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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
| x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the fiscal year ended December 31, 2010
OR
| ¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
Commission file number 000-51588
CBEYOND, INC.
(Exact name of registrant as specified in its charter)
| Delaware | 59-3636526 | |
| (State or other jurisdiction of incorporation or organization) |
(I.R.S. Employer Identification No.) | |
| 320 Interstate North Parkway, Suite 500 Atlanta, Georgia |
30339 | |
| (Address of principal executive offices) | (Zip Code) |
Registrant’s telephone number, including area code: (678) 424-2400
Securities registered pursuant to 12(b) of the Act:
Common Stock, $0.01 par value
(Title of Class)
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes ¨ No x
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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨
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 ¨ | Smaller reporting company ¨ | |||
| (Do not check if a 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
As of June 30, 2010, the aggregate market value of the common stock held by non-affiliates of the registrant was $368,957,378 based on a closing price of $12.50 on the Nasdaq Global Market on such date.
Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date.
| Title of Class |
Number of Shares Outstanding on March 3, 2011 | |
| Common Stock, $0.01 par value |
31,090,863 |
DOCUMENTS INCORPORATED BY REFERENCE
The information required by Part III of this Report, to the extent not set forth herein, is incorporated by reference from the registrant’s definitive proxy statement relating to the annual meeting of stockholders scheduled to be held on June 10, 2011. The definitive proxy statement shall be filed with the Securities and Exchange Commission within 120 days after the end of the fiscal year to which this report relates.
Table of Contents
For the Fiscal Year Ended December 31, 2010
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Table of Contents
PART I
CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS
In this document, Cbeyond, Inc. and its subsidiaries are referred to as “we,” “our,” “us,” the “Company” or “Cbeyond.”
This document contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements include, but are not limited to, statements identified by words such as “expectation,” “guidance,” “believe,” “expect” “anticipate,” “estimate,” “intend,” “plan,” “target,” “project,” and similar expressions. Such statements are based upon the current beliefs and expectations of our management and are subject to significant risks and uncertainties. Actual results may differ from those set forth in the forward-looking statements. Factors that might cause future results to differ include, but are not limited to, the following: the significant reduction in economic activity, which particularly affects our target market of small businesses; the risk that we may be unable to continue to experience revenue growth at historical or anticipated levels; the risk of unexpected increase in customer churn levels; changes in federal or state regulation or decisions by regulatory bodies that affect us; periods of economic downturn or unusual volatility in the capital markets or other negative macroeconomic conditions that could harm our business, including our access to capital markets and the impact on certain of our customers to meet their payment obligations; the timing of the initiation, progress or cancellation of significant contracts or arrangements; the mix and timing of services sold in a particular period; our ability to recruit and retain experienced management and personnel; rapid technological change and the timing and amount of startup costs incurred in connection with the introduction of new services or the entrance into new markets; our ability to maintain or attract sufficient customers in existing or new markets; our ability to respond to increasing competition; our ability to manage the growth of our operations; changes in estimates of taxable income or utilization of deferred tax assets which could significantly affect our effective tax rate; pending regulatory action relating to our compliance with customer proprietary network information; the risk that the anticipated benefits, growth prospects and synergies expected from our acquisitions may not be fully realized or may take longer to realize than expected; the possibility that economic benefits of future opportunities in an emerging industry may never materialize, including unexpected variations in market growth and demand for the acquired products and technologies; delays, disruptions, costs and challenges associated with integrating acquired companies into our existing business, including changing relationships with customers, employees or suppliers; unfamiliarity with the economic characteristics of new geographic markets; ongoing personnel and logistical challenges of managing a larger organization; our ability to retain and motivate key employees from the acquired companies; external events outside of our control, including extreme weather, natural disasters, pandemics or terrorist attacks that could adversely affect our target markets; and general economic and business conditions. You are advised to consult any further disclosures we make on related subjects in the reports we file with the Securities and Exchange Commission, or SEC, including this report in the sections titled “Part I, Item 1A. Risk Factors” and “Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Such disclosure covers certain risks, uncertainties and possibly inaccurate assumptions that could cause our actual results to differ materially from expected and historical results. We undertake no obligation to correct or update any forward-looking statements, whether as a result of new information, future events or otherwise.
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| Item 1. | Business |
OVERVIEW
We provide managed information technology, or IT, and communications services to our target market of small businesses, who generally have between 5 and 249 employees. Our services include voice services, broadband Internet access, mobile voice and data, email, voicemail, web hosting, secure backup and file sharing, fax-to-email, virtual private network, desktop security, Hosted Microsoft Exchange, mobile workforce management, Virtual Receptionist, and other IT and communications services. Our recent acquisitions (see Note 4 to the Consolidated Financial Statements (the “consolidated financial statements”)) have expanded our IT services into cloud computing with virtual and dedicated cloud servers and cloud private branch exchange or phone systems (or “PBX”). Traditionally, we have sold our services only when included with one of our integrated packages of bundled services or as a la cart services in addition to one of our packages. However, the cloud-based services now offered as a result of these recent acquisitions may be purchased separately from our integrated packages or as part of an integrated package. Our voice services (other than our mobile voice and data services) are delivered using Voice over Internet Protocol, or VoIP technology. All of such services, other than cloud-based services purchased outside of an integrated package, are delivered over our secure all-Internet Protocol, or IP, via a high capacity bandwidth connections network, which allows us to control quality of service much better than services delivered over the best-efforts public Internet. We utilize various types of high-speed connections where available and economically feasible. Our network allows us to manage quality of service and achieve network and call reliability comparable to that of traditional communications networks.
We designate revenues as either Core Managed Services or Cloud Services. Core Managed Services revenues arise from our traditional customers located in the 14 metropolitan markets where we deliver integrated packages of managed services, including broadband circuits as part of our service (our “BeyondVoice” package). Cloud Services revenues arise from services that are delivered separately from broadband circuits. In future periods we may re-designate certain Core Managed Services revenues, such as Hosted Microsoft Exchange, secure desktop, and remote backup and storage, as Cloud Services revenue for reporting purposes dependent on how we manage delivery of these services.
Our IT services appeal to small businesses that lack the in-house technical expertise and resources to build and manage the capabilities that they need in order to compete effectively in a business environment that increasingly demands a robust and reliable online presence. We believe that small businesses are becoming more interested in outsourcing many of their IT functions to a trusted provider who will host their applications “in the cloud.” Cloud computing refers to services delivered on-demand via the Internet and can be available in a secure and cost-effective manner. We provide many of our services in this manner today, in addition to those service offerings resulting from our recent acquisitions. In the future, we expect to introduce other applications hosted “in the cloud”.
We believe our all-IP network platform enables us to deliver an integrated bundle of highly reliable IT and communications services that have typically only been available to large enterprises and may otherwise be too expensive or impractical for our small business customers to obtain. We manage all aspects of our service offerings for our customers, including installation, provisioning, monitoring, proactive fault management and billing. We first launched our integrated packages of bundled services in Atlanta in April 2001, and now sell them in 14 metropolitan markets, including Dallas, Denver, Houston, Chicago, Los Angeles, San Diego, Detroit, the San Francisco Bay Area, Miami, Minneapolis, the Greater Washington D.C. Area, Seattle and Boston. Our recent acquisitions allow us to also serve customers with cloud-based services in geographic areas outside of these core markets. Our Cloud Services customers are located throughout the United States and internationally. For the year ended December 31, 2010, less than 1% of our consolidated revenue came from customers based outside of the United States.
We reported $452.0 million in revenue in 2010, as compared to $413.8 million in 2009 and $349.7 million in 2008. We reported $72.9 million, $63.1 million and $60.6 million of adjusted EBITDA, a non-GAAP
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measure, (see “Non-GAAP Financial Measures”) and net (loss) income of $(1.7) million, $(2.2) million and $3.7 million on a consolidated basis, in 2010, 2009 and 2008, respectively. Our financial results on a segment basis for reporting and management purposes are presented in Note 13 to our consolidated financial statements.
We have typically opened anywhere from one to three new markets per year for our integrated service offering. During 2011, instead of focusing on opening new markets, we will focus on incorporating the newly acquired cloud-based services into our integrated service offering, leveraging historic and expanding acquired sales channels, and increasing our product offering to take advantage of the new capabilities available through our acquisitions. We will also continue our ongoing Ethernet conversion project (see “Cost of Revenue” section in Management’s Discussion and Analysis of Financial Condition and Results of Operations) being implemented throughout our markets in order to optimize our cost structure and increase bandwidth available through our integrated packages. We anticipate resuming our geographic market expansion beginning in 2012, depending on economic, regulatory and other conditions. As of December 31, 2010, 2009 and 2008, we were providing Core Managed Service communications services to 56,972, 50,203 and 42,463 customer locations, respectively. These customer locations exclude those served exclusively by our newly established Cloud Services segment.
We provide each of our integrated packages of managed services at a competitively priced, fixed monthly fee. Certain enhanced services are available as optional add-ons at either flat monthly rates or on a usage basis. We also earn revenues for usage exceeding quantities included within the package or purchased through additional services, including long distance, mobile, conferencing and calling card minutes, mobile text messages and bandwidth used for data services. We believe that we provide a differentiated value proposition to our customers, most of which do not have dedicated in-house resources to fully address their IT and communications requirements and who therefore value the ease of use and comprehensive management that we offer. Our primary competitors, the local telephone companies, do not generally offer packages of similar managed services to our target market. We believe that this value proposition, along with our fixed-length contracts, has been crucial to achieving a relatively stable customer churn rate, which averaged approximately 1.4%, 1.5% and 1.3% for the years ended December 31, 2010, 2009 and 2008, respectively. Additionally, we believe that our expansion of cloud-based services will continue to strengthen our value proposition.
We employ a single integrated network, which uses technologies that digitize voice communications into IP packets and converges them with other data services for transport on an IP network. This is unlike traditional voice-centric circuit switched communications networks, which require separate networks in order to provide voice and data services. Compared to traditional networks using legacy technologies, our network design exploits the convergence of voice and data services that we believe requires significantly lower capital expenditures and operating costs. The integration of our network with our automated front and back office systems allows us to monitor network performance, quickly provision customers and offer our customers the ability to add or change services online, thus reducing our customer care expenses. We believe that our all-IP network and automated support systems enable us to continue to offer new services to our customers in an efficient manner.
Our Strategy
We intend to continue to grow our business in established markets, through both increasing the number of customers and increasing the number of services we provide, and to replicate our approach in additional markets. We also intend to grow our business by leveraging new distribution channels to sell our Cloud Service offerings that are not geographically limited since they are not dependent upon the presence of physical network infrastructure. To achieve our goal of profitably delivering sophisticated IT and communications tools to small businesses in our current and future markets, we have adopted a strategy with the following principal components:
| • | Focus solely on the small-business market. We target small businesses since most do not have dedicated in-house resources to fully address their IT and communications requirements. This type of customer places a high value on customer support. By focusing exclusively on small business customers, we believe we are able to differentiate ourselves from larger service providers and deliver superior service that small business customers value. |
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| • | Become the primary provider of outsourced IT and communications services to small businesses. We seek to become the primary provider through our comprehensive packages to our Core Managed Services customers or via Cloud Services to customers outside our current 14-city footprint. We believe that small businesses will increasingly outsource their critical IT and communications functions to a trusted expert third party in order to take advantage of the convenience, reliability, security and lower costs offered. We also believe that we are well positioned to benefit from this trend due to the breadth of services we offer, the quality of our service and support, and the reach of our distribution channels. |
| • | Focus on customer intimacy as a point of competitive differentiation. We strive to serve our customers by focusing on the value of our services, our service quality, convenience and strength of our relationships, in contrast to competitors whose competitive differentiation is based more on scale economies or product leadership. We use a number of measurements to judge our progress in this area, including net promoter scores and other measures of customer satisfaction arising from customer surveys, customer churn rates, and network and application performance statistics. We believe that our focus on customer intimacy, if successfully implemented over time, will lead to higher growth and profitability long term. |
| • | Offer comprehensive packages of managed IT and communications services to our Core Managed Services customers. We seek to be the single-source provider of our IT and customers’ communications service needs by including an integrated bundle of services in our BeyondVoice packages. Our packages and add-on services are designed to offer a flexible and simple means for small businesses to tailor overall service to meet their specific needs over time—including the purchase of additional quantities, volumes or capacities; upgrading to more sophisticated applications; or purchasing completely new à la carte services on top of their existing packages—while maintaining the service integration and the convenience of a single provider. Our comprehensive packages are subscribed to under fixed-length, flat-rate contracts, which typically results in stable average monthly revenue per Core Managed Services customer location (or “ARPU”), a more stable customer churn rate and greater operating efficiencies. |
| • | Increase penetration of enhanced and cloud-based services to our customer base. We focus on enhancing existing applications and developing new applications that increase customer productivity and satisfaction. As our customer base and service offering have grown, our upselling efforts to introduce new products and services to existing customers has become an increasingly important opportunity for revenue and margin growth and for maintaining a high value proposition for our customers. |
| • | Focus sales and marketing resources on achieving significant market penetration. We have chosen to focus our sales and marketing efforts on achieving deep market penetration and growing market share in a limited set of markets and gradually expanding the number of markets served, rather than taking an approach that emphasized having a sales presence in significantly more markets with lower market penetration. We believe the cloud-based services from the recent acquisitions will enable us to achieve even deeper market penetration in our existing markets by giving us a more comprehensive and competitive product offering. In addition, these acquisitions allow us to also serve customers outside of our traditional markets through distribution channels we did not previously possess, including an online sales channel and a private label reseller platform. We believe that our concentration on market share rather than market presence has resulted in our achieving profitability and economic sustainability at a faster rate and with better financial results than would have resulted from an approach that emphasized having a sales presence in significantly more markets with a lower market share. In addition, because we prefer to develop and promote sales management from within, rather than hire from outside, our steadily growing base of established markets provides a training ground for management personnel who can open new markets. |
| • | Replicate our business model in new geographical markets. Each time we expand into a new market, we adhere to the same processes for choosing, preparing, launching and operating in those markets that have proven successful in previous market launches. In launching our business in each new market, we use the same disciplined financial and operational reporting system to enable us to closely monitor our costs, market penetration and provisioning of customers and maintain standards consistent with our established markets. |
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Our Strengths
Our business is focused on rapidly growing a loyal customer base, while maintaining capital and operating efficiency. We believe we benefit from the following strengths:
| • | Our differentiated package of valuable applications. We believe that we offer a highly differentiated package of IT and communications services in order to bring “big business tools” to small businesses in an affordable, convenient manner. Our focus allows us to compete primarily on the basis of value rather than price, and we believe that we are able to command a premium in the market due to our ability to aggregate the essential IT and communications services needed to make a small business better connected and more productive. |
| • | Our customer relationships. We have approximately 57,000 small business customers who use our Core Managed Services, in addition to our newly acquired base of Cloud Services customers, all of whom comprise a stable and growing base of high quality service relationships. We believe that our customers generally view us as a trusted IT and communications expert providing high quality, reliable and convenient services supported by helpful and efficient care representatives. |
| • | Our highly regimented and personalized consultative sales model. We believe we have a distinctive approach to recruiting, training and deploying our direct sales representatives, which ensures a uniform sales culture and an effective means of acquiring new customers. Our direct sales representatives follow a disciplined daily schedule and meet face-to-face with customers each day as part of a transaction-oriented and personalized consultative selling approach. |
| • | Capital efficiency. We believe that our business approach requires lower capital and operating expenditures to bring our markets to positive cash flow compared to communications carriers using legacy technologies and operating processes. In addition, our deployment of capital in each of our markets is largely success based, meaning, over time, a large portion of our capital outlay is incurred incrementally as our customer base grows. |
| • | Our automated and integrated business processes. We believe that the combination of our disciplined approach to sales, installation and service together with our automated business processes allows us to streamline our operations and maintain low operating costs. Our front and back office systems are highly automated and are integrated to synchronize multiple tasks, including installation, billing and customer care. We believe this allows us to lower our customer service costs, efficiently monitor the performance of our network and provide automated and responsive customer support. |
| • | Our all-IP network. We are able to provide a wide range of enhanced services in a cost-efficient manner over a single network, in contrast to traditional networks, which may require separate, incremental networks or substantial network upgrades in order to support similar services. Our all-IP network architecture allows us to provide a comprehensive package of services with high network reliability and quality of service. |
| • | Our experienced management team with focus on operating excellence. Our senior management team has substantial industry experience. Our top three executive officers each have an average of over 24 years of experience in the communications industry and have worked at a broad range of communications companies, both startups and mature businesses, including local telephone companies, long distance carriers, competitive carriers, web hosting companies, Internet and data providers and mobile communications providers. |
| • | Our strong balance sheet and liquidity position. As of December 31, 2010, we had a strong balance sheet with $26.4 million in cash and cash equivalents and no outstanding debt. We believe that cash flows from operations, cash on hand and availability under our revolving line of credit will be sufficient to fund our capital expenditures and operating expenses, including those related to our current plans to expand our Ethernet network, ramp up our Cloud Services division and to continue opening up new markets, depending on economic, regulatory and other conditions. In addition, as of the date of this |
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| filing, we have an open, undrawn $75.0 million revolving line of credit with Bank of America, of which $73.7 million is available due to $1.3 million in letters of credit which are collateralized and outstanding under the revolving line of credit. The revolving line of credit is secured by substantially all of our assets. |
We believe our strategies and strengths have contributed to our financial and operating performance, including consistent growth in customers, revenue and adjusted EBITDA.
Our Customers
Prior to joining Cbeyond, the majority of our customers received basic communications services from the incumbent local telephone companies and frequently had multiple other providers for other IT and communications services. Often they simply did not utilize the kinds of IT services available through our service packages. These businesses, in most cases, did not receive the focus and personalized attention that larger enterprises enjoy and often lagged behind larger businesses in the adoption of productivity-enhancing and cost-effective IT and communications services.
Our sole focus on small businesses means no single customer or group of customers represents a significant percentage of our customer base or revenues. Similarly, no single vertical customer segment represents a significant percentage of our base. Our largest customer sectors are professional services, which include physicians, legal offices, insurance services, consulting firms, accounting firms and real estate services. Each of these sectors represents less than 10% of our customer base.
Our Core Managed Service Offerings
We offer integrated managed IT and communications services through our BeyondVoice packages over high capacity bandwidth connections. Each of these packages includes local and long distance voice services and broadband Internet access, plus a full line of managed services and mobile services that our customers can choose from to customize their package. The local and long distance voice services in our packages include enhanced 911 services, which are comparable to the 911 services offered over traditional telephone networks, and business class features, which include call forwarding, call hunting, call transfer, call waiting, caller ID and three-way calling.
In addition to the applications offered in our BeyondVoice packages, we currently offer other services, which include voicemail, email, unified messaging, web hosting, virtual private network, secure backup and file sharing, fax-to-email, Hosted Microsoft Exchange, secure desktop, mobile workforce management, Virtual Receptionist, cloud server and cloud PBX offerings, and other applications and features to our Core Managed Services customers. In the future, we plan to offer additional IT services and other software-as-a-service applications. Certain of our enhanced services are included within the integrated packages, but additional quantities or features can be added to the base packages for additional fees.
Our Cloud Services Offerings
We offer virtual server, dedicated server, and cloud PBX offerings via cloud servers to small businesses throughout the world on a stand-alone basis, in contrast to our Core Managed Services customers who may purchase cloud services as part of an integrated package of IT and communication services. We provide these services from servers located in our own data center facilities, enabling us to manage quality of service for our customers.
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Sales and Marketing
Overview
In our 14 metropolitan markets, our sales force targets small businesses primarily through face-to-face meetings with customers each day as part of a transaction-oriented and personalized consultative selling process. We adhere to the same sales and operating procedures in every geographically-based market we enter. We track the performance of our sales team by maintaining detailed activity measurements in each of our markets. Our new Cloud Services have no geographic limitation and are sold world-wide via web-sales, tele-sales and private label resellers. We intend to significantly expand these sales channels. In addition, Cloud Services have been launched to all of our existing channels.
We offer our customers comprehensive solutions simplified into our BeyondVoice packages and sold at fixed, predetermined prices. We permit our sales people to sell only our offered packages and do not allow them to make discounted sales or alter the BeyondVoice packages (other than to add enhanced services or in connection with authorized promotions). We believe that value is the primary motivating factor for our customers. We believe that our commitment to offering integrated packages of services helps to simplify the entry of orders into our automated provisioning and installation process. Through our strategy of offering bundled services, we seek to become the single-source provider for many of our customers’ IT and communications services. We believe these factors contribute to our relatively stable customer churn rates.
Sales Channels
Direct Sales. The cornerstone of our geographically-based sales efforts is our direct sales force. At full staffing, we generally target an average of 50 to 60 sales representatives per market. In addition to the sales representatives we deploy in our markets to call on customer prospects in person, we have a small group of centralized sales representatives who sell new accounts remotely from our corporate offices. Our direct sales force accounted for approximately 77.4% of our new Core Managed Services customers for the year ended December 31, 2010.
We believe we have a distinctive approach to recruiting and training our direct sales representatives which ensures a uniform sales approach and a consistent measure of revenue targets. We typically recruit individuals without prior telecommunications sales experience so that we can exclusively provide all of their formal training. These unseasoned hires are designated Territory Sales Representatives (or “TSRs”). During 2010, recognizing the need for greater experience when selling more sophisticated and comprehensive service packages, we created a higher level Sales Consultant (or “SCs”) as well. SCs typically have more extensive prior sales experience and receive more in-depth training on our enhanced service offerings than TSRs. By the end of 2010, approximately one-third of our direct sales organization were SCs, and we expect that by the end of 2011 one-half of the direct sales organization will be SCs.
A substantial part of the compensation for our sales force is based on commission. We reinforce our clear expectations of success through a system of increasing quotas and advancement for those who succeed. We promote from within, where possible, and develop our own sales management talent from promising sales representatives, who have the opportunity to advance as we grow.
Indirect Sales. We supplement our direct sales force with our channel partners, who leverage their pre-existing business relationships with the customer and act as sales agents for us. The channel partners include value-added resellers, local area network consultants and other telecommunications and IT consultants to small businesses. As compensation for their services, our channel partners receive ongoing residual payments on their sales. Our channel partners contributed approximately 22.6% of our new Core Managed Services customers for the year ended December 31, 2010.
Solutions Advisers. In addition to our Direct and Indirect Sales, which are dedicated to acquiring new customers, we have deployed solutions advisers to conduct account reviews with existing customers to insure
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that our customers are using the services and applications available to them and to upsell them to additional services and applications beyond what they initially purchased. Our solutions advisers are located in our sales branches in order to make calls in person on our existing customers as well as centrally in our corporate office in order to supplement our field solutions advisers with central staff who can interact with customers online or via telephone. We believe that the solutions advisers will have an increasingly important role in our strategy of increasing the “wallet share” of our customers, in growing the application use of our customers, and in protecting our ARPU in a price competitive environment.
Private Label Resellers. We have recently launched a new Private Label Reseller (or “PLR”) program to leverage our nationwide cloud services platform. PLRs will use their brand and resources to market, sell, invoice and provide support for their end-user customers. We will provide cloud services infrastructure and services, on-line web portals for end-user and PLR account administration, technical support for the PLRs, as well as, overall program management. We will invoice the PLRs, at a discount to our retail pricing, for the services consumed by their end-user customers. The Private Label Resellers will include value-added resellers, managed services providers, systems integrators and software vendors.
Web Sales. As a result of the recent acquisitions, we now have a web sales channel that allows end-user customers anywhere in the world to purchase cloud services, such as cloud servers and cloud PBXs, directly through the www.cbeyondcloudservices.com website. The web sales channel also provides prospective customers the opportunity to request product and pricing information via web chat or phone. We plan to continue developing and expanding the web channel through increased online marketing and marketing automation tools. Over time, we expect to offer additional cloud services through the web channel.
Referral Program
We believe we are building a culture of referrals that benefits both our direct and indirect selling efforts. We obtain new customers from our referral program through our current base of customers and through our referral partners. Our customers and referral partners are eligible to receive a one-time referral credit for each new customer they refer.
Marketing and Advertising
We focus our marketing resources on our direct and indirect sales efforts and programs that support those efforts. We market ourselves as providing “big solutions for growing your small business” to our customers. Our marketing expenses for online marketing, events, public relations media and other marketing communications program expenses for the year ended December 31, 2010 were $3.4 million.
Operations
Once a customer signs on for our service, we believe we provide a highly differentiated customer experience in each aspect of the service relationship. Our highly-automated and optimized business processes are designed to provide rapid and reliable installation, accurate billing and responsive, 24x7 care and support using both web-enabled and human resources.
We continue to put emphasis on customer service as a key differentiator to drive customer satisfaction and customer referrals for new business. We focus on defining the overall customer experience across all customer touch points and the implementation of a cohesive program to ensure customer satisfaction and higher customer retention rates. This customer experience focus has also contributed to continued improvements in our automated care and support capabilities used to service our customers and increase our operational efficiency.
Installation
We employ a team of service coordinators in each of our geographic markets to handle the order entry and, when applicable, the customer installation process. For Core Managed Services customers, the centralized circuit
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provisioning and customer activation group takes responsibility for ensuring that circuits to the customer’s location are provisioned correctly and on time, together with local number portability and the appropriate features and applications ordered by the customer. These circuits have primarily been T-1s obtained from the local telephone company historically, but we also utilize other types of high-speed connections where available and economically feasible, such as Ethernet. We seek to provision our customers within 30 to 60 calendar days. Our automated processes allow us to reduce the time and human intervention necessary to fill our access circuit orders with the local telephone company. Once an order is submitted, an outsourced technician is dispatched to the customer’s location to install the integrated access device, to connect the customer’s equipment to our network, and to activate and test the services. After installation of the integrated access device, new services added by the customer will work with the customer’s existing equipment and require no further equipment changes or capital expenditures. For existing customers who are upgraded to our Ethernet technology, a secondary device may be added to the current integrated access device at the customer location in order for customer’s equipment to function on our network.
Billing
We bill all of our customers electronically via email. Full billing detail and analytical capabilities are available to our customers on the web. We do not send any paper bills. In addition, over 50% of our customers pay us online, either via credit card, electronic funds transfer, or automatic account debit. Because we employ a simple flat-rate billing in advance, we believe that customers are able to budget their costs and minimize errors. Our flat-rate billing, electronic invoicing and online payments greatly reduces the amount of resources needed for billing functions.
Customer Care and Cbeyond Online
We offer our customers support through live access to dedicated care representatives and through online resources twenty-four hours a day, seven days a week. Although customers can choose to speak with one of our Cbeyond representatives on a real-time basis, Cbeyond Online has become our primary channel for customer care.
We offer a broad range of capabilities through Cbeyond Online, including functions allowing customers to:
| • | review requested services and accept installation orders (for new customers); |
| • | view, pay and analyze bills; |
| • | view and modify services and account features; |
| • | view and modify account information; |
| • | research products and troubleshoot issues using the section of our website devoted to frequently asked questions, which we call our Find-It-Fast knowledge base; and |
| • | submit requests for and track account changes. |
Underpinning our care and support operations is a network that provides our customers with reliable and high quality service. Our network operations group manages and tracks network performance. We have deployed state-of-the-art network monitoring and diagnostic tools to provide our care representatives and network operations center personnel with real-time insight into problem areas and the information needed to address them.
Our All-IP Network Architecture
Our Core Managed Services employs a single integrated network using technologies that digitize voice communications into IP packets and converges them with other data services for transport on an IP network. We transmit our Core Managed Services customers’ voice traffic over our secure private network and do not rely on
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the best efforts public Internet. Our network design exploits the convergence of voice and data services and requires significantly lower capital expenditures and operating costs compared to traditional networks using legacy technologies. The integration of our network with our automated front and back office systems allows us to monitor network performance, quickly provision customers and offer our customers the ability to add or change services online, thus minimizing our customer care expenses. We believe that our all-IP network and automated support systems enable us to continue to offer new services to our customers in an efficient manner.
Our IP network architecture achieves a lower cost structure than legacy designs primarily through enabling us to:
| • | buy fewer network components (and at lower cost); |
| • | lease fewer telecommunications circuits; |
| • | employ fewer staff; |
| • | rent less collocation space; |
| • | incur lower maintenance costs; and |
| • | integrate fewer support systems. |
We organize our Core Managed Services network into three groupings of equipment and circuits for purposes of network management and quality measurement:
| • | the core network, which is located in our data centers or market tandem offices, primarily comprises softswitches, backbone routers and media and feature servers; |
| • | the distribution network, which includes collocation equipment such as T-1 aggregation routers and trunking gateways, as well as DS-3 transport circuits; and |
| • | the access network, which comprises the T-1 local loops, or other access circuits such as Ethernet, and integrated access devices that connect customers’ equipment to our extended network. |
Our software monitors network quality and tracks potential problems by monitoring each of these network groupings.
The largest single monthly expense associated with our network is the cost of leasing T-1 circuits to connect to our customers. We have begun offering our services using Ethernet in place of T-1 circuits. Although not available to us on an ubiquitous basis in all areas, Ethernet technology provides us with the opportunity to offer a large percentage of our customers bandwidth at speeds well in excess of T-1 circuits while potentially reducing our ongoing operating expense. Although we have recently begun providing service to many of our customers using Ethernet technology, our business continues to rely heavily on the use of T-1 circuits. We lease T-1 circuits primarily from the local telephone companies on a wholesale basis. We are able to obtain cost-based pricing because we meet certain qualifying criteria established by the Federal Communications Commission, or the FCC, for use of these services and because we have built the processes and systems to take advantage of these wholesale circuits, in contrast to many competitive carriers, which lease T-1 circuits under special access, or retail, pricing. As a result of regulatory changes adopted via the FCC’s Triennial Review Remand Order, or TRRO, we are required to lease T-1 circuits under special access pricing when serving customers in certain geographical areas within the cities we serve. See “Government Regulation.”
We employ these wholesale T-1 circuits as follows:
| • | UNE loops. An unbundled network element, or UNE, loop is the facility that extends from the customer’s premises to our equipment collocated in the local exchange company end-office that serves that customer location. We employ UNE loops when we have a collocation in the central office that serves a customer. We use high-capacity T-1 unbundled loops to serve our customers. |
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| • | EELs. An enhanced extended link, or EEL, is a combination of an unbundled T-1 loop and an associated T-1 transport element that are joined together by the local telephone company at the end-office serving the customer location. This allows us to obtain access to customer premises without having a collocation at the serving central office. The current FCC rules require local telephone companies to provide T-1 EELs to carriers subject to certain local use criteria, which we meet. Once we achieve sufficient density from a remote office, we deploy a dedicated DS-3 transport and regroom the T-1 transport elements onto the DS-3 transport circuit and remove the T-1 transport elements. |
Historically, approximately half of our circuits were provisioned using UNE loops and half using EELs. Our monthly expenses are significantly less when using UNE loops rather than EELs, but UNE loops require us to incur the capital expenditures of central office collocation equipment. Both UNE loops and EELs are substantially less expensive for us than special access circuits. We lease DS-3 circuits from local telephone companies or competitive carriers to carry traffic from the end-office collocation to our equipment in a tandem wire center collocation. The impact of the TRRO has reduced our usage of the T-1 transport portion of EELs and resulted in the conversion and consolidation of a majority of the previously installed T-1 transports to high capacity DS-3 transport. We install central office collocation equipment in those central offices having the densest concentration of small businesses. We usually launch a market with several collocations and add collocations as the business grows. For example, in Atlanta, our most mature market, we had 15 collocations at the time of our initial public offering in November 2005 and 24 collocations as of December 31, 2010.
We currently serve just over 3% of our customers with Ethernet but are ramping up our capabilities to process conversions to Ethernet and expect to have converted at least one-third of our existing customer base by early 2012. We expect to incur capital expenditures of up to approximately $25 million through 2012 associated with the Ethernet conversions and expect to achieve significant access cost savings over time.
Competition
We broadly compete with companies that could provide both voice and enhanced services to small businesses in our markets.
As a provider of voice services, our primary competitors are the incumbent local exchange carriers, or ILECs: Qwest (currently being acquired by CenturyLink) in Denver, Minneapolis, and Seattle; AT&T in Atlanta, Dallas, Detroit, Houston, Chicago, Los Angeles, San Diego, Miami and the San Francisco Bay Area; and Verizon in the Washington, DC and Boston areas. In addition to the local telephone companies, we compete with other competitive carriers in each of our markets. These competitive carriers include XO Communications, LLC, Windstream (formerly NuVox Communications), PAETEC, Integra Telecom, Inc., TelePacific Communications and ITC^Deltacom, Inc. (recently acquired by EarthLink), among many others. Certain of these competitive carriers have adopted VoIP technology similar to that employed by us, and in the future we expect others to do so. Based on information provided by our customers at the time of activation, approximately 54% of our customers used an incumbent local exchange carrier, or ILEC, for local telephone service prior to signing with us, and the remainder used competitive local exchange carriers, or CLECs. Many of our customers, prior to joining with us, used multiple vendors for local and long distance voice services and broadband Internet access and have enjoyed the convenience of a sole-sourced service since signing with us.
In addition, there are other providers using VoIP technology, such as Vonage Holdings Corp., Skype Technologies SA, a subsidiary of eBay, Inc., deltathree, Inc. and 8x8, Inc., which offer service using the public Internet to access their customers. We do not currently view these companies as our direct competitors because they primarily serve the consumer market and businesses with fewer than four lines.
Certain cable television companies, such as Cox Communications, Inc., Comcast Cable Communications, Inc., TimeWarner Cable, Inc. and Cablevision Systems Corp., have deployed VoIP to address both consumers and business customers, primarily to compete better against local telephone companies.
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We expect that, in the future, other companies may be formed to take advantage of our VoIP-based business model. Existing companies may also expand their focus in the future to target small business customers. In addition, certain utility companies have begun experimenting with delivering voice and high-speed data services over power lines.
In connection with our BeyondMobile offering, we compete with national wireless phone companies, such as AT&T, Sprint Corporation, T-Mobile USA, Inc. and Verizon Wireless, as well as regional wireless providers.
In connection with our Cloud Services offerings, we compete with several cloud server and cloud PBX service providers. With respect to cloud server and other hosting services, we compete with companies such as Rackspace Hosting, Hosting.com, Microsoft, GoDaddy.com, and Amazon Web Services. In the cloud PBX, space we compete with hosted PBX providers such as 8x8 Inc., Telesphere, Bandwidth.com, Broadvox, SimpleSignal, and Vocalocity.
Government Regulation
As a company that sells telecommunications services as part of a bundle of managed software, our business is, in part, subject to the statutory framework established by United States Congress, or Congress, in the federal Telecommunications Act of 1996, or the Telecom Act, various state statues and varying degrees of federal, state and local regulation. In contrast to certain other IP-based carriers, we have elected to operate as a common carrier, and accordingly, our business does not rely on the regulatory classification of, or regulatory treatment for, IP-based carriers in particular. As a common carrier, we are subject to the jurisdiction of both federal and state regulatory agencies which have the authority to review our prices, terms and conditions of service. These regulatory agencies exercise minimal control over our prices and services, but do impose various obligations such as reporting, payment of fees and compliance with consumer protection and public safety requirements. Further, under limited circumstances, we are also subject to requirements placed on “interconnected VoIP providers” in addition to the requirements we are subject to as a common carrier.
We operate as a facilities-based carrier and have received all necessary state and federal authorizations to do so. Unlike resale carriers, we do not rely upon access to ILECs’, such as AT&T or Verizon, switching facilities or capabilities. As a facilities-based carrier, we have undertaken a variety of regulatory obligations, including (for example) providing access to emergency 911 systems, permitting law enforcement officials access to our network upon proper authorization, contributing to the cost of the FCC’s (and, where applicable, the state) universal service programs and making our services accessible to persons with disabilities.
By operating as a common carrier, we also benefit from certain legal rights established by federal legislation, especially the Telecom Act which gives us and other common carrier competitive entrants the right to interconnect to the networks of the ILECs and to access elements of their networks on an unbundled basis. These rights are not available to providers who do not operate as common carriers. We have used these rights to gain interconnection with the ILEC in each greater metropolitan area where we provide service and to purchase selected UNEs, at prices based on incremental cost, that provide us with dependable, high-quality digital access to our customers’ premises which we use to provide them with a bundle of management software services.
Congress, the FCC and state regulators are considering a variety of issues that may result in changes in the statutory and regulatory environment in which we operate our business. While negative federal legislation is always a possibility, we believe it unlikely that any such negative legislation will be passed by Congress in 2011; we also believe the FCC is unlikely to adopt rules that extinguish our basic right or ability to compete in the telecommunications markets and that any rule changes that affect us will likely be accompanied by transition periods sufficient to allow us to adjust our business practices accordingly. Some of the changes under consideration by Congress, the FCC and state regulators could affect our competitors differently than they affect us.
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Regulatory Framework
Although we have begun providing service to our customers using Ethernet technology over copper loops that are delivered to us without heavy reliance on ILEC-provided electronics, our business continues to rely heavily on the use of T-1 UNE loops and EELs that include T-1 loop components, for access to customer premises. Our existing strategy is based on FCC rules that require ILECs to provide us these UNEs at wholesale prices based on incremental costs in all wire centers except those with the densest concentration of loops serving business customers. This exception affects the price we pay to obtain access to T-1 loops in some of the central business districts we serve. These rules that currently govern our access to both T-1 and copper loop UNEs may change due to future FCC decisions, and we are unable to predict how such future developments may affect our business.
The Telecom Act
The Telecom Act, which substantially revised the Communications Act of 1934, established the regulatory preconditions to allow companies like us to compete for the provision of local communications services. We have developed our business, including being designated as a common carrier, and designed and constructed our networks to take advantage of the features of the Telecom Act that require cooperation from the incumbent carriers. There have been numerous attempts to revise or eliminate the basic framework for competition in the local exchange services market through a combination of federal legislation, new FCC rules and challenges to existing and proposed regulations by the incumbent carriers. We anticipate that Congress will consider a range of proposals to modify the Telecom Act over the next few years, including some proposals that could restrict or eliminate our access to elements of the ILECs’ networks. We consider it unlikely, however, that Congress would reverse the fundamental policy of encouraging competition in communications markets.
Congress may also consider legislation that would address the impact of the Internet on the Telecom Act. Such legislation could seek to clarify the regulations applicable to VoIP and Internet providers. We believe that such legislation is unlikely to result in the imposition of new regulatory obligations on us, although it is possible that it will eliminate certain regulatory obligations that apply to us as a result of our status as a common carrier.
Federal Regulation
The FCC regulates interstate and international communications services in the United States, including access to local communications networks for the origination and termination of these services. We provide interstate and international services on a common carrier basis. The FCC requires all common carriers to obtain an authorization to construct and operate communications facilities and to provide or resell communications services between the United States and international points. We have secured authority from the FCC for the installation, acquisition and operation of our wireline network facilities to provide facilities-based domestic and international services.
Unlike incumbent carriers, our retail services are not currently subject to price cap or rate of return regulation. We are therefore free to set our own prices for end-user services subject only to the general federal guidelines that our charges for interstate and international services be just, reasonable and non-discriminatory. We have filed tariffs with the FCC containing interstate rates we charge to long distance carriers for access to our network, also called interstate access charges. The rates we can charge for interstate access, unlike our end user services, are limited by FCC rules. We are also required to file periodic reports, to pay regulatory fees based on our interstate revenues and to comply with FCC regulations concerning the content and format of our bills, the process for changing a customer’s subscribed carrier and other consumer protection matters. The FCC has the authority to impose monetary forfeitures and to condition or revoke a carrier’s operating authority for violations of these requirements. Our operating costs are increased by the need to assure compliance with these regulatory obligations.
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As a key part of its regulatory mandate, the FCC constantly reviews the regulations it administers; these proceedings could eventually have some impact on our ability to buy UNEs in one or more markets we serve or wish to serve, the prices we pay for UNEs, the prices we pay for special access facilities, intercarrier compensation rates, interconnection rules, Universal Service Fund rates and other rules and regulations that impact our business. We monitor these proceedings closely and are active participants in those that could have the most impact on us, whether positive or negative. We cannot predict the outcome of these proceedings or new proceedings that may be initiated.
Changes in the universal service fund may affect the fees we are required to pay to this program, but since we and our competitors generally pass these fees through to customers, we expect any changes to have minimal competitive effect. Similarly, we do not expect changes in inter-carrier compensation rules to have a material effect on us because we derive the vast majority of our revenues directly from our customers, rather than from other carriers. Reciprocal compensation for termination of local calls is not a significant source of revenue, and we derive relatively little revenue from access charges for origination and termination of long distance calls over our network.
We expect that nationwide access to T-1 and copper loops serving current and new customer locations will continue to be available to us regardless of future changes in the FCC rules, although not necessarily at current prices. All ILECs are required, independent of the UNE rules, to offer us some form of T-1 loop and transport services as well as copper loops without associated electronics. It is possible that the FCC may establish rates for some of these services at levels that are comparable to current UNE rates, or that we may be able to negotiate reasonable prices for these services through commercial negotiations with ILECs. However, we cannot be assured that either of these possibilities will occur. If all other options were unavailable, we would be required to pay special access rates for these services. These rates are substantially higher than the rates we pay for UNEs.
CenturyLink acquisition of Qwest. CenturyLink is expected to complete its acquisition of Qwest in the first half of 2011, and the FCC is expected both to grant its approval of the transaction and to impose significant conditions upon it. We cannot predict what those conditions will be, but we expect them to be similar to those placed upon earlier mergers such at the AT&T/BellSouth merger and to provide more regulatory stability in the territory of the former-Qwest ILEC for several years; we currently provide services in the Qwest cities of Denver, Minneapolis and Seattle, and we could expand into additional Qwest cities in the future. We do not expect the acquisition to have a significant impact upon our operations as CenturyLink will be subject to the same continuing regulations and obligations as was Qwest.
State Regulation
State agencies exercise jurisdiction over intrastate telecommunications services, including local telephone service and in-state toll calls. To date, we are authorized to provide intrastate local telephone, long distance telephone and operator services in California, Colorado, Florida, Georgia, Illinois, Maryland, Massachusetts, Michigan, Minnesota, Texas, Virginia, Washington, and the District of Columbia, as well as in other states where we are not yet operational. As a condition to providing intrastate telecommunications services, we are required, among other things, to:
| • | file and maintain intrastate tariffs or price lists describing the rates, terms and conditions of our services; |
| • | comply with state regulatory reporting, tax and fee obligations, including contributions to intrastate universal service funds; and |
| • | comply with, and to submit to, state regulatory jurisdiction over consumer protection policies (including regulations governing customer privacy, changing of service providers and content of customer bills), complaints, transfers of control and certain financing transactions. |
Generally, state regulatory authorities can condition, modify, cancel, terminate or revoke certificates of authority to operate in a state for failure to comply with state laws or the rules, regulations and policies of the state regulatory authority. Fines and other penalties may also be imposed for such violations. As we expand our operations, the requirements specific to any individual state will be evaluated to ensure compliance with the rules and regulations of that state.
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In addition, the states have authority under the Telecom Act to approve or, in limited circumstances reject agreements for the interconnection of telecommunications carriers’ facilities with those of the ILEC, to arbitrate disputes arising in negotiations for interconnection and to interpret and enforce interconnection agreements. In exercising this authority, the states determine the rates, terms and conditions under which we can obtain access to the loop and transport UNEs that are required to be available under the FCC rules. The states may re-examine these rates, terms and conditions from time to time.
State governments and their regulatory authorities may also assert jurisdiction over the provision of intrastate IP communications services where they believe that their authority is broad enough to cover regulation of IP-based services. Various state regulatory authorities have initiated proceedings to examine the regulatory status of IP telephony services. We operate as a regulated carrier subject to state regulation, rules and fees and, therefore, do not expect to be affected by these proceedings. The FCC proceeding on VoIP discussed above is expected to address, among other issues, the appropriate role of state governments in the regulation of these services.
Local Regulation
In certain locations, we are required to obtain local franchises, licenses or other operating rights and street opening and construction permits to install, expand and operate our telecommunications facilities in the public rights-of-way. In some of the areas where we provide services, we pay license or franchise fees based on a percentage of gross revenues. Cities that do not currently impose fees might seek to impose them in the future, and after the expiration of existing franchises, fees could increase. Under the Telecom Act, state and local governments retain the right to manage the public rights-of-way and to require fair and reasonable compensation from telecommunications providers, on a competitively neutral and non-discriminatory basis, to recover the costs associated with government’s management of the public rights-of-way. As noted above, these activities must be consistent with the Telecom Act and may not have the effect of prohibiting us from providing telecommunications services in any particular local jurisdiction. In certain circumstances, we may be subject to local fees associated with construction and operation of telecommunications facilities in the public rights-of-way. To the extent these fees are required, we comply with requirements to collect and remit the fees.
History
We incorporated in March 2000 as Egility Communications, Inc. and changed our name in April 2000 to Cbeyond Communications, Inc. In November 2002, we recapitalized by merging the limited liability company that served as our holding company into Cbeyond Communications, Inc., the surviving entity in the merger. On July 13, 2006, we changed our name from Cbeyond Communications, Inc. to Cbeyond, Inc. Cbeyond, Inc. now serves as a holding company for our subsidiaries and directly owns all of the equity interests of our operating company, Cbeyond Communications, LLC. In addition Cbeyond Communications, LLC owns 100% of the common stock of our recent acquisition, Aretta Communications, Inc.
Intellectual Property
We currently do not own any patent registrations, applications, or licenses, but have applications pending for two patents. We maintain and protect trade secrets, know-how and other proprietary information regarding many of our business processes and related systems. We also hold several federal trademark registrations, including:
| • |
Cbeyond®; |
| • |
BeyondVoice®; |
| • |
BeyondOffice®; |
| • |
BeyondMobile®; |
| • | The last communications company a small business will ever need®; and |
| • | Cbeyond Logo. |
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Employees
At December 31, 2010 and 2009, we had 1,944 and 1,677 employees, respectively. None of our employees are represented by labor unions. We believe employee relations are generally good.
Where You Can Find More Information
Our Web site address is www.cbeyond.net. The information contained on, or that may be accessed through, our website is not part of this annual report. You may obtain free electronic copies of our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports at our investor relations website, ir.cbeyond.net/index.cfm, under the heading “SEC Filings” or on the SEC’s, Web site at www.sec.gov. We will also furnish a paper copy of such filings free of charge upon request. Investors can also read and copy any materials filed by us with the SEC at the SEC’s Public Reference Room which is located at 100 F Street, NE, Washington, DC 20549. Information about the operation of the Public Reference Room can be obtained by calling the SEC at 1-800-SEC-0330. These reports are available on our investor relations Web site as soon as reasonably practicable after we electronically file them with the SEC. You can also find our Code of Ethics on our Web site under the heading “Corporate Governance” or by requesting a copy from us.
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| Item 1A. | Risk Factors |
Risks Related to Our Business
Our growth and financial health are subject to a number of economic risks.
As widely reported, the financial markets in the United States have been experiencing significant disruption in the past three years, including, among other things, extreme volatility in security prices, severely diminished liquidity and credit availability, rating downgrades of certain investments and declining valuations of others. If the capital and credit markets continue to experience volatility and the availability of funds remains limited, it is possible that our ability to access the capital and credit markets may be limited by these conditions or other factors at a time when we would like, or need, to do so. This could have an impact on our ability to react to changing economic and business conditions. While currently these conditions have not impaired our ability to access credit markets and finance our operations, there can be no assurance that there will not be a further deterioration in financial markets and confidence in major economies.
We attempt to monitor the financial health of significant vendors because these economic conditions may also adversely affect the ability of third-party vendors important to our operations to continue as going concerns. If such vendors were to fail, we may not be able to replace them without disruptions to, or deterioration of, our service and we may also incur higher costs associated with the new vendors. Transitioning to new vendors may also result in the loss of the value of assets associated with our integration of third-party services into our network or service offering.
The depth and duration of the challenging economy on the small business sector may also reduce the size and viability of our addressable markets of small businesses, particularly in geographic areas where the economic impacts are most severe. We are unable to predict the likely duration and severity of the lingering effects of the challenging economy on the small business sector.
The success of our growth and expansion plans depends on a number of factors that are beyond our control.
We have grown our business by increasing the number of customers in existing markets, entering new geographical markets, and selling additional services to existing customers; and we plan to continue opening up to one to three new markets per year beginning in 2012, depending on economic, regulatory and other conditions. There is no guarantee we will be able to maintain our growth or that we will choose to target the same pace of market growth in the future. Our success in achieving continued growth and expansion into new markets depends upon several factors including:
| • | the availability and retention of qualified and effective personnel with the expertise required to sell and operate effectively or successfully; |
| • | the overall economic health of new and existing markets or small businesses in general; |
| • | the number and effectiveness of competitors; |
| • | the pricing structure under which we will be able to obtain circuits and purchase other services required to serve our customers; |
| • | the availability to us of technologies needed to remain competitive; |
| • | our ability to establish a relationship and work effectively with the local telephone company for the provision of access lines to customers; and |
| • | state and regulatory conditions, including the maintenance of state regulation that protects us from unfair business practices by local telephone companies or others with greater market power who have relationships with us as both competitors and suppliers. |
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Acquisitions and joint ventures may have an adverse effect on our business.
We may continue making acquisitions or entering into joint ventures as part of our long-term business strategy. These transactions involve significant challenges and risks including that the transaction does not advance our business strategy, that we do not realize a satisfactory return on our investment, or that we experience difficulty in the integration of new employees, business systems, and technology, or diversion of management’s attention from our other businesses. These events could harm our operating results or financial condition.
We may not be able to continue to grow our customer base.
We experienced an annual growth rate greater than 13% in customer locations during 2010, which was a decline compared to the growth rate in the prior year. We may not experience this same growth rate in the future, or we may not grow at all, in our current markets. Future growth in our existing markets may be more difficult than our growth has been to date due to increased or more effective competition in the future, difficulties in scaling our business systems and processes or difficulty in maintaining sufficient numbers of qualified market management personnel, sales personnel and qualified integrated access device installation service providers to obtain and support additional customers.
The fixed pricing structure for our integrated packages makes us vulnerable to price increases by our suppliers for network equipment and access fees for circuits that we lease to gain access to our customers.
We offer our integrated packages to customers at a fixed price for one, two or three years. If we experience an increase in our costs due to price increases from our suppliers, vendors or third-party carriers or increases in access fees, installation fees, interconnection fees payable to local telephone companies or other fees, we may not be able to pass these increases on to our customers immediately, and this could materially harm our results of operations.
We face intense competition from other providers of communications services that have significantly greater resources than we do. Several of these competitors are better positioned to engage in competitive pricing, which may impede our ability to implement our business model of attracting customers away from such providers.
The market for communications services is highly competitive. We compete, and expect to continue to compete, with many types of communications providers, including traditional local telephone companies. In the future, we may also face increased competition from cable companies, new VoIP-based service providers or other managed service providers with similar business models to our own. We integrated mobile services with our existing services in the first quarter of 2006 and now face competition from mobile service providers as well. Our current or future competitors may provide services comparable or superior to those provided by us, or at lower prices, or adapt more quickly to evolving industry trends or changing market requirements.
A substantial majority of our target customers are existing small businesses that are already purchasing communications services from one or more of these providers. The success of our operations is in part dependent on our ability to persuade these small businesses to leave their current providers. Many of these providers have competitive advantages over us, including substantially greater financial, personnel and other resources, better access to capital, brand name recognition and long-standing relationships with customers. These resources may place us at a competitive disadvantage in our current markets and limit our ability to expand into new markets. Because of their greater financial resources, some of our competitors can also better afford to reduce prices for their services and engage in aggressive promotional activities. Such tactics could have a negative impact on our business. For example, some of our competitors have adopted pricing plans such that the rates that they charge are not always substantially higher, and in some cases are lower, than the rates that we charge for similar services. In addition, other providers are offering unlimited or nearly unlimited use of some of their services for an attractive monthly rate. Any of the foregoing factors could require us to further reduce our prices to remain competitive or cause us to lose customers, resulting in a decrease in ARPU.
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Increasing use of VoIP technology by our competitors, entry into the market by new providers employing VoIP technology and improvements in quality of service of VoIP technology provided over the public Internet could increase competition.
Our success is based partly on our ability to provide voice and broadband services at a price that customers typically pay for voice services alone by taking advantage of cost savings achieved by employing VoIP technology, as compared to using traditional networks. The adoption of VoIP technology by other communications carriers, including existing competitors such as local telephone companies that currently use legacy technologies, could increase price competition.
Moreover, other VoIP providers could also enter the market. Because networks using VoIP technology can be deployed with less capital investment than traditional networks, there are lower barriers to entry in this market, and it may be easier for new entrants to emerge. Increased competition may require us to lower our prices or may make it more difficult for us to retain our existing customers or add new customers.
We believe we generally do not compete with VoIP providers who use the public Internet to transmit communications traffic, as these providers generally do not provide the level and quality of service typically demanded by the business customers we serve. However, future advances in VoIP technology may enable these providers to offer an improved level and quality of service to business customers over the public Internet and with lower costs than using a private network. This development could result in increased price competition and may affect our business, results of operations and financial condition.
Continued industry consolidation could further strengthen our competitors, and we could lose customers or face adverse changes in regulation.
In the past five years, Verizon merged with MCI, SBC merged with AT&T, AT&T and BellSouth merged, Comcast Cable Corporation acquired a competitive local exchange company based in the Midwest and a nationwide wholesale provider of hosted VoIP services, Windstream Corporation acquired Nuvox, Inc., a privately held CLEC and competitor, and CenturyLink announced its intention to purchase Qwest, a deal that is likely to close during 2011. The increased size and market power of these companies may have adverse consequences for us, and other large mergers may create larger and more efficient competitors. These competitors could focus their large resources on regaining share in the small business sector, and we could lose customers or not grow as rapidly. Furthermore, these companies could use their greater resources to lobby effectively for changes in federal or state regulation that could have an adverse effect on our cost structure or our right to use access circuits that they are currently required to make available to us. These changes could have a harmful effect on our future financial results.
We are susceptible to business and political risks from our use of international third-party resources that could result in delays in the development or maintenance of operational support systems and business processes.
A portion of our IT development is performed by third-parties with offshore resources. There are inherent risks in engaging offshore resources including difficulties in complying with a variety of foreign laws, unexpected changes in regulatory requirements, fluctuations in currency exchange rates, difficulties in staffing and managing foreign operations, changes in political or economic conditions and potentially adverse tax consequences. To the extent that we do not manage our international third-party vendors successfully, our business could be adversely affected.
Our operational support systems and business processes may not be adequate to effectively manage our growth.
Our continued success depends on the scalability of our systems and processes. As of December 31, 2010, none of our individual market operations have supported levels of customers substantially in excess of 10,000,
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and our centralized systems and processes have not supported more than approximately 57,000 customer locations. We cannot be certain that our systems and processes are adequate to support ongoing growth in customers. In addition, our growing managed services profile, including our new mobile services and associated new applications, may create operating inefficiencies and result in service problems if we are unsuccessful in fully integrating such new services into our existing operations. Failure to manage our future growth effectively could harm our quality of service and customer relationships, which could increase our customer churn, result in higher operating costs, write-offs or other accounting charges and otherwise materially harm our financial condition and results of operations.
We depend on local telephone companies for the installation and maintenance of our customers’ T-1 or other access lines and other network elements and facilities.
Our customers’ T-1 or other access lines are installed and maintained by local telephone companies in each of our markets. If the local telephone company does not perform the installation properly or in a timely manner, our customers could experience disruption in service and delays in obtaining our services. Since inception, we have experienced routine delays in the installation of T-1 lines by the local telephone companies to our customers in each of our markets, although these delays have not yet resulted in any material impact to our ability to compete and add customers in our markets. Any work stoppage action by employees of a local telephone company that provides us services in one of our markets could result in substantial delays in activating new customers’ lines and could materially harm our operations. Although local telephone companies may be required to pay fines and penalties to us for failures to provide us with these installation and maintenance services according to prescribed time intervals, the negative impact on our business of such failures could substantially exceed the amount of any such cash payments. Furthermore, we are also dependent on traditional local telephone companies for access to their collocation facilities, and we utilize certain of their network elements. Failure of these elements or damage to a local telephone company’s collocation facility could cause disruptions in our service.
We depend on third-party providers who install our integrated access devices at customer locations. We must maintain relationships with efficient installation service providers in our current cities and identify similar providers as we enter new markets in order to maintain quality in our operations.
The installation of integrated access devices at customer locations is an essential step that enables our customers to obtain our service. We outsource the installation of integrated access devices to a number of different installation vendors in each market. We must ensure that these vendors adhere to the timelines and quality that we require to provide our customers with a positive installation experience. In addition, we must obtain these installation services at reasonable prices. If we are unable to continue maintaining a sufficient number of installation vendors in our markets who provide high quality service at reasonable prices to us, we may have to use our own employees to perform installations of integrated access devices. We may not be able to manage such installations effectively using our own employees with the quality we desire and at reasonable costs.
Some of our services are dependent on facilities and systems maintained by or equipment manufactured by third parties over which we have no control, the failure of which could cause interruptions or discontinuation of some of our services, damage our reputation, cause us to lose customers or limit our growth.
We provide some of our existing services, such as secure desktop, by reselling to our customers services provided by third parties, and beginning in the first quarter of 2006, we started offering mobile options integrated with our existing services by reselling mobile services provided by an established national third-party mobile carrier and reselling mobile equipment manufactured by third parties. We do not have control over the networks and other systems maintained by these third parties or their equipment manufacturing processes, facilities or supply chains. If our third-party providers fail to maintain their facilities properly or fail to respond quickly to network or other problems, our customers may experience interruptions in the service they obtain from us or we may not be able to supply the needed mobile equipment. Any service interruptions experienced by our customers could negatively impact our reputation, cause us to lose customers and limit our ability to attract new customers.
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Some of the services we provide are regulated by the FCC, state public service commissions and local regulating governmental bodies. Changes in regulation could result in price increases on the circuits that we lease from the local telephone companies or losing our right to lease these circuits from them.
We operate in a highly regulated industry and are subject to regulation by telecommunications authorities at the federal, state and local levels. Changes in regulatory policy could increase the fees we must pay to third parties, make certain required inputs for our network less readily available to us or subject us to more stringent requirements that could cause us to incur additional operating expenditures.
The T-1 and copper loop connections we provide to our customers are leased primarily from our competitors, the local telephone companies. The rules of the FCC, adopted under the Telecom Act, generally entitle us to lease these connections at wholesale prices based on incremental costs. It is possible, though we believe unlikely, that Congress will pass legislation in the future that will diminish or eliminate our right to lease such connections at regulated rates.
Our rights of access to the facilities of local telephone companies may also change as a result of future regulatory decisions, including forbearance petitions, as well as court decisions. To date, no forbearance petitions have been granted that have had any impact on our operations and none are pending. This could change, however, and there is the possibility that future forbearance grants could limit our various rights under the Telecom Act.
Although we expect that we will continue to be able to obtain T-1 and other copper loop connections for our customers, we may not be able to do so at current prices. The pricing for the majority of the T-1 and other copper loop connections we use is established by state regulatory commissions and, from time to time, this pricing is reviewed and the state commission decisions are subject to appeal. If our right to obtain these connections at regulated prices based on incremental costs is further impaired, we will need either to negotiate new commercial arrangements with the local telephone companies to obtain the connections, perhaps at unfavorable rates and conditions, or to obtain other means of providing connections to our customers, which may be expensive and require a long timeframe to implement, either of which may cause us to exit such affected markets and decrease our customer base and revenues.
The FCC is also considering changing its rules for calculating incremental cost-based rates, which could result in either increases or decreases in our cost to lease these facilities. Significant increases in wholesale prices, especially for the loop element we use most extensively, could materially harm our business.
We are required to bill taxes, fees, and other amounts to our customers on behalf of government entities. Determining the services on which such amounts should be assessed and how to calculate the proper amounts can be complex and may involve judgment that an assessing entity may disagree with, exposing us to the possibility of material liabilities for amounts we did not bill to our customers, including interest and penalties.
We are required to bill taxes, fees and other amounts (collectively referred to as “taxes”) on behalf of government entities on some of the services we provide to our customers. These entities include governments and governmental authorities at the county, city, state and federal level (“taxing authorities”). Each taxing authority may have one or more taxes with unique rules as to which services are subject to each tax and how those services should be taxed. While some types of taxes may be similar among many taxing authorities, the rules and applicable rates are often unique and change from time to time. Determining which taxing authorities have jurisdiction for a customer, which taxes are applicable, and how the specific rules should be applied often involves exercising judgment and making estimations. The nature of this process creates a risk of non-compliance, such as subjecting a customer to the wrong taxing authorities. Other risks that represent higher exposure to us include interpreting rules in a manner that may differ from the taxing authority, resulting in one or more of the following outcomes: we may not charge for a tax that we may be liable for, we may charge for a tax at a rate that is lower than what we may be liable for, or we may apply the correct rate using a methodology that differs from the applicable taxing authority’s methodology. Because we sell many of our services on a bundled basis and assess different taxes on the individual components included within the bundle, there is also a risk that a taxing authority could disagree with the taxable value of a component.
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Taxing authorities can perform audits for any period or periods still open for review under the applicable statute. These statutes typically provide that periods remain open for three to four years. If we were found to be improperly assessing taxes and were assessed for multiple years of under-billing our customers we could be subject to significant assessments of past taxes, fines and interest, which could materially harm our financial condition.
The FCC is reexamining its policies towards VoIP and telecommunications in general. New or existing regulation could subject us to additional fees or increase the competition we face.
We currently operate as a regulated common carrier, which subjects us to some regulatory obligations. The FCC adopted rules applicable to “interconnected VoIP providers,” but it has not determined whether to classify interconnected VoIP providers as common carriers. The rules applicable to interconnected VoIP providers require them to provide access to emergency 911 services for all customers that are comparable to the 911 services provided by traditional telephone networks, to implement certain capabilities for the monitoring of communications by law enforcement agencies pursuant to a subpoena or court order and to contribute to the federal universal service fund. As a common carrier, we currently comply with the 911 requirements, comply with the law enforcement assistance requirements applicable to traditional telecommunications carriers and contribute to the federal universal service fund. The FCC continues to examine its policies towards services provided over IP networks, such as our VoIP technology, and the results of these proceedings could impose additional obligations, fees or limitations on us.
Regulatory decisions may also affect the level of competition we face. Reduced regulation of retail services offered by local telephone companies could increase the competitive advantages those companies enjoy, cause us to lower our prices in order to remain competitive or otherwise make it more difficult for us to attract and retain customers.
Our customer churn rate may increase.
Customer churn occurs when a customer discontinues service with us, whether voluntary or involuntary, such as a customer going out of business or switching to a competitor. Changes in the economy, increased competition from other providers, or issues with the quality of service we deliver can impact our customer churn rate. We cannot predict future pricing by our competitors, but we anticipate that price competition will continue. Lower prices offered by our competitors could contribute to an increase in customer churn. Prior to 2007, we historically maintained monthly churn rates of approximately 1.0%. Beginning with the third quarter of 2007, however, we have experienced elevated churn rates that we believe are attributable primarily to the inability of certain of our customers to meet their payment obligations as a result of deteriorating economic conditions. Our Core Managed Services experienced an average monthly churn rate of 1.4% in 2010 compared to 1.5% in 2009. We cannot predict the duration or magnitude of the currently deteriorated economic conditions or its impact on our target of small business customers. We expect our Core Managed Services average monthly churn rate to continue to be greater than 1.0% for at least as long as the current economic environment persists. Higher customer churn rates could adversely impact our revenue growth. A sustained and significant growth in the churn rate could have a material adverse effect on our business.
We obtain the majority of our network equipment and software from a limited number of third-party suppliers. Our success depends upon the quality, availability and price of these suppliers’ network equipment and software.
We obtain the majority of our network equipment and software from a limited number of third-party suppliers. In addition, we rely on these suppliers for technical support and assistance. Although we believe that we maintain good relationships with these suppliers, if any of them were to terminate our relationship or were to cease making the equipment and software we use, our ability to efficiently maintain, upgrade or expand our network could be impaired. Although we believe that we would be able to address our future equipment needs
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with equipment obtained from other suppliers, we cannot assure that such equipment would be compatible with our network without significant modifications or cost, if at all. If we were unable to obtain the equipment necessary to maintain our network, our ability to attract and retain customers and provide our services would be impaired. In addition, our success depends in part on our obtaining network equipment and software at affordable prices. Significant increases in the price of these products would harm our financial results and may increase our capital requirements.
We depend on third-party vendors for information systems. If these vendors discontinue support for the systems we use or fail to maintain quality in future software releases, we could incur substantial unplanned costs to switch or upgrade our systems or equipment, and we could sustain a negative impact on the quality of our services to customers, the development of new services and features and the quality of information needed to manage our business.
We have entered into agreements with vendors that provide for the development and operation of back office systems, such as ordering, provisioning and billing systems. We also rely on vendors to provide the systems for monitoring the performance and condition of our network. The failure of those vendors to perform their services in a timely and effective manner at acceptable costs could materially harm our growth and our ability to monitor costs, bill customers and carriers, provision customer orders, maintain the network and achieve operating efficiencies. Such a failure could also negatively impact our ability to retain existing customers or to attract new customers. In December 2010, the organization that provides our customer billing system was sold to Paetec, a competitive local exchange carrier. We are taking steps to mitigate intellectual capital, ongoing development and support risks.
We use software technology developed internally and by third-party vendors, and hardware technology developed by third-party vendors. We or any of these vendors could be the subject of a lawsuit alleging a violation of the intellectual property of third parties.
We have created software systems, purchased software from third-party vendors and purchased hardware from third-party vendors. Our contracts with these vendors provide indemnification to us should any entity allege that we are violating its intellectual property. Should an entity bring suit or otherwise pursue intellectual property claims against us based on its own technology or the technology of third-party vendors, the result of those claims could be to raise our costs or deny us access to technology currently necessary to our network or software systems.
If we are unable to generate the cash that we need to pursue our business plan, we may have to raise additional capital on terms unfavorable to our stockholders.
The actual amount of capital required to fund our operations and development may vary materially from our estimates. If our operations fail to generate the cash that we expect, we may have to seek additional capital to fund our business. If we are required to obtain additional funding in the future, we may have to sell assets, seek debt financing or obtain additional equity capital. In addition, the terms of our secured revolving line of credit with Bank of America subjects us to restrictive covenants limiting our flexibility in planning for, or reacting to changes in, our business, and any other indebtedness we incur in the future is likely to include similar covenants. If we do not comply with such covenants, our lenders could accelerate repayment of our debt or restrict our access to further borrowings. If we raise funds by selling more stock, our stockholders’ ownership in us will be diluted, and we may grant future investors rights superior to those of the common stockholders. If we are unable to obtain additional capital when needed, we may have to delay, modify or abandon some of our expansion plans. This could slow our growth, negatively affect our ability to compete in our industry and adversely affect our financial condition.
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If we cannot negotiate new (or extensions of existing) interconnection agreements with local telephone companies on acceptable terms, it will be more difficult and costly for us to provide service to our existing customers or to expand our business.
We have agreements for the interconnection of our network with the networks of the local telephone companies covering each market in which we operate. These agreements also provide the framework for service to our customers when other local carriers are involved. We will be required to negotiate new interconnection agreements to enter new markets in the future. In addition, we will need to negotiate extension or replacement agreements as our existing interconnection agreements expire. Most of our interconnection agreements have terms of three years, although the parties may mutually decide to amend the terms of such agreements. If we cannot negotiate new interconnection agreements or renew our existing interconnection agreements on favorable terms or at all, we may invoke binding arbitration by state regulatory agencies. The arbitration process is expensive and time-consuming, and the results of an arbitration may be unfavorable to us. If we are unable to obtain favorable interconnection terms, it would harm our existing operations and opportunities to grow our business in our current and new markets.
The cloud-based computing model presents execution and competitive risks.
We are transitioning to a computing environment characterized by cloud-based services used with smart client devices. Our competitors are rapidly developing and deploying cloud-based services for consumers and business customers. Pricing and delivery models are evolving. Devices and form factors influence how users access services in the cloud. We are devoting significant resources to develop and deploy our own competing cloud-based software plus services strategies. While we believe our expertise, investments in infrastructure, and the breadth of our cloud-based services provides us with a strong foundation to compete, it is uncertain whether our strategies or technologies will attract the users or generate the revenue required to be successful. In addition to software development costs, we are incurring costs to build and maintain infrastructure to support cloud computing services. These costs may reduce the operating margins we have previously achieved. Whether we are successful in this new business model depends on our execution in a number of areas, including:
| • | continuing to innovate and bring to market compelling cloud-based experiences that generate increasing traffic and market share; |
| • | maintaining the utility, compatibility and performance of our cloud-based services on the growing array of computing devices, including smartphones, handheld computers, netbooks, and tablets; and |
| • | continuing to enhance the attractiveness of our cloud platforms to third-party developers. |
We have an MVNO agreement with a nationwide wireless network provider. If we cannot negotiate extensions of this agreement on acceptable terms, it will be more difficult and costly for us to provide mobile services to our existing customers or to expand our business.
We provide mobile services to our customers under a MVNO agreement with a nationwide wireless network provider. Upon or before expiration of the current contract term in 2013, we will need to renew this agreement or enter an agreement with another provider. In addition, we will need to negotiate amendments to our MVNO agreement as services or technologies evolve in order to offer competitive services to our customers. If we cannot renew our existing agreement, enter into an agreement with another provider or negotiate amendments on favorable terms or at all, it would harm our existing operations and opportunities to grow our business in our current and new markets.
Our current and future competitors may be better positioned than we are to adapt to rapid changes in technology, and we could lose customers as a result.
The communications industry has experienced, and will probably continue to experience, rapid and significant changes in technology. Technological changes, such as the use of wireless or other alternatives to network access to customers in place of the T-1 or other access lines we lease from the local telephone companies, could render aspects of the technology we employ suboptimal or obsolete and provide a competitive
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advantage to new or larger competitors who might more easily be able to take advantage of these opportunities. Some of our competitors, including the local telephone companies, have a much longer operating history, more experience in making upgrades to their networks and greater financial resources than we do. We cannot provide assurance that we will be able to obtain access to new technologies, or that we will be able to do so as quickly or on the same terms as our competitors, or that we will be able to apply new technologies to our existing networks without incurring significant costs. In addition, responding to demand for new technologies would require us to increase our capital expenditures, which may require additional financing in order to fund. As a result of those factors, we could lose customers and our financial results could be harmed.
System disruptions could cause delays or interruptions of our service, which could cause us to lose customers or incur additional expenses.
Our success depends on our ability to provide reliable service. Although we have designed our network service to minimize the possibility of service disruptions or other outages, our service may be disrupted by problems on our system, such as malfunctions in our software or other facilities, overloading of our network and problems with the systems of competitors with which we interconnect, such as physical damage to telephone lines and power surges and outages. Although we have experienced isolated power disruptions and other outages for short time periods, we have not had system-wide disruptions of a sufficient duration or magnitude that had a significant impact on our customers or our business. Any significant disruption in our network could cause us to lose customers and incur additional expenses.
Business disruptions, including disruptions caused by security breaches, extreme weather, terrorism or other disasters, could harm our future operating results.
The day-to-day operation of our business is highly dependent on the integrity of our communications and information technology systems, and on our ability to protect those systems from damage or interruptions by events beyond our control. Sabotage, computer viruses or other infiltration by third parties could damage our systems. Such events could disrupt our service, damage our facilities, damage our reputation, and cause us to lose customers, among other things, and could harm our results of operations. In addition, a catastrophic event could materially harm our operating results and financial condition. Catastrophic events could include a terrorist attack on the United States, or major natural disasters, extreme weather, earthquake, fire, or similar event that affects our central offices, corporate headquarters, network operations center, data centers or network equipment. We believe that communications infrastructures, such as the one on which we rely, may be vulnerable in the case of such an event, and our markets, which are metropolitan markets, or Tier 1 markets, may be more likely to be the targets of terrorist activity.
There is no assurance of profitability in the future.
Although we recorded net income of $3.7 million for the year ended December 31, 2008, we recorded a net loss of $1.7 million and $2.2 million in 2010 and 2009, respectively, and have experienced losses in the past. We cannot provide any assurance that we will generate positive income in the future. Future losses could require us to slow our growth and make other changes to our business plans, and could result in an increase in our allowance against our net deferred tax assets.
If our goodwill or amortizable intangible assets become impaired we may be required to record a significant charge to earnings.
Under accounting principles generally accepted in the United States (“U.S. GAAP”), we review our amortizable intangible assets for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. Goodwill is tested for impairment at least annually. Factors that may be considered a change in circumstances, indicating that the carrying value of our goodwill or amortizable intangible assets may not be recoverable, include a decline in stock price and market capitalization, reduced future cash flow estimates, and slower growth rates in our industry. We may be required to record a significant charge in our financial statements during the period in which any impairment of our goodwill or amortizable intangible assets is determined, negatively impacting our results of operations.
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Risks Related to Our Common Stock
Future sales of shares by existing stockholders or issuances of our common stock by us could reduce our stock price.
If our existing stockholders sell substantial amounts of our common stock in the public market, the market price of our common stock could decline. In the future, we may sell additional shares of our common stock to raise capital. We cannot predict the size of future issuances or the effect, if any, that they may have on the market price of our common stock. We may also issue shares of our common stock from time to time as consideration for future acquisitions and investments. If any such acquisition or investment is significant, the number of shares that we issue may, in turn, be significant. In addition, we may grant registration rights covering those shares in connection with any such acquisitions and investments. The issuance and sales of substantial amounts of common stock, or the perception that such issuances and sales may occur, could adversely affect the market price of our common stock.
Anti-takeover provisions in our charter documents and Delaware corporate law might deter acquisition bids for us that our stockholders might consider favorable.
Our amended and restated certificate of incorporation provides for a classified board of directors; the inability of our stockholders to call special meetings of stockholders, to act by written consent, to remove any director or the entire board of directors without cause, or to fill any vacancy on the board of directors; and advance notice requirements for stockholder proposals. Our board of directors is also permitted to authorize the issuance of preferred stock with rights superior to the rights of the holders of common stock without any vote or further action by our stockholders. These provisions and other provisions under Delaware law could make it difficult for a third party to acquire us, even if doing so would benefit our stockholders.
Because we do not currently intend to pay dividends on our common stock, stockholders will benefit from an investment in our common stock only if it appreciates in value.
The continued expansion of our business will require substantial funding. Accordingly, we do not currently anticipate paying any dividends on shares of our common stock. Any determination to pay dividends in the future will be at the discretion of our board of directors and will depend upon results of operations, financial condition, contractual restrictions, restrictions imposed by applicable law and other factors our board of directors deems relevant. Accordingly, realization of a gain on stockholders’ investments will depend on the appreciation of the price of our common stock. There is no guarantee that our common stock will appreciate in value or even maintain the price at which stockholders purchased their shares.
| Item 1B. | Unresolved Staff Comments |
None.
| Item 2. | Properties |
We lease a 165,546 square-foot facility for our corporate headquarters in Atlanta, Georgia. We also lease data center facilities in Atlanta and in Dallas, Texas as well as sales office facilities that range between 15,000 to 28,000 square-feet in each of our markets. Our total rental expenses for the year ended December 31, 2010 were approximately $0.7 million for our collocation and data center facilities and approximately $7.7 million for our offices. Additionally, we own a 33,000 square-foot data center in Louisville, Kentucky as a result of a recent acquisition. Management believes that our properties, taken as a whole, are in good operating condition and are suitable for our business operations. As we expand our business into new markets, we expect to lease additional data center facilities and sales office facilities.
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| Item 3. | Legal Proceedings |
From time to time, we are involved in legal proceedings arising in the ordinary course of business. We believe that we have adequately reserved for these liabilities and that as of December 31, 2010, there is no litigation pending that could have a material adverse effect on our results of operations and financial condition.
| Item 4. | Reserved |
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PART II
| Item 5. | Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities |
Market Price Information and Dividend Policy for Our Common Stock
Our common stock is currently traded on the Nasdaq Global Market under the symbol “CBEY.”
As of March 3, 2011, there were approximately 58 holders of record of shares of our common stock.
The table below shows, for the quarters indicated, the reported high and low trading prices of our common stock on The Nasdaq Global Market:
| Market Prices | ||||||||
| High | Low | |||||||
| Calendar Year 2009 |
||||||||
| First quarter |
$ | 19.49 | $ | 12.50 | ||||
| Second quarter |
20.80 | 13.96 | ||||||
| Third quarter |
16.75 | 13.34 | ||||||
| Fourth quarter |
16.63 | 11.01 | ||||||
| Calendar Year 2010 |
||||||||
| First quarter |
$ | 16.23 | $ | 10.71 | ||||
| Second quarter |
18.05 | 12.16 | ||||||
| Third quarter |
15.55 | 11.59 | ||||||
| Fourth quarter |
15.89 | 12.22 | ||||||
As of March 3, 2011, the closing price of our common stock was $12.77.
We have never paid or declared any dividends on our common stock and do not anticipate paying any dividends in the foreseeable future. The terms of our line of credit with Bank of America restrict our ability to pay dividends on our common stock. We currently anticipate that we will use any future earnings for use in the operation of our business and to fund future growth. The decision whether to pay dividends will be made by our board of directors in light of conditions then existing, including factors such as our results of operations, financial condition and requirements, business conditions and covenants under any applicable contractual arrangements or any other factors the board of directors may consider.
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Securities Authorized for Issuance Under Equity Compensation Plans
We issue our employees share-based awards under our 2005 Equity Incentive Award Plan (the “2005 Plan”), which has been approved by our stockholders. The following table provides information as of December 31, 2010 regarding outstanding options and shares reserved for future issuance under the 2005 Plan:
| Plan Category |
Number of securities to be issued upon exercise of outstanding options, warrants and rights (a) |
Weighted- average exercise price of outstanding options, warrants and rights (b) |
Number of
securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a)) (c) |
|||||||||
| Equity compensation plans approved by security holders: |
||||||||||||
| 2005 Equity Incentive Award Plan |
2,385,636 | $ | 18.85 | 122,544 | ||||||||
| 2002 Equity Incentive Award Plan (1) |
1,318,714 | $ | 7.34 | 535,993 | ||||||||
| 2000 Equity Incentive Award Plan (1) |
1,133 | $ | 13.44 | — | ||||||||
| Equity compensation plans not approved by security holders |
— | $ | — | — | ||||||||
| Total |
3,705,483 | $ | 14.76 | 658,537 | ||||||||
| (1) | Shares remaining for issuance under the 2002 Equity Incentive Award Plan and the 2000 Equity Incentive Award Plan were rolled into the 2005 Plan, pursuant to our registration statement on Form S-8 (File No. 333-129556) filed with the SEC on November 8, 2005. |
Transfer Agent and Registrar
American Stock Transfer and Trust Company is the transfer agent and registrar for our common stock.
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| Item 6. | Selected Financial Data |
You should read the following selected consolidated financial data in conjunction with our consolidated financial statements and related notes thereto and with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this report. The consolidated statements of operations data for the years ended December 31, 2010, 2009 and 2008, and the consolidated balance sheets data as of December 31, 2010 and 2009, are derived from the audited consolidated financial statements and notes thereto included elsewhere in this report. The consolidated statements of operations data for the years ended December 31, 2007 and 2006, and the consolidated balance sheets data as of December 31, 2008, 2007 and 2006, are derived from audited consolidated financial statements not included herein. Historical results are not necessarily indicative of results to be expected in the future.
| Year Ended December 31, | ||||||||||||||||||||
| 2010 | 2009 | 2008 | 2007 | 2006 | ||||||||||||||||
| (dollars in thousands) | ||||||||||||||||||||
| Consolidated Statements of Operations Data: |
||||||||||||||||||||
| Revenue |
$ | 451,965 | $ | 413,771 | $ | 349,700 | $ | 280,034 | $ | 213,886 | ||||||||||
| Operating expenses: |
||||||||||||||||||||
| Cost of revenue (exclusive of $34,843, $31,838, $27,779, $22,896 and $22,293 depreciation and amortization, respectively) |
146,507 | 138,093 | 109,673 | 84,459 | 64,294 | |||||||||||||||
| Selling, general and administrative (exclusive of $24,461, $20,002, $13,797, $9,074 and $5,733 depreciation and amortization, respectively) |
248,327 | 228,506 | 192,354 | 153,456 | 114,408 | |||||||||||||||
| Transaction costs |
755 | — | — | — | — | |||||||||||||||
| Public offering expenses |
— | — | — | 2 | 945 | |||||||||||||||
| Depreciation and amortization (1) |
59,304 | 51,840 | 41,576 | 31,970 | 28,026 | |||||||||||||||
| Total operating expenses |
454,893 | 418,439 | 343,603 | 269,887 | 207,673 | |||||||||||||||
| Operating (loss) income |
(2,928 | ) | (4,668 | ) | 6,097 | 10,147 | 6,213 | |||||||||||||
| Other income (expense): |
||||||||||||||||||||
| Interest income |
2 | 28 | 846 | 2,700 | 1,919 | |||||||||||||||
| Interest expense |
(281 | ) | (152 | ) | (224 | ) | (252 | ) | (163 | ) | ||||||||||
| Other income, net |
1,867 | 498 | 71 | — | 241 | |||||||||||||||
| (Loss) income before income taxes |
(1,340 | ) | (4,294 | ) | 6,790 | 12,595 | 8,210 | |||||||||||||
| Income tax (expense) benefit |
(314 | ) | 2,074 | (3,094 | ) | 8,903 | (430 | ) | ||||||||||||
| Net (loss) income |
$ | (1,654 | ) | $ | (2,220 | ) | $ | 3,696 | $ | 21,498 | $ | 7,780 | ||||||||
| (1) | To conform to our current year presentation, we have reclassified amounts previously recognized as depreciation expense to non-operating other income, net. The amount excluded from depreciation and amortization expense for the years ended December 31, 2009, 2008, and 2006 was $489, $71, and $229, respectively (see Note 2 to the consolidated financial statements). |
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| Year Ended December 31, | ||||||||||||||||||||
| 2010 | 2009 | 2008 | 2007 | 2006 | ||||||||||||||||
| (amounts in thousands, except per share data and ARPU) | ||||||||||||||||||||
| Consolidated Balance Sheets Data (at period end): |
||||||||||||||||||||
| Cash and cash equivalents |
$ | 26,373 | $ | 39,267 | $ | 36,975 | $ | 56,174 | $ | 34,113 | ||||||||||
| Marketable securities |
— | — | — | — | 9,995 | |||||||||||||||
| Working capital |
(3,568 | ) | 19,801 | 17,681 | 27,410 | 20,562 | ||||||||||||||
| Total assets |
257,967 | 228,891 | 212,487 | 198,362 | 144,393 | |||||||||||||||
| Non-current portion of contingent consideration (1) |
6,035 | — | — | — | — | |||||||||||||||
| Stockholders’ equity |
173,121 | 158,605 | 143,535 | 127,318 | 91,108 | |||||||||||||||
| Other Financial Data: |
||||||||||||||||||||
| Capital expenditures (2) |
62,832 | 62,126 | 69,940 | 57,534 | 43,867 | |||||||||||||||
| Net cash provided by operating activities |
79,149 | 62,610 | 48,628 | 61,808 | 43,660 | |||||||||||||||
| Net cash used in investing activities |
(92,619 | ) | (60,729 | ) | (67,640 | ) | (45,089 | ) | (41,294 | ) | ||||||||||
| Net cash provided (used in) by financing activities |
576 | 411 | (187 | ) | 5,342 | 3,995 | ||||||||||||||
| Net (loss) income per common share, basic |
$ | (0.06 | ) | $ | (0.08 | ) | $ | 0.13 | $ | 0.77 | $ | 0.29 | ||||||||
| Net (loss) income per common share, diluted |
$ | (0.06 | ) | $ | (0.08 | ) | $ | 0.12 | $ | 0.72 | $ | 0.27 | ||||||||
| Weighted average common shares outstanding, basic |
29,366 | 28,753 | 28,339 | 27,837 | 26,951 | |||||||||||||||
| Weighted average common shares outstanding, diluted |
29,366 | 28,753 | 29,589 | 29,989 | 28,971 | |||||||||||||||
| Non-GAAP Financial Data: |
||||||||||||||||||||
| Total adjusted EBITDA (3) |
$ | 72,935 | $ | 63,126 | $ | 60,560 | $ | 52,108 | $ | 39,539 | ||||||||||
| Free cash flow (3) |
$ | 10,103 | $ | 1,000 | $ | (9,380 | ) | $ | (5,426 | ) | $ | (4,328 | ) | |||||||
| Core Managed Services ARPU (3) |
$ | 700 | $ | 744 | $ | 752 | $ | 748 | $ | 747 | ||||||||||
| (1) | Represents the long-term portion of contingent liability related to the acquisitions of MaximumASP and Aretta (see Note 4 to the consolidated financial statements). |
| (2) | Represents cash and non-cash purchases of property and equipment on a combined basis. |
| (3) | Adjusted EBITDA, free cash flow and Core Managed Services average monthly revenue per customer location, or ARPU, are not substitutes for revenue, operating (loss) income, net (loss) income, or cash flow from operating activities as determined in accordance with generally accepted accounting principles, or GAAP, as a measure of performance or liquidity. See “Non-GAAP Financial Measure” for our reasons for including adjusted EBITDA and free cash flow data in this report and for material limitations with respect to the usefulness of this measurement. The following table sets forth a reconciliation of total adjusted EBITDA and free cash flow to net (loss) income: |
| Year Ended December 31, | ||||||||||||||||||||
| 2010 | 2009 | 2008 | 2007 | 2006 | ||||||||||||||||
| Reconciliation of free cash flow and total adjusted EBITDA to net income (loss): |
||||||||||||||||||||
| Total free cash flow |
$ | 10,103 | $ | 1,000 | $ | (9,380 | ) | $ | (5,426 | ) | $ | (4,328 | ) | |||||||
| Capital expenditures |
62,832 | 62,126 | 69,940 | 57,534 | 43,867 | |||||||||||||||
| Total adjusted EBITDA |
$ | 72,935 | $ | 63,126 | $ | 60,560 | $ | 52,108 | $ | 39,539 | ||||||||||
| Depreciation and amortization |
(59,304 | ) | (51,840 | ) | (41,576 | ) | (31,970 | ) | (28,026 | ) | ||||||||||
| Non-cash share-based compensation |
(15,591 | ) | (15,954 | ) | (12,887 | ) | (9,989 | ) | (4,355 | ) | ||||||||||
| MaximumASP purchase accounting adjustment (1) |
(213 | ) | — | — | — | — | ||||||||||||||
| Transaction costs |
(755 | ) | — | — | — | — | ||||||||||||||
| Public offering expenses |
— | — | — | (2 | ) | (945 | ) | |||||||||||||
| Interest income |
2 | 28 | 846 | 2,700 | 1,919 | |||||||||||||||
| Interest expense |
(281 | ) | (152 | ) | (224 | ) | (252 | ) | (163 | ) | ||||||||||
| Other income (expense), net |
1,867 | 498 | 71 | — | 241 | |||||||||||||||
| Income (loss) before income taxes |
(1,340 | ) | (4,294 | ) | 6,790 | 12,595 | 8,210 | |||||||||||||
| Income tax (expense) benefit |
(314 | ) | 2,074 | (3,094 | ) | 8,903 | (430 | ) | ||||||||||||
| Net (loss) income |
$ | (1,654 | ) | $ | (2,220 | ) | $ | 3,696 | $ | 21,498 | $ | 7,780 | ||||||||
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| (1) | These adjustments include the effect on revenue of adjusting acquired deferred revenue balances to fair value as of the respective acquisition dates for the Cloud Services acquisitions. The reduction of the deferred revenue balances affects period-to-period financial performance comparability and revenue and earnings growth in future periods subsequent to the acquisition and is not indicative of changes in underlying results of operations. We may have similar adjustments in future periods if we have any new acquisitions. |
The following table set forth a reconciliation of total revenue to Core Managed Services ARPU:
| Year Ended December 31, | ||||||||||||||||||||
| 2010 | 2009 | 2008 | 2007 | 2006 | ||||||||||||||||
| (amounts in thousands, except ARPU) | ||||||||||||||||||||
| Reconciliation of Core Managed Services ARPU: |
||||||||||||||||||||
| Total Revenue |
$ | 451,965 | $ | 413,771 | $ | 349,700 | $ | 280,034 | $ | 213,886 | ||||||||||
| Cloud Services revenue |
(1,791 | ) | — | — | — | — | ||||||||||||||
| Intersegment eliminations |
7 | — | — | — | — | |||||||||||||||
| (A) Core Managed Servies net revenue |
450,181 | 413,771 | 349,700 | 280,034 | 213,886 | |||||||||||||||
| (B) Average Core Managed Services customers |
53,588 | 46,333 | 38,752 | 31,192 | 23,845 | |||||||||||||||
| Core Managed Services ARPU |
$ | 700 | $ | 744 | $ | 752 | $ | 748 | $ | 747 | ||||||||||
NON-GAAP FINANCIAL MEASURE
Adjusted EBITDA
We use the total adjusted EBITDA of our reportable segments as a principal indicator of the operating performance of our business on a consolidated basis. Our chief executive officer, who is our chief operating decision maker (or “CODM”), also uses our segment adjusted EBITDA to evaluate the performance of our reportable segments. EBITDA represents net income (loss) before interest, income taxes, depreciation and amortization. We define adjusted EBITDA as net income (loss) before interest, income taxes, depreciation and amortization expenses, excluding, when applicable, non-cash share-based compensation, public offering expenses or acquisition-related transaction costs, purchase accounting adjustments, gain or loss on disposal of property and equipment and other non-operating income or expense. Our total adjusted EBITDA represents the sum of adjusted EBITDA for each of our segments.
Our total adjusted EBITDA is a non-GAAP financial measure. Our management uses total adjusted EBITDA in its decision-making processes relating to the operation of our business together with GAAP measures such as revenue and income (loss) from operations.
Our calculation of total adjusted EBITDA excludes, when applicable:
| • | Non-cash share-based compensation, loss on disposal of property and equipment and other non-operating income or expense, none of which are used by management to assess the operating results and performance of our segments or our consolidated operations; |
| • | Public offering expenses or acquisition-related transaction costs; and |
| • | Purchase accounting adjustments, which include the effect on revenue of adjusting acquired deferred revenue balances to fair value as of the respective acquisition date for business acquisitions. The reduction of the deferred revenue balances affects period-to-period financial performance comparability and revenue and earnings growth in future periods subsequent to the acquisition and is not indicative of changes in underlying results of operations. |
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Our management believes that total adjusted EBITDA permits a comparative assessment of our operating performance, relative to our performance based on our GAAP results, while isolating the effects of depreciation and amortization, which may vary from period to period without any correlation to underlying operating performance, and of non-cash share-based compensation, which is a non-cash expense that varies widely among similar companies. We provide information relating to our total adjusted EBITDA so that investors have the same data that we employ in assessing our overall operations. We believe that trends in our total adjusted EBITDA are a valuable indicator of operating performance on a consolidated basis and of our operating segments’ ability to produce operating cash flow to fund working capital needs, to service debt obligations and to fund capital expenditures.
In addition, we believe total adjusted EBITDA is a useful comparative measure within the communications industry because the industry has experienced recent trends of increased merger and acquisition activity and financial restructurings, which have led to significant variations among companies with respect to capital structures and cost of capital (which affect interest expense) and differences in taxation and book depreciation of facilities and equipment (which affect relative depreciation expense), including significant differences in the depreciable lives of similar assets among various companies, as well as non-operating or infrequent charges to earnings, such as the effect of debt restructurings.
Accordingly, we believe total adjusted EBITDA allows analysts, investors and other interested parties in the communications industry to facilitate company to company comparisons by eliminating some of the foregoing variations. Total adjusted EBITDA as used in this report may not, however, be directly comparable to similarly titled measures reported by other companies due to differences in accounting policies and items excluded or included in the adjustments, which limits its usefulness as a comparative measure.
Our calculation of total adjusted EBITDA is not directly comparable to EBIT (earnings before interest and taxes) or EBITDA (earnings before interest, taxes, depreciation and amortization). In addition, total adjusted EBITDA does not reflect:
| • | our cash expenditures, or future requirements, for capital expenditures or contractual commitments; |
| • | changes in, or cash requirements for, our working capital needs; |
| • | our interest expense, or the cash requirements necessary to service interest or principal payments on our debts; |
| • | any cash requirements for the replacement of assets being depreciated and amortized, which will often have to be replaced in the future, even though depreciation and amortization are non-cash charges; and cash used for business acquisitions. |
Total adjusted EBITDA is not intended to replace operating income (loss), net income (loss) and other measures of financial performance reported in accordance with GAAP. Rather, total adjusted EBITDA is a measure of operating performance to consider in addition to those measures. Because of these limitations, total adjusted EBITDA should not be considered as a measure of discretionary cash available to us to invest in the growth of our business. We compensate for these limitations by relying primarily on our GAAP results and using total adjusted EBITDA as a supplemental financial measure.
Free Cash Flow
Free Cash Flow represents the cash that a company is able to generate after cash expenses and capital expenditures necessary to maintain or expand its asset base. We define free cash flow as adjusted EBITDA less total capital expenditures.
We believe that Free Cash Flow is an important metric for investors in evaluating how a company is currently using cash generated, and may indicate its ability to generate cash that can potentially be used by the business for capital investments, acquisitions, reduction of debt, payment of dividends, etc. Internally, we have also begun to focus on Free Cash Flow as an important operating performance metric and have designed our corporate bonus compensation plan to utilize Free Cash Flow as a component. However, we believe that Free Cash Flow is not a measure of financial performance under GAAP and may not be comparable to similarly titled measures reported by other companies. Additionally, we do not present or manage Free Cash Flow on a segment basis.
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| Item 7. | Management’s Discussion and Analysis of Financial Condition and Results of Operations |
You should read the following discussion together with our consolidated financial statements and the related notes and other financial information included elsewhere in this report. The discussion in this report contains forward-looking statements that involve risks and uncertainties, such as statements of our plans, objectives, expectations and intentions. The cautionary statements made in this report should be read as applying to all related forward-looking statements wherever they appear in this report. Our actual results could differ materially from those discussed here. See “Cautionary Notice Regarding Forward-Looking Statements” elsewhere in this report.
Overview
We formed Cbeyond and began the development of our network and business processes in early 2000. We launched our first market, Atlanta, in early 2001 and have since expanded operations into 13 additional markets. During the third quarter of 2010 we launched our 14th market, Boston. As a result of our recent acquisitions (see Note 4 to the consolidated financial statements) and our ongoing Ethernet conversion project (see “Cost of Revenue” section) being implemented throughout our markets, we currently have no plans to expand our operations into any additional markets during 2011. We anticipate resuming our market expansion plan of opening new markets beginning in 2012, depending on economic, regulatory and other conditions, and establishing operations in the 25 largest U.S. markets. Additionally, our recent acquisitions and the establishment of our Cloud Services segment allow us to deliver cloud-based services outside of these target markets (see Note 4 to our consolidated financial statements). The following comprises the historical service launch dates for our current markets (collectively we refer to our market-based segments as our “Core Managed Services”):
| Current Markets |
Service Launch Date | |
| Atlanta |
2nd Quarter 2001 | |
| Dallas |
4th Quarter 2001 | |
| Denver |
1st Quarter 2002 | |
| Houston |
1st Quarter 2004 | |
| Chicago |
1st Quarter 2005 | |
| Los Angeles |
1st Quarter 2006 | |
| San Diego |
1st Quarter 2007 | |
| Detroit |
3rd Quarter 2007 | |
| San Francisco Bay Area |
4th Quarter 2007 | |
| Miami |
1st Quarter 2008 | |
| Minneapolis |
2nd Quarter 2008 | |
| Greater Washington D.C. Area |
1st Quarter 2009 | |
| Seattle |
4th Quarter 2009 | |
| Boston |
3rd Quarter 2010 |
We aggregate markets with similar economic characteristics for segment reporting. This aggregation is consistent with the direction toward which we are increasingly moving and managing the business. Specifically, we recognize that the highest risk stage for a market is in its early stages when we are adapting our strategy and approach to accommodate a new market’s unique characteristics; including the small business climate and culture, regulatory conditions, local competitors, and the quality and availability of local employees for staffing and managing the markets. Comparatively, our established markets generally require less frequent direct corporate level management involvement because we have adapted to the local market and have seasoned local management in place, which generally results in more stable operating performance. As the number of established markets has grown, our CODM now spends the majority of his time monitoring the individual performance levels of newer markets and the effectiveness of our corporate operations rather than focusing on individual established markets. As such, we have aggregated these mature markets as one reportable segment entitled “Core Managed Services Established Markets.”
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The markets subject to aggregation are those that we consider established because they have successfully passed through the critical start-up phase and, for the reasons mentioned previously, achieved certain operating performance levels. All other markets and our corporate operations will continue to be presented as separate segments. Currently, a market is considered established upon achieving positive adjusted EBITDA for at least four consecutive fiscal quarters and otherwise sharing similar economic characteristics as the other established markets. As of June 30, 2010 and September 30, 2010, the San Francisco and Detroit market, respectively, have graduated to the Core Managed Services Established Market grouping due to their achievement of four consecutive fiscal quarters of positive adjusted EBITDA. We have updated our segment disclosure to retroactively present Detroit and San Francisco as established markets in the prior period (see Note 13 to our consolidated financial statements).
At December 31, 2010, our reportable segments were Core Managed Services Established Markets; the individual Core Managed Services Emerging Markets including metropolitan Miami, Minneapolis, the Greater Washington DC Area, Seattle and Boston; and the Cloud Services segment. In the fourth quarter of 2010 after making our recent acquisitions, we established the Cloud Services segment. We consider the Cloud Services segment as a reportable segment because the CODM is managing the Cloud Services segment as a separate business unit in terms of resource allocation and financial performance. Specifically we have established resources and executive leadership solely dedicated to integrating our recent acquisitions into an operating arm of the company that will serve new customers in addition to upselling existing customers.
We focus on adjusted EBITDA as a principal indicator of the operating performance of our business and our reportable segments. EBITDA represents net income (loss) before interest, income taxes, depreciation and amortization. We define adjusted EBITDA as net income (loss) before interest, income taxes, depreciation and amortization expenses, excluding, when applicable, non-cash share-based compensation, public offering or acquisition-related transaction costs, purchase accounting adjustments, gain or loss on disposal of property and equipment and other non-operating income or expense. In our presentation of segment financial results, adjusted EBITDA for a geographic segment does not include corporate overhead expense and other centralized operating costs. We believe that adjusted EBITDA trends are a valuable indicator of our operating segments’ relative performance and of whether our operating segments are able to produce sufficient operating cash flow to fund working capital needs, to service debt obligations and to fund capital expenditures.
We believe our business approach requires significantly less capital to launch operations compared to traditional communications companies using legacy technologies. Based on our historical experience, over time a substantial majority of our market-specific capital expenditures, such as integrated access devices installed at our customers’ locations, are success-based, incurred primarily as our customer base grows. We believe the success-based nature of our capital expenditures mitigates the risk of unprofitable expansion. We have a relatively low fixed-cost component in our budgeted capital expenditures associated with each new market we enter, particularly in comparison to service providers employing time-division multiplexing, which is a technique for transmitting multiple channels of separate data, voice and/or video signals simultaneously over a single communication medium, or circuit-switch technology, which is a switch that establishes a dedicated circuit for the entire duration of a call.
The nature of the primary components of our operating results—revenues, cost of revenue and selling, general and administrative expenses—are described below:
Revenue
We offer integrated managed IT and communications services through our BeyondVoice packages over high capacity bandwidth connections. Our BeyondVoice packages have historically been essentially a single basic product that we offered in three sizes, depending on the customer’s size and need for bandwidth. In March 2010, we began offering our services through BeyondVoice packages that were designed to address the customer’s business needs rather than the size of the customer. Based on our experience since the introduction of
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these new packages, we determined that modifications to the packages were appropriate and began making package changes in November 2010 and will complete them in the second quarter of 2011. These changes essentially combine a business-needs approach in different sizes and make mobile service an add-on. As the needs of our customers and the relative market change, we will continue to evolve our integrated service offering packages in the future as appropriate.
In addition to our core BeyondVoice packages, through our recent acquisitions we expanded the applications and other offerings we deliver via the cloud, most notably by adding virtual and dedicated servers and cloud PBX services to the suite of products available to our customer base. In addition, our recent acquisitions bring customers and distribution channels not limited to our traditional geographically concentrated markets. We expect to make our historic cloud-based services, such as Virtual Receptionist, Hosted Microsoft Exchange, and secure desktop, available through these channels over time as we integrate the acquired operations. We believe the expansion of our product offering allows us to greatly extend the breadth of services we can deliver to our customers via the web, thus further minimizing or eliminating the need for our customers to invest in complex IT infrastructure and resources while increasing our wallet share opportunity and improving our value proposition. As we continue to focus on and expand our IT services utilizing the cloud, we expect to expand our addressable customer market and provide more innovative technology to new and existing customers.
We believe that these acquisitions provide significant growth opportunities, leverage our existing channels of distribution, and expand our innovative technology and expertise. We anticipate the following benefits to our business:
| • | Entry into a large, high growth cloud services market independent of our BeyondVoice product, |
| • | Expansion of product portfolio of IT services highly relevant to small businesses, |
| • | Broad geographic opportunity outside Cbeyond’s existing 14-city footprint, |
| • | Web distribution and private label reseller channels, |
| • | Significant cross-selling and up-selling opportunities with potential positive impact on our Core Managed Services ARPU, |
| • | Opportunity to sell Cbeyond’s existing cloud-based services via the acquired online platform in the future, |
| • | Attractive customer economic model based on server virtualization, |
| • | New efficient and scalable owned 33,000 square foot data center, |
| • | And extensible platform to provide additional software and infrastructure-as-a-service offerings. |
We offer customer promotional incentives in the form of rebates and reimbursements. These rebates and reimbursements, or promotional obligations, may not ultimately be earned and claimed by customers. We refer to these unclaimed amounts as “breakage.” Prior to recording breakage, our promotional obligations are recorded as a reduction of revenue at their maximum amounts due to the lack of sufficient historical experience required to estimate the amount that would ultimately be earned and claimed by customers. We recognize the benefit of changes to these estimated customer promotional obligations once such amounts are reasonably estimable and then periodically adjust the estimated breakage to actual results, which periodically results in a significant change in estimate.
ARPU is impacted by a variety of factors, including: introduction of new packages with different pricing; changes in customers’ demand for certain products or services; changes in customer usage patterns; the proportion of customers signing three-year contracts at lower package prices as compared to shorter term contracts; the distribution of customer installations during a period; the use of customer incentives employed when needed to be competitive; as well as fluctuations in terminating access rates. Customer revenues represented approximately 98.4%, 98.2% and 98.0% of total revenues in 2010, 2009 and 2008, respectively.
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Access charges paid to us by other communications companies to terminate calls to our customers represented the remainder of total revenues. We do not currently include the Cloud Services segment revenue or the related intercompany segment revenue eliminations to calculate and report ARPU as an operating metric. Thus we only utilize Core Managed Services ARPU as our revenue metric for our traditional business.
Customer revenues are generated under contracts that run up to three-year terms. Therefore, customer churn rates have an impact on projected future revenue streams. Through mid-2007, we maintained average monthly churn rates of approximately 1.0% (we define average monthly churn rate as the average of monthly churn, which is defined for a given month as the number of customer locations disconnected in that month divided by the total number of customer locations on our network at the beginning of that month). Since that time, however, we have experienced elevated churn rates that we believe are attributable primarily to the inability of certain of our customers to meet their payment obligations as a result of deteriorated economic conditions or its impact on our target of small business customers, as well as increased competition. We cannot predict the duration or magnitude of the currently deteriorated economic environment, but we expect our monthly churn rate will continue to be more than 1.0% for at least as long as the current economic environment persists.
Cost of Revenue
Our cost of revenue represents costs directly related to the operation of our network, including payments to the local telephone companies and other communications carriers such as long distance providers and our mobile provider, for access, interconnection and transport fees for voice and Internet traffic, customer circuit installation expenses paid to the local telephone companies, fees paid to third-party providers of certain applications such as web hosting services, collocation rents and other facility costs, telecommunications-related taxes and fees and the cost of mobile handsets. The primary component of cost of revenue consists of the access fees paid to local telephone companies for high capacity circuits (primarily T-1s to date) we lease on a monthly basis to provide connectivity to our customers. These access circuits link our customers to our network equipment located in a collocation facility, which we lease from local telephone companies. The access fees for these circuits vary by state and are the primary reason for differences in cost of revenue across our markets.
As a result of the FCC’s 2005 TRRO, we are required to lease circuits under special access, or retail, rates in locations that are deemed to offer competitive facilities as outlined in the FCC’s regulations and interpreted by the state regulatory agencies.
Where permitted by regulation, we lease our access circuits on a wholesale basis as unbundled network element (or “UNE”) loops or enhanced extended links (or “EEL”s) as provided for under the FCC’s Telecommunications Elemental Long Run Incremental Cost rate structure. Where UNE pricing is not available, we pay special access rates, which may be significantly higher than UNE pricing. We lease loops when the customer’s T-1 circuit is located where it can be connected to a local telephone company’s central office where we have a collocation, and we use EELs when we do not have a central office collocation available to serve a customer’s T-1 circuit. Historically, approximately half of our circuits are provisioned using loops and half using EELs, and the impact of the TRRO has reduced our usage of the T-1 transport portion of EELs and resulted in the conversion and consolidation of a majority of the previously installed T-1 transports to high capacity DS-3 transport. Our monthly expenses are significantly less when using loops rather than EELs, but loops require us to incur the capital expenditures of central office collocation equipment. We install central office collocation equipment in those central offices having the densest concentration of small businesses. We usually launch operations in a new market with several collocations and add additional collocation facilities over time as we confirm the most advantageous locations in which to deploy the equipment. We believe our discipline of leasing these T-1 access circuits on a wholesale basis rather than on the basis of special access rates from the local telephone companies is an important component of our operating cost structure.
In addition, we have begun offering our services using Ethernet in place of T-1 circuits in a small number of locations. Although not available to us on a ubiquitous basis in all areas, Ethernet technology provides us with the opportunity to offer a large percentage of our customers bandwidth at speeds well in excess of T-1 circuits
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while potentially reducing our ongoing operating expenses. While our plans for Ethernet deployment are not final, we expect to rapidly increase the number of customers served via Ethernet beginning in the first quarter of 2011. We currently serve just over 3% of our customers with Ethernet but are ramping up our capabilities to process conversions to Ethernet and expect to have converted at least one-third of our existing customer base by early 2012. We expect to incur capital expenditures of up to $25 million through 2012 associated with the Ethernet conversions and expect to achieve significant access cost savings over time.
Another significant component of our cost of revenue is the cost associated with our mobile offering. These costs include usage-based charges, monthly recurring base charges, or some combination thereof, depending on the type of mobile product in service, and the cost of mobile equipment sold to our customers to facilitate their use of our service. The cost of mobile equipment typically exceeds our selling price of such devices due to the competitive marketplace and pricing practices for mobile services. We believe these costs are offset over time by the long-term profitability of our service contracts.
We routinely receive telecommunication cost recoveries from various local telephone companies to adjust for prior errors in billing, including the effect of price decreases retroactively applied upon the adoption of new rates as mandated by regulatory bodies. These service credits are often the result of negotiated resolutions of bill disputes that we conduct with our vendors. We also receive payments from the local telephone companies in the form of performance penalties that are assessed by state regulatory commissions based on the local telephone companies’ performance in the delivery of circuits and other services that we use in our network. Because of the many factors as noted above that impact the amount and timing of telecommunication cost recoveries, estimating the ultimate outcome of these situations is uncertain. Accordingly, we recognize telecommunication cost recoveries as offsets to cost of revenue when the ultimate resolution and amount are known and verifiable. These items do not follow any predictable trends and often result in variances when comparing the amounts received over multiple periods.
Selling, General and Administrative Expenses
Our selling, general and administrative expenses consist of salaries and related costs for employees and other expenses related to sales and marketing, engineering, information technology, billing, regulatory, administrative, collections and legal and accounting functions. In addition, share-based compensation expense is included in selling, general and administrative expenses. Our selling, general and administrative expenses include both fixed and variable costs. Fixed selling expenses include base salaries and office rents. Variable selling costs include commissions, bonuses and marketing materials. Fixed general and administrative costs include the cost of staffing certain corporate overhead functions such as IT, marketing, administrative, billing and engineering, and associated costs, such as office rent, legal and accounting fees, property taxes and recruiting costs. Variable general and administrative costs include the cost of provisioning and customer activation staff, which grows with the level of installation of new customers, and the cost of customer care and technical support staff, which grows with the level of total customers on our network. As we expand into new markets, certain fixed costs are likely to increase; however, these increases are usually intermittent and not proportional with the growth of customers.
Reclassifications
Reclassifications have been made within Item 7 herein to the years ended December 31, 2009 and 2008 to classify certain adjustments to liabilities of our former captive leasing entities from Depreciation and amortization to Other income, net. Such reclassifications were made to conform to the current presentation for the year ended December 31, 2010.
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Consolidated Results of Operations
Year Ended December 31, 2010 Compared to Year Ended December 31, 2009
Revenue and Cost of Revenue (Dollar amounts in thousands, except ARPU)
| For the Year Ended December 31, | Change from Previous Periods |
|||||||||||||||||||||||
| 2010 | 2009 | |||||||||||||||||||||||
| Dollars | % of Revenue |
Dollars | % of Revenue |
Dollars | Percent | |||||||||||||||||||
| Revenue: |
||||||||||||||||||||||||
| Customer revenue |
$ | 444,848 | 98.4 | % | $ | 406,472 | 98.2 | % | $ | 38,376 | 9.4 | % | ||||||||||||
| Terminating access revenue |
7,117 | 1.6 | % | 7,299 | 1.8 | % | (182 | ) | (2.5 | )% | ||||||||||||||
| Total revenue |
451,965 | 413,771 | 38,194 | 9.2 | % | |||||||||||||||||||
| Cost of revenue (exclusive of depreciation and amortization): |
||||||||||||||||||||||||
| Circuit access fees |
64,726 | 14.3 | % | 54,219 | 13.1 | % | 10,507 | 19.4 | % | |||||||||||||||
| Other cost of revenue |
60,306 | 13.3 | % | 52,708 | 12.7 | % | 7,598 | 14.4 | % | |||||||||||||||
| Mobile cost |
26,712 | 5.9 | % | 35,635 | 8.6 | % | (8,923 | ) | (25.0 | )% | ||||||||||||||
| Telecommunications cost recoveries |
(5,237 | ) | (1.2 | )% | (4,469 | ) | (1.1 | )% | (768 | ) | 17.2 | % | ||||||||||||
| Total cost of revenue |
146,507 | 32.4 | % | 138,093 | 33.4 | % | 8,414 | 6.1 | % | |||||||||||||||
| Gross margin (exclusive of depreciation and amortization): |
$ | 305,458 | 67.6 | % | $ | 275,678 | 66.6 | % | $ | 29,780 | 10.8 | % | ||||||||||||
| Customer data: |
||||||||||||||||||||||||
| Core Managed Services customer locations at period end |
56,972 | 50,203 | 6,769 | 13.5 | % | |||||||||||||||||||
| Core Managed Services ARPU |
$ | 700 | $ | 744 | $ | (44 | ) | (5.9 | )% | |||||||||||||||
| Core Managed Services average monthly churn rate |
1.4 | % | 1.5 | % | (0.1 | )% | ||||||||||||||||||
Revenue. Total revenue increased for the year ended December 31, 2010 compared to the year ended December 31, 2009 primarily due to an increase in the average number of Core Managed Services customers and $1.8 million in revenue from our Cloud Services segment. However in comparison to the same periods in 2009, Core Managed Services ARPU for the year ended December 31, 2010 declined $44, or 5.9%. The decline in this ARPU is primarily due to the lower prices of the new packages introduced in 2010, existing customers converting to lower priced packages, decreased charges for usage above levels of voice minutes included in our packages from customers reducing the number of additional lines and services with incremental charges, and decreased adoption of our mobile services. We believe these declines are related to the effects of the economic recession on customers and increased competitive pressures. This downward pressure has been partially offset by the value delivered through selling additional applications. In addition, we experienced an increase in redemptions of previously issued promotional incentives, which resulted in a reduction to revenue of $1.5 million, or approximately ($2) of Core Managed Services ARPU, in the year ended December 31, 2010. This is compared to an increase to revenue of $0.5 million, or approximately $1 of Core Managed Services ARPU, in the year ended December 31, 2009, related to lower redemptions of previously issued promotional incentives. We believe this change in customer behavior is directly related to the economic environment and competitive pressure.
At this time, we anticipate that our Core Managed Services ARPU will continue to decline in the short-term for the reasons noted above; however, we also anticipate that our new service packages will decrease the rate of the ARPU decline by increasing the ARPU for new customers. Long-term, we expect the introduction and adoption of the newly acquired cloud-based services, as well as new applications and other cloud-based IT services will benefit ARPU.
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Revenues from access charges paid to us by other communications companies to terminate calls to our customers have declined for the twelve-month comparison periods by approximately $0.2 million primarily due to a billing dispute filed by a major carrier during the third quarter of 2010 which had an overall negative impact on terminating access revenue of approximately $0.6 million in the year ended December 31, 2010. As we continue to evaluate the dispute and pursue a resolution, we are no longer recognizing the access charge revenue associated with this carrier due to the uncertainty of collectability. Terminating access charges have historically grown at a slower rate than our customer base due to our customers’ increased use of mobile services and reductions in access rates on interstate calls as mandated by the FCC. These rate reductions are expected to continue in the future, so we expect terminating access revenue will continue to grow at a rate slower than our customer growth and possibly decline if we are unable to reach a favorable resolution regarding the aforementioned dispute or are presented with other billing disputes.
The following comprises the segment contributions to the increase in revenue in the year ended December 31, 2010 as compared to the year ended December 31, 2009:
(Dollar amounts in thousands):
| For the Year Ended December 31, | Change from Previous Periods |
|||||||||||||||||||||||
| 2010 | 2009 | |||||||||||||||||||||||
| Segment Revenue: |
Dollars | % of Revenue |
Dollars | % of Revenue |
Dollars | Percent | ||||||||||||||||||
| Core Managed Services Established Markets |
$ | 417,414 | 92.4 | % | $ | 398,904 | 96.4 | % | $ | 18,510 | 4.6 | % | ||||||||||||
| Core Managed Services Emerging Markets: |
||||||||||||||||||||||||
| Miami |
16,557 | 3.7 | % | 9,027 | 2.2 | % | 7,530 | 83.4 | % | |||||||||||||||
| Minneapolis |
7,144 | 1.6 | % | 4,140 | 1.0 | % | 3,004 | 72.6 | % | |||||||||||||||
| Greater Washington, D.C. Area |
6,291 | 1.4 | % | 1,603 | 0.4 | % | 4,688 | 292.5 | % | |||||||||||||||
| Seattle |
2,691 | 0.6 | % | 97 | nm | 2,594 | nm | |||||||||||||||||
| Boston |
84 | nm | — | nm | 84 | nm | ||||||||||||||||||
| Core Managed Services total emerging markets |
32,767 | 7.2 | % | 14,867 | 3.6 | % | 17,900 | 120.4 | % | |||||||||||||||
| Total Core Managed Services |
450,181 | 99.6 | % | 413,771 | 100.0 | % | 36,410 | 8.8 | % | |||||||||||||||
| Cloud Services |
1,791 | 0.4 | % | — | nm | 1,791 | nm | |||||||||||||||||
| Intersegment elimination |
(7 | ) | nm | — | nm | (7 | ) | nm | ||||||||||||||||
| Total Revenue |
$ | 451,965 | $ | 413,771 | $ | 38,194 | 9.2 | % | ||||||||||||||||
nm—not meaningful
Cost of Revenue. The principal driver of the overall increase in cost of revenue is customer growth, reduced by mobile-related cost savings and beneficial telecommunication cost recoveries. Cost of revenue for 2010 also includes $0.4 million related to our Cloud Services segment.
Circuit access fees, or line charges, represent the largest single component of cost of revenue. These costs primarily relate to our lease of T-1 circuits connecting our equipment at network points of collocation to our equipment located at our customers’ premises. The increase in circuit access fees has historically correlated to the increase in the number of customers. However, we have experienced increased costs as we have expanded in certain markets with higher access fees, sold additional bandwidth to existing customers, and incurred transitional costs while migrating customers to Ethernet technology. We expect circuit access fees as a percentage of revenue to stabilize over time as we convert customers to Ethernet technology, which we believe will save operating costs in the long-term.
The other cost of revenue principally includes components such as long distance charges, installation costs to connect new circuits, the cost of transport circuits between network points of presence, the cost of local interconnection with the local telephone companies’ networks, internet access costs, the cost of third-party
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applications we provide to our customers, access costs paid by us to other carriers to terminate calls from our customers and certain taxes and fees. Other cost of revenue increased as a percentage of revenue over the prior period primarily due to customer growth outpacing revenue growth.
Mobile-related costs represent the second largest single component of cost of revenue. As a percentage of revenue, mobile service costs benefitted from a reduction in mobile device cost, which is a result of shipping fewer devices in 2010 at a more favorable average cost per device. The reduction in shipments stems from a lower percentage of new customers electing to include mobile services in their package, primarily due to a reduction in our use of promotional and other incentives. Additionally, we have been able to negotiate and achieve more efficient unit service costs. We do not currently anticipate significant changes in the percentage of customers using our mobile service in the future.
Telecommunication cost recoveries are an ongoing operational activity that fluctuate from period to period. During the year ended December 31, 2010, telecommunication cost recoveries increased $0.8 million due to TRRO-related cost recoveries, cost recoveries from negotiated resolutions of billing disputes with our telecommunication vendors across various markets, and performance penalties received from local telephone companies.
Selling, General and Administrative and Other Operating Expenses (Dollar amounts in thousands)
| For the Year Ended December 31, | Change from Previous Periods |
|||||||||||||||||||||||
| 2010 | 2009 | |||||||||||||||||||||||
| Dollars | % of Revenue |
Dollars | % of Revenue |
Dollars | Percent | |||||||||||||||||||
| Selling, general and administrative (exclusive of depreciation and amortization): |
||||||||||||||||||||||||
| Salaries, wages and benefits (excluding share-based compensation) |
$ | 150,205 | 33.2 | % | $ | 136,898 | 33.1 | % | $ | 13,307 | 9.7 | % | ||||||||||||
| Share-based compensation |
15,591 | 3.4 | % | 15,954 | 3.9 | % | (363 | ) | (2.3 | )% | ||||||||||||||
| Marketing cost |
3,440 | 0.8 | % | 2,955 | 0.7 | % | 485 | 16.4 | % | |||||||||||||||
| Other selling, general and administrative |
79,091 | 17.5 | % | 72,699 | 17.6 | % | 6,392 | 8.8 | % | |||||||||||||||
| Total SG&A |
$ | 248,327 | 54.9 | % | $ | 228,506 | 55.2 | % | $ | 19,821 | 8.7 | % | ||||||||||||
| Other operating expenses: |
||||||||||||||||||||||||
| Transaction costs |
$ | 755 | 0.2 | % | $ | — | nm | $ | 755 | nm | ||||||||||||||
| Depreciation and amortization |
59,304 | 13.1 | % | 51,840 | 12.5 | % | 7,464 | 14.4 | % | |||||||||||||||
| Total other operating expenses |
$ | 60,059 | 13.3 | % | $ | 51,840 | 12.5 | % | $ | 8,219 | 15.9 | % | ||||||||||||
| Other data: |
||||||||||||||||||||||||
| SG&A per average Core Managed Services customer |
$ | 384 | $ | 411 | $ | (27 | ) | (6.6 | )% | |||||||||||||||
| Employees |
1,944 | 1,677 | 267 | 15.9 | % | |||||||||||||||||||
Selling, General and Administrative Expenses and Other Operating Expenses. Selling, general and administrative expenses increased for the year ended December 31, 2010 compared to the year ended December 31, 2009, primarily due to increased employee costs, but decreased as a percentage of revenue during the year ended December 31, 2010 due to lower commission payments, lower share-based compensation expense, a decrease in bad debt expense, greater overall cost control measures, and government incentives of approximately $0.9 million attributable to new jobs created during 2009 and 2010. Higher employee costs, which include salaries, wages, benefits and other compensation paid to our direct sales representatives and sales agents, principally relate to the additional employees necessary to staff new markets and to serve the growth in customers. Total selling, general and administrative expenses also includes $1.1 million of additional expenses from our new Cloud Services segment in the year ended December 31, 2010.
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Share-based compensation expense decreased as a percentage of revenue and overall from the prior year, primarily related to a lower stock price in recent years.
Marketing costs have been stable as a percent of revenues over the prior year. In general, our marketing costs will increase consistent with past practice as we add customers and expand into new markets. Additionally, we expect higher marketing costs in 2011 as we promote our new Cloud Services segment and market the service to new and existing customers.
Other selling, general and administrative expenses include professional fees, outsourced services, rent and other facilities costs, maintenance, recruiting fees, travel and entertainment costs, property taxes and bad debt expense. The increase in this category of costs is primarily due to the addition of new and expanded operations needed to keep pace with the growth in customers. The stability as a percentage of revenue is partially attributable to improved bad debt expense over the prior year.
Bad debt expense was $7.5 million, or 1.7% of Core Managed Services revenues, compared to $9.1 million, or 2.2% of revenues, for the years ended December 31, 2010 and 2009, respectively. This decline is primarily driven by our decreased Core Managed Services customer churn rate since typically the rate of bad debts and customer churn are closely related.
Other operating expenses include transaction costs, and depreciation and amortization. Transaction costs include accounting, legal, consulting and other directly related professional fees associated with our recent Cloud Services acquisitions. The increase in depreciation and amortization over the prior year relates primarily to 2010 capital expenditures; $0.5 million of depreciation and amortization from assets acquired through the recent Cloud Services acquisitions; and, a $0.6 million write-down of assets related to the buildout of collocations in a planned new market prior to our decision in mid-December 2010 not to expand into this market in 2011.
Over time, as newer markets become established and as our customer base and revenues grow, we expect selling, general and administrative costs to continue to decrease as a percentage of revenue. This trend is also expected when slowing the speed of market expansion, and as more markets achieve positive Adjusted EBITDA results, as experienced in the current periods over the prior periods. Since such costs increase relative to customer growth, however, efficiency gains as a percentage of revenue are adversely impacted by declining ARPU, as illustrated by a decline of 6.6% in SG&A costs per average Core Managed Services customer compared to only a marginal improvement in SG&A costs relative to revenues. In addition, transaction costs related to acquisitions or financing activities may adversely affect selling, general and administrative costs in the short term.
Operating Loss
For the year ended December 31, 2010, our operating loss was $2.9 million compared to an operating loss of $4.7 million for the comparable period ended December 31, 2009. Substantially all of the 2010 operating loss was generated in the fourth quarter, which reflects the incurrence of approximately $1.2 million in costs associated with our Ethernet conversion project, $0.8 million of transaction costs from our Cloud Services acquisitions, and $0.6 million in asset write-offs from abandoning a planned market launch. The remaining fourth quarter 2010 operating loss resulted primarily from the decline in Core Managed Services ARPU. The overall improvement in operating loss from 2009 to 2010 is principally attributable to achieving greater scale in our emerging markets. We had nine markets with operating income during the year ended December 31, 2010, compared to seven markets for the comparable period ended December 31, 2009. Additionally, the reduction in mobile-related device and service costs has also contributed to the decreased operating loss in 2010.
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Other Income (Expense) and Income Taxes (Dollar amounts in thousands)
| For the Year Ended December 31, | Change from Previous Periods |
|||||||||||||||||||||||
| 2010 | 2009 | |||||||||||||||||||||||
| Dollars | % of Revenue |
Dollars | % of Revenue |
Dollars | Percent | |||||||||||||||||||
| Interest income |
$ | 2 | nm | $ | 28 | nm | $ | (26 | ) | (92.9 | )% | |||||||||||||
| Interest expense |
(281 | ) | (0.1 | )% | (152 | ) | nm | (129 | ) | 84.9 | % | |||||||||||||
| Other income, net |
1,867 | 0.4 | % | 498 | 0.1 | % | 1,369 | 274.9 | % | |||||||||||||||
| Income tax (expense) benefit |
(314 | ) | (0.1 | )% | 2,074 | 0.5 | % | (2,388 | ) | (115.1 | )% | |||||||||||||
| Total |
$ | 1,274 | 0.3 | % | $ | 2,448 | 0.6 | % | $ | (1,174 | ) | nm | ||||||||||||
Interest Income. We had insignificant interest income for the year ended December 31, 2010 based on our decision to shift funds from investment to non-interest bearing operating bank accounts. This decision was made because the resulting reduction in bank fees was greater than the amount of interest income we would have earned due to the low rates currently paid on our money market investments.
Interest Expense. The majority of our interest expense for the years ended December 31, 2010 and 2009 relates to commitment fees under our revolving credit facility with our creditor, and were higher in 2010 due to increasing our credit facility from $25.0 million to $40.0 million early in 2010. To a lesser extent, we have also recorded interest expense associated with contingent purchase consideration payable in the future for our recent acquisitions. During years ended December 31, 2010 and 2009, we had no amounts outstanding under our revolving line of credit.
Other income, net. Other income, net relates primarily to adjusting liabilities of our former captive leasing subsidiaries upon the expiration of various statutory periods, as discussed in Note 14 to the consolidated financial statements. During the year ended December 31, 2010, we recognized $1.9 million of income, compared to less than $0.5 million for the comparable period ended December 31, 2009.
Income Tax (Expense) Benefit. In 2010 we recorded income tax expense despite having a pre-tax loss of $1.3 million due to income taxes in states with gross receipts based taxes, which are due regardless of profit levels, and the write-off of certain deferred tax assets associated with share-based transactions (discussed more fully in Note 9 of the consolidated financial statements). We recorded an income tax benefit in 2009 on a pre-tax loss of $4.3 million in 2009. In 2009, we incurred gross receipts based state income taxes as well, but, due to the higher loss before income taxes, they were offset by the effect of the income tax benefit for federal and other non-gross receipts based state taxes. Since gross receipts based taxes are not dependent upon levels of pre-tax income and because we are near break-even at a pre-tax level, these taxes have a significant influence on our effective tax rate. As the operating results for the markets in these states become proportionately less significant to the consolidated results and as consolidated pre-tax income increases, the impact of these gross receipts based taxes on our effective tax rate will decline. The income tax amounts recorded in 2010 and 2009 benefitted from reductions in the deferred tax asset valuation allowance of approximately $0.6 million in each year. Income tax expense for 2010 also included activity related to acquisitions made in 2010, which is discussed more fully in Note 9 of the consolidated financial statements.
Our net deferred tax assets, before valuation allowance, totaled approximately $42.2 million and $43.6 million at December 31, 2010 and 2009, respectively, and primarily relate to net operating loss carryforwards. In order to realize the benefits of the net deferred tax assets of $9.0 million recognized at December 31, 2010, we will need to generate approximately $23.3 million in pre-tax income by the end of 2013, which, based on current projected performance, management expects to be able to meet. The majority of pre-tax income is projected to occur in 2012 and 2013, with 2011 projected to be near break-even. The 2011 results are significantly impacted by the expenses
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associated with the Ethernet conversion project and our integration of the Cloud Services segment, both of which have a significant favorable impact on projected 2012 and 2013 results. If future results are less favorable than our projections or if the projected benefits of our investments fall short of our expectations, we may have to increase our allowance against our net deferred tax asset with a corresponding increase to income tax expense. If we generate taxable income in excess of projections, the result would be a further reduction of the allowance against our net deferred tax asset and a corresponding benefit to income tax expense.
Year Ended December 31, 2009 Compared to Year Ended December 31, 2008
Revenue and Cost of Revenue (Dollar amounts in thousands, except ARPU)
| For the Year Ended December 31, | ||||||||||||||||||||||||
| 2009 | 2008 | Change from Previous | ||||||||||||||||||||||
| Dollars | % of Revenue |
Dollars | % of Revenue |
Dollars | Percent | |||||||||||||||||||
| Revenue: |
||||||||||||||||||||||||
| Customer revenue |
$ | 406,472 | 98.2 | % | $ | 342,874 | 98.0 | % | $ | 63,598 | 18.5 | % | ||||||||||||
| Terminating access revenue |
7,299 | 1.8 | % | 6,826 | 2.0 | % | 473 | 6.9 | % | |||||||||||||||
| Total revenue |
413,771 | 349,700 | 64,071 | 18.3 | % | |||||||||||||||||||
| Cost of revenue (exclusive of depreciation and amortization): |
||||||||||||||||||||||||
| Circuit access fees |
54,219 | 13.1 | % | 45,358 | 13.0 | % | 8,861 | 19.5 | % | |||||||||||||||
| Other cost of revenue |
52,708 | 12.7 | % | 44,051 | 12.6 | % | 8,657 | 19.7 | % | |||||||||||||||
| Mobile cost |
35,635 | 8.6 | % | 27,331 | 7.8 | % | 8,304 | 30.4 | % | |||||||||||||||
| Telecommunications cost recoveries |
(4,469 | ) | (1.1 | )% | (7,067 | ) | (2.0 | )% | 2,598 | (36.8 | )% | |||||||||||||
| Total cost of revenue |
138,093 | 33.4 | % | 109,673 | 31.4 | % | 28,420 | 25.9 | % | |||||||||||||||
| Gross margin (exclusive of depreciation and amortization): |
$ | 275,678 | 66.6 | % | $ | 240,027 | 68.6 | % | $ | 35,651 | 14.9 | % | ||||||||||||
| Customer data: |
||||||||||||||||||||||||
| Core Managed Services customer locations at period end |
50,203 | 42,463 | 7,740 | 18.2 | % | |||||||||||||||||||
| Core Managed Services ARPU |
$ | 744 | $ | 752 | $ | (8 | ) | (1.1 | )% | |||||||||||||||
| Core Managed Services average monthly churn rate |
1.5 | % | 1.3 | % | 0.2 | % | ||||||||||||||||||
Revenue. Total revenue increased for the year ended December 31, 2009 compared to the year ended December 31, 2008 primarily due to an increase in the average number of customers. However, 2009 Core Managed ARPU, or ARPU declined $8 or 1.1% compared to 2008, with the most significant decline occurring during the fourth quarter of 2009 where ARPU declined to $727, or approximately 3.6% lower than the same period in 2008. The decline in ARPU in 2009 was primarily due to increases in the impact of credits and promotional incentives issued to new customers or to retain existing customers, contract renewals at lower base prices and decreased overage charges stemming from lower levels of voice minutes used in excess of minutes included within our base package. We believe these declines were related to the effects of the economic recession on customers and increased competitive pressures. This downward pressure has been partially offset by an increase in the average applications used per customer to 7.4 in the period ended December 31, 2009 from 7.0 in the period ended December 31, 2008. In addition, we recognized benefits related to reductions to promotional obligations of $0.5 million and $0.6 million (both equating to approximately $1 of ARPU) in the years ended December 31, 2009 and 2008, respectively, related to certain customer promotional liabilities recorded in prior periods.
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Revenues from access charges paid to us by other communications companies to terminate calls to our customers increased for the twelve month comparison periods due to our customer growth but have declined as a percentage of ARPU. These terminating access charges have historically grown at a slower rate than our customer base due to our customers’ increased use of mobile services and reductions in access rates on interstate calls as mandated by the FCC.
The following comprises the segment contributions to the increase in revenue in the year ended December 31, 2009 as compared to the year ended December 31, 2008
(Dollar amounts in thousands):
| 2009 | 2008 | Change from Previous | ||||||||||||||||||||||
| Segment Revenue: |
Dollars | % of Revenue |
Dollars | % of Revenue |
Dollars | Percent | ||||||||||||||||||
| Core Managed Services Established Markets |
$ | 398,904 | 96.4 | % | $ | 347,718 | 99.4 | % | 51,186 | 14.7 | % | |||||||||||||
| Core Managed Services Emerging Markets: |
||||||||||||||||||||||||
| Miami |
9,027 | 2.2 | % | 1,396 | 0.4 | % | 7,631 | nm | ||||||||||||||||
| Minneapolis |
4,140 | 1.0 | % | 586 | 0.2 | % | 3,554 | nm | ||||||||||||||||
| Greater Washington, D.C. Area |
1,603 | 0.4 | % | — | nm | 1,603 | nm | |||||||||||||||||
| Seattle |
97 | nm | — | nm | 97 | nm | ||||||||||||||||||
| Core Managed Services total emerging markets |
14,867 | 3.6 | % | 1,982 | 0.6 | % | 12,885 | nm | ||||||||||||||||
| Total Revenue |
$ | 413,771 | $ | 349,700 | $ | 64,071 | 18.3 | % | ||||||||||||||||
Cost of Revenue. The principal driver of the increase in cost of revenue is customer growth. In addition, between 2009 and 2008, we experienced an increase in both the number of mobile handsets sold and the related mobile service costs. These mobile related increases grew at a higher rate than our overall customer growth due to a higher proportion of our customers receiving our mobile services in 2009 than in 2008, driven by both successful marketing of our BeyondMobile service to our existing customer base and a high mobile adoption rate for new customers.
Circuit access fees, or line charges, represent the largest single component of cost of revenue. These costs primarily relate to our lease of T-1 circuits connecting our equipment at network points of collocation to our equipment located at our customers’ premises. The increase in circuit access fees is mainly correlated to the increase in the number of customers.
Mobile-related costs include monthly recurring base charges or usage-based charges, depending on the type of mobile product in service, and the cost of mobile equipment sold to our customers to facilitate their use of our service. These increased monthly recurring mobile service costs have been partially offset by declining per unit rates charged to us by our underlying mobile network provider due to our growing scale and volumes.
The other principal components of cost of revenue include long distance charges, installation costs to connect new circuits, the cost of transport circuits between network points of presence, the cost of local interconnection with the local telephone companies’ networks, internet access costs, the cost of third-party applications we provide to our customers, access costs paid by us to other carriers to terminate calls from our customers and certain taxes and fees.
Telecommunication cost recoveries are an ongoing operational activity that fluctuates from period to period, with occasional transactions that result in benefits that are atypical. In addition to normal activity, and as described in Notes 13 and 14 to the consolidated financial statements, we recognized benefits to cost of revenue of approximately $0.8 million and $2.5 million in the years ended December 31, 2009 and 2008, respectively,
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relating to negotiating settlements that were less than the recorded liabilities. In 2009, we resolved multiple disputes with a large ILEC that covered multiple markets and paid approximately $2.0 million to resolve liabilities of approximately $2.8 million. In 2008, these settlements related to the Georgia Rate Remand accrual and TRRO liabilities (as described below) that spanned long periods of time. We also recognized an additional $0.9 million in benefits to cost of revenue during the year ended December 31, 2008 relating to a change in estimate associated with shortening the back billing limitation period applicable to certain amounts accrued for the Atlanta operating segment.
Selling, General and Administrative (Dollar amounts in thousands)
| For the Year Ended December 31, | ||||||||||||||||||||||||
| 2009 | 2008 | Change from Previous | ||||||||||||||||||||||
| Dollars | % of Revenue |
Dollars | % of Revenue |
Dollars | Percent | |||||||||||||||||||
| Selling, general and administrative (exclusive of depreciation and amortization): |
||||||||||||||||||||||||
| Salaries wages and benefits (excluding share-based compensation) |
$ | 136,898 | 33.1 | % | $ | 113,575 | 32.5 | % | $ | 23,323 | 20.5 | % | ||||||||||||
| Share-based compensation |
15,954 | 3.9 | % | 12,887 | 3.7 | % | 3,067 | 23.8 | % | |||||||||||||||
| Marketing cost |
2,955 | 0.7 | % | 3,029 | 0.9 | % | (74 | ) | (2.4 | ) % | ||||||||||||||
| Other selling, general and administrative |
72,699 | 17.6 | % | 62,863 | 18.0 | % | 9,836 | 15.6 | % | |||||||||||||||
| Total SG&A |
$ | 228,506 | 55.2 | % | $ | 192,354 | 55.0 | % | $ | 36,152 | 18.8 | % | ||||||||||||
| Other operating expenses: |
||||||||||||||||||||||||
| Depreciation and amortization |
51,840 | 12.5 | % | 41,576 | 11.9 | % | 10,264 | 24.7 | % | |||||||||||||||
| Total other operating expenses |
$ | 51,840 | 12.5 | % | $ | 41,576 | 11.9 | % | $ | 10,264 | 24.7 | % | ||||||||||||
| Other data: |
||||||||||||||||||||||||
| SG&A per average Core Managed Services customer |
$ | 411 | $ | 414 | $ | (3 | ) | (0.7 | ) % | |||||||||||||||
| Employees |
1,677 | 1,493 | 184 | 12.3 | % | |||||||||||||||||||
Selling, General and Administrative Expenses and Other Operating Expenses. Selling, general and administrative expenses increased for 2009 compared to 2008 primarily due to increased employee costs. Higher employee costs, which include salaries, wages, and benefits, and commissions paid to our direct sales representatives and sales agents, principally relate to the additional employees necessary to staff new markets and to serve the growth in customers. As a percentage of consolidated revenues, the expense increase in 2009 is primarily attributable to continued staffing of our newer markets, expansion of our corporate-based customer service and data center operations. Selling, general and administrative expenses include an increase of $3.1 million in share-based compensation expense for the year ended December 31, 2009. Over time, as newer markets become established and as our customer base and revenues grow, we expect selling, general and administrative costs to decrease as a percentage of revenue.
Marketing costs remained relatively consistent as a percent of revenues over the prior periods. In general, our marketing costs will increase consistent with past practice as we add customers and expand into new markets.
Other selling, general and administrative expenses include professional fees, outsourced services, rent and other facilities costs, maintenance, recruiting fees, travel and entertainment costs, property taxes and bad debt expense. The increase in this category of costs is primarily due to the addition of new, as well as expanded operations, needed to keep pace with the growth in customers. However, consistent with marketing costs, other selling, general and administrative expenses remained relatively consistent as a percent of revenues over the prior periods.
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Bad debt expense was $9.1 million, or 2.2% of revenues, compared to $6.4 million, or 1.8% of revenues, for the years ended December 31, 2009 and 2008, respectively. The rate of bad debts and customer churn are closely related; therefore, we generally expect fluctuations in each of these metrics to correlate.
Other Income (Expense) (Dollar amounts in thousands)
| For the Year Ended December 31, | ||||||||||||||||||||||||
| 2009 | 2008 | Change from Previous | ||||||||||||||||||||||
| Dollars | % of Revenue |
Dollars | % of Revenue |
Dollars | Percent | |||||||||||||||||||
| Interest income |
$ | 28 | nm | $ | 846 | 0.2 | % | $ | (818 | ) | (96.7 | ) % | ||||||||||||
| Interest expense |
(152 | ) | nm | (224 | ) | (0.1 | ) % | 72 | (32.1 | ) % | ||||||||||||||
| Other income (net) |
498 | 0.1 | % | 71 | nm | 427 | nm | |||||||||||||||||
| Income tax benefit (expense) |
2,074 | 0.5 | % | (3,094 | ) | (0.9 | ) % | 5,168 | (167.0 | ) % | ||||||||||||||
| Total income (expense) |
$ | 2,448 | 0.6 | % | $ | (2,401 | ) | (0.7 | ) % | $ | 4,849 | nm | ||||||||||||
Interest Income. Interest income decreased for the year ended December 31, 2009 primarily as a result of a decision to shift funds from investment to operating bank accounts because the resulting reduction in bank fees was greater than the amount of investment income we would have earned, due to the low rates currently paid on our money market investments. In addition, lower interest rates and lower average cash balances over the year ended December 31, 2009 contributed to the decrease in interest income.
Interest Expense. The majority of our interest expense for the year ended December 31, 2009 and 2008 relates to commitment fees under our revolving credit facility with our creditor. During 2009, we had no amounts outstanding under our revolving line of credit.
Other income, net. Other income, net relates primarily to adjusting liabilities of our former captive leasing subsidiaries upon the expiration of various statutory periods, as discussed in Note 14 to the consolidated financial statements. During the year ended December 31, 2009, we recognized $0.5 million of income, compared to less than $0.1 million for the comparable period ended December 31, 2008.
Income Tax Benefit/(Expense). We recorded an income tax benefit for 2009 compared to income tax expense in 2008 because we incurred a loss before income taxes of $4.3 million in 2009 compared to achieving income before income taxes of $6.8 million in 2008. The income tax benefit for 2009 is net of state income tax expense that results from states with gross-receipts based taxes, which are due regardless of profit levels. The amounts recorded in 2009 and 2008 also benefitted from reductions in the deferred tax asset valuation allowance of approximately $0.6 million in 2009 and $0.7 million in 2008. Additionally, the 2009 income tax benefit reflected a benefit from amounts associated with provision to return adjustments and decreased tax expense associated with share based transactions, which are more fully described in Note 9 of the consolidated financial statements.
Our net deferred tax assets, before valuation allowance, totaled approximately $43.6 million and $41.4 million at December 31, 2009 and 2008, respectively, and primarily relate to net operating loss carryforwards. Due to our history of losses, we had a full valuation allowance against this net deferred tax asset in periods prior to the fourth quarter of 2007. During the fourth quarter of 2007, we concluded that there was sufficient positive evidence present, such that we will be able to utilize a portion of these loss carryforwards to offset future taxable income, resulting in a partial reduction of the allowance against the asset to reflect the amount of net deferred tax assets that are more likely than not to be realized.
Segment Data
We monitor and analyze our financial results on a segment basis for reporting and management purposes, as is presented in Note 13 to our consolidated financial statements hereto.
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Liquidity and Capital Resources (Dollar amounts in thousands)
| For the Year Ended December 31, | Change from Previous Period | |||||||||||||||||||||||||||
| Dollars | Percent | |||||||||||||||||||||||||||
| 2010 | 2009 | 2008 | 2010 v 2009 | 2009 v 2008 | 2010 v 2009 | 2009 v 2008 | ||||||||||||||||||||||
| Cash Flows: |
||||||||||||||||||||||||||||
| Provided by operating activities |
$ | 79,149 | $ | 62,610 | $ | 48,628 | $ | 16,539 | $ | 13,982 | 26.4 | % | 28.8 | % | ||||||||||||||
| Used in investing activities |
(92,619 | ) | (60,729 | ) | (67,640 | ) | (31,890 | ) | 6,911 | 52.5 | % | (10.2 | ) % | |||||||||||||||
| Provided by financing activities |
576 | 411 | (187 | ) | 165 | 598 | 40.1 | % | (319.8 | ) % | ||||||||||||||||||
| Net (decrease)/increase in cash and cash equivalents |
$ | (12,894 | ) | $ | 2,292 | $ | (19,199 | ) | $ | (15,186 | ) | $ | 21,491 | (662.6 | ) % | (111.9 | ) % | |||||||||||
At December 31, 2010, we had cash and cash equivalents of $26.4 million. The available cash and cash equivalents are held in our bank accounts and money market accounts. The money market accounts invest primarily in direct Treasury obligations of the United States government. To date, we have not experienced any loss or lack of access to our invested cash or cash equivalents; however, we can provide no assurances that access to our invested cash and cash equivalents will not be impacted by adverse conditions in the financial markets.
At any point in time, we may have significant cash in our operating accounts with third-party financial institutions that exceed the Federal Deposit Insurance Corporation insurance limits. While we monitor the daily cash balances in our operating accounts and adjust the cash balances as appropriate, these cash balances could be impacted if the underlying financial institutions fail or become subject to other adverse conditions in the financial markets. To date we have not experienced any loss or lack of access to cash in our operating accounts. We have a corporate banking relationship with Bank of America, N.A (or “Bank of America”).
Cash Flows From Operations. Operating cash flows increased primarily from increased revenues along with a higher number of markets that are achieving positive operating cash flows in 2010 and a narrowing of the losses we are incurring in earlier stage markets as they make progress towards profitability. Furthermore as evident in our bad debt expense reduction, collection of accounts receivable has improved in the current year period compared to the prior year period, which is driving $5.6 million of positive cash flow increase over the prior year. We have also experienced cash flow savings from decreasing our inventory purchases as we have a lower percentage of new customers electing to include mobile services in their package. Additionally, as noted below we paid $2.0 million of accrued telecommunication cost settlement in 2009, with no comparable settlements in 2010. These increased operating cash flows were partially offset by higher annual bonus payments made in the current period as well as cash used in and to support our newer markets that do not yet generate positive cash flows from operations. Operating cash flows will also fluctuate favorably or unfavorably depending on the timing of significant vendor payments.
Operating cash flows increased during the year ended December 31, 2009 from the comparable period in 2008 by $14.0 million, or 28.8%. Operating cash flows increased primarily from increased revenues along with an increased number of sales markets that are achieving positive operating cash flows in 2009. These increased operating cash flows were partially offset by additional payments to suppliers and vendors to support these revenues during the year ended December 31, 2009. The increased cash flows from increased revenues were also partially offset by cash used in and to support our newer markets that do not yet generate positive cash flows from operations, as well as those markets we are preparing to launch. Operating cash provided in 2009 includes $1.9 million in lower annual bonuses and other annual compensation payments in 2009 as compared to 2008, as well as settlements in 2009 and 2008 and payments of approximately $2.0 million and $2.9 million related to accrued telecommunication costs from earlier periods that had been in dispute, respectively.
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Cash Flows From Investing Activities. Our principal cash investments are purchases of property and equipment, which fluctuate depending on growth in customers in our existing markets; the timing and number of facility and network additions needed to support our entry into new markets, expand existing markets and upgrade our network; enhancements and development costs related to our operational support systems in order to offer additional applications and services to our customers; and increases to the capacity of our data centers as our customer base and the breadth of our product portfolio expand. In addition, we have made initial investments in the deployment of Ethernet technology to reduce operating expenses and enable the provision of higher bandwidth services to our customers, and we expect to increase our Ethernet investment in future periods. We believe that capital efficiency is a key advantage of the IP-based network technology that we employ. Our cash purchases of property and equipment were $62.0 million, $60.7 million and $67.6 million for 2010, 2009 and 2008, respectively. We also incurred non-cash purchases of property and equipment, primarily related to leasehold improvements, which was $0.9 million, $1.5 million and $2.3 million in the 2010, 2009 and 2008, respectively.
Additionally, in the fourth quarter of 2010 we closed our Cloud Services acquisitions and paid closing date consideration of $30.6 million, net of cash acquired. In addition, we expect to pay up to an additional $7.0 million of contingent consideration related to these acquisitions in 2011 and 2012.
Cash Flows From Financing Activities. Cash flows provided by or used in financing activities for all periods presented relate to activity associated with employee stock option exercises and vesting of restricted shares.
We believe that cash on hand plus cash generated from operating activities will be sufficient to fund capital expenditures, operating expenses and other cash requirements associated with our future market expansion plan, depending on economic, regulatory and other conditions. Macroeconomic conditions are expected to continue to have an impact on our cash flows and customer churn rate. Our business plan assumes that cash flow from operating activities of our established markets will offset the negative cash flows from operating activities and cash flows from investing activities with respect to the additional markets we plan to launch. However, due to our recent acquisitions and our Ethernet conversion project, we do not intend to open a new market in 2011 and plan to resume our market expansion plan in 2012. We intend to adhere to our policy of fully funding all future market expansions in advance and do not anticipate entering markets without having more than sufficient cash on hand or borrowing capacity to cover projected cash needs. We believe that cash on hand is more than sufficient to fund normal operations in 2011 and beyond, including our Ethernet conversion project and our investment in the Cloud Services business. Depending on the speed of conversions, opportunities for increased conversions, and the potential for acceleration of the growth rate in Cloud Services, it is possible that our cash outflows for these investments may not coincide on a short-term basis with cash inflows. In such a circumstance, we may consider it prudent to temporarily draw against our line of credit facility. Further,while we do not anticipate a need for additional access to capital or new financing aside from our line of credit facility in the near term, we monitor the capital markets and may access those markets if our business prospects or plans change resulting in a need for additional capital, or if additional capital that may be needed can be obtained on favorable terms.
Commitments. The following table summarizes our commitments as of December 31, 2010, including commitments pursuant to debt agreements and operating lease obligations:
| Payments Due by Period (Dollars in thousands) |
||||||||||||||||||||
| Contractual Obligations |
Less than 1 Year |
1 to 3 Years | 3 to 5 years | More than 5 Years |
Total | |||||||||||||||
| Operating lease obligations (1) |
$ | 10,298 | $ | 20,849 | $ | 17,401 | $ | 8,383 | $ | 56,931 | ||||||||||
| Purchase commitments (2) |
8,854 | 1,837 | — | — | 10,691 | |||||||||||||||
| Contingent consideration liability (3) |
789 | 6,035 | — | — | 6,824 | |||||||||||||||
| Anticipated interest payments (4) |
289 | 600 | 600 | 33 | 1,522 | |||||||||||||||
| Total |
$ | 20,230 | $ | 29,321 | $ | 18,001 | $ | 8,416 | $ | 75,968 | ||||||||||
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| (1) | We lease office space in several U.S. locations. Operating lease amounts include future minimum lease payments under all our noncancelable operating leases with an initial term in excess of one year. |
| (2) | Purchase commitments represent an estimate of all open purchase orders and contractual obligations in the ordinary course of business for which we have not received the goods or services. |
| (3) | Represents the contingent consideration liability related to the acquisitions of MaximumASP and Aretta (see Note 4 to the consolidated financial statements). |
| (4) | Anticipated interest payments primarily represent commitment fees related to our open, but unused, line of credit as amended in February 2011. |
We are required under certain contractual obligations to maintain letters of credit. As of December 31, 2010, we had outstanding letters of credit totaling $1.3 million, which expire at various dates through May 2018.
Revolving Line of Credit
In addition to the sources of cash noted above, we are party to a credit agreement with Bank of America through our subsidiary, Cbeyond Communications, LLC, or LLC, which provides for a secured revolving line of credit. The credit agreement terms were subsequently amended on July 2, 2007, February 24, 2009, March 3, 2010 and February 22, 2011. As of December 31, 2010, we have an open, undrawn $40.0 million revolving line of credit with Bank of America, of which $38.7 million is available. Availability was reduced due to $1.3 million in letters of credit, which are outstanding under the revolving line of credit. The letters of credit are collateralized by our restricted cash.
On February 22, 2011 we entered into the fourth amendment of the credit agreement with Bank of America. The amendment increases the available revolving line of credit from $40.0 million to $75.0 million and extends the termination to February 22, 2016. The amendment also makes certain modifications to the interest and fees, including the applicable margins based on redefined tiers, as well as the commitment fee. The amendment also modifies certain financial covenants. The amendment retains substantially all other stipulations of the original credit agreement. As of the date of this filing, no amounts were drawn on the amended facility, and we had $73.7 million in available capacity. The following description of the line of credit briefly summarizes the facility’s terms and conditions that are material to us.
General. The amended secured revolving line of credit will terminate on February 22, 2016 extended from the original maturity date of March 3, 2013. The revolving line of credit will be available to finance working capital, capital expenditures and other general corporate purposes. Within the facility we have access to a cash management line of credit for up to $5.0 million for cash management purposes. All borrowings will be subject to the satisfaction of customary conditions, including absence of a default and accuracy of representations and warranties.
Interest and Fees. The interest rates applicable to loans under the revolving line of credit are floating interest rates that, at our option, will equal a London Interbank Offered Rate, or LIBO rate, or an alternate base rate plus, in each case, an applicable margin. The current base rate is a fluctuating interest rate equal to the higher of (a) the prime rate of interest per annum publicly announced from time to time by Bank of America, as administrative agent, as its prime rate in effect at its principal office in New York City; (b) the overnight federal funds rate plus 0.50%; and (c) the Eurodollar base rate plus 1.0%. The interest periods of the Eurodollar loans are one, two, three or six months, at our option. The amended applicable margins for LIBO rate loans or alternate base rate loans are as follows, based on the relative usage amounts:
| Usage Amount |
Eurodollar Rate |
Base Rate |
||||||
| Zero to $75.0 million |
1.75 | % | 0.75 | % | ||||
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The amended credit agreement superseded the following applicable margins and relative usage amounts, as of December 31, 2010:
| Usage Amount |
Eurodollar Rate |
Base Rate |
||||||
| Zero to $13.3 million |
2.25 | % | 1.25 | % | ||||
| $13.3 to $26.7 million |
2.50 | % | 1.50 | % | ||||
| $26.7 to $40.0 million |
2.75 | % | 1.75 | % | ||||
In addition, we are required to pay to Bank of America under the amended revolving line of credit a commitment fee for unused commitments at a per annum rate of 0.40% (or 0.50% as of December 31, 2010).
Prepayments. Voluntary prepayments of loans and voluntary reductions in the unused commitments under the revolving line of credit are permitted in whole or in part, in minimum amounts and subject to certain other limitations. Mandatory prepayments are required in an amount equal to 100% of the net cash proceeds of all asset sales or dispositions received by us or our subsidiary greater than $0.5 million in any calendar year and 100% of the net proceeds from the issuance of any debt, other than permitted debt. Mandatory prepayments will permanently reduce the revolving credit commitment.
Security. The credit agreement is secured by all assets of LLC and is guaranteed by Cbeyond, Inc. (the Parent). All assets of the consolidated entity reside with the LLC entity. In addition, Cbeyond, Inc. has no operations other than those conducted by LLC. Accordingly, all income and cash flows from operations are generated by and belong to LLC and all assets appearing on the consolidated financial statements secure the credit facility. In addition, the facility contains certain restrictive covenants that effectively prohibit us from paying cash dividends.
Covenants and Other Matters. The revolving line of credit requires us to comply with certain financial covenants, including minimum consolidated adjusted EBITDA, minimum leverage ratio, as determined by our debt divided by adjusted EBITDA, and maximum capital expenditures.
The revolving line of credit also includes certain negative covenants restricting or limiting our ability to, among other things:
| • | declare dividends or redeem or repurchase capital stock or make other stockholder distributions; |
| • | prepay, redeem or purchase certain debt; |
| • | guarantee or incur additional debt, other than certain permitted indebtedness, including permitted purchase money indebtedness and capital leases; |
| • | engage in sale leaseback transactions; |
| • | make loans or investments; |
| • | grant liens or other security interests to third parties, other than in connection with permitted indebtedness and capital leases; |
| • | engage in mergers, acquisitions, investments in other businesses, or other business combinations; |
| • | transfer assets; |
| • | change our fiscal reporting periods or method of accounting; and |
| • | enter into transactions with affiliates. |
The revolving line of credit also contains certain customary representations and warranties, affirmative covenants, notice provisions, indemnification and events of default, including change of control, cross-defaults to other debt and judgment defaults.
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Off-Balance Sheet Arrangements
We have no off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on our financial condition, results of operations, liquidity, capital expenditures or capital resources.
Critical Accounting Policies and Estimates
We prepare consolidated financial statements in accordance with GAAP in the United States, which require us to make estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures in our consolidated financial statements and accompanying notes. We believe that of our significant accounting policies, which are described in Note 2 to the consolidated financial statements included herein, those discussed below involved a higher degree of judgment and complexity and are therefore considered critical. While we have used our best estimates based on the facts and circumstances available to us at the time, different estimates reasonably could have been used in the current period, or changes in the accounting estimates that we used are reasonably likely to occur from period to period which may have a material impact on the presentation of our financial condition and results of operations. Although we believe that our estimates, assumptions and judgments are reasonable, they are based upon information presently available. Actual results may differ significantly from these estimates under different assumptions, judgments or conditions.
Revenue Recognition. Our marketing promotions include various rebates and customer reimbursements that fall under the scope of ASC 605-25, Multiple Arrangements, and ASC 605-50, Customer Payments/Incentives. In accordance with these pronouncements, we record these promotions as a reduction in revenue when earned by the customer. When these promotions are earned over time, we ratably allocate the cost of honoring the promotions over the underlying promotion period as a reduction in revenue. ASC 605-50 also requires that measurement of the obligation should be based on the estimated number of customers that will ultimately earn and claim the promotion. Accordingly, we recognize the benefit of estimated breakage on customer promotions when such amounts are reasonably estimable.
Property, Equipment and Other Long Lived Assets. We utilize significant amounts of property and equipment in providing services to our customers. We use straight-line depreciation for property, equipment, and leasehold improvements over the shorter of the life of the lease or estimated useful lives. Changes in technology or changes in the intended use of property and equipment may cause the estimated useful life or the value of these assets to change. We periodically review the appropriateness of the estimated economic useful lives for each category of property and equipment.
Periodically we assess potential impairment of our property and equipment. We perform an impairment review whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. Factors we consider important which could trigger an impairment review include, but are not limited to, significant under-performance relative to historical or projected future operating results, significant changes in the manner of our use of the acquired assets or our overall business strategy, and significant industry or economic trends. When we determine that the carrying value of a long-lived asset may not be recoverable based upon the existence of one or more of the above indicators, we determine the recoverability by comparing the carrying amount of the asset to net future undiscounted cash flows that the asset is expected to generate. We recognize an impairment charge equal to the amount by which the carrying amount exceeds the fair market value of the asset.
Software Development. We capitalize the salaries and payroll-related costs of employees and consultants who devote time to the development of certain internal-use software projects. If a project constitutes an enhancement to previously developed software, we assess whether the enhancement is significant and creates additional functionality to the software, thus resulting in capitalization. All other software development costs are expensed as incurred. We amortize capitalized software development costs over estimated useful lives of the software.
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Goodwill and Intangible Assets. Goodwill, which consists of the excess of the purchase price over the fair value of identifiable net assets of businesses acquired, will be evaluated for impairment on an annual basis on October 1, or whenever events or circumstances indicate that impairment may have occurred. The goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. When evaluating goodwill for impairment, we will first compare the book value of net assets to the fair value of the related operations. If the fair value is determined to be less than book value, a second step will be performed to compute the amount of impairment. We will estimate fair value using a discounted cash flow methodology. We allocate goodwill to reporting units based on the reporting unit expected to benefit from the combination. We will evaluate our reporting units on an annual basis and, if necessary, reassign goodwill using a relative fair value allocation approach. As 2010 was the initial year that goodwill was recorded, we will begin our annual impairment analysis as of October 1, 2011.
Intangible assets, including developed technology, customer relationships, non-compete agreements and trade names arising principally from acquisitions, are recorded at cost less accumulated amortization. For intangible assets subject to amortization, impairment is recognized if the carrying amount is not recoverable and the carrying amount exceeds the fair value of the intangible asset.
There are many assumptions and estimates used that directly impact the results of impairment testing, including an estimate of future expected revenue, earnings and cash flows, and discount rates applied to such expected cash flows in order to estimate fair value. Changes in these estimates and assumptions could materially affect the estimated fair value of an asset.
Contingencies. We accrue for contingent obligations, including estimated legal costs, when the obligation is probable and the amount is reasonably estimable. As facts concerning contingencies become known, we reassess our position and make appropriate adjustments to the financial statements. Estimates that are particularly sensitive to future changes include those related to tax, legal, and other regulatory matters, changes in the interpretation and enforcement of international laws, and the impact of local economic conditions and practices, which are all subject to change as events evolve and as additional information becomes available during the administrative and litigation process.
Allowance for Doubtful Accounts. We have established an allowance for doubtful accounts through charges to selling, general and administrative expenses. The allowance is established based upon the amount we ultimately expect to collect from customers and is estimated based on a number of factors, including a specific customer’s ability to meet its financial obligations to us, as well as general factors, such as the length of time the receivables are past due, historical collection experience and the general economic environment. Customer accounts are typically written off against the allowance approximately sixty to ninety days after disconnection of the customers’ service, when our direct collection efforts cease. Generally, customer accounts are considered delinquent and the service disconnection process begins when they are sixty days in arrears. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, or if economic conditions worsened, additional allowances may be required in the future, which could have a material effect on our consolidated financial statements. If we made different judgments or utilized different estimates for any period, material differences in the amount and timing of our expenses could result.
Share-Based Compensation. In accordance with ASC 718, Stock Compensation, we account for shared-based compensation expense using the fair value recognition provisions of ASC 718. Share-based compensation expense is measured at the grant date based on the fair value of the award as calculated by the lattice binomial option-pricing model and is recognized as expense on a straight-line basis over the requisite service period, after estimating the effect of forfeitures. Option valuation models involve input assumptions that are subjective, and hence, may result in option value that is not equal to that of the fair value observed in a market transaction between a willing buyer and willing seller. Additionally, estimated forfeiture rates assumptions are based on historical rates, and may not be indicative of future forfeiture behavior.
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Valuation Allowances for Deferred Tax Assets. We provide for the effect of income taxes on our financial position and results of operations in accordance with ASC 740, Income Taxes. Under this accounting pronouncement, income tax expense is recognized for the amount of income taxes payable or refundable for the current year and for the change in net deferred tax assets or liabilities resulting from events that are recorded for financial reporting purposes in a different reporting period than recorded in the tax return. We made assumptions, judgments and estimates to determine our current provision for income taxes and also our deferred tax assets and liabilities and any valuation allowance to be recorded against our net deferred tax asset.
Our judgments, assumptions and estimates relative to the current provision for income tax take into account current tax laws, our interpretation of current tax laws and, allowable deductions. Changes in tax law or our interpretation of tax laws could materially impact the amounts provided for income taxes in our consolidated financial position and consolidated results of operations. Our assumptions, judgments and estimates relative to the value of our net deferred tax asset take into account predictions of the amount and category of future taxable income. Actual consolidated operating results and the underlying amount and category of income or loss in future years could render our current assumptions, judgments and estimates of recoverable net deferred taxes inaccurate, thus materially impacting our consolidated financial position and consolidated results of operations.
Our valuation allowance for our net deferred tax asset is designed to take into account the uncertainty surrounding the realization of our net operating losses and our other deferred tax assets.
Recently Issued Accounting Standards
For information about recently issued accounting standards, refer to Note 3 to our consolidated financial statements.
| Item 7A. | Quantitative and Qualitative Disclosures About Market Risk |
Interest Rate Risk
All of our financial instruments that are sensitive to interest rate risk are entered into for purposes other than trading. We invest in instruments that meet high credit quality standards as specified in our investment policy guidelines. At December 31, 2010, all cash and cash equivalents that are held in money market funds invest primarily in short-term U.S. Treasury Obligations and are immediately available cash balances. Accordingly, our exposure to market risk primarily relates to changes in interest rates received on our investment in money market funds and immediately available cash. Management estimates that if the average yield of our investments changed by 100 basis points, our interest income for the year ended December 31, 2010 would have changed by less than $0.1 million. This estimate assumes that the change occurred on the first day of 2010 and that all cash and cash equivalents are held in money market funds. However as of December 31, 2010, the majority of our cash is held in operating bank accounts. The impact on our future interest income of future changes in investment yields will depend largely on our total investments.
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| Item 8. | Consolidated Financial Statements and Supplementary Data |
Report of Independent Registered Public Accounting Firm
On Internal Control Over Financial Reporting
The Board of Directors and Stockholders of
Cbeyond, Inc. and Subsidiaries
We have audited Cbeyond, Inc. and Subsidiaries’ (the “Company”) internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). The Company’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
As indicated in the accompanying Management’s Annual Report on Internal Control over Financial Reporting, management’s assessment of and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of MaximumASP and Aretta Communications, Inc., which are included in the 2010 consolidated financial statements of the Company and constituted $42.3 million and $33.7 million of total and net assets, respectively, as of December 31, 2010 and $1.8 million and $0.1 million of revenues and net income, respectively, for the year then ended. Our audit of internal control over financial reporting of the Company also did not include an evaluation of the internal control over financial reporting of MaximumASP and Aretta Communications, Inc.
In our opinion, Cbeyond, Inc. and Subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2010, based on the COSO criteria.
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We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of the Company as of December 31, 2010 and 2009, and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2010 of the Company, and our report dated March 10, 2011 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Atlanta, Georgia
March 10, 2011
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Report of Independent Registered Public Accounting Firm
On the Consolidated Financial Statements
The Board of Directors and Stockholders of
Cbeyond, Inc. and Subsidiaries
We have audited the accompanying consolidated balance sheets of Cbeyond, Inc. and Subsidiaries (the “Company”) as of December 31, 2010 and 2009, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2010. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Cbeyond, Inc. and Subsidiaries at December 31, 2010 and 2009, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2010, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 10, 2011 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Atlanta, Georgia
March 10, 2011
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CBEYOND, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Amounts in thousands, except par value amounts)
| As of | ||||||||
| December 31, 2010 |
December 31, 2009 |
|||||||
| ASSETS |
||||||||
| Current assets: |
||||||||
| Cash and cash equivalents |
$ | 26,373 | $ | 39,267 | ||||
| Accounts receivable, gross |
27,238 | 30,467 | ||||||
| Less: Allowance for doubtful accounts |
(2,354 | ) | (2,867 | ) | ||||
| Accounts receivable, net |
24,884 | 27,600 | ||||||
| Prepaid expenses |
9,665 | 7,261 | ||||||
| Inventory, net |
2,243 | 2,676 | ||||||
| Deferred tax asset, net |
938 | 1,426 | ||||||
| Other assets |
706 | 1,343 | ||||||
| Total current assets |
64,809 | 79,573 | ||||||
| Property and equipment, gross |
421,173 | 353,616 | ||||||
| Less: Accumulated depreciation and amortization |
(270,482 | ) | (216,722 | ) | ||||
| Property and equipment, net |
150,691 | 136,894 | ||||||
| Goodwill |
20,537 | — | ||||||
| Intangible assets |
10,397 | — | ||||||
| Less: Accumulated amortization |
(248 | ) | — | |||||
| Intangible assets, net |
10,149 | — | ||||||
| Restricted cash |
1,295 | 1,243 | ||||||
| Non-current deferred tax asset, net |
8,068 | 8,331 | ||||||
| Other non-current assets |
2,418 | 2,850 | ||||||
| Total assets |
$ | 257,967 | $ | 228,891 | ||||
| LIABILITIES AND STOCKHOLDERS’ EQUITY |
||||||||
| Current liabilities: |
||||||||
| Accounts payable |
$ | 15,193 | $ | 12,121 | ||||
| Accrued telecommunications costs |
16,948 | 13,705 | ||||||
| Deferred customer revenue |
10,958 | 10,047 | ||||||
| Other accrued liabilities |
24,489 | 23,899 | ||||||
| Current portion of contingent consideration |
789 | — | ||||||
| Total current liabilities |
68,377 | 59,772 | ||||||
| Other non-current liabilities |
10,434 | 10,514 | ||||||
| Contingent consideration |
6,035 | — | ||||||
| Stockholders’ equity: |
||||||||
| Common stock, $0.01 par value; 50,000 shares authorized; 29,577 and 28,973 shares issued and outstanding, respectively |
296 | 290 | ||||||
| Preferred stock, $0.01 par value; 15,000 shares authorized; no shares issued and outstanding |
— | — | ||||||
| Additional paid-in capital |
299,501 | 283,337 | ||||||
| Accumulated deficit |
(126,676 | ) | (125,022 | ) | ||||
| Total stockholders’ equity |
173,121 | 158,605 | ||||||
| Total liabilities and stockholders’ equity |
$ | 257,967 | $ | 228,891 | ||||
See accompanying notes.
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CBEYOND, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Amounts in thousands, except per share amounts)
| For the Year Ended December 31, | ||||||||||||
| 2010 | 2009 | 2008 | ||||||||||
| Revenue: |
||||||||||||
| Customer revenue |
$ | 444,848 | $ | 406,472 | $ | 342,874 | ||||||
| Terminating access revenue |
7,117 | 7,299 | 6,826 | |||||||||
| Total revenue |
451,965 | 413,771 | 349,700 | |||||||||
| Operating expenses: |
||||||||||||
| Cost of revenue (exclusive of depreciation and amortization of $34,843, $31,838 and $27,779, respectively, shown separately below) |
146,507 | 138,093 | 109,673 | |||||||||
| Selling, general and administrative (exclusive of depreciation and amortization of $24,461, $20,002 and $13,797, respectively, shown separately below) |
248,327 | 228,506 | 192,354 | |||||||||
| Transaction costs |
755 | — | — | |||||||||
| Depreciation and amortization |
59,304 | 51,840 | 41,576 | |||||||||
| Total operating expenses |
454,893 | 418,439 | 343,603 | |||||||||
| Operating (loss) income |
(2,928 | ) | (4,668 | ) | 6,097 | |||||||
| Other income (expense): |
||||||||||||
| Interest income |
2 | 28 | 846 | |||||||||
| Interest expense |
(281 | ) | (152 | ) | (224 | ) | ||||||
| Other income, net |
1,867 | 498 | 71 | |||||||||
| (Loss) income before income taxes |
(1,340 | ) | (4,294 | ) | 6,790 | |||||||
| Income tax (expense) benefit |
(314 | ) | 2,074 | (3,094 | ) | |||||||
| Net (loss) income |
$ | (1,654 | ) | $ | (2,220 | ) | $ | 3,696 | ||||
| Net (loss) income per common share: |
||||||||||||
| Basic |
$ | (0.06 | ) | $ | (0.08 | ) | $ | 0.13 | ||||
| Diluted |
$ | (0.06 | ) | $ | (0.08 | ) | $ | 0.12 | ||||
| Weighted average common shares outstanding: |
||||||||||||
| Basic |
29,366 | 28,753 | 28,339 | |||||||||
| Diluted |
29,366 | 28,753 | 29,589 | |||||||||
See accompanying notes.
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CBEYOND, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(Amounts in thousands)
| Common Stock |
Additional Paid-in Capital |
Accumulated Deficit |
Total Stockholders’ Equity |
|||||||||||||||||
| Shares | Par Value |
|||||||||||||||||||
| Balance at December 31, 2007 |
28,208 | 282 | 253,534 | (126,498 | ) | 127,318 | ||||||||||||||
| Exercise of stock options |
75 | 1 | 764 | — | 765 | |||||||||||||||
| Issuance of employee benefit plan stock |
95 | — | 1,409 | — | 1,409 | |||||||||||||||
| Share-based compensation from options to employees |
— | — | 7,387 | — | 7,387 | |||||||||||||||
| Share-based compensation from restricted shares to employees |
— | — | 3,741 | — | 3,741 | |||||||||||||||
| Share-based compensation for non-employees |
— | — | 171 | — | 171 | |||||||||||||||
| Vesting of restricted shares |
76 | 1 | (1 | ) | — | — | ||||||||||||||
| Common stock withheld as payment for withholding taxes upon the vesting of restricted shares |
(19 | ) | — | (314 | ) | — | (314 | ) | ||||||||||||
| Tax effect of share-based payments |
— | — | (638 | ) | — | (638 | ) | |||||||||||||
| Net income |
— | — | — | 3,696 | 3,696 | |||||||||||||||
| Balance at December 31, 2008 |
28,435 | 284 | 266,053 | (122,802 | ) | 143,535 | ||||||||||||||
| Exercise of stock options |
228 | 2 | 1,235 | — | 1,237 | |||||||||||||||
| Issuance of employee benefit plan stock |
165 | 2 | 3,383 | — | 3,385 | |||||||||||||||
| Share-based compensation from options to employees |
— | — | 7,246 | — | 7,246 | |||||||||||||||
| Share-based compensation from restricted shares to employees |
— | — | 6,031 | — | 6,031 | |||||||||||||||
| Share-based compensation for non-employees |
— | — | 217 | — | 217 | |||||||||||||||
| Vesting of restricted shares |
200 | 2 | (2 | ) | — | — | ||||||||||||||
| Common stock withheld as payment for withholding taxes upon the vesting of restricted shares |
(55 | ) | — | (816 | ) | — | (816 | ) | ||||||||||||
| Tax effect of share-based payments |
— | — | (10 | ) | — | (10 | ) | |||||||||||||
| Net loss |
— | — | — | (2,220 | ) | (2,220 | ) | |||||||||||||
| Balance at December 31, 2009 |
28,973 | $ | 290 | $ | 283,337 | $ | (125,022 | ) | $ | 158,605 | ||||||||||
| Exercise of stock options |
233 | 2 | 2,094 | — | 2,096 | |||||||||||||||
| Issuance of employee benefit plan stock |
83 | 1 | 2,317 | — | 2,318 | |||||||||||||||
| Share-based compensation from options to employees |
— | — | 4,236 | — | 4,236 | |||||||||||||||
| Share-based compensation from restricted shares to employees |
— | — | 8,828 | — | 8,828 | |||||||||||||||
| Share-based compensation for non-employees |
— | — | 289 | — | 289 | |||||||||||||||
| Vesting of restricted shares |
388 | 4 | (4 | ) | — | — | ||||||||||||||
| Common stock withheld as payment for withholding taxes upon the vesting of restricted shares |
(100 | ) | (1 | ) | (1,310 | ) | — | (1,311 | ) | |||||||||||
| Write-off of deferred tax asset for non-deductible share-based compensation |
— | — | (286 | ) | — | (286 | ) | |||||||||||||
| Net income |
— | — | — | (1,654 | ) | (1,654 | ) | |||||||||||||
| Balance at December 31, 2010 |
29,577 | $ | 296 | $ | 299,501 | $ | (126,676 | ) | $ | 173,121 | ||||||||||
See accompanying notes.
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CBEYOND, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Amounts in thousands)
| For the Year Ended December 31, | ||||||||||||
| 2010 | 2009 | 2008 | ||||||||||
| Operating Activities: |
||||||||||||
| Net (loss) income |
$ | (1,654 | ) | $ | (2,220 | ) | $ | 3,696 | ||||
| Adjustments to reconcile net (loss) income to net cash provided by operating activities: |
||||||||||||
| Depreciation and amortization |
59,304 | 51,840 | 41,576 | |||||||||
| Deferred taxes |
(586 | ) | (2,731 | ) | 2,597 | |||||||
| Provision for doubtful accounts |
7,459 | 9,053 | 6,406 | |||||||||
| Other non-cash income, net |
(1,867 | ) | (498 | ) | (71 | ) | ||||||
| Non-cash share-based compensation |
15,591 | 15,954 | 12,887 | |||||||||
| Tax effect of share-based payments |
— | 10 | 638 | |||||||||
| Accretion of acquistion-related contingent consideration |
22 | — | — | |||||||||
| Changes in operating assets and liabilities: |
||||||||||||
| Accounts receivable |
(4,687 | ) | (10,268 | ) | (9,625 | ) | ||||||
| Inventory |
437 | 1,351 | (1,166 | ) | ||||||||
| Prepaid expenses and other current assets |
(1,736 | ) | (1,053 | ) | (1,523 | ) | ||||||
| Other assets |
641 | (177 | ) | (1,652 | ) | |||||||
| Accounts payable |
1,644 | 1,325 | (2,187 | ) | ||||||||
| Other liabilities |
4,581 | 24 | (2,948 | ) | ||||||||
| Net cash provided by operating activities |
79,149 | 62,610 | 48,628 | |||||||||
| Investing Activities: |
||||||||||||
| Purchases of property and equipment |
(61,962 | ) | (60,650 | ) | (67,611 | ) | ||||||
| Acquisition of MaximumASP, net of cash acquired |
(28,317 | ) | — | — | ||||||||
| Acquisition of Aretta, net of cash acquired |
(2,288 | ) | — | — | ||||||||
| Increase in restricted cash |
(52 | ) | (79 | ) | (29 | ) | ||||||
| Net cash used in investing activities |
(92,619 | ) | (60,729 | ) | (67,640 | ) | ||||||
| Financing Activities: |
||||||||||||
| Taxes paid on vested restricted shares |
(1,311 | ) | (816 | ) | (314 | ) | ||||||
| Financing issuance costs |
(209 | ) | — | — | ||||||||
| Tax effect of share-based payments |
— | (10 | ) | (638 | ) | |||||||
| Proceeds from exercise of stock options |
2,096 | 1,237 | 765 | |||||||||
| Net cash provided by financing activities |
576 | 411 | (187 | ) | ||||||||
| Net increase (decrease) in cash and cash equivalents |
(12,894 | ) | 2,292 | (19,199 | ) | |||||||
| Cash and cash equivalents at beginning of period |
39,267 | 36,975 | 56,174 | |||||||||
| Cash and cash equivalents at end of period |
$ | 26,373 | $ | 39,267 | $ | 36,975 | ||||||
| Supplemental disclosure: |
||||||||||||
| Interest paid |
$ | 195 | $ | 131 | $ | 129 | ||||||
| Income taxes paid |
$ | 891 | $ | 1,450 | $ | 167 | ||||||
| Non-cash purchases of property and equipment |
$ | 870 | $ | 1,476 | $ | 2,329 | ||||||
See accompanying notes.
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CBEYOND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010
(Amounts in thousands, except per share amounts)
1. Description of Business
Cbeyond, Inc., a managed communications and information technology, or IT, service provider, incorporated on March 28, 2000 in Delaware for the purpose of providing integrated packages of voice, mobile and broadband data services to small businesses in major metropolitan areas across the United States. As of December 31, 2010, these services were provided in metropolitan Atlanta, Dallas, Denver, Houston, Chicago, Los Angeles, San Diego, Detroit, the San Francisco Bay Area, Miami, Minneapolis, the Greater Washington D.C. Area, Seattle and Boston. In addition through our recent acquisitions (see Note 4), we offer cloud-based services throughout the United States and internationally.
2. Summary of Significant Accounting Policies
Principles of Consolidation
The consolidated financial statements include the accounts of Cbeyond, Inc. and its wholly-owned subsidiaries (collectively, “we”, “our”, “us” or the “Company”). All intercompany and intersegment balances and transactions have been eliminated in consolidation.
Use of Estimates
The preparation of financial statements in conformity with U.S. generally accepted accounting principles (GAAP) requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results may differ from those estimates.
Reclassifications
We reclassified certain amounts in our prior year’s consolidated financial statements to conform to our current year presentation. The reclassification includes the following:
| • | In our December 31, 2009 and 2008 consolidated financial statements, we have reclassified and increased our non-operating other income, net by $489 and $71, respectively, to reflect amounts previously classified as depreciation and amortization resulting from certain adjustments to liabilities of our former captive leasing entities. |
Revenue Recognition
We recognize revenue when persuasive evidence of an arrangement exists, services are provided or mobile handset delivery has occurred, the fee is fixed or determinable, and collectability is reasonably assured. Revenue derived from monthly recurring charges for local voice and data services and other recurring services is billed in advance and deferred until earned. Revenues derived from services that are not included in monthly recurring charges, including long distance, excess charges over monthly rate plans and terminating access fees from other carriers, are recognized monthly as services are provided and billed in arrears.
We offer customers certain web-based services that are hosted on our technology infrastructure. Customers do not take actual license to the related software applications. We also offer cloud-based services such as virtual and dedicated servers and cloud PBX. We determined that these offerings should be accounted for as service arrangements. Because service is provided on a constant basis with no discernable pattern of performance, the related revenue is recognized on a monthly subscription basis, or straight-line, over the respective periods in which customers use the service.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
Customers who elect to receive mobile service must purchase the mobile handsets directly from us. Mobile handset revenue is recognized at the time of shipment when title to the handset passes to the customer and totaled $2,677, $4,454 and $2,757, or 0.6%, 1.1% and 0.8% of total revenues, in 2010, 2009 and 2008, respectively. Mobile handset revenue is determined based on the amounts collectable from the handset sale and is net of any handset discounts offered to the customer. The net handset revenue is typically less than our cost of the handsets, and we recognize this loss at the time of shipment to the customer.
We recognize revenues and cost of revenues on a gross basis for certain taxes assessed by governmental authorities that are imposed on and concurrent with specific revenue-producing transactions between us and our customers. These taxes and surcharges primarily include universal service fund charges and totaled $12,242, $9,963 and $8,218, respectively, for the years ended December 31, 2010, 2009 and 2008.
If we collect revenue for customer installation services, it is deferred along with a portion of the installation costs, up to the amount of installation revenue collected. The deferred installation revenue and deferred installation costs are recognized over the term of the customer contract.
We offer marketing promotions in the form of various customer rebates and reimbursements that we recognize as reductions of revenue when earned by the customers. Certain of these arrangements require customers to meet specified performance conditions to be earned. If these rebates and reimbursements, or promotional obligations, are not ultimately earned and claimed by the customer, we refer to these unclaimed amounts as “breakage”. Prior to recording breakage, we record these promotions as a reduction to revenue at their maximum amounts due to the lack of sufficient historical experience required under GAAP to estimate the amount that would ultimately be earned and claimed by customers. We record breakage once we gain sufficient historical experience and continually adjust breakage rates as we accumulate additional history. We recognized an unfavorable amount of approximately $1,473, and favorable amounts of approximately $473, and $584 from changes in estimates for these promotions in 2010, 2009 and 2008, respectively.
Our customer contracts require our customers to pay termination fees if the customer terminates their services pre-maturely. We recognize termination fees as collected.
Costs of Revenue
From time to time, we receive certain vendor-issued sales incentives in the form of payment credits for achieving specific sales milestones as outlined in each specific vendor arrangement. These incentives are designed to defray specific upfront customer acquisition costs. Since the vendor-issued incentives represent a reimbursement of costs incurred to sell the vendor’s services, such incentives are recorded as a reduction of the specifically identified customer acquisition costs and reduce cost of sales in the period that the vendor-issued sales incentives are earned.
Accounts Receivable and the Allowance for Doubtful Accounts
Accounts receivable are comprised of gross amounts invoiced to customers plus accrued revenue, which represents earned but unbilled revenue at the balance sheet date. The gross amount invoiced includes pass-through taxes and fees, which are recorded as liabilities at the time they are billed. Deferred customer revenue represents the amounts billed to customers in advance but not yet earned.
The allowance for doubtful accounts is established based upon the amount we ultimately expect to collect from customers and is estimated based on a number of factors, including customers’ ability to meet their financial obligations to us, as well as general factors, such as length of time the receivables are past due,
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
historical collection experience and the general economic environment. Customer accounts are typically written off against the allowance approximately sixty to ninety days after disconnection of the customers’ service, when our direct collection efforts cease. Customer accounts are generally considered delinquent and the service disconnection process begins when a customer is sixty days in arrears.
The following table summarizes the change in our allowance for doubtful accounts for the years ended December 31, 2010, 2009 and 2008 (in thousands):
| Balance at Beginning of Year |
Bad Debt Expense |
Less Deductions (1) |
Balance at End of Year |
|||||||||||||
| 2010 |
$ | 2,867 | $ | 7,459 | $ | (7,972 | ) | $ | 2,354 | |||||||
| 2009 |
2,374 | 9,053 | (8,560 | ) | 2,867 | |||||||||||
| 2008 |
2,983 | 6,406 | (7,015 | ) | 2,374 | |||||||||||
| (1) | Represents accounts written off during the period less recoveries of accounts previously written off. |
Bad debt expense totaled 1.7%, 2.2% and 1.8%, of revenue, in 2010, 2009 and 2008, respectively.
Cash and Cash Equivalents
Cash and cash equivalents include bank deposits and money market funds that invest primarily in securities of the U.S. government. We consider all highly liquid investments with original maturities of three months or less when acquired to be cash equivalents.
Restricted Cash
Restricted cash consists of money market funds held as collateral for letters of credit issued on our behalf (see Note 8). Some vendors providing services to us require letters of credit that may be redeemed in the event we cannot meet our obligations to the vendor. These letters of credit are issued to our vendors under our revolving line of credit, and in return, we are required to maintain cash or cash equivalents on hand with the bank at a dollar amount equal to the letters of credits outstanding. In the event market conditions change and the letters of credit outstanding increase beyond the level of restricted cash on hand at the bank, we will be required to provide additional collateral. Our collateral requirements (restricted cash) were $1,295 and $1,243 as of December 31, 2010 and 2009, respectively.
Inventories
We state our inventories at the lower of cost or market. Inventories consist primarily of new and refurbished mobile handsets and are costed using the first-in, first-out (FIFO) method. Shipping and handling costs incurred in conjunction with the sale of inventory are included as an element of cost of revenue. The cost of mobile handsets is included in cost of revenue upon shipment to a customer.
Property and Equipment
Property and equipment are stated at cost and depreciated over estimated useful lives using the straight-line method. Leasehold improvements are amortized over the shorter of the life of the lease or the duration of their useful life to us. Repair and maintenance costs are expensed as incurred. We pay certain equipment maintenance costs in advance under multi-year maintenance contracts, which are included in current and non-current assets, and amortize these costs to expense over the term of the maintenance contract.
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CBEYOND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
Network engineering costs incurred during the development phase of our networks are capitalized as part of property and equipment and recorded as construction-in progress until the projects are completed and placed into service.
We capitalize certain internal-use software development costs. For the years ended December 31, 2010, 2009 and 2008, we capitalized $17,068, $12,447 and $11,779, respectively, associated with these software development efforts. These costs are generally amortized to expense over a period of three years depending on the useful life of the related asset.
Income Taxes
We account for income taxes under the liability method, which requires us to recognize deferred income tax assets and liabilities for temporary differences between the financial reporting and tax basis of recorded assets and liabilities and the expected benefits of net operating loss and credit carryforwards. Deferred income tax assets are reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred income tax assets will not be realized. We evaluate the realizability of our deferred income tax assets, primarily resulting from net operating loss carryforwards, and adjust our valuation allowance, if necessary.
We recognize the benefit of uncertain tax positions when the position taken or expected to be taken in a tax return is more likely than not (i.e., a likelihood of more than fifty percent) of being sustained upon examination by tax authorities. A recognized tax position is then measured at the largest amount of benefit that is greater than fifty percent likely of being realized upon ultimate settlement. As of December 31, 2010 and 2009, we do not have any significant unrecognized tax benefits.
We recognize interest and penalties accrued related to unrecognized tax benefits as components of our income tax provision. We do not have any interest and penalties accrued, as of December 31, 2010 and 2009, related to unrecognized tax benefits.
Goodwill and Intangible Assets
Goodwill, which consists of the excess of the purchase price over the fair value of identifiable net assets of businesses acquired, will be evaluated for impairment on an annual basis on October 1, or whenever events or changes in circumstances indicate that impairment may have occurred. The goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. When evaluating goodwill for impairment, we will first compare the book value of net assets in a reporting unit to the fair value of the related operations in the same reporting unit. If the fair value is determined to be less than book value, a second step will be performed to compute the amount of impairment. We estimate fair value using a discounted cash flow methodology. We allocate goodwill to reporting units based on the reporting unit expected to benefit from the combination. As 2010 was the initial year that goodwill was recorded, we will begin our annual impairment analysis as of October 1, 2011.
Intangible assets, including developed technology, in-process development, customer relationships, non-compete agreements and trade names arising principally from acquisitions, are recorded at cost and then amortized to operating expense over their estimated useful lives.
Impairment and Other Losses on Long-Lived Assets
We evaluate our long-lived assets used in operations (primarily property and equipment) and intangible assets subject to amortization when events or changes in circumstances indicate that the assets might be
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
impaired. If our review indicates that the carrying value of an asset will not be recoverable, based on a comparison of the carrying value of the asset to the undiscounted future cash flows, the impairment will be measured by comparing the carrying value of the asset to the fair value. Fair value will be determined based on quoted market values, discounted cash flows or appraisals. Our review is at the lowest level for which there are identifiable cash flows that are largely independent of the cash flows of other assets.
We occasionally replace equipment and software due to obsolescence and upgrade before the end of its originally estimated useful life and incur losses on the remaining undepreciated cost. In addition, we incur losses on the remaining undepreciated cost of our equipment that we are unable to recover from former customers. This equipment resides at customer locations to enable connection to our telecommunications network. These losses are recorded as additional depreciation and amortization expense in cost of revenue and totaled $2,667, $2,235 and $2,201 for the years ended December 31, 2010, 2009 and 2008, respectively. The 2010 amount includes $585 of charges for the write down of costs related to the build out of collocations in a planned new market prior to our decision in mid-December 2010 not to expand into that market in 2011 (see Note 6).
Marketing Costs
We expense marketing costs, including advertising, as these costs are incurred. Such costs amounted to approximately $3,440, $2,955 and $3,029 during 2010, 2009 and 2008, respectively.
Concentrations of Credit Risk
Financial instruments that potentially subject us to significant concentrations of credit risk consist of trade accounts receivable, which are generally unsecured, and cash and cash equivalents. Our risk is mitigated by our accounts receivable being diversified among a large number of customers with relatively low average balances segregated by both geography and industry type. Our revenues and receivables are concentrated among small business customers and geographically in the cities in which we operate our Core Managed Services.
Our cash and cash equivalents are concentrated primarily in operating bank accounts and money market funds that invest primarily in U.S. Treasury Obligations. We believe these investments limit the risk of loss of principal.
Fair Value
The carrying amount reflected in the consolidated balance sheets for cash and cash equivalents, restricted cash, accounts receivable and accounts payable equals or approximates their respective fair values due to their short maturities.
Contingencies
We accrue for contingent obligations, including estimated legal costs, when the obligation is probable and the amount is reasonably estimable. As facts concerning contingencies become known, we reassess our position and make appropriate adjustments to the financial statements.
Share-Based Compensation
Share-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense straight-line over the period in which the entire grant vests.
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CBEYOND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
Basic and Diluted Net (Loss) Income per Share
We calculate basic (loss) income per share by dividing net (loss) income attributable to common stockholders by the weighted average number of shares of common stock outstanding for the period. Our diluted (loss) income per share is calculated in a similar manner, but includes the effect of dilutive common equivalent shares outstanding during the year. To the extent any common equivalent shares from stock options and other common stock equivalents are antidilutive, they are excluded from the computation of dilutive (loss) income per share. We were in a loss position for the year ended December 31, 2010 and 2009, resulting in no difference between basic loss per share and diluted loss per share.
The following table summarizes our basic and diluted (loss) income per share calculations (in thousands, except per share amounts):
| Year Ended December 31, | ||||||||||||
| 2010 | 2009 | 2008 | ||||||||||
| Net (loss) income |
$ | (1,654 | ) | $ | (2,220 | ) | $ | 3,696 | ||||
| Basic weighted average common shares outstanding |
29,366 | 28,753 | 28,339 | |||||||||
| Effect of dilutive securities |
— | — | 1,250 | |||||||||
| Diluted weighted average common shares outstanding |
29,366 | 28,753 | 29,589 | |||||||||
| Basic (loss) income per common share |
$ | (0.06 | ) | $ | (0.08 | ) | $ | 0.13 | ||||
| Diluted (loss) income per common share |
$ | (0.06 | ) | $ | (0.08 | ) | $ | 0.12 | ||||
Securities that were not included in the diluted net (loss) income per share calculations because they were antidilutive, are as follows (in thousands):
| Year Ended December 31, | ||||||||||||
| 2010 | 2009 | 2008 | ||||||||||
| Anti-dilutive shares |
5,220 | 4,985 | 1,836 | |||||||||
3. Accounting Standards
Recently Issued Accounting Pronouncements Not Yet Adopted
In October 2009, the Financial Accounting Standards Board (FASB) approved for issuance Accounting Standard Update (ASU) 2009-13, Revenue Arrangements with Multiple Deliverables (currently within the scope of Accounting Standards Codification (ASC) Subtopic 605-25). This update provides principles for allocating sales consideration among multiple-element revenue arrangements with an entity’s customers, allowing more flexibility in identifying and accounting for separate deliverables under an arrangement. The update introduces an estimated selling price method for valuing the elements of a bundled arrangement if vendor-specific objective evidence or third-party evidence of selling price is not available and significantly expands related disclosure requirements. This update is effective on a prospective basis for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. Alternatively, adoption may be on a retrospective basis, and early application is permitted. We will adopt this pronouncement beginning January 1, 2011 and we do not expect any impact from this adoption.
In December 2010, the Emerging Issues Task Force (EITF) of the FASB issued ASU Update 2010-29, Business Combination (Topic 805), Disclosure of Supplementary Pro Forma Information for Business Combinations (“ASU 2010-29”). ASU 2010-29 amends the supplementary pro forma disclosure requirements for business combinations. When a public entity’s business combinations are material on an individual or aggregate basis, the notes to its financial statements must provide pro forma revenue and earnings of the combined entity as
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
if the acquisition date had occurred as of the beginning of the current annual period and the comparative prior annual period, respectively. The ASU clarifies that if comparable financial statements are presented, the pro forma disclosures for both periods presented, the year in which the acquisition occurred and the prior year, should be reported as if the acquisition had occurred as of the beginning of the comparable prior annual reporting period only and not as if it had occurred at the beginning of the current annual reporting period. The ASU also expands the supplemental pro forma disclosure requirements to include a description of the nature and amount of any material non-recurring adjustments that are directly attributable to the business combination. ASU 2010-29 is effective for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2010 and should be applied prospectively. As such, ASU 2010-29 did not have any impact to the supplementary pro forma disclosure to our consolidated financial statements for the year ended December 31, 2010.
4. Acquisitions and Goodwill
On November 3, 2010, we acquired substantially all of the net assets of privately-held MaximumASP, LLC, MaximumCOLO, LLC, and Maximum Holdings, LLC (collectively known as “MaximumASP”). MaximumASP is a cloud server and dedicated hosting provider that delivers its services, including managed virtual servers and dedicated servers, over the Internet to small business customers throughout the world. On October 29, 2010, we acquired 100% of the outstanding voting stock of privately-held Aretta Communications, Inc. (“Aretta”). Aretta offers a cloud server-based private branch exchange (or “PBX”) solution to small businesses throughout the world. We believe our purchase of MaximumASP and Aretta expands our entry into the high growth cloud services market and allows the expansion of our product portfolio of IT services into our small business customer base. It also enables us to serve a broad geographic opportunity outside our existing 14 city footprint. As a result of these acquisitions, we launched the Cloud Services segment in late 2010.
The acquisition-date fair value of the consideration transferred to the shareholders (or “sellers”) of MaximumASP totaled approximately $34,031, which consisted of cash consideration of $28,791, exclusive of $94 of cash acquired, and inclusive of $28,411 paid on the date of closing, $380 paid in February 2011, and contingent consideration of $5,240. The fair value of contingent consideration represents the probability-weighted present value of earn out potential that may be remitted to the sellers, to the extent earned, upon achieving a specified range of revenue targets for the full year ended December 31, 2011 and is payable no later than March 2012. Under the contingent consideration arrangement, we are required to pay the sellers between $0 and $5,400 based on the achievement of revenue targets ranging from $10,800 to $11,400 for the full year ended December 31, 2011. If MaximumASP achieves less than $10,800 in revenue in 2011, no additional consideration will be paid.
The acquisition-date fair value of the consideration transferred to the sellers of Aretta totaled approximately $4,027, which consisted of cash consideration of $2,465, exclusive of $177 of cash acquired, and contingent consideration of $1,562. The fair value of contingent consideration represents the probability-weighted present value of earn out potential that may be remitted to the sellers, to the extent earned, upon achieving certain product development milestones in 2011, as well as upon achieving a specified range of revenue targets for the full year ended December 31, 2011. The revenue-related contingent consideration is payable no later than March 2012. The maximum potential contingent consideration is $1,600, consisting of $800 for the product development milestones and $800 for the 2011 revenue achievement. The 2011 revenue targets range from $1,600 to $2,200 under the arrangement. If the 2011 revenue from Aretta is less than $1,600, then no amount of additional revenue-related consideration will be paid.
The fair value of the arrangement of the contingent consideration was estimated by applying the income approach and was based on significant inputs that are not observable in the market, representing a Level 3
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measurement as defined under ASC 820, Fair Value Measurements and Disclosures. Key assumptions include the discount rate representative of the time value of money for the period to the settlement date and probability adjusted revenue achievement in calendar year 2011 ranging from $11,350 to over $11,400 for MaximumASP and from $2,000 to over $2,200 for Aretta. As of December 31, 2010, there were no changes in the range of outcomes for the contingent consideration recognized, and the total amount of current and non-current contingent consideration liability recorded was $6,824, inclusive of interest accretion. Additionally, certain sellers of MaximumASP and Aretta became employees of Cbeyond, Inc., and thus the total contingent consideration liability is payable primarily to these employees.
The following table summarizes the estimated fair values of the assets acquired and liabilities assumed on the respective dates of acquisition. These fair values are preliminary and are subject to change pending the finalization of our valuation procedures:
| MaximumASP | Aretta | Total | ||||||||||
| Current assets |
$ | 179 | $ | 183 | $ | 362 | ||||||
| Property, plant, and equipment |
9,803 | 122 | 9,925 | |||||||||
| Identified intangible assets |
8,200 | 2,197 | 10,397 | |||||||||
| Total identifiable assets acquired |
18,182 | 2,502 | 20,684 | |||||||||
| Accounts payable and accrued liabilities |
1,388 | 150 | 1,538 | |||||||||
| Deferred revenue |
580 | 33 | 613 | |||||||||
| Deferred tax liability |
— | 1,012 | 1,012 | |||||||||
| Total liabilities assumed |
1,968 | 1,195 | 3,163 | |||||||||
| Net identifiable assets acquired |
16,214 | 1,307 | 17,521 | |||||||||
| Goodwill |
17,817 | 2,720 | 20,537 | |||||||||
| Net assets acquired |
$ | 34,031 | $ | 4,027 | $ | 38,058 | ||||||
All identifiable intangible assets, other than goodwill, were determined to have finite lives ranging from two to ten years. The weighted-average useful life of the identifiable intangible assets associated with MaximumASP is 9.6 years, primarily related to the ten-year life we assigned to the acquired customer relationships, and 4 years associated with Aretta. We recorded $248 of total amortization expense on a straight-line basis for the year ended December 31, 2010 related to these assets.
Goodwill has preliminarily been assigned to our Cloud Services segment, and is primarily attributable to expected synergies unique to our sales and marketing channels that we believe provides us a competitive advantage in the market we serve. All the goodwill related to the MaximumASP acquisition is expected to be deductible for income tax purposes. For Aretta, none of the goodwill is deductible for income tax purposes.
Pro forma Reporting and Transaction Costs
The results of operations of both Maximum and Aretta have been included in our consolidated results of operations from their respective acquisition dates. For the year ended December 31, 2010, our results include $1,791 of revenue and $65 of net income from these acquisitions.
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The following represents our pro forma consolidated revenue and net loss as if Maximum and Aretta had been acquired as of January 1, 2010 and 2009, respectively, and had been included in our consolidated results for the entire years ending December 31, 2010 and 2009, respectively. These amounts include pre-acquisition results of Maximum and Aretta and reflect additional depreciation and amortization, and their consequential tax effects, as if the fair value of the acquired assets had been recognized at the beginning of each respective period (unaudited):
| Year ended | ||||||||
| December 31, 2010 |
December 31, 2009 |
|||||||
| Revenue |
$ | 461,991 | $ | 424,493 | ||||
| Net loss |
$ | (2,644 | ) | $ | (3,561 | ) | ||
All transaction costs associated with the acquisitions have been charged to expense as incurred. For the year ended December 31, 2010, we incurred $755 in total transaction-related costs, and we have separately classified these costs within our operating expenses.
5. Intangible Assets
The following table provides information regarding our intangible assets, none of which is indefinite lived:
| December 31, 2010 | ||||||||||||||||
| Intangible assets: |
Useful life range (years) |
Gross carrying amount | Accumulated Amortization |
Net carrying amount |
||||||||||||
| Customer relationships |
10 | $ | 7,770 | $ | 130 | $ | 7,640 | |||||||||
| In-process Development |
— | 788 | — | 788 | ||||||||||||
| Developed Technology |
3-4 | 1,572 | 101 | 1,471 | ||||||||||||
| Trade Name |
2-3 | 204 | 12 | 192 | ||||||||||||
| Non-competes |
2 | 63 | 5 | 58 | ||||||||||||
| Total |
$ | 10,397 | $ | 248 | $ | 10,149 | ||||||||||
Customer relationships are derived from the MaximumASP acquisition and were assigned based on the valuation of single and multi-year customer contracts that are subject to extension, renewal, or termination. In estimating the fair value of these assets, we have assumed renewal of these contracts at a rate consistent with Maximum’s historical experience.
Amortization expense on intangible assets was $248 for the year ended December 31, 2010. Intangible assets are recorded at cost and are amortized on a straight-line basis over their estimated lives. The weighted-average useful life of all the identifiable intangible assets is 8.4 years. As of December 31, 2010, amortization expense on intangible assets for the next five years was expected to be as follows:
| Year ending December 31, |
Amount | |||
| 2011 |
$ | 1,489 | ||
| 2012 |
1,481 | |||
| 2013 |
1,420 | |||
| 2014 |
1,227 | |||
| 2015 |
777 | |||
We had no intangible assets as December 31, 2009.
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6. Property and Equipment
Property and equipment consist of:
| Year Ended December 31, | ||||||||||||
| Useful Lives | 2010 | 2009 | ||||||||||
| (In years) | ||||||||||||
| Land |
$ | 675 | $ | — | ||||||||
| Building |
25 | 5,500 | — | |||||||||
| IRU |
20 | 1,625 | 1,625 | |||||||||
| Network equipment |
2-7 | 236,937 | 209,350 | |||||||||
| Leasehold improvements |
3-10 | 27,585 | 25,578 | |||||||||
| Computers and software |
2-7 | 121,309 | 90,886 | |||||||||
| Furniture and fixtures |
5-7 | 7,354 | 6,797 | |||||||||
| Construction-in progress |
20,188 | 19,380 | ||||||||||
| 421,173 | 353,616 | |||||||||||
| Less accumulated depreciation and amortization |
(270,482 | ) | (216,722 | ) | ||||||||
| Property and equipment, net |
$ | 150,691 | $ | 136,894 | ||||||||
Beginning in 2007, we began purchasing network capacity under long-term contracts, typically 20 years, for the indefeasible right of use (IRU) of fiber network infrastructure owned by others. These investments are capitalized as part of our network assets because the terms of these contracts represent substantially all of the estimated economic life of the fiber. Once placed in service, IRUs are amortized over the remaining contract term. The first IRU was placed in service in early 2008. Accumulated amortization of these assets totaled $215 and $134 as of December 31, 2010 and 2009, respectively.
We routinely offer certain programs to our customers whereby we will directly pay third party vendors for the costs of installing hardware necessary to provide service at the customer’s location. We capitalize these costs and classify them as network equipment. During the years ended December 31, 2010 and 2009, $2,120 and $2,954 of vendor installation program costs were capitalized as network equipment, respectively.
As a result of our recent acquisitions and our ongoing Ethernet conversion project being implemented throughout our markets, we currently have no plans to expand our operations into any additional geographic markets during 2011. As such we recorded the accelerated depreciation of previously capitalized assets related to the buildout of collocations in a planned new market prior to our decision in mid- December 2010 not to expand into that market in 2011. This resulted in $585 of additional depreciation expense during the year ended December 31, 2010. Additionally, as a result of our recent acquisition, we acquired a data center in Kentucky and have recorded the associated land and building in property and equipment as of December 31, 2010.
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7. Other Accrued Liabilities
| December 31, 2010 |
December 31, 2009 |
|||||||
| Accrued bonus |
$ | 9,948 | $ | 8,740 | ||||
| Accrued other compensation and benefits |
2,251 | 1,631 | ||||||
| Accrued sales taxes |
1,235 | 3,137 | ||||||
| Accrued other taxes |
4,309 | 4,958 | ||||||
| Accrued promotions |
1,325 | 1,699 | ||||||
| Deferred rent |
10,920 | 11,260 | ||||||
| Other accrued expenses |
4,935 | 2,988 | ||||||
| Current and non-current other accrued liabilities |
34,923 | 34,413 | ||||||
| Less: |
||||||||
| Other non-current liabilities |
1,359 | 914 | ||||||
| Non-current portion of deferred rent |
9,075 | 9,600 | ||||||
| Total current portion of other accrued liabilities |
$ | 24,489 | $ | 23,899 | ||||
8. Revolving Line of Credit
On February 8, 2006, we entered into a credit agreement with Bank of America through our subsidiary, Cbeyond Communications, LLC, or LLC, which originally provided for a secured revolving line of credit for up to $25,000 through February 2011, and was subsequently amended and increased to $40,000. The credit agreement terms were amended on July 2, 2007, February 24, 2009, March 3, 2010, and February 22, 2011.
On February 22, 2011 we entered into the fourth amendment of the credit agreement with Bank of America. The amendment increases the available revolving line of credit from $40,000 to $75,000 and extends the term of the facility to February 22, 2016. The amendment also makes certain modifications to the interest and fees, including the applicable margins based on redefined tiers, as well as the commitment fee. The amendment also modifies certain financial covenants. The amendment retains substantially all other stipulations of the original credit agreement. As of the date of this filing no amounts were drawn on the revolving credit facility, and we had $73,705 in available capacity.
The interest rates applicable to loans under the revolving line of credit are floating interest rates that, at our option, will equal a London Interbank Offered Rate, or LIBO rate, or an alternate base rate plus, in each case, an applicable margin. The current base rate is a fluctuating interest rate equal to the higher of (a) the prime rate of interest per annum publicly announced from time to time by Bank of America, as administrative agent, as its prime rate in effect at its principal office in New York City and (b) the overnight federal funds rate plus 0.50%. The interest periods of the Eurodollar loans are one, two, three or six months, at our option. The amended applicable margins for LIBO rate loans or alternate base rate loans are as follows, based on the relative usage amounts:
| Usage Amount |
Eurodollar Rate | Base Rate | ||||||
| Zero to $75,000 |
1.75 | % | 0.75 | % | ||||
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The amended credit agreement superseded the following applicable margins and relative usage amounts, as of December 31, 2010:
| Usage Amount |
Eurodollar Rate | Base Rate | ||||||
| Zero to $13,333 |
2.25 | % | 1.25 | % | ||||
| $13,333 to $26,667 |
2.50 | % | 1.50 | % | ||||
| $26.667 to $40,000 |
2.75 | % | 1.75 | % | ||||
In addition, we are required to pay to Bank of America under the amended revolving line of credit a commitment fee for unused commitments at a per annum rate of 0.40% (or 0.50% as of December 31, 2010).
The credit agreement is secured by all assets of LLC and is guaranteed by Cbeyond, Inc. (the Parent). All assets of the consolidated entity reside with the LLC entity. In addition, Cbeyond, Inc. has no operations other than those conducted by LLC. Accordingly, all income and cash flows from operations are generated by and belong to LLC and all assets appearing on the consolidated financial statements secure the credit facility. In addition, the facility contains certain restrictive covenants that effectively prohibit us from paying cash dividends.
At December 31, 2010 and 2009, respectively, no amounts were drawn on the revolving credit facility and $38,705 and $23,757 of the $40,000 and $25,000 line of credit was available due to reductions of $1,295 and $1,243 for outstanding letters of credit. The letters of credit are collateralized by our restricted cash (see Note 2). In addition, substantially all of our assets are pledged as collateral under the revolving line of credit with Bank of America.
9. Income Taxes
In 2010, 2009 and 2008, we utilized net operating loss carryforwards to offset the majority of our taxable income. Current income taxes recognized relate primarily to Alternative Minimum Tax (AMT) or to states that either do not have net operating loss carryforwards or that have taxing jurisdictions that do not consider net operating losses.
The current and deferred income tax provision (benefit) for the years ended December 31, 2010, 2009 and 2008 are as follows.
| 2010 | 2009 | 2008 | ||||||||||
| Current |
||||||||||||
| Federal |
$ | 66 | $ | 69 | $ | 222 | ||||||
| State |
834 | 588 | 910 | |||||||||
| Total current |
900 | 657 | 1,132 | |||||||||
| Deferred |
||||||||||||
| Federal |
377 | (1,412 | ) | 2,502 | ||||||||
| State |
(351 | ) | (741 | ) | 134 | |||||||
| Change in valuation allowance |
(612 | ) | (578 | ) | (674 | ) | ||||||
| Total deferred |
(586 | ) | (2,731 | ) | 1,962 | |||||||
| Income tax provision (benefit) |
$ | 314 | $ | (2,074 | ) | $ | 3,094 | |||||
The current provision for federal income taxes during the years ended December 31, 2010, 2009 and 2008 consisted of AMT because we could only offset 90% of AMT taxable income with AMT net operating losses in
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those years. AMT payments result in a credit that will be used to offset regular income taxes due in future periods, when and if we pay regular income tax. We also recorded current state tax expense in 2010, 2009 and 2008 primarily as a result of the Texas Margin Tax that totaled $673, $694 and $789 in 2010, 2009 and 2008, respectively. This tax is not dependent upon levels of pre-tax income and has a significant influence on our effective tax rate.
The 2010 income tax expense also considers the acquisition of and activity related to two acquisitions since the dates of purchase. Basis differences exist for tax deductible goodwill and transaction costs capitalized for tax purposes. In connection with the stock acquisition, initial deferred tax liabilities of $1,012 were recognized for book basis in excess of tax basis for tangible and intangible assets, resulting in an increase to goodwill.
During the twelve months ended December 31, 2010, certain restricted shares vested where the market price on the vesting date was lower than the market price on the date the restricted shares were originally granted. This resulted in realizing a lower actual tax deduction than was deducted for financial reporting purposes. As a result, we wrote off deferred tax assets of $1,094 relating to the share-based compensation that had been recognized for these restricted shares for financial reporting purposes, with the charge going first to exhaust the Company’s accumulated additional-paid-in-capital pool, and the remainder charged to income tax expense. In addition, a portion of our valuation allowance against other deferred tax assets was no longer required and was reduced as an income tax benefit.
The following table summarizes the significant differences between the U.S. federal statutory tax rate (35%) and our effective tax rate for financial statement purposes for the years ended December 31, 2010, 2009 and 2008:
| 2010 | 2009 | 2008 | ||||||||||
| Federal income tax provision at statutory rate |
$ | (469 | ) | $ | (1,503 | ) | $ | 2,377 | ||||
| Reduction in 2009 Texas Margin Tax |
(4 | ) | (95 | ) | — | |||||||
| State income taxes, net of federal benefit |
380 | 236 | 679 | |||||||||
| Nondeductible expenses |
279 | 150 | 200 | |||||||||
| Nondeductible share-based compensation costs |
808 | — | 441 | |||||||||
| Other |
1 | (78 | ) | 71 | ||||||||
| State tax credits generated in prior year, net of federal tax benefit |
(69 | ) | (206 | ) | — | |||||||
| Change in valuation allowance |
(612 | ) | (578 | ) | (674 | ) | ||||||
| Income tax provision (benefit) |
$ | 314 | $ | (2,074 | ) | $ | 3,094 | |||||
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The income tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective income tax bases give rise to deferred tax assets and liabilities. As of December 31, 2010 and 2009, the deferred tax assets and liabilities are as follows:
| 2010 | 2009 | |||||||
| Deferred tax assets: |
||||||||
| Net operating loss (federal and state) |
$ | 33,745 | $ | 35,589 | ||||
| Deferred rent |
4,135 | 4,265 | ||||||
| Allowance for doubtful accounts |
896 | 1,087 | ||||||
| Accrued telecommunication liabilities |
620 | 775 | ||||||
| Accrued liabilities |
1,820 | 1,374 | ||||||
| Share-based compensation expense |
12,118 | 10,674 | ||||||
| Other |
3,177 | 2,761 | ||||||
| Gross deferred tax assets |
56,511 | 56,525 | ||||||
| Deferred tax liabilities: |
||||||||
| Property and equipment |
12,810 | 12,283 | ||||||
| Intangible Assets |
720 | — | ||||||
| Other |
763 | 661 | ||||||
| Gross deferred tax liabilities |
14,293 | 12,944 | ||||||
| Net deferred tax assets |
42,218 | 43,581 | ||||||
| Valuation allowance |
(33,212 | ) | (33,824 | ) | ||||
| Net deferred tax assets |
9,006 | 9,757 | ||||||
| Less non-current net deferred tax assets |
(8,068 | ) | (8,331 | ) | ||||
| Current net deferred tax assets |
$ | 938 | $ | 1,426 | ||||
At December 31, 2010, we have federal net operating loss carryforwards of approximately $118,677 and state net operating loss carryforwards of $105,085, which begin expiring in 2021. The federal net operating loss carryforward consists of net operating losses unrelated to share-based compensation of $82,173 (with a corresponding deferred tax asset of $28,761) and net operating losses related to share-based compensation of $36,504. We follow the “with and without approach”, including indirect effects, which considers the impact of share-based compensation deductions last when computing the tax benefits of share-based compensation. Under this approach, any regular income tax benefit derived from net operating losses related to share-based compensation is reflected as additional paid-in-capital at the time such benefit is realized.
Our net deferred tax assets, before valuation allowance, totaled approximately $42,218 and $43,581 at December 31, 2010 and 2009, respectively, and primarily relate to net operating loss carryforwards. In order to realize the benefits of the deferred tax asset recognized at December 31, 2010, we will need to generate approximately $23,300 in pre-tax income by the end of 2013, which, based on current projected performance, management expects to be able to meet. The majority of pre-tax income is projected to occur in 2012 and 2013, with 2011 projected to be near break-even. We believe that the 2011 results will be significantly impacted by the expenses associated with the Ethernet conversion project and our integration of the Cloud Services segment, both of which are projected to have a significant favorable impact on projected 2012 and 2013 results. If future results are less favorable than our projections or if the projected benefits of our investments fall short of our expectations, we may have to increase our allowance against our net deferred tax asset with a corresponding increase to income tax expense. If we generate taxable income in excess of projections, the result would be a further reduction of the allowance against our net deferred tax asset and a corresponding benefit to income tax expense.
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We continually evaluate whether we have any limitations on our ability to utilize net operating loss carryforwards under Internal Revenue Code Section 382 due to changes in ownership and periodically engage third party experts to perform a formal study. The most recent formal study was updated through late 2009 with the conclusion that there were ownership changes sufficient to cause an annual limitation on the use of net operating losses. However, the limitation significantly exceeds our projected annual taxable income projections, so we believe the current limitation will have no effect on the ultimate realization of the available net operating losses. However, utilization of these net operating loss carryforwards may be limited in future years if significant ownership changes were to occur subsequent to our most recent study.
The tax years 2007 to 2010, according to statute, remain open to examination by the major taxing jurisdictions to which we are subject. Due to the use of net operating losses generated in tax years prior to the statutory three-year limit, earlier tax years of 2001 to 2006 may also be subject to examination.
10. Employee Benefit Plan
401(k) Plan
We have a 401(k) Defined Contribution Retirement Plan (the Plan) for the benefit of eligible employees and their beneficiaries. All regular employees are eligible to participate in the Plan on the first day of the month following 90 days of employment provided they have reached the age of 18. The Plan provides for an employee deferral up to the dollar limit that is set by the IRS.
Effective July 1, 2008, we increased our employer-based match to 50% of contributions up to 4% of eligible compensation to all 401(k) plan participants as well as provided a discretionary contribution of 1.5% of eligible compensation to all Plan eligible employees who were employed on June 30, the last day of the plan year. Our match and discretionary contribution are both funded in Company stock subsequent to the 401(k) plan year-end. Our contribution vests over time; however, the employees may elect to sell the shares immediately in order to diversify their investments. Although the match and contribution are provided in Company shares, Company shares are not otherwise an investment option, and the employees may not use funds in their 401(k) to purchase additional Company shares.
Effective January 1, 2010, the new plan year was January 1 to December 31. Prior to December 31, 2009, the plan year was July 1 to June 30. The plan ended a short year that began July 1, 2009 and ended December 31, 2009 in order to effect the annual plan year change. Effective January 1, 2010, we began to match 100% of the first 1% of eligible compensation contributed, and up to 50% of the next 5% of eligible compensation contributed. The maximum match attainable is 3.5% of eligible compensation. We also eliminated the discretionary match in 2010.
We have a commitment to contribute shares to the Plan at the end of each plan year. The number of shares is variable based on the share price on the last day of the plan year when the obligation becomes fixed and payable.
During the years ended December 31, 2010, 2009 and 2008, we recognized $2,238, $2,460 and $1,588, respectively, of share-based compensation expense relating to the match and contribution under the Plan. As of the last day of the 401(k) plan year, our contribution relating to the year ended December 31, 2010 became fixed based on the active 401(k) plan participants as of the end of the new plan year (December 31). Accordingly, we contributed 153 shares of Company stock to the respective employees’ 401(k) accounts in February 2011.
Additionally, our contribution relating to the plan years ended December 31, 2009 and June 30, 2009 and June 30, 2008 became fixed based on the active 401(k) plan participants at that time, and we contributed 83, 165 and 95 shares of Company stock to the respective employees’ 401(k) accounts in January 2010, July 2009 and July 2008, respectively.
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Deferred Compensation Plan
We maintain a self-directed, non-qualified unfunded deferred compensation plan that provides supplemental retirement benefits in excess of limits imposed on qualified plans by U.S. tax laws for certain executives and other highly compensated employees. Under the plan, participants may elect to defer receipt of a portion of their annual compensation. Amounts deferred under the plan are invested at the participants’ discretion in various investment choices.
Our deferred compensation obligation for the plan is included on our consolidated balance sheets in other non-current liabilities. Investment earnings, administrative expenses, changes in investment values and increases or decreases in the deferred compensation liability resulting from changes in the investment values are recorded in our consolidated statements of operations. Deferred compensation plan assets are included in other non-current assets on our consolidated balance sheets. As of December 31, 2010 and 2009, deferred compensation plan assets are $901 and $596, and plan liabilities are $949 and $586, respectively.
11. Share-Based Compensation Plans
We maintain share-based compensation plans that permit the grant of nonqualified stock options, incentive stock options, restricted stock and stock purchase rights, collectively referred to as share-based awards. Substantially all of the share-based awards vest at a rate of 25% per year over four years, although the Board of Directors may occasionally approve a different vesting period. Options are granted at exercise prices not less than the fair market value of our common stock on the grant date. The fair market value of our common stock is determined by the closing price of our common stock on the grant date. Our current policy defines the grant date for options as the second day following a quarterly earnings release for previously approved standard option grants. Share-based option awards expire 10 years after the grant date. Upon an exercise of options or a release of restricted stock, new shares are issued out of our approved stock plans. As of December 31, 2010, we had 659 share-based awards available for future grant. Compensation expense related to share-based awards for the years ended December 31, 2010, 2009 and 2008 totaled $15,591, $15,954 and $12,887, respectively.
We also grant equity instruments to non-employees. All transactions in which goods or services are the consideration received for the issuance of equity instruments are accounted for based on the fair value of the equity instrument issued, which we deem more reliably measurable than the fair value of the consideration received. The measurement date of the fair value of the equity instrument issued is the date on which the counterparty’s performance is complete.
Stock Options
The following table summarizes the weighted average grant date fair values and the binomial option-pricing model assumptions that were use to estimate the grant date fair value of options during the years ended December 31, 2010, 2009 and 2008:
| Years ended December 31, | ||||||||||||
| 2010 | 2009 | 2008 | ||||||||||
| Grant date fair value |
$ | 7.05 | $ | 7.82 | $ | 8.88 | ||||||
| Assumptions: |
||||||||||||
| Expected dividend yield |
0.0 | % | 0.0 | % | 0.0 | % | ||||||
| Expected volatility |
56.3 | % | 58.1 | % | 51.3 | % | ||||||
| Risk-free interest rate |
2.4 | % | 1.9 | % | 2.9 | % | ||||||
| Expected multiple of share price to exercise price upon exercise |
2.2 | 2.3 | 2.4 | |||||||||
| Post vest cancellation rate |
2.7 | % | 5.7 | % | 6.2 | % | ||||||
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We evaluate the appropriateness of the underlying assumptions each time we estimate the fair value of equity instruments requiring measurement. To assist in validating our assumptions, we periodically engage consultants with relevant experience to assess and evaluate its assumptions.
The risk-free interest rate used in estimating the fair value of options is based on U.S. Treasury zero-coupon securities over the appropriate period. We also use historical data to estimate the expected multiple of share price to exercise price upon exercise, volatility and the post-vest cancellation rate of options granted.
| 2010 | 2009 | 2008 | ||||||||||||||||||||||
| Options | Exercise Price |
Options | Exercise Price |
Options | Exercise Price |
|||||||||||||||||||
| Outstanding at beginning of year |
3,894 | $ | 14.82 | 4,212 | $ | 14.55 | 3,476 | $ | 14.31 | |||||||||||||||
| Granted |
233 | 13.24 | 87 | 14.37 | 1,031 | 17.33 | ||||||||||||||||||
| Exercised (A) |
(233 | ) | 8.99 | (228 | ) | 5.43 | (75 | ) | 10.24 | |||||||||||||||
| Forfeited or cancelled |
(188 | ) | 21.49 | (177 | ) | 20.21 | (220 | ) | 25.19 | |||||||||||||||
| Expired |
(1 | ) | 13.43 | — | — | — | — | |||||||||||||||||
| Outstanding at end of year |
3,705 | 14.76 | 3,894 | 14.82 | 4,212 | 14.55 | ||||||||||||||||||
| Vested and expected to vest at end of year (B) |
3,663 | $ | 14.70 | 3,842 | $ | 14.77 | 4,056 | $ | 14.35 | |||||||||||||||
| (A) | The total intrinsic value of options exercised during the years ended December 31, 2010, 2009 and 2008 was $1,372, $3,090, and $562 |
| (B) | As of December 31, 2010, the aggregate intrinsic value of options vested and expected to vest was $13,717. |
| Outstanding | Exercisable | |||||||||||||||||||||||
| Range of Exercise Prices |
Options Outstanding |
Weighted Average Remaining Life (years) |
Weighted Average Exercise Price |
Options Outstanding (A) |
Weighted Average Remaining Life (years) |
Weighted Average Exercise Price |
||||||||||||||||||
| $3.88 |
746 | 2.24 | $ | 3.88 | 746 | 2.24 | $ | 3.88 | ||||||||||||||||
| 11.00 to 14.00 |
1,524 | 5.41 | 11.84 | 1,278 | 4.72 | 11.62 | ||||||||||||||||||
| 15.00 to 19.00 |
343 | 7.63 | 16.25 | 199 | 7.34 | 16.43 | ||||||||||||||||||
| 19.01 to 22.00 |
552 | 6.71 | 19.81 | 354 | 6.45 | 19.90 | ||||||||||||||||||
| $29.00 to 34.00 |
423 | 6.17 | 29.96 | 326 | 6.16 | 29.97 | ||||||||||||||||||
| Over $36.00 |
117 | 6.66 | 38.74 | 96 | 6.65 | 38.64 | ||||||||||||||||||
| 3,705 | 5.30 | $ | 14.76 | 2,999 | 4.70 | $ | 13.85 | |||||||||||||||||
| (A) | As of December 31, 2010, the aggregate intrinsic value of options exercisable was $13,183. |
As of December 31, 2010, unrecognized share-based compensation expense related to unvested stock option awards totals approximately $3,873 and is expected to be recognized over a weighted-average period of 1.82 years.
Restricted Shares
Restricted shares generally vest at a rate of 25% per year over four years or at the attainment of certain performance targets as of the determination date, although the Board of Directors may occasionally approve a different vesting period. Restricted shares cancel, where applicable, if service or performance targets have not been met.
During the years ended December 31, 2010, 2009 and 2008, we granted 894, 589, and 703 restricted shares, respectively. Approximately 220 of the restricted shares granted in 2008 were performance shares to certain
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executives for which the ultimate number of shares earned depend upon the attainment of meeting certain EBITDA levels. On February 12, 2010, we cancelled 190 restricted shares whose vesting depended upon meeting certain minimum annual adjusted EBITDA levels by 2010 and 2012 as we determined that achieving the performance criteria necessary for these awards to vest was not probable. On February 25, 2010, the affected executives were granted 160 shares of restricted stock that vest in 50% increments in February 2011 and 2012. The shares were issued at a total grant-date fair value of $2,032. We recognized $811 of share-based compensation expense from these awards during the year ended December 31, 2010.
The following table summarizes our restricted share award activity during the years ended December 31, 2010, 2009 and 2008 (shares in thousands):
| 2010 | 2009 | 2008 | ||||||||||||||||||||||
| Shares | Weighted Average Grant- Date Fair Value |
Shares | Weighted Average Grant- Date Fair Value |
Shares | Weighted Average Grant- Date Fair Value |
|||||||||||||||||||
| Outstanding at beginning of year |
1,126 | $ | 18.76 | 844 | $ | 21.78 | 233 | $ | 30.94 | |||||||||||||||
| Granted |
894 | 13.33 | 589 | 15.79 | 703 | 19.93 | ||||||||||||||||||
| Vested (A) |
(388 | ) | 19.28 | (200 | ) | 22.79 | (76 | ) | 30.79 | |||||||||||||||
| Cancelled |
(190 | ) | 17.09 | — | — | — | — | |||||||||||||||||
| Forfeited |
(129 | ) | 14.84 | (107 | ) | 18.69 | (16 | ) | 24.88 | |||||||||||||||
| Outstanding at end of year |
1,313 | $ | 15.53 | 1,126 | $ | 18.76 | 844 | $ | 21.78 | |||||||||||||||
| (A) | The fair value of restricted shares that vested during the years ended December 31, 2010, 2009 and 2008 was $5,133, $3,021 and $1,267 respectively. |
As of December 31, 2010, unrecognized shared-based compensation expense related to unvested restricted share awards outstanding totals approximately $13,133 and is expected to be recognized over a weighted-average period of 2.18 years.
On October 19, 2010, the Board of Directors approved a voluntary management share-based compensation plan that would allow members of management the option of converting cash performance-based compensation under our corporate bonus plan to shares of common stock based on his or her election to participate in the plan. Eligible participants were given until November 19, 2010 to make the election, and the right to elect to participate expired at that time. Each participant’s performance-based compensation that is eligible for equity conversion is limited to the portion of the corporate bonus plan pertaining to achievement of our revenue target in the fourth quarter of 2010. The number of shares to be granted shall be based on the closing share price of our stock on March 15, 2011. The shares earned by the participants in this plan vest at various points in 2011. During the year ended December 31, 2010, we recognized $234 of share-based compensation expense under this plan, and will recognize the remaining unvested share-based compensation of $226 over a weighted average remaining period of 4 months subsequent to December 31, 2010.
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12. Commitments
We have entered into various non-cancelable operating leases, with expirations through June 2016, for office space used in its operations. We also lease customer circuits from ILECs under minimum agreements for volume and term commitments in order to obtain more favorable pricing on a per circuit basis. Future minimum obligations under these arrangements as of December 31, 2010 are as follows:
| Operating Leases |
Purchase Obligations |
Anticipated Credit Facility Payments |
||||||||||
| 2011 |
$ | 10,298 | $ | 8,854 | $ | 289 | ||||||
| 2012 |
10,750 | 1,312 | 300 | |||||||||
| 2013 |
10,099 | 525 | 300 | |||||||||
| 2014 |
9,457 | — | 300 | |||||||||
| 2015 |
7,944 | — | 300 | |||||||||
| Thereafter |
8,383 | — | 33 | |||||||||
| Total |
$ | 56,931 | $ | 10,691 | $ | 1,522 | ||||||
Total rent expense for the years ended December 31, 2010, 2009 and 2008 was $8,374, $8,029 and $6,483, respectively. Certain real estate leases have fixed escalation clauses, holidays, and leasehold improvement allowances. Such leasehold improvement allowances were $870, $1,476 and $2,329 in 2010, 2009 and 2008, respectively. These allowances are capitalized as leasehold improvements, which are depreciated over the shorter of their useful lives or the lease term. The benefits of the allowances and the minimum lease payments under such operating leases are recorded on a straight-line basis over the life of the lease. Our lease agreements also generally have lease renewal options that are at our discretion and range in terms. Other non-current liabilities primarily consists of the long-term portion of our deferred rent liability, and is $10,434 and $10,514 as of December 31, 2010 and 2009, respectively.
Our anticipated credit facility payments primarily represent commitment fees related to our open, but unused, line of credit as amended in February 2011 (see Note 8). At December 31, 2010, we had outstanding letters of credit of $1,295. These letters of credit expire at various times through May 2016 and collateralize certain of our obligations to third party vendors.
13. Segment Information
Our management monitors and analyzes financial results on a segment basis for reporting and management purposes. Specifically, our chief operating decision maker allocates resources to and evaluates the performance of our operating segments based, depending on which segment, on revenue, direct operating expenses, and Adjusted EBITDA (defined below). The accounting policies of our reportable segments are the same as those described in the summary of significant accounting policies.
We aggregate geographic markets with similar economic characteristics for segment disclosure purposes. This aggregation is consistent with the direction toward which we are increasingly moving and managing the business. Specifically, we recognize that the highest risk stage for a market is in its early stages when we are adapting our strategy and approach to accommodate a new market’s unique characteristics; including the small business climate and culture, regulatory conditions, local competitors, and the quality and availability of local employees for staffing and managing the markets. Comparatively, our established markets generally require less frequent direct corporate level management involvement because we have adapted to the local market and have seasoned local management in place, which generally results in more stable operating performance. As the number of established markets has grown, our CODM now spends the majority of his time monitoring the individual performance levels of newer markets and the effectiveness of our corporate operations rather than focusing on individual established markets. As such, we have aggregated these mature markets as one reportable segment entitled “Core Managed Services Established Markets.”
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The markets subject to aggregation are those that we consider established because they have successfully passed through the critical start-up phase and, for the reasons mentioned previously, achieved certain operating performance levels. All other markets, our corporate operations and cloud services will continue to be presented as separate segments. Our segment disclosure will continue to include individual market data for each geographic market in addition to aggregate data for the established markets as a group. Currently, a market is considered established upon achieving positive adjusted EBITDA for at least four consecutive fiscal quarters and otherwise sharing similar economic characteristics as the other established markets. As of June 30, 2010 and September 30, 2010, the San Francisco and Detroit market, respectively, have been re-categorized to the Core Managed Services Established Market grouping due to their achievement of four consecutive fiscal quarters of positive adjusted EBITDA. We have updated our segment tables below to retroactively present Detroit and San Francisco as established markets in the prior periods.
At December 31, 2010, our reportable segments were Core Managed Services Established Markets; the individual Core Managed Services Emerging Markets including metropolitan Miami, Minneapolis, the Greater Washington DC Area, Seattle and Boston; and the Cloud Services segment. In the fourth quarter of 2010 after making our recent acquisitions, we established the Cloud Services segment. We consider the Cloud Services segment as a reportable segment because the CODM is managing the Cloud Services segment as a separate business unit in terms of resource allocation and financial performance. Specifically we have established resources and executive leadership solely dedicated to integrating our recent acquisitions into an operating arm of the company that will serve new customers in addition to up selling existing customers.
The operating results and capital expenditures from our market-based segments reflect the costs of a pre-launch phase in each market in which the local network is installed and initial staffing is hired, followed by a startup phase, beginning with the launch of service operations, when customer installations begin. Sales efforts, service offerings and the prices charged to customers for services are generally consistent across operating segments. Operating expenses include costs of revenue and selling, general and administrative costs incurred directly in each market. Although network design and market operations are generally consistent across all operating segments, certain costs differ among the various geographical markets. These cost differences result from different numbers of network central office collocations, prices charged by the local telephone companies for customer T-1 access circuits, prices charged by local telephone companies and other telecommunications providers for transport circuits, office rents and other costs that vary by region.
The balance of our operations is in the Corporate group, for which the operations consist of corporate executive, administrative and support functions and centralized operations, which includes network operations, customer care and provisioning. The Corporate group is treated as a separate segment consistent with the manner in which management monitors and analyzes financial results. Corporate costs are not allocated to the other segments because such costs are managed and controlled on a functional basis that spans all markets, with centralized, functional management held accountable for corporate results. Management also believes that the decision not to allocate these centralized costs provides a better evaluation of each revenue-producing geographic segment. Management does not report assets by segment since it manages assets and makes decisions on technology deployment and other investments on a company-wide rather than on a local market basis. The CODM does not use segment assets in evaluating the performance of operating segments. As a result, management does not believe that segment asset disclosure is meaningful information to investors. In addition to segment results, we use total Adjusted EBITDA to assess the operating performance of the overall business. Because the CODM evaluates the performance of each segment on the basis of Adjusted EBITDA as the primary metric for measuring segment profitability, management believes that segment Adjusted EBITDA data should be available to investors so that investors have the same data that management employs in assessing our overall operations. The CODM also uses revenue to measure operating results and assess performance, and both revenue and Adjusted EBITDA are presented herein.
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EBITDA is a non-GAAP financial measure commonly used by investors, financial analysts and ratings agencies. EBITDA is generally defined as net income (loss) before interest, income taxes, depreciation and amortization. However, we use Adjusted EBITDA, also a non-GAAP financial measure, to further exclude, when applicable, non-cash share-based compensation, public offering or acquisition-related transaction costs, purchase accounting adjustments, gain or loss on asset dispositions and non-operating income or expense. Adjusted EBITDA is presented because this financial measure, in combination with revenue and operating expenses, is an integral part of the internal reporting system used by our CODM to assess and evaluate the performance of the business and our operating segments, both on a consolidated and on an individual basis.
The tables below present information about our operating segments:
| Twelve Months Ended December 31, | ||||||||||||
| 2010 | 2009 | 2008 | ||||||||||
| Revenues |
||||||||||||
| Core Managed Services Established Markets |
$ | 417,414 | $ | 398,904 | $ | 347,718 | ||||||
| Core Managed Services Emerging Markets: |
||||||||||||
| Miami |
16,557 | 9,027 | 1,396 | |||||||||
| Minneapolis |
7,144 | 4,140 | 586 | |||||||||
| Greater Washington DC Area |
6,291 | 1,603 | — | |||||||||
| Seattle (4) |
2,691 | 97 | — | |||||||||
| Boston (5) |
84 | — | — | |||||||||
| Core Managed Services total emerging markets |
32,767 | 14,867 | 1,982 | |||||||||
| Total Core Managed Services |
450,181 | 413,771 | 349,700 | |||||||||
| Cloud Services |
1,791 | — | — | |||||||||
| Intersegment elimination |
(7 | ) | — | — | ||||||||
| Total revenues |
$ | 451,965 | $ | 413,771 | $ | 349,700 | ||||||
| Adjusted EBITDA |
||||||||||||
| Core Managed Services Established Markets (1) (2) |
$ | 188,578 | $ | 171,227 | $ | 149,062 | ||||||
| Core Managed Services Emerging Markets: |
||||||||||||
| Miami |
(311 | ) | (4,483 | ) | (4,899 | ) | ||||||
| Minneapolis |
(949 | ) | (3,881 | ) | (3,182 | ) | ||||||
| Greater Washington DC Area |
(4,035 | ) | (5,347 | ) | (594 | ) | ||||||
| Seattle (4) |
(5,196 | ) | (1,629 | ) | (11 | ) | ||||||
| Boston (5) |
(2,739 | ) | (1 | ) | — | |||||||
| Core Managed Services total emerging markets |
(13,230 | ) | (15,341 | ) | (8,686 | ) | ||||||
| Total Core Managed Services |
175,348 | 155,886 | 140,376 | |||||||||
| Cloud services |
569 | — | — | |||||||||
| Corporate |
(102,982 | ) | (92,760 | ) | (79,816 | ) | ||||||
| Total adjusted EBITDA (3) |
$ | 72,935 | $ | 63,126 | $ | 60,560 | ||||||
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| Twelve Months Ended December 31, | ||||||||||||
| 2010 | 2009 | 2008 | ||||||||||
| Operating income (loss) |
||||||||||||
| Core Managed Services Established Markets (1) (2) |
$ | 163,058 | $ | 145,212 | $ | 125,326 | ||||||
| Core Managed Services Emerging Markets: |
||||||||||||
| Miami |
(1,947 | ) | (5,685 | ) | (5,477 | ) | ||||||
| Minneapolis |
(1,982 | ) | (4,751 | ) | (3,525 | ) | ||||||
| Greater Washington DC Area |
(5,480 | ) | (6,423 | ) | (604 | ) | ||||||
| Seattle (4) |
(6,085 | ) | (1,820 | ) | (11 | ) | ||||||
| Boston (5) |
(2,926 | ) | (2 | ) | — | |||||||
| Core Managed Services total emerging markets |
(18,420 | ) | (18,681 | ) | (9,617 | ) | ||||||
| Total Core Managed Services |
144,638 | 126,531 | 115,709 | |||||||||
| Cloud services |
(158 | ) | — | — | ||||||||
| Corporate |
(147,408 | ) | (131,199 | ) | (109,612 | ) | ||||||
| Total operating (loss) income (3) |
$ | (2,928 | ) | $ | (4,668 | ) | $ | 6,097 | ||||
| Depreciation and amortization expense |
||||||||||||
| Core Managed Services Established Markets |
$ | 24,681 | $ | 25,053 | $ | 23,044 | ||||||
| Core Managed Services Emerging Markets: |
||||||||||||
| Miami |
1,557 | 1,114 | 532 | |||||||||
| Minneapolis |
985 | 817 | 310 | |||||||||
| Greater Washington DC Area |
1,405 | 1,023 | 3 | |||||||||
| Seattle (4) |
852 | 172 | — | |||||||||
| Boston (5) |
175 | 1 | — | |||||||||
| Core Managed Services total emerging markets |
4,974 | 3,127 | 845 | |||||||||
| Total Core Managed Services |
29,655 | 28,180 | 23,889 | |||||||||
| Cloud services |
503 | — | — | |||||||||
| Corporate |
29,146 | 23,660 | 17,687 | |||||||||
| Total depreciation and amortization expense |
$ | 59,304 | $ | 51,840 | $ | 41,576 | ||||||
| Capital expenditures |
||||||||||||
| Core Managed Services Established Markets |
$ | 22,045 | $ | 23,239 | $ | 27,154 | ||||||
| Core Managed Services Emerging Markets: |
||||||||||||
| Miami |
1,706 | 2,325 | 3,653 | |||||||||
| Minneapolis |
695 | 1,158 | 2,705 | |||||||||
| Greater Washington DC Area |
923 | 1,253 | 4,171 | |||||||||
| Seattle (4) |
1,632 | 3,003 | 529 | |||||||||
| Boston (5) |
2,099 | 309 | — | |||||||||
| Core Managed Services total emerging markets |
7,055 | 8,048 | 11,058 | |||||||||
| Total Core Managed Services |
29,100 | 31,287 | 38,212 | |||||||||
| Cloud services |
413 | — | — | |||||||||
| Corporate |
33,319 | 30,839 | 31,728 | |||||||||
| Total capital expenditures |
$ | 62,832 | $ | 62,126 | $ | 69,940 | ||||||
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| Twelve Months Ended December 31, | ||||||||||||
| 2010 | 2009 | 2008 | ||||||||||
| Reconciliation of Adjusted EBITDA to net income: |
||||||||||||
| Total adjusted EBITDA for operating segments |
$ | 72,935 | $ | 63,126 | $ | 60,560 | ||||||
| Depreciation and amortization |
(59,304 | ) | (51,840 | ) | (41,576 | ) | ||||||
| Non-cash share-based compensation |
(15,591 | ) | (15,954 | ) | (12,887 | ) | ||||||
| MaximumASP purchase accounting adjustment (6) |
(213 | ) | — | — | ||||||||
| Transaction costs |
(755 | ) | — | — | ||||||||
| Interest income |
2 | 28 | 846 | |||||||||
| Interest expense |
(281 | ) | (152 | ) | (224 | ) | ||||||
| Other income, net |
1,867 | 498 | 71 | |||||||||
| Income tax (expense) benefit |
(314 | ) | 2,074 | (3,094 | ) | |||||||
| Net (loss) income |
$ | (1,654 | ) | $ | (2,220 | ) | $ | 3,696 | ||||
| (1) | During 2008, we settled outstanding cost of revenue obligations relating to previous periods for approximately $2,436 less than the recorded liability, resulting in a benefit to cost of revenue for Core Managed Services Established Markets. See Triennial Review Remand Order discussion in Note 14. We also recognized an additional benefit of approximately $921 in cost of revenue that arose due to a change in estimate relating to shortening the back billing limitation period for certain recorded obligations resulting from regulatory precedents established by the Georgia Public Service. |
| (2) | During 2010, we recognized a benefit of approximately $724 to cost of revenue for telecommunication cost recoveries. See Triennial Review Remand Order discussion in Note 14. |
| (3) | During 2009, we settled an outstanding cost of revenue obligation relating to previous periods for approximately $832 less than the recorded liability resulting in a benefit to cost of revenue across several markets. |
| (4) | We launched service to customers in the Seattle market in the fourth quarter of 2009. |
| (5) | We launched service to customers in the Boston market in the third quarter of 2010. |
| (6) | These adjustments include the effect on revenue of adjusting acquired deferred revenue balances to fair value as of the respective acquisition dates for the Cloud Services acquisitions. The reduction of the deferred revenue balances affects period-to-period financial performance comparability and revenue and earnings growth in future periods subsequent to the acquisition and is not indicative of changes in underlying results of operations. We may have this adjustment in future periods if we have any new acquisitions. |
14. Contingencies
Triennial Review Remand Order
In February 2005, the Federal Communications Commission or FCC issued its Triennial Review Remand Order or TRRO and adopted new rules, effective March 11, 2005, governing the obligations of incumbent local exchange carriers or ILECs to afford access to certain of their network elements, if at all, and the cost of such facilities. The TRRO reduced the ILECs’ obligations to provide high-capacity loops within, and dedicated transport facilities between, certain ILEC wire centers that were deemed to be or become sufficiently competitive, based upon various factors such as the number of fiber-based collocators and/or the number of business access lines within a wire center. In addition, certain caps were imposed regarding the number of unbundled network element (UNE) facilities that the ILECs are required to make available on a single route or into a single building. Where the wire center conditions or the caps were exceeded, the TRRO eliminated the ILECs’ obligations to provide these high-capacity circuits to competitors at the discounted rates historically received under the federal 1996 Telecommunications Act. If in the future, the conditions or caps are exceeded in additional locations, ILEC UNE obligations could be further reduced.
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The rates charged by ILECs for our high-capacity circuits in place on March 11, 2005 that were affected by the FCC’s new rules were increased 15% effective for one year until March 2006. In addition, by March 10, 2006, we were required to transition those existing facilities to alternative arrangements, such as other competitive facilities or the higher-priced “special access services” offered by the ILECs, unless another rate had been negotiated. Subject to any contractual protections under our existing interconnection agreements with ILECs, beginning March 11, 2005, we were also potentially subject to the ILECs’ higher “special access” pricing for any new installations of DS-1 loops and/or DS-1 (the capacity equivalent of a T-1) and DS-3 (the capacity equivalent of 28 T-1s) transport facilities in the affected ILEC wire centers, on the affected transport routes, or that exceeded the caps.
Beginning on March 11, 2005, we began estimating and accruing the difference between the new pricing resulting from the TRRO and the pricing being invoiced by ILECs. We continue to accrue certain amounts relating to the implementation of the TRRO due to billing rates that continue to reflect pre-TRRO pricing. As of December 31, 2010 and December 31, 2009, respectively, our accrual totals $1,629 and $2,044. The accrued liability balance at December 31, 2010 and December 31, 2009, respectively, includes additional costs of revenue of $309 and $1,214 related to the implementation of TRRO. These additional costs were offset by $724 and $2,207 in reductions to the liability during the year ended December 31, 2010 and December 31, 2009, respectively. The 2009 reductions include settlements relating to negotiating payments that were less than the TRRO liabilities recorded. In connection with these settlements and the back billing limitation referenced in Note 13, we recognized benefits to cost of revenue of approximately $532 (total settlement benefit of $832, however; only $532 is TRRO related) in 2009. All of the aforementioned benefits to cost of revenue were recorded as telecommunications cost recoveries. These estimates of remaining TRRO obligations are for all markets and, where alternate pricing or settlement agreements have not been reached, are based on special access rates available under volume and/or term pricing plans. We believe volume and/or term pricing plans are the most probable pricing regime to which we are subject based on our experience and our intent to enter into volume and/or term commitments where more attractively priced alternatives do not exist.
A portion of these accrued expenses have never been invoiced by the ILECs and are generally subject to either a two-year statutory back billing period limitation or a 12-month contractual back billing limitation. Unbilled TRRO expenses that pass the statutory back billing period are usually reversed as a benefit to cost of revenue and a reduction of the corresponding liability.
Regulatory and Customer-based Taxation Contingencies
We operate in a highly regulated industry and are subject to regulation and oversight by telecommunications authorities at the federal, state and local levels. Decisions made by these agencies, including the various rulings made to date regarding interpretation and implementation of the TRRO, compliance with various federal and state rules and regulations and other administrative decisions are frequently challenged through both the regulatory process and through the court system. Challenges of this nature often are not resolved for long periods of time and occasionally include retroactive impacts. At any point in time, there are a number of similar matters before the various regulatory agencies that could be either beneficial or adverse to our operations. In addition, we are always at risk of non-compliance, which can result in fines and assessments. We regularly evaluate the potential impact of matters undergoing challenges and matters involving compliance with regulations to determine whether sufficient information exists to require either disclosure and/or accrual. However, due to the nature of the regulatory environment, reasonably estimating the range of possible outcomes and the probabilities of the possible outcomes is difficult since many matters could range from a gain contingency to a loss contingency.
We are required to bill taxes, fees and other amounts (collectively referred to as “taxes”) on behalf of government entities at the county, city, state and federal level (“taxing authorities”). Each taxing authority may
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have one or more taxes with unique rules as to which services are subject to each tax and how those services should be taxed, the application of which involves judgment and heightens the risk of non-compliance. Because we sell many of our services on a bundled basis and assess different taxes on the individual components included within the bundle, there is also a risk that a taxing authority could disagree with the taxable value of a bundled component.
Taxing authorities periodically perform audits to verify compliance and include all periods that remain open under applicable statutes, which range from three to four years. At any point in time, we are undergoing audits that could result in significant assessments of past taxes, fines and interest if we were found to be non-compliant. During the course of an audit, a taxing authority may, as a matter of policy, question our interpretation and/or application of their rules in a manner that, if we were not successful in substantiating our position, could potentially result in a significant financial impact to us. In the course of preparing our financial statements and disclosures, we consider whether information exists which would warrant specific disclosure and/or accrual in such situations. To date, we have been successful in satisfactorily demonstrating our compliance and have concluded audits with either no assessment or assessments that were not material to us. However, we cannot be assured that in every such audit in the future the merits of our position or the reasonableness of our interpretation and application of rules will prevail.
Dissolution of Captive Leasing Subsidiaries
Effective December 31, 2006, we dissolved and collapsed our captive leasing subsidiaries. These subsidiaries historically purchased assets sales tax-free and leased the assets to our operating companies as a means of preserving cash flow during our start-up phase of operations. During 2006, we determined that the nature of our operations and experience with asset duration did not justify the administrative cost and effort of maintaining these subsidiaries. In connection with the dissolution, a final accounting of all activity under the leasing subsidiaries was performed, and certain sales tax underpayments were identified and accrued. These liabilities, along with other liabilities related to the captive leasing subsidiaries that existed at the time of collapse, are included in Other Accrued Liabilities. Over time, we have adjusted the liabilities related to captive leasing subsidiaries for any statutory periods that have expired. For the year ended December 31, 2010, we recorded adjustments to these liabilities that fell into expired statutory periods resulting in a benefit of $1,867, to other income, net. Statutory periods will continue to expire through the first quarter of 2011.
Legal Proceedings
From time to time, we are involved in legal proceedings arising in the ordinary course of business. We believe that we have adequately reserved for these liabilities and that as of December 31, 2010, there is no litigation pending that could have a material adverse effect on our results of operations and financial condition.
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CBEYOND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
15. Selected Quarterly Financial Data (unaudited)
| First Quarter |
Second Quarter |
Third Quarter |
Fourth Quarter |
|||||||||||||
| 2010 |
||||||||||||||||
| Revenue |
$ | 110,515 | $ | 111,753 | $ | 113,456 | $ | 116,241 | ||||||||
| Gross profit (exclusive of depreciation and amortization) |
74,126 | 76,450 | 77,163 | 77,719 | ||||||||||||
| Depreciation and amortization expense |
14,282 | 14,331 | 14,506 | 16,185 | ||||||||||||
| Operating income (loss) |
572 | 148 | (771 | ) | (2,877 | ) | ||||||||||
| Income (loss) before income taxes |
2,064 | 202 | (751 | ) | (2,855 | ) | ||||||||||
| Net income (loss) |
1,039 | (98 | ) | (608 | ) | (1,987 | ) | |||||||||
| Net income (loss) per common share—basic |
0.04 | — | (0.02 | ) | (0.07 | ) | ||||||||||
| Net income (loss) per common share—diluted |
0.03 | — | (0.02 | ) | (0.07 | ) | ||||||||||
| First Quarter |
Second Quarter |
Third Quarter |
Fourth Quarter |
|||||||||||||
| 2009 |
||||||||||||||||
| Revenue |
$ | 98,260 | $ | 101,837 | $ | 105,955 | $ | 107,719 | ||||||||
| Gross profit (exclusive of depreciation and amortization) |
66,381 | 67,372 | 69,931 | 71,994 | ||||||||||||
| Depreciation and amortization expense |
11,633 | 12,134 | 13,259 | 14,814 | ||||||||||||
| Operating (loss) income |
(713 | ) | (1,954 | ) | (2,131 | ) | 130 | |||||||||
| (Loss) income before income taxes |
(682 | ) | (1,832 | ) | (2,154 | ) | 374 | |||||||||
| Net income (loss) |
59 | (2,206 | ) | (998 | ) | 925 | ||||||||||
| Net income (loss) per common share—basic |
— | (0.08 | ) | (0.03 | ) | 0.03 | ||||||||||
| Net income (loss) per common share—diluted |
— | (0.08 | ) | (0.03 | ) | 0.03 | ||||||||||
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| Item 9. | Changes in and Disagreements With Accountants on Accounting and Financial Disclosure |
None.
| Item 9A. | Controls and Procedures |
Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(b) as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed by us in reports we file or submit under the Exchange Act is (1) recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and (2) is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.
Management’s Annual Report On Internal Control Over Financial Reporting
On November 2, 2010, we acquired substantially all of the net assets of privately-held MaximumASP, LLC, MaximumCOLO, LLC, and Maximum Holdings, LLC (collectively “MaximumASP”). On October 29, 2010, we acquired 100% of the outstanding voting stock of privately-held Aretta Communications, Inc. As permitted by Securities and Exchange Commission guidance, the scope of our Section 404 evaluation for the fiscal year ended December 31, 2010 excludes the internal control over financial reporting of the acquired operations of MaximumASP or Aretta. MaximumASP and Aretta are included in our consolidated financial statements from the date of acquisition. MaximumASP and Aretta represented approximately $42.3 million and $33.7 million of total assets and net assets, respectively, as of December 31, 2010 and approximately $1.8 million and $0.1 million of revenues and net income, respectively, for the year then ended. From the acquisition date to December 31, 2010, the processes and systems of the acquired operations were discrete and did not significantly affect our internal control over financial reporting for our other consolidated subsidiaries.
Management is responsible for establishing and maintaining adequate internal control over financial reporting. With the participation of our Chief Executive Officer and Chief Financial Officer, management conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2010 based on the Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management concluded that our internal control over financial reporting was effective as of December 31, 2010. There were no changes in our internal control over financial reporting during the quarter ended December 31, 2010 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Our independent registered public accounting firm, Ernst & Young LLP, has audited and reported on our consolidated financial statements and the effectiveness of our internal control over financial reporting, which appear in Item 8 of this Annual Report.
| Item 9B. | Other Information |
None.
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PART III
| Item 10. | Directors, Executive Officers and Corporate Governance |
The information required by this Item 10 will be contained in our definitive proxy statement issued in connection with the 2011 annual meeting of stockholders to be filed with the SEC within 120 days after December 31, 2010 and is incorporated herein by reference.
Our Board of Directors has adopted a Code of Ethics. This Code of Ethics applies to all of our directors, officers and employees and all such individuals are required to strictly adhere to the principles as described in the Code of Ethics. The Code of Ethics is available on our Web site at www.cbeyond.net. The foregoing information is also available in print upon request.
| Item 11. | Executive Compensation |
The information required by this Item 11 will be contained in our definitive proxy statement under the captions “The Board of Directors and Committees,” “Executive Compensation,” “Compensation Discussion and Analysis,” and “Compensation Committee Interlocks and Participation” issued in connection with the 2011 annual meeting of stockholders to be filed with the SEC within 120 days after December 31, 2010 and is incorporated herein by reference.
| Item 12. | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters |
The information required by this Item 12 will be contained in our definitive proxy statement under the caption “Security Ownership of Certain Beneficial Owners” issued in connection with the 2011 annual meeting of stockholders to be filed with the SEC within 120 days after December 31, 2010 and is incorporated herein by reference.
| Item 13. | Certain Relationships and Related Transactions, and Director Independence |
The information required by this Item 13 will be contained in our definitive proxy statement under the caption “Certain Relationships and Related Transactions” issued in connection with the 2011 annual meeting of stockholders to be filed with the SEC within 120 days after December 31, 2010 and is incorporated herein by reference.
| Item 14. | Principal Accounting Fees and Services |
The information required by this Item 14 will be contained in our definitive proxy statement under the caption “Ratification of Independent Registered Public Accounting Firm” issued in connection with the 2011 annual meeting of stockholders to be filed with the SEC within 120 days after December 31, 2010 and is incorporated herein by reference.
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PART IV
| Item 15. | Exhibits, Financial Statement Schedules |
(a) (1) Financial Statements.
The response to this item is included in Item 8.
(2) Financial Statement Schedule. None
All schedules are omitted because they are not required or the required information is shown in the consolidated financial statements or notes thereto.
(3) Exhibits
See the response to Item 15(b) below.
(b) Exhibits.
The following exhibits are filed as part of, or are incorporated by reference into, this report on Form 10-K:
INDEX TO EXHIBITS
| Exhibit No. |
Description of Exhibit | |
| 2.1(a) | Asset Purchase Agreement, dated November 3, 2010, by and among the Company, Cbeyond Communications, LLC, MaximumASP, LLC, MaximumColo, LLC and Maximum Holdings, LLC, and Silas Boyle and Wade Lewis, each in his individual capacity. | |
| 3.1(b) | Second Amended and Restated Certificate of Incorporation of Cbeyond, Inc., as amended. | |
| 3.2(c) | Second Amended and Restated Bylaws of Cbeyond Communications, Inc. | |
| 10.1(c) | Third Amended and Restated Registration Rights Agreement, dated as of December 29, 2004, by and among Cbeyond Communications, Inc. and the other signatories thereto. | |
| 10.2(c) | 2005 Equity Incentive Award Plan of Cbeyond Communications, Inc. | |
| 10.3(c) | 2002 Equity Incentive Plan of Cbeyond Communications, Inc. | |
| 10.4(c) | 2000 Stock Incentive Plan (as amended) of Cbeyond Communications, Inc. | |
| 10.5(c) | Form of Stock Option Grant Notice and Stock Option Agreement under the 2005 Equity Incentive Award Plan of Cbeyond Communications, Inc. | |
| 10.6(c) | Form of Restricted Stock Award Grant Notice and Restricted Stock Award Agreement under the 2005 Equity Incentive Plan of Cbeyond Communications, Inc. | |
| 10.7(c) | Form of Amended and Restated At-Will Employment Agreement. | |
| 10.8(d) | Credit Agreement, dated as of February 8, 2006, by and among Cbeyond Communications, LLC, Bank of America and the other parties thereto. | |
| 10.9(e) | First Amendment to Credit Agreement, dated as of July 2, 2007, by and among Cbeyond Communications, LLC, Bank of America and the other parties thereto. | |
| 10.10(f) | Form of Indemnity Agreement by and between Cbeyond and each of the executive officers. | |
| 10.11(g) | Form of At-Will Employment Agreement by and between Cbeyond and James Geiger. | |
| 10.12(g) | Form of At-Will Employment Agreement by and between Cbeyond and J. Robert Fugate. | |
| 10.13(g) | Form of At-Will Employment Agreement by and between Cbeyond and each of Robert Morrice, Brooks Robinson, Chris Gatch, Joseph Oesterling and Richard Batelaan. | |
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| Exhibit No. |
Description of Exhibit | |
| 10.14(h) | Waiver and Second Amendment to Credit Agreement, dated as of February 24, 2009, by and among Cbeyond Communications, LLC, Bank of America and the other parties thereto. | |
| 10.15(i) | Cbeyond Inc.’s 2005 Equity Incentive Award Plan, as amended and restated on June 12, 2009. | |
| 10.16(i) | Cbeyond Inc.’s Senior Executive Bonus Plan, as adopted on June 12, 2009. | |
| 10.17(j) | Third Amendment to Credit Agreement, dated as of March 3, 2010, by and among Cbeyond Communications, LLC, Bank of America and the other parties thereto. | |
| 10.18(k) | Fourth Amendment to Credit Agreement, dated as of February 22, 2011, by and among Cbeyond Communications, LLC, Bank of America and other parties thereto. | |
| 14.1(l) | Cbeyond Inc.’s Code of Ethics | |
| 21.1 | Subsidiaries of Cbeyond, Inc. (filed herewith) | |
| 23.1 | Consent of Ernst & Young LLP, independent registered public accounting firm (filed herewith). | |
| 31.1 | Certification of the Chief Executive Officer, James F. Geiger, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith). | |
| 31.2 | Certification of the Chief Financial Officer, J. Robert Fugate, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith). | |
| 32.1 | Certification of the Chief Executive Officer, James F. Geiger, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (furnished herewith). | |
| 32.2 | Certification of the Chief Financial Officer, J. Robert Fugate, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (furnished herewith). | |
| (a) | Incorporated by reference to Form 8-K dated November 3, 2010 filed on November 3, 2010 (File No. 000-51588). |
| (b) | Incorporated by reference to Registration Statement on Firm S-1 filed on September 19, 2006 (File No. 333-137445), as amended by Amendment No. 1 filed on September 25, 2006. |
| (c) | Incorporated by reference to Registration Statement on Form S-1 filed on May 16, 2005 (File No. 333-124971), as amended by Amendment No. 1 filed on June 30, 2005, by Amendment No. 2 filed on July 27, 2005, by Amendment No. 3 filed on August 24, 2005, by Amendment No. 4 filed on September 20, 2005, by Amendment No. 5 filed on October 3, 2005, by Amendment No. 6 filed on October 5, 2005, by Amendment No. 7 filed on October 7, 2005 and by Amendment No. 8 filed on October 27, 2005. |
| (d) | Incorporated by reference to Form 8-K dated February 14, 2006 filed on February 14, 2006 (File No. 000-51588). |
| (e) | Incorporated by reference to Form 10-Q for second quarter 2007, filed on August 7, 2007 (File No. 000-51588). |
| (f) | Incorporated by reference to Form 10-Q for third quarter 2007 filed on November 6, 2007 (File No. 000-51588). |
| (g) | Incorporated by reference to Exhibits 10.11, 10.12 and 10.13 of Form 10-K for the fiscal year ended December 31, 2007 filed on February 29, 2008 (File No. 000-51588). |
| (h) | Incorporated by reference to Form 10-K for the fiscal year ended December 31, 2008 filed on March 6, 2009 (File No. 000-51588). |
| (i) | Incorporated by reference to Cbeyond Inc.’s definitive proxy statement for the 2009 Annual Meeting of Stockholders filed on April 24, 2009 (File No. 000-51588). |
| (j) | Incorporated by reference to Form 10-K for the fiscal year ended December 31, 2009 filed on March 5, 2010 (File No. 000-51588). |
| (k) | Incorporated by reference to Form 8-K dated February 28, 2011 filed on February 28, 2011 (File No. 000-51588). |
| (l) | Incorporated by reference to Form 10-K for the fiscal year ended December 31, 2005 filed on March 31, 2006 (File No. 000-51588). |
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Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
| CBEYOND, INC. | ||
| By: |
/s/ James F. Geiger | |
| James F. Geiger Chairman, President and Chief Executive Officer | ||
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
| Signature |
Title |
Date | ||
| /s/ James F. Geiger James F. Geiger |
Chairman, President and Chief Executive Officer |
March 10, 2011 | ||
| /s/ J. Robert Fugate J. Robert Fugate |
Executive Vice President and Chief Financial Officer |
March 10, 2011 | ||
| /s/ Henry C. Lyon Henry C. Lyon |
Vice President and Chief Accounting Officer |
March 10, 2011 | ||
| /s/ John Chapple John Chapple |
Director |
March 10, 2011 | ||
| /s/ Douglas C. Grissom Douglas C. Grissom |
Director |
March 10, 2011 | ||
| /s/ D. Scott Luttrell D. Scott Luttrell |
Director |
March 10, 2011 | ||
| /s/ Martin Mucci Martin Mucci |
Director |
March 10, 2011 | ||
| /s/ Kevin Costello Kevin Costello |
Director |
March 10, 2011 | ||
| /s/ David A. Rogan David A. Rogan |
Director |
March 10, 2011 | ||
| /s/ Larry Thompson Larry Thompson |
Director |
March 10, 2011 | ||
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