    165.3       87.1  
Cash and cash equivalents, end of period
  $ 173.0     $ 110.0  
                 
Supplemental cash flow information:
               
Cash paid for interest
  $ 1.5     $ 1.3  
Cash paid for income taxes
  $ 0.3     $ 2.8  
                 
Supplemental non-cash financing activities:
               
Issuance of shares of common stock in cashless exercise of stock purchase warrants
  $ 3.9     $  
Non-cash purchase of shares into treasury in cashless exercise of stock purchase warrants
  $ 3.9     $  

The accompanying notes are an integral part of these consolidated financial statements.

 
4

 

ABOVENET, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in millions)

(Unaudited)

   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
   
2010
   
2009
   
2010
   
2009
 
                         
Net income
  $ 16.3     $ 24.6     $ 29.9     $ 52.0  
Foreign currency translation adjustments
    (0.3 )           (0.5 )     0.5  
Change in fair value of interest rate swap contracts
    0.2       0.2       0.2       0.2  
Comprehensive income
  $ 16.2     $ 24.8     $ 29.6     $ 52.7  

The accompanying notes are an integral part of these consolidated financial statements.

 
5

 

ABOVENET, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(in millions, except share and per share information)

NOTE 1:    BACKGROUND AND ORGANIZATION

The Company is a facilities-based provider of technologically advanced, high-bandwidth, fiber optic communications infrastructure and co-location services to communications carriers and corporate and government customers, principally in the United States (“U.S.”) and United Kingdom (“U.K.”).

NOTE 2:    BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES

A summary of the basis of presentation and the significant accounting policies followed in the preparation of these consolidated financial statements is as follows:

Stock Split

On August 3, 2009, the Board of Directors of the Company authorized a two-for-one common stock split, effected in the form of a 100% stock dividend, which was distributed on September 3, 2009.  Each shareholder of record on August 20, 2009 received one additional share of common stock for each share of common stock held on that date.  All share and per share information for all periods presented, including warrants, options to purchase common shares, restricted stock units, warrant and option exercise prices, shares reserved under the Company’s 2003 Incentive Stock Option and Stock Unit Grant Plan (the “2003 Plan”) and the Company’s 2008 Equity Incentive Plan  (the “2008 Plan”), weighted average fair value of options granted, common stock and additional paid-in capital accounts on the consolidated balance sheets and consolidated statement of shareholders’ equity, have been retroactively adjusted to reflect the two-for-one stock split.

Basis of Presentation and Use of Estimates

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) and pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”).  These consolidated financial statements include the accounts of the Company, as applicable.  They do not include all of the information and footnotes required by U.S. GAAP for complete financial statements.  In the opinion of management, all adjustments (consisting of normal recurring accruals), considered necessary for a fair presentation have been included.  These unaudited consolidated financial statements should be read in conjunction with the Company’s consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2009.  Operating results for the three and six months ended June 30, 2010 are not necessarily indicative of the results that may be expected for the year ending December 31, 2010.

The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the consolidated financial statements, the disclosure of contingent assets and liabilities in the consolidated financial statements and the accompanying notes and the reported amounts of revenue and expenses during the periods presented.  Estimates are used when accounting for certain items such as accounts receivable allowances, property taxes, transaction taxes and deferred taxes.  The estimates the Company makes are based on historical factors, current circumstances and the experience and judgment of the Company’s management.  The Company evaluates its assumptions and estimates on an ongoing basis and may employ outside experts to assist in the Company’s evaluations.  Actual amounts and results could differ from such estimates due to subsequent events which could have a material effect on the Company’s financial statements covering future periods.

 
6

 

ABOVENET, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)

Fresh Start Accounting

On May 20, 2002, Metromedia Fiber Network, Inc. (“MFN”) and substantially all of its domestic subsidiaries (each a “Debtor” and collectively, the “Debtors”) filed voluntary petitions for reorganization under Chapter 11 of the United States Bankruptcy Code (the “Bankruptcy Code”) with the United States Bankruptcy Court for the Southern District of New York (the “Bankruptcy Court”).  The Debtors remained in possession of their assets and properties and continued to operate their businesses and manage their properties as debtors-in-possession under the jurisdiction of the Bankruptcy Court.

On July 1, 2003, the Debtors filed an amended Plan of Reorganization (“Plan of Reorganization”) and amended Disclosure Statement (“Disclosure Statement”).  On July 2, 2003, the Bankruptcy Court approved the Disclosure Statement and related voting procedures.  On August 21, 2003, the Bankruptcy Court confirmed the Plan of Reorganization.

The Debtors emerged from proceedings under Chapter 11 of the Bankruptcy Code on September 8, 2003 (the “Effective Date”).  In accordance with its Plan of Reorganization, MFN changed its name to AboveNet, Inc. (together with its subsidiaries, the “Company”) on August 29, 2003.  Equity interests in MFN received no distribution under the Plan of Reorganization and the equity securities of MFN were cancelled.

On September 8, 2003, the Company authorized 10,000,000 shares of preferred stock (with a $0.01 par value) and 30,000,000 shares of common stock (with a $0.01 par value).  On June 24, 2010, the shareholders approved an amendment to the Company’s certificate of incorporation, increasing the number of authorized shares of common stock from 30,000,000 to 200,000,000.  See Note 8, “Shareholders’ Equity - Amendment to the Company’s Amended and Restated Certificate of Incorporation.”

The holders of common stock are entitled to one vote for each issued and outstanding share, and will be entitled to receive dividends, subject to the rights of the holders of preferred stock when and if declared by the Board of Directors.  Preferred stock may be issued from time to time in one or more classes or series, each of which classes or series shall have such distributive designation as determined by the Board of Directors.  During 2006, the Company reserved for issuance, from the 10,000,000 shares authorized of preferred stock described above, 500,000 shares of $0.01 par value junior preferred stock in connection with the adoption of the Amended and Restated Rights Agreement (as defined in Note 8, “Shareholders’ Equity,” below).  In the event of any liquidation, the holders of the common stock will be entitled to receive the assets of the Company available for distribution, after payments to creditors and holders of preferred stock.

In 2003, the Company issued 17,500,000 shares of common stock, of which 17,498,276 were delivered and 1,724 shares were determined to be undeliverable and were cancelled, the rights to purchase 3,338,420 shares of common stock at a price of $14.97715 per share, under a rights offering (of which rights to purchase 3,337,984 shares of common stock have been exercised), five year stock purchase warrants to purchase 1,418,918 shares of common stock exercisable at a price of $10.00 per share, and seven year stock purchase warrants to purchase 1,669,316 shares of common stock exercisable at a price of $12.00 per share.  In addition, 2,129,912 shares of common stock were originally reserved for issuance under the Company’s 2003 Plan.  See Note 7, “Stock-Based Compensation.”

The Company’s emergence from bankruptcy resulted in a new reporting entity with no retained earnings or accumulated losses, effective as of September 8, 2003.  Although the Effective Date of the Plan of Reorganization was September 8, 2003, the Company accounted for the consummation of the Plan of Reorganization as if it occurred on August 31, 2003 and implemented fresh start accounting as of that date.  There were no significant transactions during the period from August 31, 2003 to September 8, 2003.  Fresh start accounting requires the Company to allocate the reorganization value of its assets and liabilities based upon their estimated fair values, in accordance with Statement of Position 90-7, “Financial Reporting by Entities in Reorganization under the Bankruptcy Code” (now known as Financial Accounting Standards Board Accounting Standards Codification (“FASB ASC”) 852-10).  The Company developed a set of financial projections, which were utilized by an expert to assist the Company in estimating the fair value of its assets and liabilities.  The expert utilized various valuation methodologies, including (1) a comparison of the Company and its projected performance to that of comparable companies; (2) a review and analysis of several recent transactions of companies in similar industries to the Company; and (3) a calculation of the enterprise value based upon the future cash flows of the Company’s projections.

 
7

 

ABOVENET, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)

Adopting fresh start accounting resulted in material adjustments to the historical carrying values of the Company’s assets and liabilities.  The reorganization value was allocated by the Company to its assets and liabilities based upon their fair values.  The Company engaged an independent appraiser to assist the Company in determining the fair market value of its property and equipment.  The determination of fair values of assets and liabilities was subject to significant estimates and assumptions.  The unaudited fresh start adjustments reflected at September 8, 2003 consisted of the following: (i) reduction of property and equipment; (ii) reduction of indebtedness; (iii) reduction of vendor payables; (iv) reduction of the carrying value of deferred revenue; (v) increase of deferred rent to fair market value; (vi) cancellation of MFN’s common stock and additional paid-in capital, in accordance with the Plan of Reorganization; (vii) issuance of new AboveNet, Inc. common stock and additional paid-in capital; and (viii) elimination of the comprehensive loss and accumulated deficit accounts.

Principles of Consolidation

The consolidated financial statements include the accounts of the Company, and its wholly-owned subsidiaries.  Consolidation is generally required for investments of more than 50% of the outstanding voting stock of an investee, except when control is not held by the majority owner.  All significant intercompany accounts and transactions have been eliminated in consolidation.

Revenue Recognition

The Company follows SEC Staff Accounting Bulletin ("SAB") No. 101, “Revenue Recognition in Financial Statements,” (now known as FASB ASC 605-10), as amended by SEC SAB No. 104, “Revenue Recognition,” (also now known as FASB ASC 605-10).

Revenue derived from leasing fiber optic telecommunications infrastructure and the provision of telecommunications and co-location services is recognized as services are provided.  Non-refundable payments received from customers before the relevant criteria for revenue recognition are satisfied are included in deferred revenue in the accompanying consolidated balance sheets and are subsequently amortized into income over the fixed contract term.

Prior to October 1, 2009, the Company generally amortized revenue related to installation services on a straight-line basis over the contracted customer relationship (two to twenty years).  In the fourth quarter of 2009, the Company completed a study of its historic customer relationship period.  As a result, commencing October 1, 2009, the Company began amortizing revenue related to installation services on a straight-line basis generally over the estimated customer relationship period (generally ranging from three to twenty years).

Contract termination revenue is recognized when a customer discontinues service prior to the end of the contract period for which the Company had previously received consideration and for which revenue recognition was deferred.  Contract termination revenue is also recognized when customers have made early termination payments to the Company to settle contractually committed purchase amounts that the customer no longer expects to meet or when the Company renegotiates or discontinues a contract with a customer and as a result is no longer obligated to provide services for consideration previously received and for which revenue recognition has been deferred.  Additionally, the Company includes receipts of bankruptcy claim settlements from former customers as contract termination revenue when received.  Contract termination revenue amounted to $0.6 and $0.8 in the three months ended June 30, 2010 and 2009, respectively, and $1.6 and $2.7 in the six months ended June 30, 2010 and 2009, respectively.

 
8

 

ABOVENET, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)

Non-Monetary Transactions

The Company may exchange capacity with other capacity or service providers.  In December 2004, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 153, “Exchanges of Nonmonetary Assets - An Amendment of APB Opinion No. 29,” (“SFAS No. 153”), (now known as FASB ASC 845-10).  SFAS No. 153 amends Accounting Principles Board Opinion No. 29, “Accounting for Nonmonetary Transactions,” (“APB No. 29”) (also now known as FASB ASC 845-10) to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance.  SFAS No. 153 is to be applied prospectively for nonmonetary exchanges occurring in fiscal periods beginning after June 15, 2005.  The Company’s adoption of SFAS No. 153 on July 1, 2005 did not have a material effect on the consolidated financial position or results of operations of the Company.  Prior to the Company’s adoption of SFAS No. 153, nonmonetary transactions were accounted for in accordance with APB No. 29, where an exchange for similar capacity is recorded at a historical carryover basis and dissimilar capacity is accounted for at fair market value with recognition of any gain or loss.  There were no gains or losses from nonmonetary transactions for the three and six months ended June 30, 2010 and 2009.

Operating Leases

The Company leases office and equipment space, and maintains equipment rentals, right-of-way contracts, building access fees and network capacity under various non-cancelable operating leases.  The lease agreements, which expire at various dates through 2023, are subject, in many cases, to renewal options and provide for the payment of taxes, utilities and maintenance.  Certain lease agreements contain escalation clauses over the term of the lease related to scheduled rent increases resulting from the pass through of increases in operating costs, property taxes and the effect on costs from changes in consumer price indices.  In accordance with SFAS No. 13, “Accounting for Leases,” (now known as FASB ASC 840), the Company recognizes rent expense on a straight-line basis and records a liability representing the difference between straight-line rent expense and the amount payable as an increase or decrease to a deferred liability.  Any leasehold improvements related to operating leases are amortized over the lesser of their economic lives or the remaining lease term.  Rent-free periods and other incentives granted under certain leases are recorded as reductions to rent expense on a straight-line basis over the related lease terms.

Cash and Cash Equivalents and Restricted Cash and Cash Equivalents

For the purposes of the consolidated statements of cash flows, the Company considers cash in banks and short-term highly liquid investments with an original maturity of three months or less to be cash and cash equivalents.  Cash and cash equivalents and restricted cash and cash equivalents are stated at cost, which approximates fair value.  Restricted cash and cash equivalents are comprised of amounts that secure outstanding letters of credit issued in favor of various third parties.

Accounts Receivable, Allowance for Doubtful Accounts and Sales Credits

Accounts receivable are customer obligations for services sold to such customers under normal trade terms.  The Company’s customers are primarily communications carriers, and corporate enterprise and government customers, located primarily in the U.S. and U.K.  The Company performs periodic credit evaluations of its customers’ financial condition.  The Company provides allowances for doubtful accounts and sales credits.  Provisions for doubtful accounts are recorded in selling, general and administrative expenses, while allowances for sales credits are recorded as reductions of revenue.  The adequacy of the reserves is evaluated utilizing several factors including length of time a receivable is past due, changes in the customer’s creditworthiness, customer’s payment history, the length of the customer’s relationship with the Company, current industry trends and the current economic climate.

 
9

 

ABOVENET, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)

Property and Equipment

Property and equipment owned at the Effective Date are stated at their estimated fair values as of the Effective Date based on the Company’s reorganization value, net of accumulated depreciation and amortization incurred since the Effective Date.  Purchases of property and equipment subsequent to the Effective Date are stated at cost, net of depreciation and amortization.  Major improvements are capitalized, while expenditures for repairs and maintenance are expensed when incurred.  Costs incurred prior to a capital project’s completion are reflected as construction in progress and are a part of network infrastructure assets, as described below and included in property and equipment on the respective balance sheets.  At June 30, 2010 and December 31, 2009, the Company had $34.9 and $26.9, respectively, of construction in progress.  Certain internal direct labor costs of constructing or installing property and equipment are capitalized.  Capitalized direct labor is determined based upon a core group of field engineers and IP engineers and reflects their capitalized salary, plus related benefits, and is based upon an allocation of their time between capitalized and non-capitalized projects.  These individuals’ salaries are considered to be costs directly associated with the construction of certain infrastructure and customer installations.  The salaries and related benefits of non-engineers and supporting staff that are part of the engineering departments are not considered part of the pool subject to capitalization.  Capitalized direct labor amounted to $2.8 and $2.9 for the three months ended June 30, 2010 and 2009, respectively, and $5.8 and $5.6 for the six months ended June 30, 2010 and 2009, respectively.  Depreciation and amortization is provided on a straight-line basis over the estimated useful lives of the assets, with the exception of leasehold improvements, which are amortized over the lesser of the estimated useful lives or the term of the lease.

Estimated useful lives of the Company’s property and equipment are as follows:
 
Network infrastructure assets and storage huts (except for risers, which are 5 years)
 
20 years
     
HVAC and power equipment
 
12 to 20 years
     
Software and computer equipment
 
3 to 4 years
     
Transmission and IP equipment
 
5 to 7 years
     
Furniture, fixtures and equipment
 
3 to 10 years
     
Leasehold improvements
 
Lesser of estimated useful life or the lease term

When property and equipment is retired or otherwise disposed of, the cost and accumulated depreciation is removed from the accounts, and resulting gains or losses are reflected in net income.

From time to time, the Company is required to replace or re-route existing fiber due to structural changes such as construction and highway expansions, which is defined as “relocation.”  In such instances, the Company fully depreciates the remaining carrying value of network infrastructure removed or rendered unusable and capitalizes the new fiber and associated construction costs of the relocation placed into service, which is reduced by any reimbursements received for such costs.  The Company capitalized relocation costs amounting to $0.2 and $1.0 for the three months ended June 30, 2010 and 2009, respectively, and $0.4 and $1.7 for the six months ended June 30, 2010 and 2009, respectively.  The Company fully depreciated the remaining carrying value of the network infrastructure rendered unusable, which on an original cost basis, totaled $0.03 and $0.05 ($0.03 and $0.04 on a net book value basis) for the three and six months ended June 30, 2010, respectively, and, which on an original cost basis, totaled $0.10 and $0.20 ($0.07 and $0.14 on a net book value basis) for the three and six months ended June 30, 2009, respectively.  To the extent that relocation requires only the movement of existing network infrastructure to another location, the related costs are included in the Company’s results of operations.

In accordance with SFAS No. 34, “Capitalization of Interest Cost,” (now known as FASB ASC 835-20), interest on certain construction projects would be capitalized.  Such amounts were considered immaterial, and accordingly, no such amounts were capitalized during the three and six months ended June 30, 2010 and 2009.

 
10

 

ABOVENET, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)

In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” (now known as FASB ASC 360-10-35), the Company periodically evaluates the recoverability of its long-lived assets and evaluates such assets for impairment whenever events or circumstances indicate that the carrying amount of such assets (or group of assets) may not be recoverable.  Impairment is determined to exist if the estimated future undiscounted cash flows are less than the carrying value of such asset.  The Company considers various factors to determine if an impairment test is necessary.  The factors include: consideration of the overall economic climate, technological advances with respect to equipment, its strategy and capital planning.  Since June 30, 2006, no event has occurred nor has the business environment changed to trigger an impairment test for assets in revenue service and operations.  The Company also considers the removal of assets from the network as a triggering event for performing an impairment test.  Once an item is removed from service, unless it is to be redeployed, it may have little or no future cash flows related to it.  The Company performed annual physical counts of such assets that are not in revenue service or operations (e.g., inventory, primarily spare parts) at September 30, 2009 and 2008.  With the assistance of a valuation report of the assets in inventory, prepared by an independent third party on a basis consistent with SFAS No. 157, “Fair Value Measurements,” (now known as FASB ASC 820-10), and pursuant to FASB ASC 360-10-35, the Company determined that the fair value of certain of such assets was less than the carrying value and thus recorded a provision for equipment impairment of $0.4 for the year ended December 31, 2009.  The Company also recorded a provision for equipment impairment of $0.8 in the year ended December 31, 2009 to record the loss in value of certain equipment, most of which was eventually sold to an unaffiliated third party.  See Note 3, “Change in Estimate.”  The Company provided allowances for impairment of $0.2 and $0.5 in the six months ended June 30, 2010 and 2009, respectively, which were recorded in the three months ended June 30, 2010 and 2009, respectively.

Treasury Stock

Treasury stock is accounted for under the cost method.

Asset Retirement Obligations

In accordance with SFAS No. 143, “Accounting for Asset Retirement Obligations,” (now known as FASB ASC 410-20), the Company recognizes the fair value of a liability for an asset retirement obligation in the period in which it is incurred if a reasonable estimate of fair value can be made.  The Company has asset retirement obligations related to the de-commissioning and removal of equipment, restoration of leased facilities and the removal of certain fiber and conduit systems.  Considerable management judgment is required in estimating these obligations.  Important assumptions include estimates of asset retirement costs, the timing of future asset retirement activities and the likelihood of contractual asset retirement provisions being enforced.  Changes in these assumptions based on future information could result in adjustments to these estimated liabilities.

Asset retirement obligations are generally recorded as “other long-term liabilities,” are capitalized as part of the carrying amount of the related long-lived assets included in property and equipment, net, and are depreciated over the life of the associated asset.  Asset retirement obligations aggregated $7.4 and $7.2 at June 30, 2010 and December 31, 2009, respectively, of which $3.9 and $3.8 were included in “Accrued expenses,” and $3.5 and $3.4 were included in “Other long-term liabilities” at such dates.  Accretion expense, which is included in “Interest expense,” amounted to $0.07 and $0.02 for the three months ended June 30, 2010 and 2009, respectively, and $0.14 and $0.10 for the six months ended June 30, 2010 and 2009, respectively.

 
11

 

ABOVENET, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)

Income Taxes

The Company accounts for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes,” (now known as FASB ASC 740).  Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between financial statement carrying amounts of existing assets and liabilities and their respective tax basis, net operating losses and tax credit carryforwards, and tax contingencies.  Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.  After an evaluation of the realizability of the Company’s deferred tax assets, the Company reduced its valuation allowance by $183.0 during the fourth quarter of 2009.  See Note 5, “Income Taxes,” for a further discussion.

The Company is subject to audits by various taxing authorities, and these audits may result in proposed assessments where the ultimate resolution results in the Company owing additional taxes.  The Company is required to establish reserves under FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” (now known as FASB ASC 740-10), when the Company believes there is uncertainty with respect to certain positions and the Company may not succeed in realizing the tax benefit.  The Company believes that its tax return positions are appropriate and supportable under relevant tax law.  The Company has evaluated its tax positions for items of uncertainty in accordance with FASB ASC 740-10 and has determined that its tax positions are highly certain within the meaning of FASB ASC 740-10.  The Company believes the estimates and assumptions used to support its evaluation of tax benefit realization are reasonable.  Accordingly, no adjustments have been made to the consolidated financial statements for the three and six months ended June 30, 2010 and 2009.  The provision for income taxes, income taxes payable and deferred income taxes are provided for in accordance with the liability method.  Deferred tax assets and liabilities are determined based on differences between the financial reporting and tax basis of assets and liabilities and are measured by applying enacted tax rates and laws to taxable years in which such differences are expected to reverse.

The Company’s reorganization resulted in a significantly modified capital structure as a result of applying fresh-start accounting in accordance with FASB ASC 852-10 on the Effective Date.  Fresh start accounting has important consequences on the accounting for the realization of valuation allowances, related to net deferred tax assets that existed on the Effective Date but which arose in pre-emergence periods.  Prior to 2009, fresh start accounting required the reversal of these allowances to be recorded as a reduction of intangible assets until exhausted and thereafter as additional paid in capital.  Beginning in 2009, in accordance with SFAS141(R), “Business Combinations (Revised),” (now known as FASB ASC 805), future utilization of such benefit will reduce income tax expense.  This treatment does not result in any change in liabilities to taxing authorities or in cash flows.

Undistributed earnings of the Company’s foreign subsidiaries are considered to be indefinitely reinvested and therefore, no provision for domestic taxes has been provided thereon.  Upon repatriation of those earnings, in the form of dividends or otherwise, the Company would be subject to domestic income taxes, offset (all or in part) by foreign tax credits, related to income and withholding taxes payable to the various foreign countries.  Determination of the amount of unrecognized deferred domestic income tax liability is not practicable due to the complexities associated with its hypothetical calculation; however, unrecognized foreign tax credit carryforwards would be available to reduce some portion of the domestic liability.
 
The Company’s policy is to recognize interest and penalties accrued as a component of operating expense.  As of the date of adoption of FASB ASC 740-10, the Company did not have any accrued interest or penalties associated with any unrecognized income tax benefits, nor was any interest expense recognized during the three and six months ended June 30, 2010 and 2009.

 
12

 

ABOVENET, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)

Foreign Currency Translation and Transactions

The Company’s functional currency is the U.S. dollar.  For those subsidiaries not using the U.S. dollar as their functional currency, assets and liabilities are translated at exchange rates in effect at the balance sheet date and income and expense transactions are translated at average exchange rates during the period.  Resulting translation adjustments are recorded directly to a separate component of shareholders’ equity and are reflected in the accompanying consolidated statements of comprehensive income.  The Company’s foreign exchange transaction gains (losses) are generally included in “other income (expense), net” in the consolidated statements of operations.

Stock Options

On September 8, 2003, the Company adopted the fair value provisions of SFAS No. 148, “Accounting for Stock-Based Compensation Transition and Disclosure,” (“SFAS No. 148”), (now known as FASB ASC 718-10).  SFAS No. 148 amended SFAS No. 123, “Accounting for Stock-Based Compensation,” (“SFAS No. 123”), (also now known as FASB ASC 718-10), to provide alternative methods of transition to SFAS No. 123’s fair value method of accounting for stock-based employee compensation.  See Note 7, “Stock-Based Compensation.”

Under the fair value provisions of SFAS No. 123, the fair value of each stock-based compensation award is estimated at the date of grant, using the Black-Scholes option pricing model for stock option awards.  The Company did not have a historical basis for determining the volatility and expected life assumptions in the model due to the Company’s limited market trading history; therefore, the assumptions used for these amounts are an average of those used by a select group of related industry companies.  Most stock-based awards have graded vesting (i.e. portions of the award vest at different dates during the vesting period).  The Company recognizes the related stock-based compensation expense of such awards on a straight-line basis over the vesting period for each tranche in an award.  Upon consummation of the Company’s Plan of Reorganization, all then outstanding stock options were cancelled.

Effective January 1, 2006, the Company adopted SFAS No. 123R, “Share-Based Payment,” (“SFAS No. 123R”), (now known as FASB ASC 718), using the modified prospective method.  SFAS No. 123R requires all share-based awards granted to employees to be recognized as compensation expense over the vesting period, based on fair value of the award.  The fair value method under SFAS No. 123R is similar to the fair value method under SFAS No. 123 with respect to measurement and recognition of stock-based compensation expense except that SFAS No. 123R requires an estimate of future forfeitures, whereas SFAS No. 123 allowed companies to estimate forfeitures or recognize the impact of forfeitures as they occur.  As the Company recognized the impact of forfeitures as they occurred under SFAS No. 123, the adoption of SFAS No. 123R did result in different accounting treatment, but it did not have a material impact on the Company’s consolidated financial statements.

There were no options to purchase shares of common stock granted during the three and six months ended June 30, 2010 and 2009.

Restricted Stock Units

Compensation cost for restricted stock unit awards is measured based upon the quoted closing market price for the Company’s stock on the date of grant.  The compensation cost is recognized on a straight-line basis over the vesting period.  See Note 7, “Stock-Based Compensation.”

Stock Warrants

In connection with the Plan of Reorganization described in Note 1, “Background and Organization,” the Company issued to holders of general unsecured claims as part of the settlement of such claims (i) five year warrants to purchase 1,418,918 shares of common stock with an exercise price of $10.00 per share (expired September 8, 2008) and (ii) seven year warrants to purchase 1,669,316 shares of common stock with an exercise price of $12.00 per share (expiring September 8, 2010).  The stock warrants are treated as equity upon their exercise based upon the terms of the warrant and cash received.  18,208 and 13,222 seven year stock warrants to purchase shares of common stock were exercised during the three months ended June 30, 2010 and 2009, respectively.  437,634 and 13,622 stock warrants to purchase shares of common stock were exercised during the six months ended June 30, 2010 and 2009, respectively.

 
13

 

ABOVENET, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)

Under the terms of the five year and seven year warrant agreements (collectively, the “Warrant Agreements”), if the market price of the Company’s common stock, as defined in the Warrant Agreements, 60 days prior to the expiration date of the respective warrants, is greater than the warrant exercise price, the Company is required to give each warrant holder notice that at the warrant expiration date, the warrants would be deemed to have been exercised pursuant to the net exercise provisions of the respective Warrant Agreements (the “Net Exercise”), unless the warrant holder elects, by written notice, to not exercise its warrants.  Under the Net Exercise, shares issued to the warrant holders would be reduced by the number of shares necessary to cover the aggregate exercise price of the shares, valuing such shares at the current market price, as defined in the Warrant Agreements.  Any fractional shares, otherwise issuable, would be paid in cash.

During the six months ended June 30, 2010, seven year warrants to purchase 323,084 shares of common stock were exercised pursuant to the Net Exercise provisions described above, of which 261,390 shares were issued and 61,694 shares were deemed repurchased.  There were no Net Exercises during the three and six months ended June 30, 2009 or during the three months ended June 30, 2010.  Additionally, seven year warrants to purchase 18,208 and 114,550 shares of common stock were exercised during the three and six months ended June 30, 2010, respectively.  At June 30, 2010, seven year warrants to purchase 420,896 shares of common stock were outstanding.

Derivative Financial Instruments

The Company utilizes derivative financial instruments known as interest rate swaps (“derivatives”) to mitigate its exposure to interest rate risk.  The Company purchased the first interest rate swap on August 4, 2008 to hedge the interest rate on the $24.0 (original principal) portion of the Term Loan (as such term is defined in Note 4, “Note Payable”) and the Company purchased a second interest rate swap on November 14, 2008 to hedge the interest rate on the additional $12.0 (original principal) portion of the Term Loan provided by SunTrust Bank.  The Company accounted for the derivatives under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” (now known as FASB ASC 815).  FASB ASC 815 requires that all derivatives be recognized in the financial statements and measured at fair value regardless of the purpose or intent for holding them.  By policy, the Company has not historically entered into derivatives for trading purposes or for speculation.  Based on criteria defined in FASB ASC 815, the interest rate swaps were considered cash flow hedges and were 100% effective.  Accordingly, changes in the fair value of derivatives are, and will be, recorded each period in accumulated other comprehensive loss.  Changes in the fair value of the derivatives reported in accumulated other comprehensive loss will be reclassified into earnings in the period in which earnings are impacted by the variability of the cash flows of the hedged item.  The ineffective portion of all hedges, if any, is recognized in current period earnings.  The unrealized net loss recorded in accumulated other comprehensive loss at June 30, 2010 and December 31, 2009 was $1.0 and $1.2, respectively, for the interest rate swaps.  The mark-to-market value of the cash flow hedges will be recorded in other non-current assets or other long-term liabilities, as applicable, and the offsetting gains or losses in accumulated other comprehensive loss.

On January 1, 2009, the Company adopted SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities – an amendment of FASB Statement No. 133,” (now known as FASB ASC 815-10).  FASB ASC 815-10 changes the disclosure requirements for derivatives and hedging activities.  Entities are required to provide enhanced disclosures about (i) how and why an entity uses derivatives; (ii) how derivatives and related hedged items are accounted for under FASB ASC 815; and (iii) how derivatives and related hedged items affect an entity’s financial position and cash flows.

 
14

 

ABOVENET, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)

The Company minimizes its credit risk relating to counterparties of its derivatives by transacting with multiple, high-quality counterparties, thereby limiting exposure to individual counterparties, and by monitoring the financial condition of its counterparties.

All derivatives were recorded on the Company’s consolidated balance sheets at fair value.  Accounting for the gains and losses resulting from changes in the fair value of derivatives depends on the use of the derivative and whether it qualifies for hedge accounting in accordance with FASB ASC 815.  At June 30, 2010 and December 31, 2009, the Company’s consolidated balance sheet included net interest rate swap derivative liabilities of $1.0 and $1.2, respectively.

Derivatives recorded at fair value in the Company’s consolidated balance sheets as of June 30, 2010 and December 31, 2009 consisted of the following:

   
Derivative Liabilities
 
Derivatives designated as hedging instruments
 
June 30, 2010
   
December 31, 2009
 
Interest rate swap agreements (*)
  $ 1.0     $ 1.2  
                 
Total derivatives designated as hedging instruments
  $ 1.0     $ 1.2  

The derivative liabilities are two interest rate swap agreements with original three year terms.  They are both considered to be long-term liabilities for financial statement purposes.

Interest Rate Swap Agreements

The notional amounts provide an indication of the extent of the Company’s involvement in such agreements but do not represent its exposure to market risk.  The following table shows the notional amount outstanding, maturity date, and the weighted average receive and pay rates of the interest rate swap agreement as of June 30, 2010.
 
 
 
 
 
Weighted Average Rate
 
Notional Amount
 
Maturity Date
 
Pay
   
Receive
 
$ 20.4  
August 2011
  3.65%    
0.83%
 
                       
  10.2  
November 2011
  2.635%    
0.44%
 
                       
$ 30.6                    

Interest expense under these agreements, and the respective debt instruments that they hedge, are recorded at the net effective interest rate of the hedged transaction.

The notional amounts of the swap arrangements have since been reduced by amounts corresponding to reductions in the outstanding principal balances.

 
15

 

ABOVENET, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)

Fair Value of Financial Instruments

The Company adopted SFAS No. 157, “Fair Value Measurements,” (now known as FASB ASC 820-10), for the Company’s financial assets and liabilities effective January 1, 2008.  This pronouncement defines fair value, establishes a framework for measuring fair value, and requires expanded disclosures about fair value measurements.  FASB ASC 820-10 emphasizes that fair value is a market-based measurement, not an entity-specific measurement, and defines fair value as the price that would be received to sell an asset or transfer a liability in an orderly transaction between market participants at the measurement date.  FASB ASC 820-10 discusses valuation techniques, such as the market approach (comparable market prices), the income approach (present value of future income or cash flow) and the cost approach (cost to replace the service capacity of an asset or replacement cost), which are each based upon observable and unobservable inputs.  Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions. FASB ASC 820-10 utilizes a fair value hierarchy that prioritizes inputs to fair value measurement techniques into three broad levels:
 
Level 1:
Observable inputs such as quoted prices for identical assets or liabilities in active markets.
   
Level 2:
Observable inputs other than quoted prices that are directly or indirectly observable for the asset or liability, including quoted prices for similar assets or liabilities in active markets; quoted prices for similar or identical assets or liabilities in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable.
   
Level 3:
Unobservable inputs that reflect the reporting entity’s own assumptions.

The Company’s investment in overnight money market institutional funds, which amounted to $158.9 and $154.1 at June 30, 2010 and December 31, 2009, respectively, is included in cash and cash equivalents on the accompanying balance sheets and is classified as a Level 1 asset.

The Company is party to two interest rate swaps, which are utilized to modify the Company’s interest rate risk.  The Company recorded the mark-to-market value of the interest rate swap contracts of $1.0 and $1.2 in other long-term liabilities in the consolidated balance sheet at June 30, 2010 and December 31, 2009, respectively.  The Company used third parties to value each of the interest rate swap agreements at June 30, 2010 and December 31, 2009, as well as its own market analysis to determine fair value.  The fair value of the interest rate swap contracts are classified as Level 2 liabilities.

The Company’s consolidated balance sheets include the following financial instruments: short-term cash investments, trade accounts receivable, trade accounts payable and note payable.  The Company believes the carrying amounts in the financial statements approximate the fair value of these financial instruments due to the relatively short period of time between the origination of the instruments and their expected realization or the interest rates which approximate current market rates.

 
16

 

ABOVENET, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)

Concentration of Credit Risk

Financial instruments which potentially subject the Company to concentration of credit risk consist principally of temporary cash investments and accounts receivable.  The Company does not enter into financial instruments for trading or speculative purposes.  The Company’s cash and cash equivalents are invested in investment-grade, short-term investment instruments with high quality financial institutions.  The Company’s trade receivables, which are unsecured, are geographically dispersed, and no single customer accounts for greater than 10% of consolidated revenue or accounts receivable, net.  The Company performs ongoing credit evaluations of its customers’ financial condition.  The allowance for non-collection of accounts receivable is based upon the expected collectability of all accounts receivable.  The Company places its cash and cash equivalents primarily in commercial bank accounts in the U.S.  Account balances generally exceed federally insured limits.

401(k) and Other Post-Retirement Benefits

The Company has a Profit Sharing and 401(k) Plan (the “Plan”) for its employees in the U.S., which permits employees to make contributions to the Plan on a pre-tax salary reduction basis in accordance with the provisions of the Internal Revenue Code and permits the employer to provide discretionary contributions.  All full-time U.S. employees are eligible to participate in the Plan at the beginning of the month following three months of service.  Eligible employees may make contributions subject to the limitations defined by the Internal Revenue Code.  The Company matches 50% of a U.S. employee’s contributions, up to the amount set forth in the Plan.  Matched amounts vest based upon an employee’s length of service.  The Company’s subsidiaries in the U.K. have a different plan under which contributions are made up to a maximum of 8% when U.K. employee contributions reach 5% of salary.  Under the U.K. plan, contributions are made at two levels.  When a U.K. employee contributes 3% or more but less than 5% of their salary to the plan, the Company’s contribution is fixed at 5% of the salary.  When a U.K. employee contributes over 5% of their salary to the plan, the Company’s contribution is fixed at 8% of the salary (regardless of the percentage of the contribution in excess of 5%).

The Company contributed $0.4 for each of the three months ended June 30, 2010 and 2009 and contributed $0.9 for each of the six months ended June 30, 2010 and 2009, net of forfeitures for its obligations under these plans.

Taxes Collected from Customers

In June 2006, the Emerging Issues Task Force (“EITF”) ratified the consensus on EITF No. 06-3, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation),” (“EITF No. 06-3”), (now known as FASB ASC 605-45).  FASB ASC 605-45 requires that companies disclose their accounting policies regarding the gross or net presentation of certain taxes.  Taxes within the scope of FASB ASC 605-45 are any taxes assessed by a governmental authority that are directly imposed on a revenue-producing transaction between a seller and a customer and may include, but are not limited to, sales, use, value added and some excise taxes.  In addition, if such taxes are significant, and are presented on a gross basis, the amounts of those taxes should be disclosed.  The Company adopted EITF No. 06-3 effective January 1, 2007.  The Company records Universal Service Fund (“USF”) contributions relating to certain services it provides on a net basis in accordance with the guidelines of EITF No. 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent,”  (also now known as FASB ASC 605-45).  The Company’s policy is to record all such fees, contributions and taxes within the scope of FASB ASC 605-45 on a net basis.

Reclassifications

Certain reclassifications have been made to the consolidated financial statements for the three and six months ended June 30, 2010 to conform to the classifications used for the three and six months ended June 30, 2010.

 
17

 

ABOVENET, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)

Recently Issued Accounting Pronouncements

During the third quarter of 2009, the Company adopted the FASB Accounting Standards Update No. 2009-01, “Amendments based on SFAS No. 168 - The   FASB Accounting Standards Codification TM and the Hierarchy of Generally Accepted Accounting Principles,” (the “Codification”).  The Codification became the single source of authoritative GAAP in the U.S., other than rules and interpretative releases issued by the SEC.  The Codification reorganized GAAP into a topical format that eliminates the previous GAAP hierarchy and instead established two levels of guidance – authoritative and nonauthoritative.  All non-grandfathered, non-SEC accounting literature that was not included in the Codification became nonauthoritative.  The adoption of the Codification did not change previous GAAP, but rather simplified user access to all authoritative literature related to a particular accounting topic in one place.  Accordingly, the adoption had no impact on the Company’s financial position, results of operations or cash flows.  All references to previous GAAP citations in the Company’s consolidated financial statements have been updated for the new references under the Codification.

In September 2006, the FASB issued SFAS No. 157, “The Fair Value Measurements,” (“SFAS No. 157”), (now known as FASB ASC 820-10), effective for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years.  FASB ASC 820-10 establishes a framework for measuring fair value under accounting principles generally accepted in the U.S. and expands disclosures about fair value measurement.  In February 2008, the FASB deferred the adoption of SFAS No. 157 as provided by FASB Staff Position No. FAS 157-2, (also now known as FASB ASC 820-10), for one year as it applies to certain items, including assets and liabilities initially measured at fair value in a business combination, reporting units and certain assets and liabilities measured at fair value in connection with goodwill impairment tests in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” (now known as FASB ASC 350), and long-lived assets measured at fair value for impairment assessments under SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” (now known as FASB ASC 360-10-35).  The Company adopted this statement on January 1, 2008 with respect to its financial assets and liabilities, as discussed above.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” (now known as FASB ASC 825).  FASB ASC 825 gives entities the option to carry most financial assets and liabilities at fair value, with changes in fair value recorded in earnings.  This statement, which was effective in the first quarter of fiscal 2009, did not have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations (Revised),” (“SFAS No. 141(R)”), (now known as FASB ASC 805), to replace SFAS No. 141, “Business Combinations.”  FASB ASC 805 requires the use of the acquisition method of accounting, defines the acquirer, establishes the acquisition date and broadens the scope to all transactions and other events in which one entity obtains control over one or more other businesses.  This statement is effective for business combinations or transactions entered into for fiscal years beginning on or after December 15, 2008.  The adoption of this statement did not have a material impact on the Company’s financial position, results of operations or cash flows.

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements – an amendment of ARB No. 51,” (“SFAS No. 160”), (now known as FASB ASC 810-10-65).  FASB ASC 810-10-65 establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the retained interest and gain or loss when a subsidiary is deconsolidated.  This statement is effective for financial statements issued for fiscal years beginning on or after December 15, 2008.  The adoption of this statement did not have a material impact on the Company’s financial position, results of operations or cash flows.

 
18

 

ABOVENET, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)

  In December 2007, the SEC issued SAB No. 110, “Certain Assumptions Used in Valuation Methods – Expected Term,” (now known as FASB ASC 718-10).  FASB ASC 718-10 allows companies to continue to use the simplified method, as defined in SAB No. 107, “Share-Based Payment,” (also now known as FASB ASC 718-10), to estimate the expected term of stock options under certain circumstances.  The simplified method for estimating expected term uses the mid-point between the vesting term and the contractual term of the stock option.  The Company has analyzed the circumstances in which the use of the simplified method is allowed.  The Company has opted to use the simplified method for stock options it granted in 2008 because management believes that the Company does not have sufficient historical exercise data to provide a reasonable basis upon which to estimate the expected term due to the limited period of time the Company’s shares of common stock have been publicly traded.  There were no options to purchase shares of common stock granted during the three and six months ended June 30, 2010 and 2009.

In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities – an amendment of FASB Statement No. 133,” (“SFAS No. 161”), (now known as FASB ASC815), which requires additional disclosures about the objectives of using derivative instruments, the method by which the derivative instruments and related hedged items are accounted for under FASB Statement No. 133, (also now known as FASB ASC 815) and its related interpretations; and the effect of derivative instruments and related hedged items on financial position, financial performance and cash flows.  This statement also requires disclosure of the fair values of derivative instruments and their gains and losses in a tabular format.  This statement is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early adoption encouraged. The adoption of this statement did not have a material impact on the Company’s financial position, results of operations or cash flows.

In April 2008, the FASB issued EITF No. 07-5, “Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock,” (“EITF No. 07-5”), (now known as FASB ASC 815-40).  FASB ASC 815-40 provides guidance on determining what types of instruments or embedded features in an instrument held by a reporting entity can be considered indexed to its own stock for the purpose of evaluating the first criteria of the scope exception in paragraph 11 (a) of SFAS No. 133.  This issue is effective for financial statements issued for fiscal years beginning after December 15, 2008 and early application is not permitted.  The adoption of this issue did not have a material impact on the Company’s financial position, results of operations or cash flows.

In June 2008, the FASB issued EITF No. 08-3, “Accounting by Lessees for Maintenance Deposits under Lease Agreements,” (“EITF No. 08-3”), (now known as FASB ASC 840-10).  FASB ASC 840-10 mandates that all nonrefundable maintenance deposits should be accounted for as a deposit.  When the underlying maintenance is performed, the deposit is expensed or capitalized in accordance with the lessee’s maintenance accounting policy.  This issue is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2008.  The adoption of this issue did not have a material impact on the Company’s financial position, results of operations or cash flows.

In June 2008, the FASB issued EITF No. 03-6-1, “Determining Whether Instruments Granted in Shared-Based Payment Transactions are Participating Securities,” (“EITF No. 03-6-1”), (now known as FASB ASC 260-10).  FASB ASC 260-10 provides that unvested share-based payment awards that contain non-forfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of earnings per share pursuant to the two-class method.  This issue is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years.  Upon adoption, a company is required to retrospectively adjust its earnings per share date (including any amounts related to interim periods, summaries of earnings and selected financial data) to conform to provisions of FASB ASC 260-10.  The adoption of this issue did not have a material impact on the Company’s financial position, results of operations or cash flows.

In April 2009, the FASB issued Staff Position No. FAS 107-1 and APB 28-1, “Interim Disclosures about Fair Value of Financial Instruments,” (“FSP No. FAS 107-1 and APB 28-1”), (now known as FASB ASC 825).  This statement amends SFAS No. 107, “Disclosures about Fair Value of Financial Instruments,” (now known as FASB ASC 825-10), to require disclosures about fair value of financial instruments in interim as well as in annual financial statements.  This statement also amends APB Opinion No. 28, “Interim Financial Reporting,” (now known as FASB ASC 270-10-50), to require those disclosures in all interim financial results, financial position and financial statement disclosures.  This statement became effective for the Company for the three months ended June 30, 2009.  This statement did not have a material impact on the Company’s financial position, results of operations or cash flows.


 
19

 

ABOVENET, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)

In May 2009, the FASB issued SFAS No. 165, "Subsequent Events," ("SFAS No. 165"), (now known as FASB ASC 855-10), effective for interim or annual financial periods ending after June 15, 2009.  For calendar year entities, SFAS No. 165 became effective for the three months ended June 30, 2009.  The objective of FASB ASC 855-10 is to establish general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued.  In particular, FASB ASC 855-10 sets forth (1) the period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition or disclosure in the financial statements; (2) the circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements; and (3) the disclosures that an entity should make about events or transactions that occurred after the balance sheet date.  The adoption of this statement did not have a material impact on the Company’s financial position, results of operations or cash flows.

In August 2009, the FASB issued ASU No. 2009-5, "Fair Value Measurements and Disclosures (Topic 820) - Measuring Liabilities at Fair Value."  ASU No. 2009-5 provides clarification 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 the quoted price of the identical liability when traded as an asset, quoted prices for similar liabilities or similar liabilities when traded as assets, or another valuation technique that is consistent with the principles of ASC Topic 820.  ASU No. 2009-5 is effective for the first reporting period (including interim periods) beginning after issuance.  The adoption of ASU No. 2009-5 did not have a material impact on the Company’s financial position, results of operations or cash flows.

In October 2009, the FASB issued ASU No. 2009-13, "Revenue Recognition (Topic 605) - Multiple Deliverable Revenue Arrangements." ASU No. 2009-13 eliminates the residual method of allocation and requires that arrangement consideration be allocated at the inception of the arrangement to all deliverables using the relative selling price method and expands the disclosures related to multiple-deliverable revenue arrangements.  ASU No. 2009-13 is effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with earlier adoption permitted.  The adoption of ASU No. 2009-13 did not have a material impact on the Company’s financial position, results of operations or cash flows.

In January 2010, the FASB issued ASU No. 2010-02, "Consolidation (Topic 810) - Accounting and Reporting for Decreases in Ownership of a Subsidiary - a Scope Clarification." ASU No. 2010-02 clarifies that the scope of the decrease in ownership provisions of Topic 810 applies to a subsidiary or group of assets that is a business, a subsidiary that is a business that is transferred to an equity method investee or a joint venture or an exchange of a group of assets that constitutes a business for a noncontrolling interest in an entity and does not apply to sales in substance of real estate.  ASU No. 2010-02 is effective as of the beginning of the period in which an entity adopts SFAS No. 160 or, if SFAS No. 160 has been previously adopted, the first interim or annual period ending on or after December 15, 2009, applied retrospectively to the first period that the entity adopted SFAS No. 160.  The adoption of ASU No. 2010-02 did not have a material impact on the Company’s financial position, results of operations or cash flows.

In January 2010, the FASB issued ASU No. 2010-06, "Fair Value Measurements and Disclosures (Topic 820) - Improving Disclosures about Fair Value Measurements."  ASU 2010-06 requires new disclosures regarding transfers in and out of the Level 1 and 2 and activity within Level 3 fair value measurements and clarifies existing disclosures of inputs and valuation techniques for Level 2 and 3 fair value measurements.  ASU 2010-06 also includes conforming amendments to employers' disclosures about postretirement benefit plan assets.  The new disclosures and clarifications of existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosure of activity within Level 3 fair value measurements, which is effective for fiscal years beginning after December 15, 2010, and for interim periods within those years.  The adoption of ASU No. 2010-06 did not have a material impact on the Company’s financial position, results of operations or cash flows.

In February 2010, the FASB issued ASU 2010-09, "Subsequent Events (Topic 855) - Amendments to Certain Recognition and Disclosure Requirements."  ASU 2010-09 requires an entity that is an SEC filer to evaluate subsequent events through the date that the financial statements are issued and removes the requirement that an SEC filer disclose the date through which subsequent events have been evaluated.  ASU 2010-09 was effective upon issuance.  The adoption of ASU 2010-09 had no effect on the Company’s financial position, results of operations or cash flows.

 
20

 

ABOVENET, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)

In April 2010, the FASB issued ASU 2010-13, "Compensation - Stock Compensation (Topic 718) - Effect of Denominating the Exercise Price of a Share-Based Payment Award in the Currency of the Market in Which the Underlying Equity Security Trades."  ASU 2010-13 provides amendments to Topic 718 to clarify that an employee share-based payment award with an exercise price denominated in the currency of a market in which a substantial portion of the entity's equity securities trades should not be considered to contain a condition that is not a market, performance, or service condition.  Therefore, an entity would not classify such an award as a liability if it otherwise qualifies as equity.  The amendments in ASU 2010-13 are effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2010.  The adoption of ASU 2010-13 will not have a material impact on the Company’s financial position, results of operations or cash flows.

NOTE 3: CHANGE IN ESTIMATE

Effective January 1, 2008, the Company changed the estimated useful lives for its spare parts (which are classified as inventory) from five years to the respective asset class lives of such parts, which range from seven to twenty years.  The effect of this change was not material.  Effective October 1, 2009, the Company changed the estimated useful lives for certain HVAC and power equipment from 20 years to 12 to 15 years and certain components of infrastructure (risers) from 20 years to 5 years.  Effective January 1, 2010, the Company changed the estimated useful lives for its IP equipment from 7 years to 5 years.  Additionally, the Company changed the estimated useful lives for certain capitalized labor from 20 years to 7 years.  The effect of these changes on the Company’s future operating results will not be material.

NOTE 4:  NOTE PAYABLE

Secured Credit Facility

On February 29, 2008, the Company, excluding certain foreign subsidiaries, entered into a Credit and Guaranty Agreement (as amended, the “Credit Agreement”) providing for a $60.0 senior secured credit facility (the “Secured Credit Facility”), consisting of an $18.0 revolving credit facility (the “Revolver”) and a $42.0 term loan facility (the “Term Loan”).  The initial lenders under the Secured Credit Facility were Societe Generale and CIT Lending Services Corporation.  The Secured Credit Facility is secured by substantially all of the Company’s domestic assets.  The Term Loan was comprised of $24.0, which was advanced at closing and up to $18.0 of which originally could be drawn within nine months of closing at the Company’s option (the “Delayed Draw Term Loan”).  In September 2008, the Delayed Draw Term Loan option, which was originally scheduled to expire on November 25, 2008, was extended to June 30, 2009 and then subsequently extended to December 31, 2009.  The Revolver and the Term Loan each have a term of five years from the closing date of the Secured Credit Facility.  The Company paid a non-refundable work fee of $0.1 to the lenders, which was credited against the upfront fee of 1.5% ($0.9) of the total amount of the Secured Credit Facility that was paid at closing and paid $0.3 to its unaffiliated third party financial advisors who assisted the Company.  Additionally, the Company is liable for an unused commitment fee of 0.50% per annum or 0.75% per annum, depending on the utilization of the Secured Credit Facility.  Interest accrues at LIBOR (30, 60, 90 or 180 day rates) or at the announced base rate of the administrative agent at the Company’s option, plus the applicable margins, as defined.  The Company has chosen 30 day LIBOR as the interest rate during the term of the interest rate swap (30 day LIBOR was 0.35375% at June 30, 2010).  Additionally, the Company was originally required to maintain an unrestricted cash balance at all times of at least $20.0.  On February 29, 2008, the Company received proceeds of $24.0, before the deduction of debt acquisition costs, under the Term Loan.  As required under the provisions of the Term Loan, the initial advance was at the base rate of interest, plus the margin (8.25% at February 29, 2008) and converted to LIBOR, plus 3.25% per annum (6.26%) on March 5, 2008.

In addition, the Company’s ability to draw upon the available commitments under the Revolver is subject to compliance with all of the covenants contained in the Credit Agreement and the Company’s continued ability to make certain representations and warranties.  Among other things, these covenants imposed limits on annual capital expenditures in 2008, 2009 and 2010, provide that the Company’s net total funded debt ratio cannot at any time exceed a specified amount and require that the Company maintain a minimum consolidated fixed charges coverage ratio.  In addition, the Credit Agreement prohibits the Company from paying dividends (other than in its own shares or other equity securities) and from making certain other payments, including payments to acquire the Company’s equity securities other than under specified circumstances, which include the repurchase of the Company’s equity securities from employees and directors in an aggregate amount not to exceed $15.0.  The Company was in compliance with all of its debt covenants as of June 30, 2010.

 
21

 

ABOVENET, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)

On September 26, 2008, the Company executed a joinder agreement to the Secured Credit Facility that added SunTrust Bank as an additional lender and increased the amount of the Secured Credit Facility to $90.0 effective October 1, 2008.  In connection with the joinder agreement, the Company paid a $0.45 fee at closing and an aggregate of $0.25 of advisory fees.  The availability under the Revolver increased to $27.0, the Term Loan increased to $36.0 and the available Delayed Draw Term Loan increased to $27.0.  The additional amount of the Term Loan of $12.0 was advanced on October 1, 2008.

Effective August 4, 2008, the Company entered into a swap arrangement under which it fixed its borrowing costs with respect to the $24.0 (original principal) Term Loan outstanding for three years at 3.65%, plus the applicable margin of 3.25%, which was reduced to 3.00% on September 30, 2008 upon the filing of the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.

On November 14, 2008, the Company entered into a swap arrangement under which it fixed its borrowing costs with respect to the additional $12.0 (original principal) under the Term Loan borrowed on October 1, 2008 for three years at 2.635% per annum, plus the applicable margin of 3.00%.

On June 29, 2009, the Company and the Lenders entered into an amendment to the Credit Agreement, which extended the availability of the Delayed Draw Term Loan commitments from June 30, 2009 to December 31, 2009, and provided for the reduction of these commitments by $0.81 on each of June 30, 2009, September 30, 2009 and December 31, 2009.  In addition, the Company’s obligation to maintain a minimum balance of $20.0 in cash deposits at all times was eliminated.

On December 31, 2009, the Company borrowed $24.57 under the Delayed Draw Term Loan.  The borrowings under the Delayed Draw Term Loan bear interest at 30 day LIBOR (0.35375% at June 30, 2010) plus the applicable margin of 3.00%.  The Delayed Draw Term Loan provides for monthly payments of interest and quarterly payments of principal of $0.81, which commenced on March 31, 2010, increasing to $1.08 starting on June 30, 2012 with the balance of $14.04, plus accrued interest due on February 28, 2013.

On March 4, 2010, the Company and the Lenders entered into an amendment to the Credit Agreement to clarify the principal repayment schedule for the Delayed Draw Term Loan.

The Term Loan provides for monthly payments of interest and quarterly installments of principal of $1.08, which commenced on June 30, 2009.  The quarterly installment of principal increased to $1.89 beginning March 31, 2010 to take into consideration the Delayed Draw Term Loan repayment schedule.  The aggregate quarterly principal repayment increases to $2.52 on June 30, 2012 with the balance of $32.76, plus accrued unpaid interest, due on February 28, 2013.

The Company executed a $1.0 standby letter of credit in favor of New York City to secure the Company’s franchise agreement, which is collateralized by $1.0 of availability under the Revolver.  The standby letter of credit, originally scheduled to expire May 1, 2010, was renewed and extended until May 1, 2011.  At June 30, 2010, the Company had $26.0 available under the Revolver.

 
22

 

ABOVENET, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)

NOTE 5:  INCOME TAXES

Income taxes have been provided based upon the tax laws and rates in the countries in which operations are conducted and income is earned.  The provision for (benefit from) income taxes for the three and six months ended June 30, 2010 and 2009 are as follows:
 
   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
   
2010
   
2009
   
2010
   
2009
 
Federal
  $ 9.1     $     $ 17.1     $ (5.3 )
State
    1.4       0.2       2.7       0.4  
Foreign
    0.6             0.9        
Total provision for (benefit from) income taxes
  $ 11.1     $ 0.2     $ 20.7     $ (4.9 )

At the end of each interim period, the Company estimates the annual effective tax rate and applies that rate to its ordinary quarterly earnings.  The tax expense or benefit related to significant, unusual or extraordinary items that will be separately reported or reported net of their related tax effect, are individually computed and are recognized in the interim period in which those items occur.  In addition, the effect of changes in enacted tax laws or rates or tax status is recognized in the interim period in which the change occurs.

The computation of the annual estimated effective tax rate at each interim period requires certain estimates and significant judgment including, but not limited to, the expected operating income for the year, projections of the proportion of income earned and taxed in various jurisdictions, permanent and temporary differences, and the likelihood of recovering deferred tax assets generated in the current year.  The accounting estimates used to compute the provision for income taxes may change as new events occur, more experience is acquired, additional information is obtained or as the tax environment changes.

For the three months ended June 30, 2010 and 2009, the effective income tax rates were 40.6% and 0.8%, respectively. For the six months ended June 30, 2010 and 2009, the effective income tax rates were 40.9% and (10.4)%, respectively.

The Company believes it is more likely than not that it will utilize these assets to reduce or eliminate tax payments in future periods.  The Company’s evaluation encompassed (i) a review of its recent history of profitability in the U.S. and the U.K. for the past three years; (ii) a review of internal financial forecasts demonstrating its expected capacity to utilize deferred tax assets; and (iii) a reassessment of tax benefits recognition under FASB ASC 740.

NOTE 6:  INCOME PER COMMON SHARE

Basic net income per common share is computed as net income or net loss divided by the weighted average number of common shares outstanding for the period.  Total weighted average shares utilized in computing basic net income per common share were 25,145,224 and 23,026,298 for the three months ended June 30, 2010 and 2009, respectively.  Total weighted average shares utilized in computing diluted net income per common share were 26,194,883 and 25,227,006 for the three months ended June 30, 2010 and 2009, respectively.  Dilutive securities include options to purchase shares of common stock, restricted stock units and stock warrants.  For the three months ended June 30, 2010, there were no potentially dilutive securities excluded from the calculation of diluted income per common share.  For the three months ended June 30, 2009, potentially dilutive securities to acquire 13,400 shares of common stock were excluded from the calculation of diluted income per common share as they were anti-dilutive.  For the six months ended June 30, 2010 and 2009, total weighted average shares utilized in computing basic net income per common share were 25,045,423 and 22,974,578, respectively.  For the six months ended June 30, 2010 and 2009, total weighted average shares utilized in computing diluted net income per common share were 26,205,457 and 24,968,436, respectively.  For the six months ended June 30, 2010, there were no potentially dilutive securities excluded from the calculation of diluted income per common share.  For the six months ended June 30, 2009, potentially dilutive securities to acquire 52,650 shares of common stock were excluded from the calculation of diluted income per share as they were anti-dilutive.

 
23

 

ABOVENET, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)

NOTE 7:   STOCK-BASED COMPENSATION

 2008 Equity Incentive Plan

On August 29, 2008, the Board of Directors of the Company approved the Company’s 2008 Plan.  The 2008 Plan is administered by the Company’s Compensation Committee.  Any employee, officer, director or consultant of the Company or subsidiary of the Company selected by the Compensation Committee is eligible to receive awards under the 2008 Plan.  Stock options, restricted stock, restricted and unrestricted stock units and stock appreciation rights may be awarded to eligible participants on a stand alone, combination or tandem basis.  1,500,000 shares of the Company’s common stock may be issued pursuant to awards granted under the 2008 Plan.  The number of shares available for grant and the terms of outstanding grants are subject to adjustment for stock splits, stock dividends and other capital adjustments.

Stock-based compensation expense for each period relates to share-based awards granted under the Company’s 2008 Plan described above and the Company’s 2003 Plan, and reflect awards outstanding during such period, including awards granted both prior to and during such period.  The 2003 Plan became effective on September 8, 2003.  Under the 2003 Plan, the Company was authorized to issue, in the aggregate, share-based awards of up to 2,129,912 common shares to employees, directors and consultants who are selected to participate.  Under the 2003 Plan, as of June 30, 2010, 1,169,432 common shares had been issued pursuant to vested restricted stock units (including shares repurchased by the Company), 771,223 shares had been issued pursuant to options exercised to purchase common shares, 155,179 common shares were reserved pursuant to outstanding options to purchase shares of common stock and 34,078 common shares were cancelled.  No shares are available for future grants under the 2003 Plan.

Under the 2008 Plan, as of June 30, 2010, 2,000 common shares had been issued pursuant to the exercise of options to purchase shares of common stock, 307,862 common shares were issued pursuant to the delivery of vested restricted stock units (including shares repurchased by the Company), 8,000 common shares were reserved pursuant to outstanding options to purchase shares of common stock, 635,372 were reserved pursuant to outstanding restricted stock units and 546,766 common shares were reserved for future grants.

Stock Options

There were no options to purchase shares of common stock granted during the three and six months ended June 30, 2010 and 2009.

The Company recognized non-cash stock-based compensation expense amounting to $0.1 for the six months ended June 30, 2009 with respect to stock options granted in prior periods.  The Company did not recognize stock-based compensation expense for the three and six months ended June 30, 2010 and for the three months ended June 30, 2009.

 
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ABOVENET, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)

Restricted Stock Units

The Company did not award any restricted stock units during the three and six months ended June 30, 2010 and 2009.  The Company recognized non-cash stock-based compensation expense related to restricted stock units granted in prior periods of $2.1 and $2.9 for the three months ended June 30, 2010 and 2009, respectively, which had the effect of decreasing net income by $0.05 per basic and diluted common share for the three months ended June 30, 2010 and by $0.12 per basic common share and by $0.11 per diluted common share for the three months ended June 30, 2009.  The Company recognized non-cash stock-based compensation expense related to restricted stock units of $4.2 and $5.7 for the six months ended June 30, 2010 and 2009, respectively, which had the effect of decreasing net income by $0.10 per basic and diluted common share for the six months ended June 30, 2010 and by $0.25 per basic common share and by $0.23 per diluted common share for the six months ended June 30, 2009.  Additionally, during the three months ended March 31, 2010, the Company delivered 14,000 shares of common stock to its Chief Executive Officer, William LaPerch, pursuant to vested performance-based restricted stock units granted to him in September 2008.  In accordance with the terms of Mr. LaPerch’s stock unit agreement, the Company purchased an aggregate of 5,459 shares of common stock from Mr. LaPerch at $54.73 per share, the closing price of the Company’s common stock on the date of delivery, in order to satisfy minimum tax withholding obligations.

NOTE 8:   SHAREHOLDERS’ EQUITY

A. Stock Split

On August 3, 2009, the Board of Directors of the Company authorized a two-for-one common stock split, effected in the form of a 100% stock dividend, which was distributed on September 3, 2009.  Each shareholder of record on August 20, 2009 received one additional share of common stock for each share of common stock held on that date.  All share and per share information in all periods presented, including warrants, options to purchase common shares, restricted stock units, warrant and option exercise prices, shares reserved under the 2003 Plan and the 2008 Plan, weighted average fair value of options granted, common stock and additional paid-in capital accounts on the consolidated balance sheets and consolidated statement of shareholders’ equity, have been retroactively adjusted to reflect the two-for-one stock split.

B. Amendment to the Company’s Amended and Restated Certificate of Incorporation

On June 24, 2010, the Company’s stockholders approved an amendment to the Company’s Amended and Restated Certificate of Incorporation (the “Amendment”) to increase the number of authorized shares of our common stock, par value $0.01 per share, from 30 million to 200 million.  The number of authorized shares of preferred stock remained at 10 million.

The increase in the number of our authorized shares of common stock could have an anti-takeover effect by discouraging or hindering efforts to acquire control of the Company.  The Company would be able to use the additional shares to oppose a hostile takeover attempt or delay or prevent changes in control or management of the Company.  This is not the intent of the Board of Directors in adopting the Amendment, nor has the Amendment been adopted in response to any known threat to acquire control of the Company.

The increase in the authorized shares of common stock became effective upon the filing of the Amendment with the Secretary of State of the State of Delaware on June 24, 2010.

 
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ABOVENET, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)

C. Rights Agreement

On August 3, 2006, the Company entered into a Rights Agreement (the “Rights Agreement”) with American Stock Transfer & Trust Company, as rights agent, which was amended and restated on August 3, 2009 and subsequently amended as of January 26, 2010 (as amended, the “Amended and Restated Rights Agreement”).  The Amended and Restated Rights Agreement was ratified by the Company’s stockholders at its annual meeting on June 24, 2010.  As a result, the Rights (as defined below) under the Amended and Restated Rights Agreement will remain in effect until August 7, 2012, unless sooner terminated by the Company’s Board of Directors.  The following description of the Amended and Restated Rights Agreement does not purport to be complete and is qualified in its entirety by reference to the Amended and Restated Rights Agreement included as Exhibit 4.1 to the Company’s Current Report on Form 8-K filed with the SEC on August 3, 2009, and the Amendment to Amended and Restated Rights Agreement, dated as of January 26, 2010, between AboveNet, Inc. and American Stock Transfer & Trust Company, LLC included as Exhibit 4.1 to the Company’s Current Report on Form 8-K filed with the SEC on January 28, 2010.

In connection with the initial Rights Agreement, the Company’s Board of Directors declared a dividend distribution of one preferred share purchase right (a “Right”) for each then outstanding share of the Company’s common stock, par value $0.01 per share (the “Common Shares”).  The dividend was paid on August 7, 2006 to the stockholders of record on that date.

Until the earlier to occur of (i) the date that is 10 days following the date of a public announcement that a person, entity or group of affiliated or associated persons have acquired beneficial ownership of 15% or more of the outstanding Common Shares (an “Acquiring Person”) or (ii) 10 business days (or such later date as may be determined by action of the Company’s Board of Directors prior to such time as any person or entity becomes an Acquiring Person) following the commencement of, or announcement of an intention to commence, a tender offer or exchange offer the consummation of which would result in any person or entity becoming an Acquiring Person (the earlier of such dates being called the “Distribution Date”), the Rights will be evidenced by the Common Share certificates or book-entry shares.

The Rights are not exercisable until the Distribution Date.  Each Right, upon becoming exercisable, will entitle the holder to purchase from the Company a specified fraction of a share of the Company’s Series A Junior Participating Preferred Stock (the “Preferred Shares”) at the then effective purchase price.  The Rights will expire on August 7, 2012, unless earlier redeemed or exchanged.

The number of outstanding Rights and the number of Preferred Shares issuable upon exercise of the Rights are also subject to adjustment in the event of a stock split of the Common Shares or a stock dividend on the Common Shares payable in Common Shares or subdivisions, consolidation or combinations of the Common Shares occurring, in any case, prior to the Distribution Date.  The purchase price payable and the number of preferred shares or other securities or other property issuable upon exercise of the Rights are subject to adjustment from time to time to prevent dilution as described in the Amended and Restated Rights Agreement.  As a result of the Company’s stock split discussed above, appropriate adjustments under the Amended and Restated Rights Agreement have been made.


 
26

 

ABOVENET, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)

In the event that any person or group of affiliated or associated persons becomes an Acquiring Person, proper provision will be made so that each holder of a Right, other than Rights beneficially owned by the Acquiring Person and its associates and affiliates (which will thereafter be void), will have the right to receive upon exercise, in lieu of Preferred Shares, that number of Common Shares having a market value of two times the then effective exercise price of the Right (or, if such number of shares is not and cannot be authorized, the Company may issue preferred shares, cash, debt, stock or a combination thereof in exchange for the Rights).

In the event that the Company is acquired in a merger or other business combination transaction or 50% or more of its consolidated assets or earning power are sold to an Acquiring Person, its associates or affiliates or certain other persons, proper provision will be made so that each holder of a Right, other than Rights beneficially owned by the Acquiring Person and its associates and affiliates (which will thereafter be void), will thereafter have the right to receive, upon the exercise thereof at the then current exercise price of the Right, in lieu of Preferred Shares, that number of shares of common stock of the acquiring company, which at the time of such transaction will have a market value of two times the then effective exercise price per Right.

At any time after a person becomes an Acquiring Person and prior to the acquisition by such Acquiring Person of 50% or more of the outstanding Common Shares, the Company may exchange the Rights (other than Rights owned by such Acquiring Person or group which have become void), in whole or in part, at an exchange ratio of one share of common stock per Right (or, at the election of the Company, the Company may issue cash, debt, stock or a combination thereof in exchange for the Rights), subject to adjustment.

At any time prior to the earlier of (i) such time that a person has become an Acquiring Person or (ii) the final expiration date, the Company may redeem all, but not less than all, of the outstanding Rights at a price of $0.005 per Right (the “Redemption Price”).  The Rights may also be redeemed at certain other times as described in the Amended and Restated Rights Agreement.  Immediately upon any redemption of the Rights, the right to exercise the Rights will terminate and the only right of the holders of Rights will be to receive the Redemption Price.

The terms of the Rights may be amended by the Company’s Board of Directors without the consent of the holders of the Rights, except that from and after such time as the rights are distributed no such amendment may adversely affect the interest of the holders of the Rights other than the interests of an Acquiring Person or its affiliates or associates.

Until a Right is exercised, the holder thereof, as such, will have no rights as a stockholder of the Company, including, without limitation, the right to vote or to receive dividends.

 
27

 

ABOVENET, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)

D. 2010 Employee Stock Purchase Plan

On June 24, 2010, the Company’s stockholders approved the AboveNet, Inc. 2010 Employee Stock Purchase Plan (the “Stock Purchase Plan”), which was adopted by the Board of Directors on April 28, 2010.  The Stock Purchase Plan is administered by the Compensation Committee of the Board of Directors.  The aggregate number of shares of common stock that may be issued pursuant to the Stock Purchase Plan is 300,000, subject to increase or decrease by reason of stock splits, reclassifications, stock dividends, and the like.

Eligibility and Participation

All employees of the Company, or any of its designated subsidiaries, who have completed at least ninety (90) days of employment on or before the first day of the applicable offering period are eligible to participate in the Stock Purchase Plan, subject to certain limitations imposed by the Internal Revenue Code and certain other limitations set forth in the Stock Purchase Plan.  An employee may not participate in the Stock Purchase Plan if, immediately after he or she joined, he or she would own stock and/or hold rights to purchase stock possessing 5% or more of the total combined voting power or value of all classes of stock of the Company or of any subsidiary of the Company.  Officers of the Company that are subject to the reporting requirements of Section 16(a) under the Securities Exchange Act of 1934 (“Section 16 Officers”) are also not eligible to participate.  The Stock Purchase Plan also limits an employee’s rights to purchase stock under all employee stock purchase plans (those subject to Section 423 of the Internal Revenue Code) of the Company and its subsidiaries so that such rights may not accrue at a rate that exceeds $0.025 at fair market value of such stock (determined as of the first day of the offering period) for each calendar year in which such right to purchase stock is outstanding at any time.  In addition, no employee may purchase more than 200 shares of common stock under the Stock Purchase Plan in any offering period (and no more than 100 shares of common stock in the offering period for 2010).  As of July 1, 2010, we had a total of approximately 660 employees who would have been eligible to participate in the Stock Purchase Plan.

Offering Periods; Purchase Price

The Stock Purchase Plan operates by a series of offering periods of approximately 10 months duration commencing on each January 16 and ending on November 15 (except that the offering period in 2010 will be from September 1 to November 15).  The purchases are made for participants at the end of each offering period by applying payroll deductions accumulated over the course of the offering period towards such purchases.  The price at which these purchases will be made will equal 85% of the lesser of the fair market value of the common stock as of the first day of the offering period or the fair market value on the last day of the offering period.

 
28

 

ABOVENET, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)

NOTE 9:  LITIGATION

The Company is subject to various legal proceedings and claims which arise in the normal course of business.  The Company evaluates, among other things, the degree of probability of an unfavorable outcome and reasonably estimates the amount of potential loss.

Global Voice Networks Limited (“GVN”)

 AboveNet Communications UK Limited, the Company’s U.K. operating subsidiary (“ACUK”), was a party to a duct purchase and fiber lease agreement (the “Duct Purchase Agreement”) with EU Networks Fiber UK Ltd, formerly GVN.  A dispute between the parties arose regarding the extent of the network duct that was sold and fiber that was leased to GVN pursuant to the Duct Purchase Agreement.  As a result of this dispute, in 2006, GVN filed a claim against ACUK in the High Court of Justice in London seeking ownership of the disputed portion of the network duct, the right to lease certain fiber and associated damages.  In December 2007, the court ruled in favor of GVN with respect to the disputed duct and fiber.  In early February 2008, ACUK delivered most of the disputed duct and fiber to GVN.  Additionally, under the original ruling, the Company was also required to construct the balance of the disputed duct and fiber and deliver it to GVN pursuant to a schedule ordered by the court.  Additional portions of the disputed duct and fiber were constructed and subsequently delivered and other portions are scheduled for delivery.  The Company also had certain repair and maintenance obligations that it must perform with respect to such duct.  GVN was also seeking to enforce an option requiring ACUK to construct 180 to 200 chambers for GVN along the network.  In June 2008, the Company paid $3.0 in damages pursuant to the liability trial.  Additionally, the Company reimbursed GVN $1.8 for legal fees.  Additionally, the Company’s legal fees aggregated $2.4.  Further, the Company has incurred or is obligated for costs totaling $2.7 to build additional network.  In early August 2008, the Company reached a settlement agreement under which the Company paid GVN $0.6 and agreed to provide additional construction of duct at an estimated cost of $1.2 and provide GVN limited additional access to ACUK’s network.  GVN and ACUK provided mutual releases of all claims against each other, including ACUK’s repair obligation and chamber construction obligations discussed above.  The Company recorded a loss on litigation of $11.7 at December 31, 2007, of which $0.8, $8.5 and $0.7 was paid in 2007, 2008 and 2009, respectively, and $0.6 was included in accrued expenses at December 31, 2009.  The obligation was denominated in British Pounds; therefore, the amounts have been affected by currency fluctuations.  The Company had a remaining accrual balance of $0.4 for this loss on litigation included in the Company’s consolidated balance sheet at June 30, 2010.

SBC Telecom, Inc. (“SBC”)

The Company was a party to a fiber lease agreement with SBC, a subsidiary of AT&T, entered into in May 2000.  The Company believed that SBC was obligated under this agreement to lease 40,000 fiber miles, reducible to 30,000 under certain circumstances, for a term of 20 years at a price set forth in the agreement, which was subject to adjustment based upon the number of fiber miles leased (the higher the volume of fiber miles leased, the lower the price per fiber mile).  SBC disagreed with such interpretation of the agreement and in 2003 the issue was litigated before the Bankruptcy Court.  In November 2003, the Bankruptcy Court agreed with the Company’s interpretation of the agreement, which decision SBC did not appeal.  Subsequently, SBC also alleged that the Company was in breach of its obligations under such agreement and that therefore the Company was unable to assume the agreement upon its emergence from bankruptcy.  The Company disagreed with SBC’s position, however in December 2005, the Bankruptcy Court agreed with SBC.  In 2006, the Company appealed certain aspects of the decision to the District Court for the Southern District of New York but the District Court denied the Company’s appeal.  In March 2007, the Company filed a notice of appeal to the Second Circuit Court of Appeals seeking relief with respect to the Bankruptcy Court’s determination that the Company was in default of the agreement with SBC.  During the term of the agreement, SBC has paid the Company at the higher rate per fiber mile to reflect the reduced volume of services SBC believes it was obligated to take, in accordance with its understanding of the fiber lease agreement.  However, for financial statement purposes, the Company billed and recorded revenue based on the lower amount per fiber mile for the fiber miles accepted by SBC, which was $2.3 and $2.0, for the years ended December 31, 2008 and 2007, respectively.

 
29

 

ABOVENET, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)

In July 2008, the Company and SBC entered into the “Stipulation and Release Agreement” under which a new service agreement was executed for the period from July 10, 2008 to December 31, 2010.  Under this new service agreement, SBC agreed to continue to purchase the existing services at the current rate for such services.  Further, SBC will have a fixed minimum payment commitment, which declines over the contract term.  SBC may cancel service at any time, subject to the notice provisions, but is subject to the payment commitment.  The payment commitment may be satisfied by the existing services or SBC may order new services.  Additionally, the May 2000 fiber lease agreement with SBC was terminated and the Company and SBC released each other from any claims related to that agreement.  The difference between the amount paid by SBC and the amount recognized by the Company as revenue, which aggregated $3.5 at July 10, 2008 ($3.2 at December 31, 2007), was recorded as contract termination revenue for the year ended December 31, 2008.

Southeastern Pennsylvania Transportation Authority (“SEPTA”)

In October 2008, SEPTA filed a claim in the Philadelphia County Court of Common Pleas against the Company for trespass with regard to portions of the Company’s network allegedly residing on SEPTA property in Pennsylvania.  SEPTA seeks unspecified damages for trespass and/or a determination that the Company’s network must be removed from SEPTA’s property.  The Company has responded to the claim and also filed a motion in the Bankruptcy Court seeking a determination that the claim is barred based on the discharge of claims and injunction contained in the Plan of Reorganization.  The Company believes that it has meritorious defenses to SEPTA’s claims.

NOTE 10:  RELATED PARTY TRANSACTIONS

A member of the Company’s Board of Directors, Richard Postma, is also the Co-Chairman, Chief Executive Officer and co-founder of a telecommunications company.  The Company sold services and/or material in the normal course of business to this telecommunications company in the amount of $0.1 for each of the three months ended June 30, 2010 and 2009, and $0.2 for each of the six months ended June 30, 2010 and 2009.  No amounts were outstanding at each of June 30, 2010 and December 31, 2009.  Mr. Postma also serves as the Chief Executive Officer of and holds a minority ownership interest in a construction company.  The Company purchased certain installation and construction services totaling $0.03 in 2009 and $0.13 in 2008 from such construction firm.  All activity between the Company and these entities were conducted as independent arms length transactions consistent with similar terms and circumstances with any other customers or vendors.  All accounts between the two parties are settled in accordance with invoice terms.

 
30

 

ABOVENET, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)

NOTE 11:  SEGMENT REPORTING

SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” (now known as FASB ASC 280-10), defines operating segments as components of an enterprise for which separate financial information is available and which is evaluated regularly by the Company’s chief operating decision maker in deciding how to assess performance and allocate resources.  The Company operates its business as one operating segment.

Geographic Information

 Below is the Company’s revenue based on the location of its entity providing service.  Long-lived assets are based on the physical location of the assets.  The following table presents revenue and long-lived asset information for geographic areas:

   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
   
2010
   
2009
   
2010
   
2009
 
Revenue
                       
United States
  $ 92.1     $ 80.4     $ 180.5     $ 159.0  
United Kingdom
    10.0       8.5       20.1       16.1  
Eliminations
    (1.3 )     (0.9 )     (2.6 )     (1.7 )
Consolidated Worldwide
  $ 100.8     $ 88.0     $ 198.0     $ 173.4  

   
As of
 
   
June 30, 2010
   
December 31, 2009
 
Long-lived assets
           
United States
  $ 463.7     $ 440.8  
United Kingdom
    27.8       28.3  
Other
           
Consolidated Worldwide
  $ 491.5     $ 469.1  

NOTE 12: OTHER INCOME (EXPENSE), NET

Other income (expense), net consists of the following:

   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
   
2010
   
2009
   
2010
   
2009
 
Gain on settlement or reversal of liabilities
  $     $     $ 0.4     $ 0.7  
Gain on settlement of insurance claim
    0.2             0.2        
(Loss) gain on foreign currency
    (0.1 )     3.2       (1.2 )     2.6  
Loss on disposition of property and equipment
    (0.1 )     (0.7 )           (0.9 )
Other
    0.2             0.2        
Total
  $ 0.2     $ 2.5     $ (0.4 )   $ 2.4  

 
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ABOVENET, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)

NOTE 13: COMMITMENTS AND CONTINGENCIES

Employment Contracts

The Company maintains employment agreements with its key executives.  The agreements include, among other things, certain change in control and severance provisions.

In September 2008, the Company entered into new employment agreements with certain of its senior officers (the “Executive Officers”).  Each of the employment agreements is for a term which ends November 16, 2011 with automatic extensions for an additional one-year period unless cancelled by the executive or the Company in writing at least 120 days prior to the end of the applicable term.  Each of the contracts provides for a base rate of compensation, which may increase (but cannot decrease) during the term of the contract.  Additionally, each contract provides for incentive cash bonus targets for each executive.  Each of the Executive Officers will generally be entitled to the same benefits offered to the Company’s other executives.  Each of the employment contracts provides for the payment of severance and the provision of certain other benefits in connection with certain termination events.  The employment contracts also include confidentiality, non-compete and assignment of intellectual property covenants by each of the Executive Officers.

In October 2008, the Company entered into an employment agreement with Mr. Joseph P. Ciavarella under which Mr. Ciavarella agreed to become the Company’s Senior Vice President and Chief Financial Officer.  The employment agreement is on substantially the same general terms as the September 2008 employment agreements described above.

Internal Revenue Service

In September 2008, the Company was notified by the Internal Revenue Service (the “IRS”) that it was reclassifying certain individuals, classified by the Company as independent contractors, to employees and, accordingly, assessing certain payroll taxes and penalties totaling $0.3.  The Company disputed this position citing relief provided by IRC Section 530 and IRC Section 3509.  On January 13, 2009, the IRS made a settlement offer to the Company, which the Company executed on March 10, 2009 and the IRS countersigned on May 11, 2009.  Under the terms of the proposed settlement agreement, the Company agreed to pay $0.015 to the IRS to fully discharge any federal employment tax liability it may owe for 2005.  The IRS agreed not to dispute the classification of “such workers” for federal employment tax purposes for any period from January 1, 2005 to March 31, 2009.  Beginning April 1, 2009, the Company agreed to treat “Consultants,” as described in the settlement agreement, who perform equivalent duties as employees of the Company as employees.  Finally, the Company agreed to extend the statute of limitations with respect to federal employment tax payments for the period covered by the settlement agreement (January 1, 2005 to March 31, 2009) to April 1, 2012.

 
32

 

ABOVENET, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)

New York City Franchise Agreement

As a result of certain ongoing litigation with a third party, the Department of Information Technology and Telecommunications of the City of New York (“DOITT”) has informed the Company that they have temporarily suspended any discussions regarding renewals of telecommunications franchises in the City of New York.  As a result, it is the Company’s understanding that DOITT has not renewed any recently expired franchise agreement, including the Company’s franchise agreement which expired on December 20, 2008.  Prior to the expiration of the Company’s franchise agreement, the Company sought out and received written confirmation from DOITT that the Company’s franchise agreement provides a basis for the Company to continue to operate in the City of New York pending conclusion of renewal discussions.  The Company intends to continue to operate under its expired franchise agreement pending any renewal.  The Company believes that a number of other operators in the City of New York are operating on a similar basis.  Based on the Company’s discussions with DOITT and the written confirmation that the Company has received, the Company does not believe that DOITT intends to take any adverse actions with respect to the operation of any telecommunications providers as the result of their expired franchise agreements and, that if it attempted to do so, it would face a number of legal obstacles.  Nevertheless, any attempt by DOITT to limit the Company’s operations as the result of its expired franchise agreement could have a material adverse effect on the Company’s business, financial condition and results of operations.

Capital Investments and Network Expansion
 
The Company, from time to time, commits capital for, among other things, (i) customer capital (to connect customers to the network); (ii) expansion and improvement of infrastructure; and (iii) equipment.  The Company also commits capital for investments in selected markets and has announced its intention to open up Denver as a market and expand into Paris, Amsterdam and Frankfurt in Europe.  Based upon the Company’s investment plans, its capital expenditures for 2010 are expected to be between $150 and $160, of which $57.5 was spent during the six months ended June 30, 2010.  The Company believes it has sufficient liquidity to fund such investments.
 
 
33

 

ITEM 2. 
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis should be read together with the Company’s consolidated financial statements and related notes appearing in this Quarterly Report on Form 10-Q and in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.

Business

Overview

AboveNet, Inc. (which together with its subsidiaries is sometimes hereinafter referred to as the “Company,” “AboveNet,” “we,” “us,” “our” or “our Company”) provides high-bandwidth connectivity solutions primarily to large corporate enterprise clients and communication carriers, including Fortune 1000 and FTSE 500 companies, in the United States (“U.S.”) and the United Kingdom (“U.K.”).  Our communications infrastructure and global Internet protocol (“IP”) network are used by a broad range of companies such as commercial banks, brokerage houses, insurance companies, investment banks, media companies, social networking companies, web-centric companies, law firms and medical and health care institutions.  Our customers rely on our high speed, private optical network for electronic commerce and other mission-critical services, such as business Internet applications, regulatory compliance, disaster recovery and business continuity.  We provide lit broadband services over our metro networks, long haul network and global IP network utilizing equipment that we own and operate.  In addition, we also provide dark fiber services to selected customers.  Unlike competitive local exchange carriers (“CLECs”), we do not provide voice services, services to residential customers or a wide range of lower-bandwidth services.  We also resell equipment and provide certain other services to customers, which are sold at our cost, plus a margin.

Metro networks.  We are a facilities-based provider that operates fiber-optic networks in 15 markets in the U.S., plus the U.K. (London).  We refer to these networks as our metro networks.  These metro networks have significant reach and breadth.  They consist of over 2.0 million fiber miles across over 6,000 cable route miles in the U.S. and in London.  In addition, we have built an inter-city fiber network between New York and Washington D.C. of over 177,000 fiber miles.  We recently announced plans to open the Denver market by the end of 2010 in conjunction with a customer network build.  We also plan to provide certain services in Paris, Amsterdam and Frankfurt by the end of 2010 through a dense wavelength-division multiplexing (“DWDM”) system operating on a leased fiber network.

Long haul network.  Through construction, acquisition and leasing activities, we have created a nationwide fiber-optic communications network spanning approximately 12,000 cable route miles that connects each of our U.S. metro networks.  We run DWDM equipment over this fiber to provide large amounts of bandwidth capability between our metro networks for our customer needs and for our IP network.  We use capacity on the Japan-US Cable Network (“JUS”) to provide connectivity from the U.S. to Japan and capacity on the Trans-Atlantic undersea telecommunications network (“TAT-14”) and other trans-Atlantic cables to provide connectivity from the U.S. to Europe.  We refer to this network as our long haul network.  We recently connected Miami to the long haul network and our planned Denver metro network is already connected to the long haul network.  We also plan to connect Paris, Amsterdam and Frankfurt to the long haul network through a DWDM system operating on a leased fiber network by the end of 2010.

IP networkWe operate a Tier 1 IP network over our metro and long haul networks with connectivity to the U.S., Europe and Japan.  Our IP network operates using advanced routers and switches that facilitate the delivery of IP transit services and IP-based virtual private network (“VPN”) services.  A hallmark of our IP network is that we have direct connectivity to a large number of IP networks operated by others through peering agreements and to many of the most important bandwidth centers and peering exchanges.
 
34

 
Business Strategy

Our primary strategy is to become the preferred provider of high-bandwidth connectivity solutions in our target markets.  Specifically, we are focused on the sale of high-bandwidth transport solutions to enterprise customers.  The following are the key elements of our strategy:

 
·
Connect to data centers where many enterprise customers locate their information technology infrastructure.
 
·
Target broadband communications infrastructure customers who have significant bandwidth requirements and high security needs.
 
·
Provide a high level of customization of our services in order to meet our customers’ requirements.
 
·
Deliver the services we offer over our metro networks, which often provide our customers with a dedicated pair of fibers.  This use of dedicated fiber is a low latency, physically secure, flexible and scalable communications solution, which we believe is difficult for many of our competitors to replicate because most of their networks do not have comparable fiber density.
 
·
Use our metro fiber assets to drive the adoption of leading edge inter-city wide area network (WAN) services such as IP VPN services and long haul connectivity solutions.
 
·
Intensify our focus on sales to media companies with high-bandwidth requirements.
 
·
Fulfill the needs of customers that are required to comply with financial and other regulations related to data availability, disaster recovery and business continuity.
 
·
Target Internet connectivity customers that can leverage the scalability and flexibility of fiber access to their premises to drive their electronic commerce and other high-bandwidth applications, such as social networking, gaming and digital media transmission.

We are able to provide high quality, customized services at competitive prices as a result of a number of factors, including:

 
·
Our significant experience providing high-end customized network solutions for enterprises and telecommunications carriers (also referred to as carriers).
 
·
Our focus on providing certain core optical services rather than the full range of telecommunications services.
 
·
Our metro networks typically include fiber cables with 432, and in some cases 864, fibers in each cable, which is substantially more fiber than we believe most of our competitors have installed, and provide us with sufficient fiber inventory to supply dedicated fiber services to customers.
 
·
Our modern networks with advanced fiber-optic technology are less costly to operate and maintain than older networks.
 
·
Our employment of state-of-the-art technology in all elements of our networks, from fiber to optical and IP equipment, provides leading edge solutions to customers.
 
·
The architecture of our metro networks, which facilitates high performance solutions in terms of loss and latency.
 
·
The spare conduit we install, where practical, allows us to install additional fiber-optic cables on many routes without the need for additional rights-of-way, which reduces expansion and upgrade costs in the future, and provides significant capacity for future growth.

 
35

 

Our Networks and Technology

Metro Networks

The foundation of our business is our metro fiber optic networks in the following domestic metropolitan areas and London in the U.K.

 
·
Boston
 
·
New York City metro
 
·
Philadelphia
 
·
Baltimore
 
·
Washington, D.C./Northern Virginia corridor
 
·
Atlanta
 
·
Houston
 
·
Dallas
 
·
Austin
 
·
Phoenix
 
·
Los Angeles
 
·
San Francisco Bay area
 
·
Portland
 
·
Seattle
 
·
Chicago

Including fiber acquired by us through leases and indefeasible rights-of-use (“IRUs”), as well as fiber provided by us to others through leases and IRUs, our metro networks consist of over 2.0 million fiber miles and over 6,000 cable route miles.  The network footprint typically allows us to serve central offices, carrier hotels, network POPs, data centers, enterprise locations and traffic aggregation points, not just in the central business district but across the entire metropolitan area in each market.  Within our metro networks, our infrastructure provides ample opportunity to access many additional buildings by virtue of its extensive footprint coverage and over 5,700 network access points that can be utilized to build laterals or connect to other networks, thereby providing access to additional locations.

We also recently announced plans to open our metro network in Denver by the end of 2010.  We also plan to provide certain services in Paris, Amsterdam and Frankfurt by the end of 2010 through a DWDM system operating on a leased fiber network.

Key Metro Network Attributes
 
 
·
Network Density - Our metro networks typically contain 432 and up to 864 fiber strands in each cable.  We believe that this fiber density is significantly greater than that of most of our competitors.  This high fiber count allows us to add new customers in a timely and cost effective manner by focusing incremental construction and capital expenditures on the laterals that serve customer premises, as opposed to fiber and capacity upgrades in our core networks.  Thus, we have spare network capacity available for future growth to connect an increasing number of customers.

 
·
Modern Fiber – We have deployed modern, high-quality optical fiber that can be used for a wide range of network applications.  Standard single mode fiber is typically included on most cables while longer routes also contain non-zero dispersion shifted fiber that is optimized for longer distance applications operating in the 1550 nm range.  Much of our network is well positioned to support the more stringent requirements of transport at rates of 40 Gbps and above.

 
36

 

 
·
High Performance Architecture – We design customer networks with direct, optimum routing between key areas and in a manner that minimizes the number of POP locations, which enables us to deliver our services at a high level of performance.  Because most of our metro lit services are delivered over dedicated fibers not shared with other customers, each customer’s private network can be optimized for its specific application.  Further, by using dedicated fiber, we can deliver our services without the need to transition between various shared or legacy networks.  As a result, our customers experience enhanced performance in terms of parameters such as latency and jitter, which can be caused by equipment interface transitions.  The use of dedicated fibers for customers also permits us to address future technology changes that may take place on a customer specific basis.

 
·
Extensive Reach – Our metro markets typically have significant footprints and cover a wide geography.  For example, the New York market includes a significant Manhattan presence and extends from Stamford, CT in the north through Delaware in the south, covering a large part of New Jersey.  Similarly, the San Francisco market extends through to San Jose and the Dallas network incorporates the Fort Worth area.

On-Net Buildings

Our metro networks connect to over 2,400 buildings in the U.S. and the U.K. through our lateral cables, which cover approximately 1,100 route miles and approximately 140,000 fiber miles (which are part of the 2.0 million fiber miles previously described).  These connected buildings are referred to as on-net buildings.

 
·
Enterprise Buildings - Our network extends to over 1,900 enterprise locations, many of which house some of the biggest corporate users of network services in the world.  These locations also include many private data centers and hub locations that are mission-critical for our customers.

 
·
Network POPs - We operate over 120 network POPs with functionality ranging from simple, passive cross-connect locations to sites that offer interconnectivity to other service providers and co-location facilities for customer equipment, including over 20 Type 1 POPs.  These POPs are typically larger presences located in major carrier hotels complete with network co-location and interconnectivity services.

 
·
Central Offices, Carrier Hotels and Data Centers - Our network connects to over 200 central offices in the markets that we serve.  The network also has a presence in most significant carrier hotels and data centers within our active markets.

 
·
Additional Buildings - In addition to the on-net buildings that we connect to with our own fiber laterals, we have access to additional buildings through other network providers with which we have agreements to provide fiber connectivity to our customers.

Long Haul Network

We operate a nationwide long haul network interconnecting each of our metro networks that spans approximately 12,000 route miles.  With the exception of the route between New York and Washington, D.C., which we constructed and own, our domestic long haul network is based on fiber either leased or acquired, typically under long-term agreements.  We have deployed DWDM equipment along this network that provides significant bandwidth capability between our metro networks.  This network is based on ultra long haul technology that requires fewer intermediate regeneration points to deliver our services between major cities and expands our high-bandwidth service capability between our metro markets.  We recently connected Miami to the long haul network and our planned Denver metro network is already connected to the long haul network.

In addition to our U.S.-based facilities, we are a member of the TAT-14 consortium, which, together with other capacity leased by us on other trans-Atlantic cables, provides us with undersea capacity between the U.S. and Europe.  We are also currently a member of the JUS consortium which provides us with undersea capacity between the U.S. and Japan.  We use leased circuit capacity in continental Europe to provide connectivity to Paris, Amsterdam and Frankfurt.  We plan to replace that circuit capacity with a leased fiber long haul network over which we will operate DWDM equipment by the end of 2010.  We also operate lit networks in the U.S. connecting to certain key undersea cable landing stations including Manasquan and Tuckerton in New Jersey to connect to the TAT-14 and have leased capacity to Morrow Bay, California to connect to the JUS.  In the U.K., we have leased fiber between the TAT-14 landing stations in Bude and London over which we operate a high-capacity DWDM system.  Together, these networks provide us with high-bandwidth capability among our metro networks and certain key markets in Europe and Japan.

 
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IP Network

We operate a global Tier 1 IP network with connectivity in the U.S., Europe and Japan.  In the U.S., most of our metro networks have multiple IP hubs where we can provide Internet connectivity.  We peer and provide connectivity in high-bandwidth data centers and Internet exchange locations, including many of those operated by the major providers, such as Equinix.  We have extended our ability to provide IP connectivity through our metro networks by using our fiber to bring our services to a wider set of customers.  In addition to the U.S., the IP network has a presence in each of Tokyo, London, Paris, Amsterdam and Frankfurt, including the major exchanges in these markets such as LINX, AMS-IX and JPIX.  We recently established an IP presence in Miami and plan to add additional IP locations in London, Paris and Amsterdam by the end of 2010.

The core portion of our IP backbone network is based on multiple 10 Gbps long haul links and utilizes advanced Juniper and Cisco routers and switches to direct traffic to appropriate destinations.  Our IP core infrastructure is based on next generation equipment that supports advanced IP services such as VPNs and is optimized to support high-bandwidth customers.

As a Tier 1 IP network provider, we have peering arrangements with most other providers which allow us to exchange traffic with these other IP networks.  We have devoted a substantial amount of time and resources to building our substantial peering infrastructure and relationships.  We believe that this extensive peering fabric combined with our advanced network results in a positive customer experience.

Network Management

Our network management center (“NMC”) is located in Herndon, Virginia and provides round-the-clock surveillance, provisioning and customer service.  Our metro networks, long haul network, IP network and the private networks we set up for our customers, which link together two or more of their locations, are constantly monitored in order to respond to any degrading network conditions and network outages.  Our NMC responds to all customer network inquiries via a trouble ticketing system.  The NMC’s staff serves as the focal point for managing our service level agreements, or SLAs, with our customers and coordinating network maintenance activities.

Rights-of-Way

We obtain right-of-way agreements and governmental authorizations to enable us to install, operate, access and maintain our networks, which are located on both public and private property.  In some jurisdictions, a construction permit from the local municipality is all that is required for us to install and operate that portion of the network.  In other jurisdictions, a license agreement, permit or franchise may also be required.  These licenses, permits and franchises are generally for a term of limited duration.  Where necessary, we enter into right-of-way agreements for use of private property, often under multi-year agreements.  We lease underground conduit and overhead pole space and license rights-of-way from entities such as incumbent local exchange carriers (“ILECs”), utilities, railroads, state highway authorities, local governments and transit authorities.  We strive to obtain rights-of-way that afford us the opportunity to expand our networks as our business further develops.

Services

  Initially, our primary business was to lease dark fiber to telecommunications carriers, enterprises, Internet and web-centric businesses and other customers that wanted to operate their own networks, often under long term agreements.  Since 2003, we have shifted the focus of our business by leveraging our extensive fiber footprint and deploying capital to extend our fiber footprint to customers with high-bandwidth requirements within and between our metro markets.  This transformation has allowed us to serve a much larger marketplace with differentiated services principally provided over our dedicated fiber.  Unlike CLECs, we do not provide voice services, services to residential customers or a wide range of lower-bandwidth services.

In late 2008, we modified our service groupings and related revenue to more accurately reflect our focus on delivering high-bandwidth services.  The new groups are: fiber infrastructure services, metro services and WAN services.

 
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Fiber Infrastructure Services

Our fiber infrastructure services focus on the lease of dedicated dark fiber to telecommunications carriers, enterprises, Internet and web-centric businesses and other customers that operate their own networks independent of the incumbent telecom companies.  In addition to leasing dark fiber, we offer maintenance of dark fiber networks, the provisioning of co-location and in-building interconnection services, typically at our POP locations, and also provide certain telecommunication services on a time and materials basis.

Our fiber infrastructure services feature:

 
·
An extensive network footprint that extends well beyond the central business district in most markets.
 
·
The expertise and capability to add off-net locations to the network in a cost competitive manner.
 
·
Modern, high quality fiber with direct routing that meets stringent technical requirements.
 
·
Customized ring configurations and redundancy requirements in a private dedicated service.
 
·
7x24 monitoring of the network by our NMC.

Demand for fiber services is driven by key business initiatives including business continuity and disaster recovery, network consolidation and convergence, growth of wireless communications, and industry-specific applications such as high definition video transport and patient record management.  Typically, Fortune 1000 and FTSE 500 enterprises with telecom intensive needs in industries such as financial services, social networking, technology, media, retail, energy and healthcare comprise the target customer base for our fiber optic infrastructure offerings.

Metro Services

We offer a number of high-bandwidth metro service offerings in our active metro markets ranging from 100 Mbps to 40 Gbps connectivity.  These services range from simple point-to-point ethernet connectivity to complex multi-node wavelength-division multiplexing (“WDM”) solutions.  Our metro services have a number of important features that differentiate us from many of our competitors:

 
·
A substantial portion of our metro services are deployed over dedicated fiber from end-to-end, representing a private network for each customer.
 
·
This dedicated fiber provides customers with significant scalability for any increasing traffic demand.
 
·
A service based on dedicated fiber provides a high level of security, a key concern for many high-bandwidth customers across a range of industries.
 
·
The absence of a shared network eliminates many of the equipment interfaces of most other networks that can impact performance such as latency and cause service interruptions.
 
·
Some of our metro services are offered without the need for the customer to provide space and power, which may be difficult or expensive to obtain in many data centers.

We offer private, customized optical network deployments that we build for our largest customers with very specific needs.  These customers are typically large enterprise companies that have significant bandwidth requirements and value a completely private solution.  These solutions often involve extensive network construction to specific critical customer locations such as private data centers and trading platforms with dedicated WDM equipment configured in accordance with the customer’s needs.

In the past several years, we have expanded our metro services capability beyond customers with very high-bandwidth (multiple wave) requirements by offering a number of wave and ethernet products aimed to serve more moderate bandwidth/circuit requirements.  These offerings include basic and enhanced wave services, which are based on dedicated, private fiber and equipment infrastructure from end-to-end and provide a solution for customers looking for a WDM-based service between two metro locations.  The Basic Wave offering provides our lowest cost wave service, while our Enhanced Wave service has a slightly higher initial cost, but provides the customer substantial ability to expand its service capabilities.

We have also expanded our WDM solutions in a number of markets through our Core Wave offering, which provides wave services through pre-positioned equipment and allows faster turn up of services and greater flexibility of use.

 
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We also offer a full range of Metro Ethernet services including point-to-point and multi-point service configurations at 100 Mbps, 1000 Mbps and 10,000 Mbps speeds.  We offer three different classes of our Metro Ethernet services with three different price points (higher, middle and lower) based upon level of service: (1) Private Metro Ethernet which utilizes customer dedicated equipment and fiber to deliver a completely private service with all of the associated operational, performance and security benefits; (2) Dedicated Metro Ethernet which utilizes shared equipment with reserved/guaranteed capacity, delivered to the customer location through dedicated fiber; and (3) Standard Metro Ethernet which utilizes shared equipment on a shared capacity basis, delivered to the customer location through dedicated fiber.

WAN Services

We offer a number of wave, ethernet and IP-based services within our WAN Services offering.  Most of these services provide connectivity solutions between our metro markets and target high-bandwidth customers requiring transmission speeds of at least 100 Mbps.  In addition, we provide high-speed Internet connectivity to our customers including high-end enterprise, web-centric and carrier/cable companies.  Each of our WAN services is differentiated by our significant metro fiber resources that allow us to extend the capability of our core networks to the customer in a secure and cost-effective manner.

Our long haul services provide inter-city connectivity between our U.S. metro markets at a variety of speeds ranging from 1 Gbps to 10 Gbps on our ultra long haul network.  Our service offerings require a minimum of regeneration sites, which improves our ability to be competitive from both a price and speed of installation perspective while reducing the number of equipment interfaces required to deliver our service.

The attractiveness of our long haul services to our customers is further enhanced by our ability to extend the service from our long haul POP to the customer’s premises through our metro networks, thereby providing an end-to-end solution.  This flexibility and reach enables us to provide our long haul services on a differentiated basis.

We operate a Tier 1 IP network that provides high quality Internet connectivity for enterprise, web-centric, Internet and cable companies.  We offer connectivity to the Internet at 100 Mbps, 1 Gbps and 10 Gbps port levels in most of our active metro markets in the U.S. and in London and in other cities in Europe.  We believe our extensive number of peering partners, global reach and uncongested network approach result in a positive experience for our customers.  In addition to selling IP connectivity at data centers and other major IP exchanges, we offer our Metro IP service where we combine our metro fiber reach to deliver Internet connectivity to customer premises.  This service offering extends our significant IP capability, without the dilutive impact of traditional, shared access methods, to the customer location over dedicated fiber that will support full port speeds.

We also offer a suite of advanced ethernet and IP VPN services that provide connectivity between multiple locations in different cities for our customers.  These services provide flexibility such as the ability to prioritize different traffic streams and the ability to converge multiple services across the same infrastructure.  These advanced VPN services, which include VPLS services, offer point-to-point and multipoint connectivity solutions based on MPLS technologies with the same high-bandwidth scalability that our IP connectivity service allows.  Unlike most of our competitors, these services can be extended from our POPs to customer locations within one of our metro markets through dedicated fiber, thereby avoiding transitions through shared or legacy networks that can reduce performance quality.

Sales and Marketing

Our sales force is based across most of our current U.S. metro markets and London.  We also plan to add a sales presence in each of Paris, Amsterdam and Frankfurt.  Our U.S. sales force is comprised of approximately 80 sales professionals and is supported by a team of sales engineers who provide technical support during the sales process.  Our sales force primarily focuses on enterprise customers, including Fortune 1000 companies in the U.S. and FTSE 500 companies in London, that have large bandwidth requirements.  This represents a change from our focus on wholesale sales to carrier customers in previous years.  Since 2004, the vast majority of our new sales have been to enterprise customers.

 
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Our sales strategy includes:

 
·
Positioning ourselves as a premier provider of private fiber optic transport solutions and Internet connectivity services.
 
·
Focusing on Fortune 1000 enterprises as well as content rich data companies (i.e. media, health care and financial services) that require customized private optical solutions.
 
·
Expanding our sales reach through independent sales agents who specialize in specific geographic and vertical markets.
 
·
Emphasizing the high quality, cost effective, secure and scalable nature of our private optical solutions.
 
·
Communicating our capabilities through targeted marketing communication campaigns aimed at specific vertical markets to increase our brand awareness in a cost effective manner.

Customers

We serve a broad array of customers including leading companies in the financial services, web-centric, media/entertainment, and telecommunications sectors.  Our networks meet the requirements of many large enterprise customers with high data transfer and storage needs and stringent security demands.  Major web-centric companies similarly have needs for significant bandwidth and reliable networks.  Media and entertainment companies that deliver bandwidth-intensive video and multimedia applications over their networks are also a growing component of our customer base.  Telecommunications service providers continue to utilize our metro fiber networks to connect to their customers, as well as to data centers and other traffic aggregation points.  Key drivers for growth in the consumption of telecommunications and bandwidth services include the increasing demand for disaster recovery and business continuity solutions, compliance requirements under complex regulations such as the Sarbanes-Oxley Act or the Health Insurance Portability and Accountability Act (“HIPAA”) and exponential growth in data transmissions due to new modalities for communications, media distribution and commerce.

Executive Summary

Overview

The components of our operating income are revenue, costs of revenue, selling and general and administrative expenses and depreciation and amortization.  Below is a description of these components.  We are reporting operating income for the three and six months ended June 30, 2010 and 2009, as shown in our unaudited consolidated statements of operations included elsewhere in this Quarterly Report on Form 10-Q.

Industry

The demand for high-bandwidth telecommunications services continues to increase.  We believe that our experience in the provision of these services, our customer base and our robust and extensive network should enable us to take advantage of this growing demand.  Although the competitive landscape in the telecommunications industry is challenging and constantly shifting, we believe that we are well positioned for continued growth in the future.

Key Performance Indicators

Our senior management reviews a group of financial and non-financial performance metrics in connection with the management of our business.  These metrics facilitate timely and effective communication of results and key decisions, allowing management to react quickly to changing requirements and changes in our key performance indicators.  Some of the key financial indicators we use include cash flow, monthly expense analysis, new customer installations, net new revenue booked, capital committed and expended and net revenue attrition.  We define net revenue attrition as the reduction in monthly recurring revenue (“MRR”) for customers with net decreases in MRR (as a result of terminations, price declines and other decreases, which are offset by any increases) divided by total revenue (excluding contract termination revenue) over a given period.

Some of the most important non-financial performance metrics measure headcount, IP traffic growth, installation intervals and network service performance levels.  We manage our employee headcount changes to ensure sufficient resources are available to service our customers and control expenses.  All employees have been categorized into, and are managed within, integrated groups such as sales, operations, engineering, finance, legal and human resources.  Our worldwide headcount was 671 as of June 30, 2010, 587 of which were employed in the U.S., 82 in the U.K., one in the Netherlands and one in Japan.

 
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2010 Highlights

Our consolidated revenue increased by $24.5 million, or 14.1%, from $173.4 million for the six months ended June 30, 2009 to $197.9 million for the six months ended June 30, 2010, which included a $10.3 million increase in our domestic metro services.  Additionally, in the U.S., our revenue from fiber infrastructure and WAN services increased by $5.6 million and $5.7 million, respectively, for the six months ended June 30, 2010 compared to the six months ended June 30, 2009.  Other revenue (which includes contract termination revenue) was $3.9 million for the six months ended June 30, 2010, compared to $4.2 million for the six months ended June 30, 2009.  Revenue from our foreign operations, primarily in the U.K., increased by $3.2 million for the six months ended June 30, 2010 compared to the six months ended June 30, 2009.

For the six months ended June 30, 2010, we generated operating income of $53.4 million and net income of $29.9 million, compared to operating income of $46.7 million and net income of $52.0 million for the six months ended June 30, 2009.  At June 30, 2010, we had $173.0 million of unrestricted cash, compared to $165.3 million of unrestricted cash at December 31, 2009, an increase in liquidity of $7.7 million.  The increase in unrestricted cash at June 30, 2010 was primarily attributable to cash provided by operating activities of $67.7 million and cash generated by the exercise of stock purchase warrants and options to purchase shares of common stock totaling $1.8 million, partially offset by the use of cash to purchase property and equipment of $57.5 million and for the scheduled debt service payments totaling $3.7 million.  See below in this Item 2 under, “Liquidity and Capital Resources,” for further discussion.

For the six months ended June 30, 2010, our cash flow generated by operating activities increased as a result of the improvement in operating results described above.  We believe, based on our business plan, that our existing cash, cash from our operating activities and funds available under our Secured Credit Facility will be sufficient to fund our operations, planned capital expenditures and other liquidity requirements at least through September 30, 2011.  See below in this Item 2 under, “Liquidity and Capital Resources,” for further information relating to the Secured Credit Facility.

Outlook

We believe that based upon our contracted projects awaiting delivery to customers, we will continue to add to our revenue base in 2010.  Additionally, we have a strong cash position and access to financing through our Secured Credit Facility, if needed.  Sales orders for the six months ended June 30, 2010 were higher than sales orders for the six months ended June 30, 2009.  While net revenue attrition, as previously defined, for the six months ended June 30, 2010 was in line with net revenue attrition for the six months ended June 30, 2009, we cannot predict our net revenue attrition for the balance of 2010.

In early 2010, we announced a number of growth initiatives, which included expansion of services to several new markets in the U.S. and Europe.  This includes connecting Miami to our long haul network and by the end of 2010, opening the Denver metro market and providing certain metro services over leased fiber in Paris, Amsterdam and Frankfurt.  We have also increased our investments in customer capital (capital spent to fulfill customer service orders) for laterals to customer locations (including both enterprise locations and data centers) and backbone network infrastructure investments in our existing markets in order to extend the reach of our networks and improve services to existing and prospective customers and increase revenue opportunities.  We believe that we have adequate liquidity to make such additional investments.

In the fourth quarter of 2009, we reduced the valuation allowance with respect to certain deferred tax assets.  These deferred tax assets are expected to be used to reduce income tax payments in 2010 and future years.  Provisions for income tax expense in 2010 will be reported based upon pre-tax book income, plus permanent differences at our effective state, federal and foreign income tax rates, as applicable.  These tax provisions have had the effect, and will continue to have the effect, of reducing net income and earnings per share in 2010 and in future periods.

 
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Revenue

Revenue derived from leasing fiber optic telecommunications infrastructure and the provision of telecommunications and co-location services is recognized as services are provided.  Non-refundable payments received from customers before the relevant criteria for revenue recognition are satisfied are included in deferred revenue in the accompanying consolidated balance sheets and are subsequently amortized into income over the fixed contract term.

A substantial portion of our revenue is derived from multi-year contracts for services we provide.  We are often required to make an initial outlay of capital to extend our network and purchase equipment for the provision of services to our customers.  Under the terms of most contracts, the customer is required to pay a termination fee or contractual damages (which decline over the contract term) if the contract were terminated by the customer without basis before its expiration to ensure that we recover our initial capital investment, plus an acceptable return.  We also derive a portion of our revenues from annual and month-to-month contracts.

Costs of revenue

Costs of revenue primarily include the following: (i) real estate expenses for all operational sites; (ii) costs incurred to operate our networks, such as licenses, right-of-way, permit fees and professional fees related to our networks; (iii) third party telecommunications, fiber and conduit expenses; (iv) repairs and maintenance costs incurred in connection with our networks; and (v) employee-related costs relating to the operation of our networks.

Selling, General and Administrative Expenses (“SG&A”)

SG&A primarily consist of (i) employee-related costs such as salaries and benefits for employees not directly attributable to the operation of our networks, in addition to stock-based compensation expenses and incentive bonus expenses for all employees; (ii) real estate expenses for all administrative sites; (iii) professional, consulting and audit fees; (iv) certain taxes (other than income taxes), including property taxes and trust fund-related taxes not passed through to customers; and (v) regulatory costs, insurance, telecommunications costs, professional fees, and license and maintenance fees for internal software and hardware.

Depreciation and amortization

Depreciation and amortization consists of the ratable measurement of the use of property and equipment.  Depreciation and amortization for network assets commences when such assets are placed in service and is provided on a straight-line basis over the estimated useful lives of the assets, with the exception of leasehold improvements, which are amortized over the lesser of the estimated useful lives or the term of the lease.

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the U.S. (“U.S. GAAP”).  The preparation of these financial statements in conformity with U.S. GAAP requires management to make judgments, estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenue and expenses during the reporting period.  Management continually evaluates its judgments, estimates and assumptions based on historical experience and available information.  The following is a discussion of the items within our consolidated financial statements that involve significant judgments, assumptions, uncertainties and estimates.  The estimates involved in these areas are considered critical because they require high levels of subjectivity and judgment to account for highly uncertain matters, and if actual results or events differ materially from those contemplated by management in making these estimates, the impact on our consolidated financial statements could be material.  For a full description of our significant accounting policies, see Note 2, “Basis of Presentation and Significant Accounting Policies,” to the accompanying consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q.
 
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Fresh Start Accounting

Our emergence from bankruptcy resulted in a new reporting entity with no retained earnings or accumulated losses, effective as of September 8, 2003.  Although the Effective Date of the Plan of Reorganization was September 8, 2003, we accounted for the consummation of the Plan of Reorganization as if it occurred on August 31, 2003 and implemented fresh start accounting as of that date.  There were no significant transactions during the period from August 31, 2003 to September 8, 2003.  Fresh start accounting requires us to allocate the reorganization value of our assets and liabilities based upon their estimated fair values, in accordance with Statement of Position 90-7, “Financial Reporting by Entities in Reorganization under the Bankruptcy Code” (“SOP 90-7”) (now known as FASB ASC 852-10).  We developed a set of financial projections, which were utilized by an expert to assist us in estimating the fair value of our assets and liabilities.  The expert utilized various valuation methodologies, including (1) a comparison of the Company and our projected performance to that of comparable companies; (2) a review and analysis of several recent transactions of companies in similar industries to ours; and (3) a calculation of the enterprise value based upon the future cash flows of our projections.

Adopting fresh start accounting resulted in material adjustments to the historical carrying values of our assets and liabilities.  The reorganization value was allocated to our assets and liabilities based upon their fair values.  We engaged an independent appraiser to assist us in determining the fair market value of our property and equipment.  The determination of fair values of assets and liabilities was subject to significant estimates and assumptions.  The unaudited fresh start adjustments reflected at September 8, 2003 consisted of the following: (i) reduction of property and equipment; (ii) reduction of indebtedness; (iii) reduction of vendor payables; (iv) reduction of the carrying value of deferred revenue; (v) increase of deferred rent to fair market value; (vi) cancellation of MFN’s common stock and additional paid-in capital, in accordance with the Plan of Reorganization; (vii) issuance of new AboveNet, Inc. common stock and additional paid-in capital; and (viii) elimination of the comprehensive loss and accumulated deficit accounts.

Revenue Recognition

We follow SEC Staff Accounting Bulletin ("SAB") No. 101, “Revenue Recognition in Financial Statements,” (now known as FASB ASC 605-10), as amended by SEC SAB No. 104, “Revenue Recognition,” (also now known as FASB ASC 605-10).

Revenue derived from leasing fiber optic telecommunications infrastructure and the provision of telecommunications and co-location services is recognized as services are provided.  Non-refundable payments received from customers before the relevant criteria for revenue recognition are satisfied are included in deferred revenue in the accompanying consolidated balance sheets and are subsequently amortized into income over the fixed contract term.

Prior to October 1, 2009, we generally amortized revenue related to installation services on a straight-line basis over the contracted customer relationship (two to twenty years).  In the fourth quarter of 2009, we completed a study of our historic customer relationship period.  As a result, commencing October 1, 2009, we began amortizing revenue related to installation services on a straight-line basis generally over the estimated customer relationship period (generally ranging from three to twenty years).

Contract termination revenue is recognized when a customer discontinues service prior to the end of the contract period for which we had previously received consideration and for which revenue recognition was deferred.  Contract termination revenue is also recognized when customers have made early termination payments to us to settle contractually committed purchase amounts that the customer no longer expects to meet or when we renegotiate or discontinue a contract with a customer and as a result are no longer obligated to provide services for consideration previously received and for which revenue recognition has been deferred.  Additionally, we include receipts of bankruptcy claim settlements from former customers as contract termination revenue when received.  Contract termination revenue amounted to $0.6 million and $0.8 million in the three months ended June 30, 2010 and 2009, respectively, and $1.6 million and $2.7 million in the six months ended June 30, 2010 and 2009, respectively.

 
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Accounts Receivable Reserves

Sales Credit Reserves

During each reporting period, we make estimates for potential future sales credits to be issued in respect of current revenue, related to service interruptions and customer disputes, which are recorded as a reduction in revenue.  We analyze historical credit activity and changes in customer demand related to current billing and service interruptions when evaluating our credit reserve requirements.  We reserve for known service interruptions as incurred.  We review customer disputes and reserve against those we believe to be valid claims.  We also estimate a sales credit reserve related to unknown billing errors and disputes based on such historical credit activity.  The determination of the general sales credit and customer dispute credit reserve requirements involves significant estimations and assumptions.

Allowance for Doubtful Accounts

During each reporting period, we make estimates for potential losses resulting from the inability of our customers to make required payments.  We analyze our reserve requirements using several factors, including the length of time a particular customer’s receivables are past due, changes in the customer’s creditworthiness, the customer’s payment history, the length of the customer’s relationship with us, the current economic climate and current industry trends.  A specific reserve requirement review is performed on customer accounts with larger balances.  A reserve analysis is also performed on accounts not subject to specific review utilizing the factors previously mentioned.  Changes in the financial viability of significant customers, worsening of economic conditions and changes in our ability to meet service level requirements may require changes to our estimate of the recoverability of the receivables.  Revenue previously unrecognized, which is recovered through litigation, negotiations, settlements and judgments, is recognized as termination revenue in the period collected.  The determination of both the specific and general allowance for doubtful accounts reserve requirements involves significant estimations and assumptions.

Property and Equipment

Property and equipment owned at the Effective Date are stated at their estimated fair values as of the Effective Date based on our reorganization value, net of accumulated depreciation and amortization incurred since the Effective Date.  Purchases of property and equipment subsequent to the Effective Date are stated at cost, net of depreciation and amortization.  Major improvements are capitalized, while expenditures for repairs and maintenance are expensed when incurred.  Costs incurred prior to a capital project’s completion are reflected as construction in progress and are part of network infrastructure assets, as described below and included in property and equipment on the respective balance sheets.  At June 30, 2010 and December 31, 2009, we had $34.9 million and $26.9 million, respectively, of construction in progress.  Certain internal direct labor costs of constructing or installing property and equipment are capitalized.  Capitalized direct labor is determined based upon a core group of field engineers and IP engineers and reflects their capitalized salary, plus related benefits, and is based upon an allocation of their time between capitalized and non-capitalized projects.  These individuals’ salaries are considered to be costs directly associated with the construction of certain infrastructure and customer installations.  The salaries and related benefits of non-engineers and supporting staff that are part of the engineering departments are not considered part of the pool subject to capitalization.  Capitalized direct labor amounted to $2.8 million and $2.9 million for the three months ended June 30, 2010 and 2009, respectively, and $5.8 million and $5.6 million for the six months ended June 30, 2010 and 2009, respectively.  Depreciation and amortization is provided on a straight-line basis over the estimated useful lives of the assets, with the exception of leasehold improvements, which are amortized over the lesser of the estimated useful lives or the term of the lease.

 
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Estimated useful lives of our property and equipment are as follows:
 
Network infrastructure assets and storage huts (except for risers, which are 5 years)
 
20 years
     
HVAC and power equipment
 
12 to 20 years
     
Software and computer equipment
 
3 to 4 years
     
Transmission and IP equipment
 
5 to 7 years
     
Furniture, fixtures and equipment
 
3 to 10 years
     
Leasehold improvements
 
Lesser of estimated useful life or the lease term

When property and equipment is retired or otherwise disposed of, the cost and accumulated depreciation is removed from the accounts, and resulting gains or losses are reflected in net income.

From time to time, we are required to replace or re-route existing fiber due to structural changes such as construction and highway expansions, which is defined as “relocation.”  In such instances, we fully depreciate the remaining carrying value of network infrastructure removed or rendered unusable and capitalize the new fiber and associated construction costs of the relocation placed into service, which is reduced by any reimbursements received for such costs.  We capitalized relocation costs amounting to $0.2 million and $1.0 million for the three months ended June 30, 2010 and 2009, respectively, and $0.4 million and $1.7 million for the six months ended June 30, 2010 and 2009, respectively.  We fully depreciated the remaining carrying value of the network infrastructure rendered unusable, which on an original cost basis, totaled $0.03 million and $0.05 million ($0.03 million and $0.04 million on a net book value basis) for the three and six months ended June 30, 2010, respectively, and, which on an original cost basis, totaled $0.10 million and $0.20 million ($0.07 million and $0.14 million on a net book value basis) for the three and six months ended June 30, 2009, respectively.  To the extent that relocation requires only the movement of existing network infrastructure to another location, the related costs are included in our results of operations.

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 34, “Capitalization of Interest Cost,” (now known as FASB ASC 835-20), interest on certain construction projects would be capitalized.  Such amounts were considered immaterial, and accordingly, no such amounts were capitalized during the three and six months ended June 30, 2010 and 2009.

In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” (now known as FASB ASC 360-10-35), we periodically evaluate the recoverability of our long-lived assets and evaluate such assets for impairment whenever events or circumstances indicate that the carrying amount of such assets (or group of assets) may not be recoverable.  Impairment is determined to exist if the estimated future undiscounted cash flows are less than the carrying value of such assets.  We consider various factors to determine if an impairment test is necessary.  The factors include: consideration of the overall economic climate, technological advances with respect to equipment, our strategy and capital planning.  Since June 30, 2006, no event has occurred nor has the business environment changed to trigger an impairment test for assets in revenue service and operations.  We also consider the removal of assets from the network as a triggering event for performing an impairment test.  Once an item is removed from service, unless it is to be redeployed, it may have little or no future cash flows related to it.  We performed annual physical counts of such assets that are not in revenue service or operations (e.g., inventory, primarily spare parts) at September 30, 2009 and 2008.  With the assistance of a valuation report of the assets in inventory, prepared by an independent third party on a basis consistent with SFAS No. 157, “Fair Value Measurements,” (now known as FASB ASC 820-10), and pursuant to FASB ASC 360-10-35, we determined that the fair value of certain of such assets was less than the carrying value and thus recorded a provision for equipment impairment of $0.4 million for the year ended December 31, 2009.  The Company also recorded a provision for equipment impairment of $0.8 million in the year ended December 31, 2009 to record the loss in value of certain equipment, most of which was eventually sold to an unaffiliated third party.  See Note 3, “Change in Estimate,” to the accompanying consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q.  We provided allowances for impairment of $0.2 million and $0.5 million in the six months ended June 30, 2010 and 2009, respectively, which were recorded in the three months ended June 30, 2010 and 2009, respectively.

 
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Asset Retirement Obligations

In accordance with SFAS No. 143, “Accounting for Asset Retirement Obligations,” (now known as FASB ASC 410-20), we recognize the fair value of a liability for an asset retirement obligation in the period in which it is incurred if a reasonable estimate of fair value can be made.  We have asset retirement obligations related to the de-commissioning and removal of equipment, restoration of leased facilities and the removal of certain fiber and conduit systems.  Considerable management judgment is required in estimating these obligations.  Important assumptions include estimates of asset retirement costs, the timing of future asset retirement activities and the likelihood of contractual asset retirement provisions being enforced.  Changes in these assumptions based on future information could result in adjustments to these estimated liabilities.

Asset retirement obligations are generally recorded as “other long-term liabilities,” are capitalized as part of the carrying amount of the related long-lived assets included in property and equipment, net, and are depreciated over the life of the associated asset.  Asset retirement obligations aggregated $7.4 million and $7.2 million at June 30, 2010 and December 31, 2009, respectively, of which $3.9 million and $3.8 million, respectively, were included in “Accrued expenses,” and $3.5 million and $3.4 million, respectively, were included in “Other long-term liabilities” at such dates.  Accretion expense, which is included in “Interest expense,” amounted to $0.07 million and $0.02 million for the three months ended June 30, 2010 and 2009, respectively, and $0.14 million, and $0.10 million for the six months ended June 30, 2010 and 2009, respectively.

Derivative Financial Instruments

We utilize derivative financial instruments known as interest rate swaps (“derivatives”) to mitigate our exposure to interest rate risk.  We purchased the first interest rate swap on August 4, 2008 to hedge the interest rate on the $24.0 million (original principal) portion of the Term Loan and we purchased a second interest rate swap on November 14, 2008 to hedge the interest rate on the additional $12.0 million (original principal) portion of the Term Loan provided by SunTrust Bank.  See Note 4, “Note Payable,” to the accompanying consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q.  We accounted for the derivatives under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” (now known as FASB ASC 815).  FASB ASC 815 requires that all derivatives be recognized in the financial statements and measured at fair value regardless of the purpose or intent for holding them.  By policy, we have not historically entered into derivatives for trading purposes or for speculation.  Based on criteria defined in FASB ASC 815, the interest rate swaps were considered cash flow hedges and were 100% effective.  Accordingly, changes in the fair value of derivatives are, and will be, recorded each period in accumulated other comprehensive loss.  Changes in the fair value of the derivatives reported in accumulated other comprehensive loss will be reclassified into earnings in the period in which earnings are impacted by the variability of the cash flows of the hedged item.  The ineffective portion of all hedges, if any, is recognized in current period earnings.  The unrealized net loss recorded in accumulated other comprehensive loss at June 30, 2010 and December 31, 2009 was $1.0 million and $1.2 million, respectively, for the interest rate swaps.  The mark-to-market value of the cash flow hedges will be recorded in other non-current assets or other long-term liabilities, as applicable, and the offsetting gains or losses in accumulated other comprehensive loss.

On January 1, 2009, we adopted SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities – an amendment of FASB Statement No. 133,” (now known as FASB ASC 815-10).  FASB ASC 815-10 changes the disclosure requirements for derivatives and hedging activities.  Entities are required to provide enhanced disclosures about (i) how and why an entity uses derivatives; (ii) how derivatives and related hedged items are accounted for under FASB ASC 815; and (iii) how derivatives and related hedged items affect an entity’s financial position and cash flows.

We minimize our credit risk relating to counterparties of our derivatives by transacting with multiple, high-quality counterparties, thereby limiting exposure to individual counterparties, and by monitoring the financial condition of our counterparties.

All derivatives were recorded in our consolidated balance sheets at fair value.  Accounting for the gains and losses resulting from changes in the fair value of derivatives depends on the use of the derivative and whether it qualifies for hedge accounting in accordance with FASB ASC 815.  At June 30, 2010 and December 31, 2009, our consolidated balance sheet included net interest rate swap derivative liabilities of $1.0 million and $1.2 million, respectively.

 
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Derivatives recorded at fair value in our consolidated balance sheets as of June 30, 2010 and December 31, 2009 consisted of the following:

   
Derivative Liabilities
(In millions)
 
Derivatives designated as hedging instruments
 
June 30, 2010
   
December 31, 2009
 
Interest rate swap agreements (*)
  $ 1.0     $ 1.2  
                 
Total derivatives designated as hedging instruments
  $ 1.0     $ 1.2  

 (*)
The derivative liabilities are two interest rate swap agreements with original three year terms.  They are both considered to be long-term liabilities for financial statement purposes.

Interest Rate Swap Agreements

The notional amounts provide an indication of the extent of our involvement in such agreements but do not represent our exposure to market risk.  The following table shows the notional amount outstanding, maturity date, and the weighted average receive and pay rates of the interest rate swap agreements as of June 30, 2010.

Notional Amount
     
Weighted Average Rate
 
(In millions)
 
Maturity Date
 
Pay
   
Receive
 
$ 20.4  
August 2011
 
3.65%
 
 
0.83%
 
                       
  10.2  
November 2011
  2.635%    
0.44%
 
                       
$ 30.6                    

Interest expense under these agreements, and the respective debt instruments that they hedge, are recorded at the net effective interest rate of the hedged transaction.

The notional amounts of the swap arrangements have since been reduced by amounts corresponding to reductions in the outstanding principal balances.

Fair Value of Financial Instruments

We adopted SFAS No. 157, “Fair Value Measurements,” (“SFAS No. 157”) (now known as FASB ASC 820-10), for our financial assets and liabilities effective January 1, 2008.  This pronouncement defines fair value, establishes a framework for measuring fair value, and requires expanded disclosures about fair value measurements.  FASB ASC 820-10 emphasizes that fair value is a market-based measurement, not an entity-specific measurement, and defines fair value as the price that would be received to sell an asset or transfer a liability in an orderly transaction between market participants at the measurement date.  FASB ASC 820-10 discusses valuation techniques, such as the market approach (comparable market prices), the income approach (present value of future income or cash flow) and the cost approach (cost to replace the service capacity of an asset or replacement cost), which are each based upon observable and unobservable inputs.  Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect our market assumptions.  FASB ASC 820-10 utilizes a fair value hierarchy that prioritizes inputs to fair value measurement techniques into three broad levels:
 
Level 1:
 
Observable inputs such as quoted prices for identical assets or liabilities in active markets.
     
Level 2:
 
Observable inputs other than quoted prices that are directly or indirectly observable for the asset or liability, including quoted prices for similar assets or liabilities in active markets; quoted prices for similar or identical assets or liabilities in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable.
     
Level 3:
 
Unobservable inputs that reflect the reporting entity’s own assumptions.

 
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Our investment in overnight money market institutional funds, which amounted to $158.9 million and $154.1 million at June 30, 2010 and December 31, 2009, respectively, is included in cash and cash equivalents on the accompanying balance sheets and is classified as a Level 1 asset.

We are party to two interest rate swaps, which are utilized to modify our interest rate risk.  We recorded the mark-to-market value of the interest rate swap contracts of $1.0 million and $1.2 million in other long-term liabilities in the consolidated balance sheet at June 30, 2010 and December 31, 2009, respectively.  We used third parties to value each of the interest rate swap agreements at June 30, 2010 and December 31, 2009, as well as our own market analysis to determine fair value.  The fair value of the interest rate swap contracts are classified as Level 2 liabilities.

Our consolidated balance sheets include the following financial instruments: short-term cash investments, trade accounts receivable, trade accounts payable and note payable.  We believe the carrying amounts in the financial statements approximate the fair value of these financial instruments due to the relatively short period of time between the origination of the instruments and their expected realization or the interest rates which approximate current market rates.
   
Concentration of Credit Risk
 
Financial instruments, which potentially subject us to concentration of credit risk, consist principally of temporary cash investments and accounts receivable.  We do not enter into financial instruments for trading or speculative purposes.  Our cash and cash equivalents are invested in investment-grade, short-term investment instruments with high quality financial institutions.  Our trade receivables, which are unsecured, are geographically dispersed, and no single customer accounts for greater than 10% of consolidated revenue or accounts receivable, net.  We perform ongoing credit evaluations of our customers’ financial condition.  The allowance for non-collection of accounts receivable is based upon the expected collectability of all accounts receivable.  We place our cash and cash equivalents primarily in commercial bank accounts in the U.S.  Account balances generally exceed federally insured limits.
   
Foreign Currency Translation and Transactions
 
Our functional currency is the U.S. dollar.  For those subsidiaries not using the U.S. dollar as their functional currency, assets and liabilities are translated at exchange rates in effect at the applicable balance sheet date and income and expense transactions are translated at average exchange rates during the period.  Resulting translation adjustments are recorded directly to a separate component of shareholders’ equity and are reflected in the accompanying consolidated statements of comprehensive income.  Our foreign exchange transaction gains (losses) are generally included in “other income (expense), net” in the consolidated statements of operations.
   
Income Taxes
 
We account for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes,” (now known as FASB ASC 740).  Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between financial statement carrying amounts of existing assets and liabilities and their respective tax basis, net operating losses and tax credit carryforwards, and tax contingencies.  Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.
    
We are subject to audits by various taxing authorities, and these audits may result in proposed assessments where the ultimate resolution results in us owing additional taxes.  We are required to establish reserves under FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” (now known as FASB ASC 740-10), when we believe there is uncertainty with respect to certain positions and we may not succeed in realizing the tax benefit.  We believe that our tax return positions are appropriate and supportable under relevant tax law.  We have evaluated our tax positions for items of uncertainty in accordance with FASB ASC 740-10 and have determined that our tax positions are highly certain within the meaning of FASB ASC 740-10.  We believe the estimates and assumptions used to support our evaluation of tax benefit realization are reasonable.  Accordingly, no adjustments have been made to the consolidated financial statements for the three and six months ended June 30, 2010 and 2009.

 
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Deferred Taxes
 
Our current and deferred income taxes, and associated valuation allowances, are impacted by events and transactions arising in the normal course of business as well as by both special and non-recurring items.  Assessment of the appropriate amount and classification of income taxes is dependent on several factors, including estimates of the timing and realization of deferred income tax on income and deductions.  Actual realization of deferred tax assets and liabilities may materially differ from these estimates as a result of changes in tax laws as well as unanticipated future transactions impacting related income tax balances.

The assessment of a valuation allowance on deferred tax assets is based on the likelihood that a portion of our deferred tax assets will be realized in future periods.  The weight of all available evidence is considered in determining realizability of our deferred tax assets.  Deferred tax liabilities are first applied to the deferred tax assets reducing the need for a valuation allowance.  Future utilization of the remaining net deferred tax assets would require the ability to forecast future earnings.  Based on past performance and management’s estimation of future income, we do not believe that sufficient evidence exists to release the entire valuation allowance as of December 31, 2009.
 
As part of our evaluation of deferred tax assets in the fourth quarter of 2009, we recognized a tax benefit of $183.0 million at December 31, 2009 relating to the reduction of certain valuation allowances previously established in the U.S. and the U.K.  We believe it is more likely than not that we will utilize these deferred tax assets to reduce or eliminate tax payments in future periods.  This reduction in valuation allowance had the effect of increasing net income by $183.0 million for the year ended December 31, 2009.  Our evaluation encompassed (i) a review of our recent history of profitability in the U.S. and the U.K. for the past three years; (ii) a review of internal financial forecasts demonstrating our expected capacity to utilize deferred tax assets; and (iii) a reassessment of tax benefits recognition under FASB ASC 740.

Stock-Based Compensation
 
On September 8, 2003, we adopted the fair value provisions of SFAS No. 148, “Accounting for Stock-Based Compensation Transition and Disclosure,” (“SFAS No. 148”), (now known as FASB ASC 718-10).  SFAS No. 148 amended SFAS No. 123, “Accounting for Stock-Based Compensation,” (“SFAS No. 123”), (also now known as FASB ASC 718-10), to provide alternative methods of transition to SFAS No. 123’s fair value method of accounting for stock-based employee compensation.  See Note 7, “Stock-Based Compensation,” to the accompanying consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q.

Under the fair value provisions of SFAS No. 123, the fair value of each stock-based compensation award is estimated at the date of grant, using the Black-Scholes option pricing model for stock option awards.  We did not have a historical basis for determining the volatility and expected life assumptions in the model due to our limited market trading history; therefore, the assumptions used for these amounts are an average of those used by a select group of related industry companies.  Most stock-based awards have graded vesting (i.e. portions of the award vest at different dates during the vesting period).  We recognize the related stock-based compensation expense of such awards on a straight-line basis over the vesting period for each tranche in an award.  Upon consummation of our Plan of Reorganization, all then outstanding stock options were cancelled.

Effective January 1, 2006, we adopted SFAS No. 123(R), “Share-Based Payment,” (“SFAS No. 123(R)”), (now known as FASB ASC 718), using the modified prospective method.  SFAS No. 123(R) requires all share-based awards granted to employees to be recognized as compensation expense over the vesting period, based on fair value of the award.  The fair value method under SFAS No. 123(R) is similar to the fair value method under SFAS No. 123 with respect to measurement and recognition of stock-based compensation expense except that SFAS No. 123(R) requires an estimate of future forfeitures, whereas SFAS No. 123 permitted companies to estimate forfeitures or recognize the impact of forfeitures as they occurred.  As we had recognized the impact of forfeitures as they occurred under SFAS No. 123, the adoption of SFAS No. 123(R) resulted in a change in our accounting treatment, but it did not have a material impact on our consolidated financial statements.

For a description of our stock-based compensation programs, see Note 7, “Stock-Based Compensation,” to the accompanying consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q.

There were no options to purchase shares of common stock granted during the three and six months ended June 30, 2010 and 2009.

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Results of Operations for the Six Months Ended June 30, 2010 Compared to the Six Months Ended June 30, 2009

Consolidated Results (dollars in millions for the table set forth below):

   
Six Months Ended June 30,
   
$ Increase/
   
% Increase/
 
   
2010
   
2009
   
(Decrease)
   
(Decrease)
 
Revenue
  $ 197.9     $ 173.4     $ 24.5       14.1 %
Costs of revenue (excluding depreciation and amortization, shown separately below)
    67.2       61.7       5.5       8.9 %
Selling, general and administrative expenses
    46.6       40.8       5.8       14.2 %
Depreciation and amortization
    30.7       24.2       6.5       26.9 %
Operating income
    53.4       46.7       6.7       14.3 %
Other income (expense):
                               
Interest income
          0.3       (0.3 )  
NM
 
Interest expense
    (2.4 )     (2.3 )     0.1       4.3 %
Other (expense) income, net
    (0.4 )     2.4       (2.8 )     (116.7 )%
Income before income taxes
    50.6       47.1       3.5       7.4 %
Provision for (benefit from) income taxes
    20.7       (4.9 )     25.6    
NM
 
Net income
  $ 29.9     $ 52.0     $ (22.1 )     (42.5 )%
 
NM—not meaningful


We use the term “consolidated” below to describe the total results of our two geographic segments, the U.S. and the U.K. and others.  Throughout this document, unless otherwise noted, amounts discussed are consolidated amounts.

Net Income.  Our net income for the six months ended June 30, 2010 was $29.9 million, compared to $52.0 million for the six months ended June 30, 2009, a decrease of $22.1 million.  The primary reasons for the decrease in net income were the change from a net benefit from income taxes of $4.9 million to a provision for income taxes of $20.7 million totaling a change of $25.6 million, an increase in costs of revenue of $5.5 million, an increase in selling, general and administrative expenses of $5.8 million, an increase in depreciation and amortization of $6.5 million and a change (decrease) in other (expense) income, net, of $2.8 million, which were partially offset by an increase in revenue of $24.5 million.  These changes are discussed more fully below.

Revenue.  Consolidated revenue was $197.9 million for the six months ended June 30, 2010, compared to $173.4 million for the six months ended June 30, 2009, an increase of $24.5 million, or 14.1%.  Revenue from our U.S. operations increased by $21.3 million, or 13.4%, from $158.7 million for the six months ended June 30, 2009 to $180.0 million for the six months ended June 30, 2010.  The principal reason for this increase was the continued growth in each of our metro, fiber infrastructure and WAN services.  This continued growth in revenue for each of these services is attributable principally to revenue from service installations exceeding reductions in revenue from contract terminations and any contractual price decreases.  U.S. revenue from metro services increased by $10.3 million, or 23.1%, from $44.6 million for the six months ended June 30, 2009 to $54.9 million for the six months ended June 30, 2010, U.S. revenue from fiber infrastructure services increased by $5.6 million, or 7.2%, from $77.6 million for the six months ended June 30, 2009 to $83.2 million for the six months ended June 30, 2010 and U.S. revenue from WAN services increased by $5.7 million, or 17.6%, from $32.3 million for the six months ended June 30, 2009 to $38.0 million for the six months ended June 30, 2010.  These increases were partially offset by a decrease of $0.3 million, or 7.1%, in other revenue, which includes domestic contract termination revenue, from $4.2 million for the six months ended June 30, 2009 to $3.9 million for the six months ended June 30, 2010.  Revenue from our foreign operations, primarily in the U.K., increased by $3.2 million, or 21.8%, from $14.7 million for the six months ended June 30, 2009 to $17.9 million for the six months ended June 30, 2010.  The primary reason for this increase was due to an increase in revenue at the local currency level due to an increase in provisioning of services.  Also contributing to this increase was $0.2 million of contract termination revenue earned during the six months ended June 30, 2010 and a 2.2% increase in the translation rate due to the strengthening of the British pound to the U.S. dollar in the six months ended June 30, 2010 compared to the six months ended June 30, 2009.  There was no contract termination revenue earned in the U.K. during the six months ended June 30, 2009.

 
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Costs of revenue.  Consolidated costs of revenue for the six months ended June 30, 2010 was $67.2 million, compared to $61.7 million for the six months ended June 30, 2009, an increase of $5.5 million, or 8.9%.  Consolidated costs of revenue as a percentage of revenue was 34.0% for the six months ended June 30, 2010, compared to 35.6% for the six months ended June 30, 2009, resulting in consolidated gross profit margin of 66.0% and 64.4% for the six months ended June 30, 2010 and 2009, respectively.  The costs of revenue for our U.S. operations was $61.0 million and $56.5 million for the six months ended June 30, 2010 and 2009, respectively, an increase of $4.5 million, or 8.0%.  The increase in domestic costs of revenue for the six months ended June 30, 2010 compared to the six months ended June 30, 2009 was attributable principally to (i) an increase of $2.7 million in co-location expenses, to support our IP network services and increase our presence in third party data centers; (ii) an increase of $0.9 million for expenses associated with third party network costs; (iii) an increase of $0.7 million in amounts rebilled to customers for equipment sales (for which there was a corresponding increase in related revenue); and (iv) an increase of $0.4 million in payroll-related expenses.  These increases were partially offset by the reversal of $0.4 million during the three months ended June 30, 2010 due to previously accrued right-of-way expenses (as a result of negotiations with the relevant jurisdiction).  Additionally, the six month periods ended June 30, 2010 and 2009 include a provision for equipment impairment relating to inventory of $0.2 million and $0.5 million, respectively, which was recorded in the three months ended June 30, 2010 and 2009, respectively.  The costs of revenue for our foreign operations was $6.2 million for the six months ended June 30, 2010, compared to $5.2 million for the six months ended June 30, 2009, an increase of $1.0 million, or 19.2%.  This increase was due primarily to increases in third party network costs, co-location expenses and leased fiber costs, which were needed to support the increases in our current and future operations totaling $1.5 million, partially offset by a one-time benefit of a reduction in certain business tax rates on fiber by the Valuation Office Agency in the U.K., which was effective retroactively back to 2005, reducing amounts paid or accrued by $0.5 million.  In addition, the results for the six months ended June 30, 2010 compared to the six months ended June 30, 2009 reflect a 2.2% increase in the translation rate.
 
Selling, General and Administrative Expenses (“SG&A”).  Consolidated SG&A for the six months ended June 30, 2010 was $46.6 million, compared to $40.8 million for the six months ended June 30, 2009, an increase of $5.8 million, or 14.2%.  SG&A as a percentage of revenue was 23.5% for each of the six months ended June 30, 2010 and 2009.  In the U.S., SG&A was $41.4 million for the six months ended June 30, 2010, compared to $35.9 million for the six months ended June 30, 2009, an increase of $5.5 million, or 15.3%.  SG&A for our U.S. operations for the six months ended June 30, 2010 compared to the six months ended June 30, 2009 increased primarily due to (i) an increase of $3.8 million in domestic payroll and payroll-related expenses from $19.9 million for the six months ended June 30, 2009 to $23.7 million for the six months ended June 30, 2010, which is attributable to an increase in annual merit increases for domestic employees effectuated on March 1, 2010, an increase in sales commissions due to an increase in year over year sales and a sales incentive program in effect in the first quarter of 2010; (ii) an increase of $0.8 million for property taxes; (iii) an increase of $0.3 million in occupancy-related expenses; (iv) an increase of $0.2 million in professional fees; and (v) an increase of $1.6 million in other operating expenses, primarily due to increases in computer software and maintenance of $0.6 million, commissions paid to third party sales agents of $0.4 million and training and seminar expenses of $0.2 million.  These increases were partially offset by a reduction of $1.5 million in domestic non-cash stock-based compensation expense from $5.2 million for the six months ended June 30, 2009 to $3.7 million for the six months ended June 30, 2010.  SG&A from our foreign operations was $5.2 million for the six months ended June 30, 2010, compared to $4.9 million for the six months ended June 30, 2009, an increase of $0.3 million, or 6.1%.  Increases in professional fees and the year over year increase in the translation rate were the primary reasons for this increase.

Depreciation and amortization.  Consolidated depreciation and amortization was $30.7 million for the six months ended June 30, 2010, compared to $24.2 million for the six months ended June 30, 2009, an increase of $6.5 million, or 26.9%.  Consolidated depreciation and amortization as a percentage of revenue was 15.5% for the six months ended June 30, 2010, compared to 14.0% for the six months ended June 30, 2009.  The increase in consolidated depreciation and amortization was primarily attributable to (i) additions of property and equipment for the six months ended June 30, 2010 and the full period effect of depreciation on property and equipment acquired during 2009 and (ii) the change (reduction) in estimated useful lives of certain property and equipment effectuated on October 1, 2009 and January 1, 2010, partially offset by the reduction of depreciation with respect to certain assets, which became fully depreciated between the two periods.

Interest income.  Interest income, substantially all of which was earned in the U.S., decreased by $0.3 million for the six months ended June 30, 2010 compared to the six months ended June 30, 2009.  This decrease was primarily due to the decrease in short-term interest rates during the six months ended June 30, 2010 compared to the six months ended June 30, 2009, partially offset by an increase in average balances available for investment.

Interest expense.  Interest expense, substantially all of which was incurred in the U.S., includes interest expense on borrowed amounts under the Secured Credit Facility, availability fees on the unused portion of the Secured Credit Facility, the amortization of debt acquisition costs (including upfront fees) related to the Secured Credit Facility, interest expense related to a capital lease obligation, interest accrued on certain tax liabilities, interest on the outstanding balance of the deferred fair value rent liabilities established at fresh start and interest accretion relating to asset retirement obligations.  Interest expense was $2.4 million for the six months ended June 30, 2010, compared to $2.3 million for the six months ended June 30, 2009, an increase of $0.1 million, or 4.3%.

 
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Other (expense) income, net. Other (expense) income, net is composed primarily of income or expense from non-recurring transactions and is not comparative from a trend perspective.  Consolidated other (expense) income, net was a net expense of $0.4 million for the six months ended June 30, 2010, compared to other income, net of $2.4 million for the six months ended June 30, 2009, a change (decrease) of $2.8 million.  In the U.S., other income, net was $0.7 million for the six months ended June 30, 2010, compared to other income, net of $0.4 million for the six months ended June 30, 2009, an increase of $0.3 million.  For our foreign operations, other (expense) income, net was a net expense of $1.1 million for the six months ended June 30, 2010, compared to other income, net of $2.0 million for the six months ended June 30, 2009, a change (decrease) of $3.1 million.  For the six months ended June 30, 2010, consolidated other expense, net was comprised of a net loss on foreign currency of $1.2 million, offset by gains arising from the settlement or reversal of certain tax liabilities of $0.4 million, a gain from the settlement of an insurance claim of $0.2 million and other gains of $0.2 million.  For the six months ended June 30, 2009, consolidated other income, net was comprised of a gain on foreign currency of $2.6 million and gains arising from the reversal of certain tax liabilities of $0.7 million, offset by a net loss on the sale or disposition of property and equipment of $0.9 million.
 
Provision for (benefit from) income taxes. We recorded a provision for income taxes of $20.7 million for the six months ended June 30, 2010, compared to a benefit from income taxes of $4.9 million for the six months ended June 30, 2009.  The provision for income taxes for the six months ended June 30, 2010 was calculated at our effective tax rate based upon our pre-tax book income (adjusted for permanent differences in both the U.S. and the U.K.), resulting in a tax provision of $20.5 million, plus a provision for certain capital-based state taxes of $0.2 million.  Because of the anticipated loss for federal income tax purposes for 2009, we recorded a carryback benefit to 2007 and 2008 and released a portion of the valuation allowance previously established against deferred tax assets in the six months ended June 30, 2009.