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

FORM 10-Q

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

For the Quarterly Period Ended September 30, 2011

Commission File Number 000-51211

Global Telecom & Technology, Inc.
(Exact Name of Registrant as Specified in Its Charter)

Delaware                                             
20-2096338                                             
(State or Other Jurisdiction of
(I.R.S. Employer Identification No.)
Incorporation or Organization)
 

8484 Westpark Drive
Suite 720
McLean, Virginia 22102
(703) 442-5500
(Address including zip code, and telephone number, including area
code of principal executive officers)

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 o

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 o No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large Accelerated Filer o
Accelerated Filer o
Non-Accelerated Filer o
Smaller reporting company x
 (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 o No x

As of November 10, 2011, 18,749,861 shares of common stock, par value $.0001 per share, of the registrant were outstanding.
 
 
 

 

 
Page
PART I — FINANCIAL INFORMATION
 
Item 1. Financial Statements (unaudited)
 
Condensed Consolidated Balance Sheets
3
Condensed Consolidated Statements of Income
4
Condensed Consolidated Statement of Stockholders’ Equity
5
Condensed Consolidated Statements of Cash Flows
6
Notes to Condensed Consolidated Financial Statements
7
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
17
Item 3. Quantitative and Qualitative Disclosures about Market Risk
23
Item 4. Controls and Procedures
23
PART II — OTHER INFORMATION
 
Item 1. Legal Proceedings
24
Item 1A. Risk Factors
24
Item 6. Exhibits
36
SIGNATURES
37
CERTIFICATIONS
 
 
 
2

 
 
PART 1 – Financial Information

ITEM 1. FINANCIAL STATEMENTS

Global Telecom & Technology, Inc.
Condensed Consolidated Balance Sheets
(Amounts in thousands, except for share and per share data)
 
   
September 30, 2011
   
December 31, 2010
 
         
(Note 1)
 
ASSETS
           
Current assets:
           
Cash and cash equivalents 
  $ 6,963     $ 6,562  
Accounts receivable, net of allowances of $2,861 and $4,123, respectively
    8,197       5,787  
Deferred contract costs
    1,409       536  
Prepaid expenses and other current assets
    2,397       1,105  
Total current assets
    18,966       13,990  
                 
Property and equipment, net
    3,639       1,674  
Intangible assets, net
    12,554       5,732  
Other assets
    4,387       3,519  
Goodwill
    40,950       29,046  
Total assets
  $ 80,496     $ 53,961  
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
               
Current liabilities:
               
Accounts payable
  $ 13,402     $ 9,279  
Accrued expenses and other current liabilities
    11,589       6,831  
Short-term debt
    8,062       2,245  
Deferred revenue
    6,380       5,898  
Total current liabilities
    39,433       24,253  
                 
Long-term debt
    22,022       12,020  
Deferred revenue and other long-term liabilities
    1,050       605  
Total liabilities
    62,505       36,878  
                 
Commitments and contingencies
               
                 
Stockholders' equity:
               
Common stock, par value $.0001 per share, 80,000,000 shares authorized, 18,749,861 and 17,880,254 shares issued and outstanding as of September 30, 2011 and December 31, 2010, respectively
    2       2  
Additional paid-in capital
    62,199       61,497  
Accumulated deficit
    (43,801 )     (44,129 )
Accumulated other comprehensive loss
    (409 )     (287 )
Total stockholders' equity
    17,991       17,083  
Total liabilities and stockholders' equity
  $ 80,496     $ 53,961  

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.
 
 
3

 

Global Telecom & Technology, Inc.
Condensed Consolidated Statements of Income
(Unaudited)
(Amounts in thousands, except for share and per share data)
 
   
Three Months Ended
   
Nine Months Ended
 
   
September 30, 2011
   
September 30, 2010
   
September 30, 2011
   
September 30, 2010
 
                         
Revenue:
                       
Telecommunications services sold
  $ 24,035     $ 20,011     $ 65,639     $ 60,304  
                                 
Operating expenses:
                               
Cost of telecommunications services provided
    16,972       13,946       46,164       42,641  
Selling, general and administrative expense
    4,641       4,500       13,719       13,217  
Restructuring costs, employee termination and other items
    -       -       958       -  
Depreciation and amortization
    1,160       688       2,725       2,105  
                                 
Total operating expenses
    22,773       19,134       63,566       57,963  
                                 
Operating income
    1,262       877       2,073       2,341  
                                 
Other income (expense):
                               
Interest expense, net
    (803 )     (370 )     (1,579 )     (1,063 )
Other income (expense), net
    5       (67 )     (77 )     (287 )
                                 
Total other income (expense)
    (798 )     (437 )     (1,656 )     (1,350 )
                                 
Income before income taxes
    464       440       417       991  
                                 
Provision for (benefit from) income taxes
    21       (9 )     89       74  
                                 
Net income
  $ 443     $ 449     $ 328     $ 917  
                                 
Earnings per share:
                               
Basic
  $ 0.02     $ 0.03     $ 0.02     $ 0.05  
Diluted
  $ 0.02     $ 0.03     $ 0.02     $ 0.05  
                                 
Weighted average shares:
                               
Basic
    18,717,614       16,767,451       18,549,996       16,718,007  
Diluted
    18,952,606       16,974,514       18,771,319       16,951,038  

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

 
4

 

Global Telecom & Technology, Inc.
Condensed Consolidated Statement of Stockholders’ Equity
(Unaudited)
(Amounts in thousands, except for share data)

                           
Accumulated
       
               
Additional
         
Other
       
    Common Stock    
Paid-In
   
Accumulated
   
Comprehensive
       
   
Shares
   
Amount
   
Capital
   
Deficit
   
Loss
   
Total
 
Balance, December 31, 2010
    17,880,254     $ 2     $ 61,497     $ (44,129 )   $ (287 )   $ 17,083  
                                                 
Share-based compensation for options issued
    -       -       134       -       -       134  
                                                 
Share-based compensation for restricted stock issued
    459,607       -       321       -       -       321  
                                                 
Shares issued related to December 2009 acquisition
    210,000       -       -       -       -       -  
                                                 
Shares issued in February 2011 units offering
    200,000       -       247       -       -       247  
                                                 
Comprehensive income (loss):
                                               
Net income
    -       -       -       328       -       328  
Change in accumulated foreign currency translation loss
    -       -       -       -       (122 )     (122 )
Comprehensive income
                                            206  
                                                 
Balance, September 30, 2011
    18,749,861     $ 2     $ 62,199     $ (43,801 )   $ (409 )   $ 17,991  
 
The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

 
5

 

Global Telecom & Technology, Inc.
Condensed Consolidated Statements of Cash Flows
(Unaudited)
(Amounts in thousands)

   
Nine Months Ended
 
   
September 30, 2011
   
September 30, 2010
 
             
Cash flows from operating activities:
           
Net income
  $ 328     $ 917  
Adjustments to reconcile net income to net cash provided by (used in) operating activities
               
Depreciation and amortization
    2,725       2,105  
Shared -based compensation
    455       504  
Debt discount amortization
    230       -  
Change in fair value of warrant liability
    (38 )        
                 
Changes in operating assets and liabilities, net of effects of acquisition:
               
Accounts receivable, net
    362       746  
Deferred contract cost, prepaid expenses, income tax refund receivable and other current assets
    (313 )     (289 )
Other assets
    (773 )     (3,084 )
Accounts payable
    (254 )     (592 )
Accrued expenses and other current liabilities
    (425 )     (3,877 )
Deferred revenue and other long-term liabilities
    (1,905 )     224  
                 
Net cash provided by (used in) operating activities
    392       (3,346 )
                 
Cash flows from investing activities:
               
Acquisition of businesses, net of cash acquired
    (14,604 )     -  
Purchases of property and equipment
    (480 )     (135 )
                 
Net cash used in investing activities
    (15,084 )     (135 )
                 
Cash flows from financing activities:
               
Promissory note repayment
    -       (250 )
Principal payments on capital leases
    (244 )     (253 )
Borrowing on line of credit
    2,162       969  
Repayment of term loan
    (1,580 )     -  
Payment of notes payable
    -       (3,146 )
Payment of convertible notes payable
    -       (4,000 )
Issuance of term loan, net of fees
    14,462       10,000  
Issuance of sub ordinated notes
    153       1,546  
Issuance of units offering common shares
    247       935  
                 
Net cash provided by financing activities
    15,200       5,801  
                 
Effect of exchange rate changes on cash
    (107 )     (85 )
                 
Net increase in cash and cash equivalents
    401       2,235  
                 
Cash and cash equivalents at beginning of period
    6,562       5,548  
                 
Cash and cash equivalents at end of period
  $ 6,963     $ 7,783  
                 
Supplemental disclosure of cash flow information
               
Cash paid for interest
  $ 1,137     $ 300  
                 
Supplemental disclosure of non cash investing and financing activities (Note 3)
               
Packet Exchange acquisition related:
               
Fair value of liabilities assumed
  $ 9,869     $ -  
Fair value of assets aquired
    16,015       -  
Fair value of promissory note
    709       -  
Fair value of warrant liability
    389       -  

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.
 
 
6

 
 
Global Telecom & Technology, Inc.
Notes to Condensed Consolidated Financial Statements

NOTE 1 — ORGANIZATION AND BUSINESS

Organization and Business

Global Telecom & Technology, Inc. (“GTT” or the “Company”) is a Delaware corporation which was incorporated on January 3, 2005. GTT is a global telecommunications carrier and leading network integrator serving the data communications needs of large enterprise, government and carrier clients in over 80 countries. We combine our own network assets with the networks of over 800 suppliers worldwide to deliver cost-effective, scalable solutions supporting each client’s unique requirements. Through our proprietary Client Management Database (CMD), GTT provides streamlined service design and quotation, rapid service implementation, and global 24x7 monitoring and support. GTT is headquartered in the Washington, DC metro region with offices in London, Dusseldorf, and Denver.

GTT serves as the holding company for two operating subsidiaries, Global Telecom & Technology Americas, Inc. (“GTTA”) and GTT — EMEA Ltd. (“GTTE”) and their respective subsidiaries (collectively, hereinafter, the “Company”).

Unaudited Interim Financial Statements

The accompanying unaudited condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) and should be read in conjunction with the Company’s audited financial statements and footnotes thereto for the year ended December 31, 2010, included in the Company’s Annual Report on Form 10-K filed on March 11, 2011. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) have been omitted pursuant to such rules and regulations.  However, the Company believes that the disclosures are adequate to prevent the information from being misleading.  The unaudited condensed consolidated financial statements reflect all adjustments (consisting primarily of normal recurring adjustments) that are, in the opinion of management, necessary for a fair presentation of the Company’s consolidated financial position and the results of operations.  The operating results for the nine months ended September 30, 2011, are not necessarily indicative of the results to be expected for the full fiscal year 2011 or for any other interim period.  The December 31, 2010 condensed consolidated balance sheet has been derived from the audited financial statements as of that date, but does not include all disclosures required by GAAP.

Use of Estimates and Assumptions

The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect certain reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results can, and in many cases will, differ from those estimates.

Accounting for Derivative Instruments

    The Company accounts for derivative instruments in accordance with ASC 815, Derivatives and Hedging , which establishes accounting and reporting standards for derivative instruments and hedging activities, including certain derivative instruments imbedded in other financial instruments or contracts. The Company also considers the ASC 815 Subtopic 40, Contracts in Entity’s Own Equity , which provides criteria for determining whether freestanding contracts that are settled in a company’s own stock, including common stock warrants, should be designated as either an equity instrument, an asset or as a liability.

    The Company also considers in ASC 815, the guidance for determining whether an equity-linked financial instrument (or embedded feature) issued by an entity is indexed to the entity’s stock, and therefore, qualifying for the first part of the scope exception in paragraph 15-74 of ASC 718, Compensation—Stock Compensation . The Company evaluated the conversion feature embedded in its convertible notes payable based on the criteria of ASC 815 to determine whether the conversion feature would be required to be bifurcated from the convertible notes and accounted for separately as derivative liabilities. As a result, the Company recorded a warrant liability in the amount of $427,000 at June 30, 2010, which is included in other long-term liabilities.  At September 30, 2011, the warrant liability was marked to market which resulted in a gain of $38,000 for the three and nine months then ended.  The balance of the warrant liability was $389,000 at September 30, 2011, which is included in other long-term liabilities.   
 
 
7

 
Comprehensive Income (Loss)

     Comprehensive income (loss) consists of net income and other comprehensive income (loss). Other comprehensive income (loss) includes certain changes in equity that are excluded from net income. Specifically, foreign currency translation adjustments are included in comprehensive loss and accumulated other comprehensive loss.

   
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
   
2011
   
2010
   
2011
   
2010
 
   
(In thousands)
   
(In thousands)
 
                         
Net income
  $ 443     $ 449     $ 328     $ 917  
Other comprehensive income (loss)
                               
Change in accumulated foreign currency translation loss
    108       (128 )     (122 )     (82 )
                                 
Total comprehensive income
  $ 551     $ 321     $ 206     $ 835  

NOTE 2 — RECENT ACCOUNTING PRONOUNCEMENTS
 
In May 2011, the FASB issued ASU No. 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs, which amends the current fair value measurement and disclosure guidance of ASC Topic 820, Fair Value Measurement, to include increased transparency around valuation inputs and investment categorization. The guidance provided in ASU No. 2011-04 is effective prospectively for interim and annual periods beginning after December 15, 2011. The Company does not expect the adoption of these provisions to have a material impact on its consolidated statements of income and balance sheets.

In June 2011, the FASB issued ASU No. 2011-05, Comprehensive Income (Topic 220)—Presentation of Comprehensive Income (ASU 2011-05). ASU 2011-05 eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders’ equity. Instead, ASU 2011-05 requires entities to report all non-owner changes in stockholders’ equity in either a single continuous statement of comprehensive income, or in two separate, but consecutive statements. ASU 2011-05 does not change the items that must be reported in other comprehensive income, or when an item must be reclassified to net income.  ASU 2011-05 requires retrospective application and is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. Other than the presentational changes that will be required by ASU 2011-05, the adoption of ASU 2011-05 is not expected to have any impact on our consolidated financial statements.

In September 2011, the FASB has issued ASU No. 2011-08, Intangibles—Goodwill and Other (Topic 350): Testing Goodwill for Impairment. ASU 2011-08 is intended to simplify how entities, both public and nonpublic, test goodwill for impairment. ASU 2011-08 permits an entity to first assess qualitative factors to determine whether it is “more likely than not” that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test described in Topic 350, Intangibles-Goodwill and Other. The more-likely-than-not threshold is defined as having a likelihood of more than 50%. ASU 2011-08 is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. The Company has early adopted the provisions of the ASU and, accordingly, has performed an assessment of qualitative factors as disclosed in Note 5.
 
NOTE 3 — ACQUISITION

On June 6, 2011, GTT acquired privately-held PacketExchange. Based in London, PacketExchange provides customized Ethernet network solutions for approximately 500 customers worldwide.  PacketExchange‘s redundant network stretches across over 20 major cities in Europe, USA and Asia.

The Company accounted for the acquisition using the purchase method of accounting with GTT treated as the acquiring entity. Accordingly, consideration paid by the Company to complete the acquisition of PacketExchange has been allocated to PacketExchange’s assets and liabilities based upon their estimated fair values as of the date of completion of the acquisition, June 6, 2011. The Company estimated the fair value of PacketExchange’s assets and liabilities based on discussions with PacketExchange’s management, due diligence and information presented in financial statements.  The intangible assets acquired were related to customer relationships.
 
 
8

 
 
   
Amounts in
 
   
thousands
 
Purchase Price:
     
Debt extinguished by GTT at closing
  $ 11,767  
Accrued liabilities extinguished by GTT at closing
    4,074  
Total cash consideration
    15,841  
Fair value of liabilities assumed
    9,869  
Fair value of debt assumed
    709  
Fair value of deferred consideration
    1,500  
Total consideration rendered
  $ 27,919  
         
Purchase Price Allocation:
       
Acquired Assets
       
Current assets, including cash acquired of $1,238
  $ 5,823  
Property and equipment
    2,455  
Intangible assets
    7,578  
Other assets
    159  
Total fair value of assets acquired
    16,015  
Goodwill
    11,904  
Total consideration
  $ 27,919  
 
The following schedule presents unaudited consolidated pro forma results of operations as if the acquisition had occurred on January 1, 2010. This information does not purport to be indicative of the actual results that would have occurred if the acquisition had actually been completed January 1, 2010, nor is it necessarily indicative of the future operating results or the financial position of the combined company. The unaudited pro forma results of operations do not reflect the cost of any integration activities or benefits that may result from synergies that may be derived from any integration activities.
 
   
Three Months Ended September
   
Nine Months Ended September 30,
 
   
2011
   
2010
   
2011
   
2010
 
                         
Amounts in thousands, except per share data
                       
Revenue
  $ 24,035     $ 26,695     $ 76,370     $ 80,900  
                                 
Net income (loss)
  $ 443     $ (920 )   $ (455 )   $ (654 )
                                 
Net income (loss) per share:
                               
Basic
  $ 0.02     $ (0.05 )   $ (0.02 )   $ (0.04 )
Diluted
  $ 0.02     $ (0.05 )   $ (0.02 )   $ (0.04 )
                                 
Basic
    18,717,614       16,767,451       18,549,996       16,718,007  
Diluted
    18,952,606       16,767,451       18,549,996       16,718,007  

NOTE 4 — FAIR VALUE MEASUREMENTS

The Company accounts for fair value measurements in accordance with ASC 820, Fair Value Measurements, as it relates to financial assets and financial liabilities. ASC 820 establishes a framework for measuring fair value in accounting principles generally accepted in the United States of America and expands disclosures about fair value measurements. ASC 820 applies under other previously issued accounting pronouncements that require or permit fair value measurements but does not require any new fair value measurements.
 
 
9

 
 
ASC 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. ASC 820 establishes a fair value hierarchy that distinguishes between (1) market participant assumptions developed based on market data obtained from independent sources (observable inputs) and (2) an entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs).

The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy under ASC 820 are described as follows:
 
 
·
Level 1- Unadjusted quoted prices in active markets for identical assets or liabilities that are accessible at the measurement date.

 
·
Level 2- Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability; and inputs that are derived principally from or corroborated by observable market data by correlation or other means.

 
·
Level 3- Inputs that are unobservable for the asset or liability.

The following section describes the valuation methodologies that we used to measure financial instruments at fair value.

The Company considers the valuation of its warrant liability as a Level 3 liability based on unobservable inputs. The Company uses the Black-Scholes pricing model to measure the fair value of the warrant liability. The model required the input of highly subjective assumptions including volatility of 64%, expected term of 5 years, risk-free interest rate of 1.6% and a dividend yield of 0%.

The following table presents the liabilities that are measured and recognized at fair value on a recurring basis classified under the appropriate level of the fair value hierarchy as of September 30, 2011:
 
   
Level 1
   
Level 2
   
Level 3
   
Total
 
Liabilities:
                       
Warrant liability
  $     $     $ 389,000     $ 389,000  

Rollforward of Level 3 liabilities are as follows:

Balance at December 31, 2010
  $ -  
Issuance of warrants
    427,000  
Change in warrant liability
    (38,000 )
Balance at September 30, 2011
  $ 389,000  

The carrying amounts of cash equivalents, investments, receivables, accounts payable, and accrued expenses approximate fair value due to the immediate or short-term maturity of these financial instruments. The fair value of notes payable is determined using current applicable rates for similar instruments as of the balance sheet date and approximates the carrying value of such debt.
 
  NOTE 5 — GOODWILL AND INTANGIBLE ASSETS

During the third quarter of 2011, the Company completed its annual goodwill impairment testing in accordance with ASC Topic 350.  On August 10, 2011, the FASB announced Accounting Standards Update 2011-08, Intangibles—Goodwill and Other (Topic 350), Testing Goodwill for Impairment.  The amendments in the Update permit an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test described in Topic 350.
 
 
10

 
 
After performing the qualitative assessment, the Company determined that it is more likely than not that the fair value of the reporting unit is greater than its carrying amount and, therefore, the first and second steps of the goodwill impairment test are unnecessary and concluded that no impairment existed.
 
During the second quarter of 2011, the Company recorded goodwill in the amount of $11.9 million in connection with the PacketExchange acquisition.  Additionally, $7.6 million of the purchase price was allocated to intangible assets related to customer relationships which are subject to straight-line amortization.
 
During the third quarter of 2011, the Company entered into a sales novation agreement which assigned and transferred to the Company certain service level agreements and all rights under those agreements, as well as certain supply agreements and obligations thereunder.  The Company valued the customer relationships from the novation and recorded $1.0 million in intangible assets.
 
     The following table summarizes the Company’s intangible assets as of September 30, 2011 and December 31, 2010 (amounts in thousands):
 
        September 30, 2011  
   
Amortization
 
Gross Asset
   
Accumulated
   
Net Book
 
   
Period
 
Cost
   
Amortization
   
Value
 
Customer contracts
 
4-7 years
  $ 13,378     $ 2,278     $ 11,100  
Carrier contracts
 
1 year
    151       151       -  
Noncompete agreements
 
4-5 years
    3,531       3,358       173  
Software
 
7 years
    4,935       3,654       1,281  
        $ 21,995     $ 9,441     $ 12,554  
 
        December 31, 2010  
   
Amortization
 
Gross Asset
   
Accumulated
   
Net Book
 
   
Period
 
Cost
   
Amortization
   
Value
 
Customer contracts
 
4-5 years
  $ 4,800     $ 1,186     $ 3,614  
Carrier contracts
 
1 year
    151       151       -  
Noncompete agreements
 
4-5 years
    3,531       3,165       366  
Software
 
7 years
    4,935       3,183       1,752  
        $ 13,417     $ 7,685     $ 5,732  
 
Amortization expense was $0.7 million and $0.4 million for the three months ended September 30, 2011 and 2010, respectively. Amortization expense was $1.8 million and $1.9 million for the nine months ended September 30, 2011 and 2010, respectively.
 
Estimated amortization expense related to intangible assets subject to amortization is as follows (amounts in thousands):
 
2011 remaining
  $ 732  
2012
    2,889  
2013
    2,753  
2014
    2,149  
2015
    1,286  
2016 and beyond
    2,745  
Total
  $ 12,554  
 
 
11

 
 
NOTE 6 — EMPLOYEE SHARE-BASED COMPENSATION BENEFITS

The Company adopted its 2006 Employee, Director and Consultant Stock Plan (the “2006 Plan”) in October 2006. In addition to stock options, the Company may also grant restricted stock or other stock-based awards under the 2006 Plan. The maximum number of shares issuable over the term of the 2006 Plan, as amended, is limited to 3,500,000 shares.

The Company adopted its 2011 Employee, Director and Consultant Stock Plan (the “2011 Plan”) in June 2011.  In addition to stock options, the Company may also grant restricted stock or other stock-based awards under the 2011 Plan. The maximum number of shares issuable over the term of the 2011 Plan is limited to 3,000,000 shares.  The 2006 Plan will continue according to its terms.

Stock Options

The Company recognized compensation expense for stock options of approximately $43,000 and $47,000 for the three months ended September 30, 2011 and 2010, and approximately $134,000 and $130,000 for the nine months September 30, 2011 and 2010, respectively, related to stock options issued to employees and consultants, which is included in selling, general and administrative expense on the accompanying unaudited condensed consolidated statements of income. The Company granted to employees 304,000 and 333,000 stock options with a total fair value of $278,000 and $310,000 during the nine months ended September 30, 2011 and 2010, respectively.

Restricted Stock

During the three and nine months ended September 30, 2011, the Company granted to certain employees and members of its Board of Directors restricted stock.   This includes shares issued to non-employee members of the Company’s Board of Directors who elected to be paid a portion of their annual fees in restricted stock.  Total noncash compensation expense is recorded in selling, general and administrative expenses.
 
         
Non-Employee
       
         
Members of Board
       
Amounts in thousands
 
Employees
   
of Directors
   
Total
 
Three months ended September 30, 2011
                 
Restricted stock shares granted
    -       32       32  
Fair value of shares granted
  $ -     $ 38     $ 38  
Restricted stock compensation expense
  $ -     $ -     $ 95  
 
         
Non-Employee
       
         
Members of Board
       
Amounts in thousands
 
Employees
   
of Directors
   
Total
 
Nine months ended September 30, 2011
                 
Restricted Stock Shares Granted
    242       93       335  
Fair Value of Shares Granted
  $ 292     $ 112     $ 404  
Restricted Stock Compensation Expense
  $ -     $ -     $ 321  
 
 
12

 
 
NOTE 7 — DEBT

The following summarizes the debt activity of the Company during the nine months ended September 30, 2011 (amounts in thousands):
 
               
SVB Line of
         
Subordinated
   
Capital Lease/
 
   
Total Debt
   
SVB Term Loan
   
Credit
   
BIA Note
   
Notes
   
Promissory Note
 
                                     
Debt obligation as of December 31, 2010
  $ 14,265     $ 9,500     $ 2,338     $ -     $ 2,183     $ 244  
                                                 
Subordinated notes issuance
    153       -       -       -       153       -  
                                                 
Debt discount amortization
    230       -       -       27       203       -  
                                                 
Draw on Line of Credit
    2,162       -       2,162       -       -       -  
                                                 
Increase in SVB Term Loan
    6,333       6,333       -       -       -       -  
                                                 
Issuance of BIA Note, net of discount
    8,073       -       -       8,073       -       -  
                                                 
Repayment of SVB Term Loan
    (1,580 )     (1,580 )     -       -       -       -  
                                                 
Principal payments on capital lease
    (244 )     -       -       -       -       (244 )
                                                 
Seller Note Assumed
    692       -       -       -       -       692  
                                                 
Debt obligation as of September 30, 2011
  $ 30,084     $ 14,253     $ 4,500     $ 8,100     $ 2,539     $ 692  
 
Term Loan and Line of Credit

On June 6, 2011, immediately following the PacketExchange acquisition, the Company and its subsidiaries GTTA, GTTE, WBS Connect LLC, a Colorado limited liability company (“WBS”, and together with the Company, GTTA and GTTE, collectively, the “Existing Borrower”), PacketExchange (Ireland) Limited, a company incorporated and existing under the laws of Ireland (“PEIRL”), PacketExchange (Europe) Limited, a private limited company incorporated and registered in England and Wales (“PELTD”), PacketExchange (USA), Inc., a Delaware corporation (“PEUSA”), PacketExchange, Inc., a Delaware corporation (“PEINC”, and together with PEIRL, PELTD and PEUSA, collectively, the “New Borrower”) (the New Borrower and the Existing Borrower together are the “Borrower”) entered into a joinder and first loan modification agreement (the “Modification Agreement”) with Silicon Valley Bank, which amends that certain Loan and Security Agreement (the “Loan Agreement”), dated September 30, 2010, by and among Silicon Valley Bank and the Existing Borrower.

The Modification Agreement increases the amount of the term loan facility from $10 million to $15 million (the “Term Loan”), while the revolving line of credit facility in the aggregate principal amount of up to $5 million (the “Line of Credit”) remains unchanged. The Modification Agreement contains customary representations, warranties and covenants of the Borrower and customary events of default. In connection with negotiating the terms of the Modification Agreement, it was noted that the Company would benefit by separating the financing provided under the Loan Agreement into separate U.S. and non-U.S. financings. Accordingly, the Company and Silicon Valley Bank restructured the terms of the Loan Agreement on June 29, 2011 to implement this separation. The obligations of the Borrower under the Modification Agreement are secured by substantially all of Borrower’s tangible and intangible assets pursuant to the Loan Agreement.

The Term Loan matures on June 1, 2016. The Borrower shall repay the Term Loan in sixty (60) equal installments of principal and interest, with interest accruing at a floating per annum rate equal to Silicon Valley Bank’s prime rate plus 3.75%, unless the Borrower achieves certain performance criteria, in which case the interest rate shall be equal to Silicon Valley Bank’s prime rate plus 2.75%.
 
 
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The Line of Credit will continue to mature on September 29, 2012 and the principal amount outstanding under the Line of Credit shall continue to accrue interest at a floating per annum rate equal to Silicon Valley Bank’s prime rate plus 2%, unless the Borrower achieves certain performance criteria, in which case the interest rate shall be equal to Silicon Valley Bank’s prime rate plus 1.0%.
 
Note Purchase Agreement for Second Lien Credit Facility

Concurrent with entering in to the Modification Agreement, on June 6, 2011, the Company and its subsidiaries GTTA, WBS, PEUSA and PEINC (collectively, the “Note Borrower”) entered into a note purchase agreement (the “Purchase Agreement”) with the BIA Digital Partners SBIC II LP (“BIA”).  The Purchase Agreement provides for a total commitment of $12.5 million, of which $7.5 million was immediately funded (the “Notes”).  The Notes were issued at a discount to face value of $0.4 million and the discount is being amortized, into interest expense, over the life of the notes. The remaining $5.0 million of the committed financing may be called by the Note Borrower on or before August 11, 2011, subject to extension to December 31, 2011 at the sole option of BIA.  On September 19, 2011, BIA agreed to extend the commitment period and funded the Note Borrower an additional $1.0 million. The Purchase Agreement contains customary representations, warranties and covenants of the Note Borrower and customary events of default. The obligations of the Note Borrower under the Purchase Agreement are secured by substantially all of Borrower’s tangible and intangible assets pursuant to the Purchase Agreement.

The Notes mature on June 6, 2016. The obligations evidenced by the Notes shall bear interest at a rate of 13.5% per annum, of which (i) at least 11.5% per annum shall be payable, in cash, monthly (“Cash Interest Portion”) and (ii) 2.0% per annum shall be, at the Note Borrower’s option, paid in cash or paid-in-kind. If the Note Borrower achieves certain performance criteria, the obligations evidenced by the Notes shall bear interest at a rate of 12.0% per annum, with a Cash Interest Portion of at least 11.0% per annum.

The obligations of the Note Borrower under the Note Purchase Agreement are guaranteed by TEK and GTGS (GTGS and TEK, together, the “Note Guarantors”) pursuant to unconditional guaranties executed by each Guarantor in favor of BIA (each a “Note Guaranty”). Each Guaranty is secured by a second lien on each Guarantor’s tangible and intangible assets pursuant to a security agreement containing representations, warranties and covenants substantially similar to those made under the Note Purchase Agreement with respect to the Note Borrower. Pursuant to a pledge agreement (the “Pledge Agreement”), dated June 6, 2011, by and between BIA and the Company and GTTA, the obligations of the Note Borrower under the Note Purchase Agreement are also secured by a pledge in all of the equity interests of the Company and GTTA in their respective United States subsidiaries and a pledge of 65% of the voting equity interests and all of the non-voting equity interests of the Company and GTTA in their respective non-United States subsidiaries.

Concurrent with entering into the Note Purchase Agreement, Silicon Valley Bank and BIA entered into an Intercreditor and Subordination Agreement which governs, among other things, ranking and collateral access for the respective lenders.

Warrant

On June 6, 2011, pursuant to the Purchase Agreement, the Company issued to BIA a warrant (the “Warrant”) to purchase from the Company 634,648 shares of the Company’s common stock, at an exercise price equal to $1.144 per share (as adjusted from time to time as provided in the Warrant). Upon a change of control (as defined in the Purchase Agreement) or the repayment of the Notes prior to the maturity date of the Notes, the holder of the Warrant shall have the option to require the Company to repurchase the Warrant from the holder at a price equal to the value of the Warrant on the date of such change of control or repayment.  The Company evaluated the down round ratchet feature embedded in the Warrant and after considering ASC 480, Distinguishing Liabilities from Equity , which establishes standards for how an issuer classifies and measures in its statement of financial position certain financial instruments with characteristics of both liabilities and equity, and ASC 815,   Derivatives and Hedging, the Company concluded the warrants should be treated as a derivative and recorded a liability for the amount of $427,000.  At September 30, 2011, the warrant liability was marked to market which resulted in a gain of $38,000 for the three and nine months then ended.  The balance of the warrant liability was $389,000 at September 30, 2011, which is included in other long-term liabilities.
 
Subordinated Notes

On February 8, 2010, the Company completed a units offering (“February 2010 Units”) in which it sold 500 units consisting of debt and common stock at a purchase price of $10,000 per unit, resulting in $5.0 million of proceeds to the Company.  Each unit consisted of 2,970 shares of the Company’s common stock, and $7,000 in principal amount of the Company’s subordinated promissory notes due February 8, 2012.  The subordinated promissory notes were issued at a discount to face value of $0.2 million and the discount is being amortized, into interest expense, over the life of the notes. Interest on the subordinated promissory notes accrues at 10% per annum.  Accrued but unpaid interest was $138,000 as of September 30, 2011.
 
 
14

 
 
The proceeds from the February 2010 Units were to be applied by the Company to finance a portion of the purchase price under an asset purchase agreement with Global Capacity. On April 30, 2010, the asset purchase agreement with Global Capacity expired without consummation of the acquisition.  On May 13, 2010, investors representing $1.5 million in aggregated principal amount of the Company’s subordinated promissory notes and $0.9 million of the Company’s common stock waived the right to receive their refund and elected to retain some or all of their subordinated promissory notes. In May 2011, $1.4 million of the February 2010 Units subordinated notes were amended to mature in four equal installments on March 31, June 30, September 30 and December 31, 2013, and are included in long-term debt as of September 30, 2011. The remaining  $0.1 million of the February 2010 Units subordinated notes are included in short-term debt as of September 30, 2011.
 
On December 31, 2010, the Company completed a financing transaction in which it issued 212 Units, valued at $10,000 per unit (“December 2013 Units”).  Each unit consisted of 5,000 shares of the Company’s common stock, and $5,000 in principal amount of the Company’s subordinated promissory notes due December 31, 2013.  The subordinated promissory notes were issued at a discount to face value of $0.2 million and the discount is being amortized, into interest expense, over the life of the notes.  In total, the Company issued 1,060,000 shares of the Company’s common stock and $1.1 million in principal amount of subordinated promissory notes.

On February 16, 2011, the Company and the holders of the December 2013 Units amended the offering solely to increase the aggregate principal amount available for issuance from $1.1 million to $1.6 million. On February 16, 2011, the Company also completed a financing transaction in which it issued 40 Units, at a purchase price of $10,000 per Unit, for gross proceeds of $0.4 million. Each Unit was comprised of 5,000 shares of the Company’s common stock, and $5,000 in principal amount of subordinated promissory notes.  The subordinated promissory notes were issued at a discount to face value of $47,000 and the discount is being amortized, into interest expense, over the life of the notes.

As of September 30, 2011, the subordinated notes payable had a balance of $2.5 million. The balance includes notes totaling $1.9 million due to a related party, Universal Telecommunications, Inc. H. Brian Thompson, the Company’s Executive Chairman of the Board of Directors, is also the head of Universal Telecommunications, Inc., his own private equity investment and advisory firm. Also, included in the balance is $0.2 million of the notes held by officers and directors of the Company.

Promissory Note and Capital Lease

As part of the December 2009 acquisition, the Company assumed approximately $0.6 million in capital lease obligations payable in monthly installments through April 2011 and issued approximately $0.3 million in subordinated seller notes to the sellers, due in monthly installments and payable in full by October 2010.  The Company paid in full both the subordinated seller notes and the capital lease obligations as of September 30, 2011.

As part of the June 2011 acquisition of PacketExchange, the Company assumed a promissory note of approximately $0.7 million.
 
NOTE 8 — INCOME TAXES

Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and for operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the year in which those temporary differences are expected to be recovered or settled. Valuation allowances are recorded against deferred tax assets when it is more likely than not that some portion or all of a deferred tax asset will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the period in which those temporary differences become deductible. The scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies are evaluated in determining whether it is more likely than not that deferred tax assets will be realized.
  
The Company and certain of its subsidiaries file income tax returns in the U.S. federal jurisdiction, various states and foreign jurisdictions. The Company’s foreign jurisdictions are primarily the United Kingdom and Germany.

A valuation allowance has been recorded against the Company’s deferred tax assets to the extent those assets are not offset by deferred tax liabilities which have a structural certainty of reversal, or those assets that cannot be realized against prior period taxable income.
 
 
15

 

NOTE 9 — RESTRUCTURING COSTS, EMPLOYEE TERMINATION AND OTHER ITEMS

During the nine months ended September 30, 2011, the Company incurred costs associated with executing and closing the PacketExchange, including legal fees, professional fees, transfer taxes and travel.  The Company also incurred costs associated with closing certain PacketExchange facilities.

The restructuring charges and accruals established by the Company, and activities related thereto, are summarized as follows (amounts in thousands):

   
Charges net of
             
   
reversals
   
Cash uses
   
Total
 
Balance, December 31, 2010
  $ -     $ -     $ -  
Legal, advisory, consulting fees
    457       (310 )     147  
Transfer taxes and related fees
    153       (108 )     45  
Lease abandonment
    329       (20 )     309  
Travel and other expenses
    19       (18 )     1  
Balance, September 30, 2011
  $ 958     $ (456 )   $ 502  
 
The majority of the remaining balance of restructuring costs, employee termination and other items as of September 30, 2011 is expected to be paid in 2011 and 2012.

NOTE 10 — EARNINGS PER SHARE

Basic income per share is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding. Diluted earnings per share reflect, in periods with earnings and in which they have a dilutive effect, the effect of common shares issuable upon exercise of stock options, warrants, and convertible securities.

The table below details the calculations of earnings per share (in thousands, except for share amounts):  

   
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
   
2011
   
2010
   
2011
   
2010
 
                         
Numerator for basic and diluted EPS – income available to common stockholders
  $ 443     $ 449     $ 328     $ 917  
                                 
Denominator for basic EPS – weighted average shares
    18,717,614       16,767,451       18,549,996       16,718,007  
Effect of dilutive securities
    234,991       207,063       221,323       233,031  
Denominator for diluted EPS – weighted average shares
    18,952,606       16,974,514       18,771,319       16,951,038  
                                 
Earnings per share: Basic and diluted
  $ 0.02     $ 0.03     $ 0.02     $ 0.05  
 
 The table below details the anti-dilutive items that were excluded in the computation of earnings per share (in thousands):
 
   
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
   
2011
   
2010
   
2011
   
2010
 
                         
Class Z warrants
    12,090       12,090       12,090       12,090  
Convertible notes
    -       970       -       970  
Stock options
    677       576       677       540  
Totals
    12,767       13,636       12,767       13,600  

At September 30, 2011, we had 12,090,000 Class Z warrants outstanding, each of which entitles the holder to purchase a share of our common stock at an exercise price of $5.00 per share on or before April 10, 2012.
 
 
16

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

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our financial statements and related notes that appear elsewhere in this report and in our annual report on Form 10-K for the year ended December 31, 2010. In addition to historical consolidated financial information, the following discussion contains forward-looking statements that reflect plans, estimates and beliefs of management of the Company. When used in this document, the words “anticipate”, “believe”, “plan”, “estimate” and “expect” and similar expressions, as they relate to the Company or its management, are intended to identify forward-looking statements. Such statements reflect the current views of management with respect to future events and are subject to certain risks, uncertainties and assumptions. Our actual results could differ materially from those discussed in the forward-looking statements. For a more detailed description of these risks and factors, please see the Company’s 2010 Annual Report on Form 10-K filed with the Securities and Exchange Commission and Item 1A Part II of this quarterly report on Form 10-Q.

Overview

GTT is a global telecommunications carrier and leading network integrator serving the data communications needs of large enterprise, government and carrier clients in over 80 countries. We combine our own network assets with the networks of over 800 suppliers worldwide to deliver cost-effective, scalable solutions supporting each client’s unique requirements. Through our proprietary Client Management Database (CMD), GTT provides streamlined service design and quotation, rapid service implementation, and global 24x7 monitoring and support. GTT is headquartered in the Washington, DC metro region with offices in London, Dusseldorf, and Denver.

The Company sells services largely through a direct sales force located across the globe, as well as strong agent channel relationships. The Company generally competes with traditional, facilities-based providers and other services providers in each of our global markets. As of September 30, 2011, our customer base was comprised of over 1,000 businesses.  Our five largest customers accounted for approximately 19% of consolidated revenues during the quarter ended September 30, 2011.

Costs and Expenses

The Company’s cost of revenue consists of the expenses directly related to the services provided to customers.  The key terms and conditions appearing in both supplier and customer agreements are substantially the same, with margin applied to the suppliers’ costs. There are no wages or overheads included in these costs. From time to time, the Company has agreed to certain special commitments with vendors in order to obtain better rates, terms and conditions for the procurement of services from those vendors. These commitments include volume purchase commitments and purchases on a longer-term basis than the term for which the applicable customer has committed.

Our supplier contracts do not have any market related net settlement provisions. The Company has not entered into, and has no plans to enter into, any supplier contracts which involve financial or derivative instruments. The supplier contracts are entered into solely for the direct purchase of telecommunications capacity, which is resold by the Company in its normal course of business.

Other than cost of revenue, the Company’s most significant operating expenses are employment costs.  As of September 30, 2011, the Company had 94 employees and employment costs comprised approximately 13% of total operating expenses for the nine months ended September 30, 2011.

Locations of Offices and Origins of Revenue

We are headquartered just outside of Washington, DC, in McLean, Virginia, and have offices in London, Düsseldorf and Denver.  For the nine months ended September 30, 2011, approximately 71% of our consolidated revenue was earned from operations based in the United States. Approximately 22% of our revenue was generated from operations based in the United Kingdom and 7% from operations in Germany and Japan.
 
 
17

 
 
Critical Accounting Policies and Estimates
 
In May 2011, the FASB issued ASU No. 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs, which amends the current fair value measurement and disclosure guidance of ASC Topic 820, Fair Value Measurement, to include increased transparency around valuation inputs and investment categorization. The guidance provided in ASU No. 2011-04 is effective prospectively for interim and annual periods beginning after December 15, 2011. The Company does not expect the adoption of these provisions to have a material impact on its consolidated statements of income and balance sheets.

In June 2011, the FASB issued ASU No. 2011-05, Comprehensive Income (Topic 220)—Presentation of Comprehensive Income (ASU 2011-05). ASU 2011-05 eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders’ equity. Instead, ASU 2011-05 requires entities to report all non-owner changes in stockholders’ equity in either a single continuous statement of comprehensive income, or in two separate, but consecutive statements. ASU 2011-05 does not change the items that must be reported in other comprehensive income, or when an item must be reclassified to net income.  ASU 2011-05 requires retrospective application and is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. Other than the presentational changes that will be required by ASU 2011-05, the adoption of ASU 2011-05 is not expected to have any impact on our consolidated financial statements.

In September 2011, The FASB has issued ASU No. 2011-08, Intangibles—Goodwill and Other (Topic 350): Testing Goodwill for Impairment. ASU 2011-08 is intended to simplify how entities, both public and nonpublic, test goodwill for impairment. ASU 2011-08 permits an entity to first assess qualitative factors to determine whether it is “more likely than not” that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test described in Topic 350, Intangibles-Goodwill and Other. The more-likely-than-not threshold is defined as having a likelihood of more than 50%. ASU 2011-08 is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. The Company has early adopted the provisions of the ASU, and accordingly, has performed an assessment of qualitative factors.

Results of Operations of the Company

Three months ended September 30, 2011 Compared to Three months ended September 30, 2010

Overview. The financial information presented in the tables below is comprised of the unaudited condensed consolidated financial information of the Company for the three months ended September 30, 2011 and 2010 (amounts in thousands):

   
Three Months Ended September 30,
 
   
2011
   
2010
 
             
Revenue
  $ 24,035     $ 20,011  
Cost of revenue
    16,972       13,946  
                 
Gross margin
    7,063       6,065  
      29.4 %     30.3 %
Operating expenses, depreciation and amortization
    5,801       5,188  
                 
Operating income
  $ 1,262     $ 877  
                 
Net income
  $ 443     $ 449  
 
Revenue. Revenue for the three months ended September 30, 2011, was $24.0 million, generated by services provided during the period to existing customers and new sales generated by the Company’s global sales organization. Revenue during the three months ended September 30, 2010 was $20.0 million.  The increase in revenue was due primarily to the acquisition of PacketExchange which occurred on June 6, 2011.

Cost of Revenue and Gross Margin. Cost of revenue and gross margin for the three months ended September 30, 2011, were $17.0 million and $7.1 million, respectively. For the three months ended September 30, 2010, cost of revenue and gross margin were $13.9 million and $6.1 million, respectively. The increase in cost of revenue was due primarily to the acquisition of PacketExchange which occurred on June 6, 2011.
 
 
18

 
 
Operating Expenses. Operating expenses, exclusive of cost of revenue, were $5.8 million and $5.2 million for the three months ended September 30, 2011 and 2010, respectively. The primary cause of the increase is associated with the increase in fixed assets and intangible assets from the PacketExchange acquisition, which produced a higher depreciation and amortization.  These changes are illustrated in the table below (amounts in thousands):
 
   
Three Months Ended September 30,
 
   
2011
   
2010
 
             
Selling, general and administrative expenses (excluding noncash compensation)
  $ 4,503     $ 4,350  
Noncash compensation
    138       150  
Amortization of intangible assets
    729       461  
Depreciation
    431       227  
                 
Totals
  $ 5,801     $ 5,188  
 
Nine months ended September 30, 2011 Compared to Nine months ended September 30, 2010

Overview. The financial information presented in the tables below is comprised of the unaudited condensed consolidated financial information of the Company for the nine months ended September 30, 2011 and 2010 (amounts in thousands):
 
    
Nine Months Ended September 30,
 
   
2011
   
2010
 
             
Revenue
  $ 65,639     $ 60,304  
Cost of revenue
    46,164       42,641  
                 
Gross margin
    19,475       17,663  
      29.7 %     29.3 %
Operating expenses, depreciation and amortization
    17,402       15,322  
Operating income
  $ 2,073     $ 2,341  
                 
Net income
  $ 328     $ 917  

Revenue. Revenue for the nine months ended September 30, 2011, was $65.6 million, generated by services provided during the period to existing customers and new sales generated by the Company’s global sales organization. Revenue during the nine months ended September 30, 2010 was $60.3 million.  The increase in revenue was due primarily to the acquisition of PacketExchange which occurred on June 6, 2011.

Cost of Revenue and Gross Margin. Cost of revenue and gross margin for the nine months ended September 30, 2011, were $46.2 million and $19.5 million, respectively. For the nine months ended September 30, 2010, cost of revenue and gross margin were $42.6 million and $17.7 million, respectively. The increase in revenue was due primarily to the acquisition of PacketExchange which occurred on June 6, 2011.

Operating Expenses. Operating expenses, exclusive of cost of revenue, were $17.4 million and $15.3 million for the nine months ended September 30, 2011 and 2010, respectively. The primary cause of the increase is the $1.0 million in restructuring costs associated with the PacketExchange acquisition, including legal fees, professional fees, transfer taxes and travel, as well as the depreciation and amortization related to the PacketExchange assets acquired.   These changes are illustrated in the table below (amounts in thousands):
 
   
Nine Months Ended September 30,
 
   
2011
   
2010
 
             
Selling, general and administrative expenses (excluding noncash compensation)
  $ 13,264     $ 12,713  
Noncash compensation
    455       504  
Restructuring costs, employee termination and other items
    958       -  
Amortization of intangible assets
    1,756       1,423  
Depreciation
    969       682  
                 
Totals
  $ 17,402     $ 15,322  

 
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Liquidity and Capital Resources

Debt

The following summarizes the debt activity of the Company during the nine months ended September 30, 2011 (amounts in thousands):
 
               
SVB Line of
         
Subordinated
   
Capital Lease/
 
   
Total Debt
   
SVB Term Loan
   
Credit
   
BIA Note
   
Notes
   
Promissory Note
 
                                     
Debt obligation as of December 31, 2010
  $ 14,265     $ 9,500     $ 2,338     $ -     $ 2,183     $ 244  
                                                 
Subordinated notes issuance
    153       -       -       -       153       -  
                                                 
Debt discount amortization
    230       -       -       27       203       -  
                                                 
Draw on Line of Credit
    2,162       -       2,162       -       -       -  
                                                 
Increase in SVB Term Loan
    6,333       6,333       -       -       -       -  
                                                 
Issuance of BIA Note, net of discount
    8,073       -       -       8,073       -       -  
                                                 
Repayment of SVB Term Loan
    (1,580 )     (1,580 )     -       -       -       -  
                                                 
Principal payments on capital lease
    (244 )     -       -       -       -       (244 )
                                                 
Seller Note Assumed
    692       -       -       -       -       692  
                                                 
Debt obligation as of September 30, 2011
  $ 30,084     $ 14,253     $ 4,500     $ 8,100     $ 2,539     $ 692  
 
Term Loan and Line of Credit

On June 6, 2011, immediately following the PacketExchange acquisition, the Company and its subsidiaries GTTA, GTTE, WBS Connect LLC, a Colorado limited liability company (“WBS”, and together with the Company, GTTA and GTTE, collectively, the “Existing Borrower”), PacketExchange (Ireland) Limited, a company incorporated and existing under the laws of Ireland (“PEIRL”), PacketExchange (Europe) Limited, a private limited company incorporated and registered in England and Wales (“PELTD”), PacketExchange (USA), Inc., a Delaware corporation (“PEUSA”), PacketExchange, Inc., a Delaware corporation (“PEINC”, and together with PEIRL, PELTD and PEUSA, collectively, the “New Borrower”) (the New Borrower and the Existing Borrower together are the “Borrower”) entered into a joinder and first loan modification agreement (the “Modification Agreement”) with Silicon Valley Bank, which amends that certain Loan and Security Agreement (the “Loan Agreement”), dated September 30, 2010, by and among Silicon Valley Bank and the Existing Borrower.

The Modification Agreement increases the amount of the term loan facility from $10 million to $15 million (the “Term Loan”), while the revolving line of credit facility in the aggregate principal amount of up to $5 million (the “Line of Credit”) remains unchanged. The Modification Agreement contains customary representations, warranties and covenants of the Borrower and customary events of default. In connection with negotiating the terms of the Modification Agreement, it was noted that the Company would benefit by separating the financing provided under the Loan Agreement into separate U.S. and non-U.S. financings. Accordingly, the Company and Silicon Valley Bank restructured the terms of the Loan Agreement on June 29, 2011 to implement this separation. The obligations of the Borrower under the Modification Agreement are secured by substantially all of Borrower’s tangible and intangible assets pursuant to the Loan Agreement.

The Term Loan matures on June 1, 2016. The Borrower shall repay the Term Loan in sixty (60) equal installments of principal and interest, with interest accruing at a floating per annum rate equal to Silicon Valley Bank’s prime rate plus 3.75%, unless the Borrower achieves certain performance criteria, in which case the interest rate shall be equal to Silicon Valley Bank’s prime rate plus 2.75%.

The Line of Credit will continue to mature on September 29, 2012 and the principal amount outstanding under the Line of Credit shall continue to accrue interest at a floating per annum rate equal to Silicon Valley Bank’s prime rate plus 2%, unless the Borrower achieves certain performance criteria, in which case the interest rate shall be equal to Silicon Valley Bank’s prime rate plus 1.0%.
 
 
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 Note Purchase Agreement for Second Lien Credit Facility

Concurrent with entering in to the Modification Agreement, on June 6, 2011, the Company and its subsidiaries GTTA, WBS, PEUSA and PEINC (collectively, the “Note Borrower”) entered into a note purchase agreement (the “Purchase Agreement”) with the BIA Digital Partners SBIC II LP (“BIA”).  The Purchase Agreement provides for a total commitment of $12.5 million, of which $7.5 million was immediately funded (the “Notes”).  The Notes were issued at a discount to face value of $0.4 million and the discount is being amortized, into interest expense, over the life of the notes. The remaining $5.0 million of the committed financing may be called by the Note Borrower on or before August 11, 2011, subject to extension to December 31, 2011 at the sole option of BIA.  On September 19, 2011, BIA agreed to extend the commitment period and funded the Note Borrower an additional $1.0 million.  The Purchase Agreement contains customary representations, warranties and covenants of the Note Borrower and customary events of default. The obligations of the Note Borrower under the Purchase Agreement are secured by substantially all of Borrower’s tangible and intangible assets pursuant to the Purchase Agreement.

The Notes mature on June 6, 2016. The obligations evidenced by the Notes shall bear interest at a rate of 13.5% per annum, of which (i) at least 11.5% per annum shall be payable, in cash, monthly (“Cash Interest Portion”) and (ii) 2.0% per annum shall be, at the Note Borrower’s option, paid in cash or paid-in-kind. If the Note Borrower achieves certain performance criteria, the obligations evidenced by the Notes shall bear interest at a rate of 12.0% per annum, with a Cash Interest Portion of at least 11.0% per annum.

The obligations of the Note Borrower under the Note Purchase Agreement are guaranteed by TEK and GTGS (GTGS and TEK, together, the “Note Guarantors”) pursuant to unconditional guaranties executed by each Guarantor in favor of BIA (each a “Note Guaranty”). Each Guaranty is secured by a second lien on each Guarantor’s tangible and intangible assets pursuant to a security agreement containing representations, warranties and covenants substantially similar to those made under the Note Purchase Agreement with respect to the Note Borrower. Pursuant to a pledge agreement (the “Pledge Agreement”), dated June 6, 2011, by and between BIA and the Company and GTTA, the obligations of the Note Borrower under the Note Purchase Agreement are also secured by a pledge in all of the equity interests of the Company and GTTA in their respective United States subsidiaries and a pledge of 65% of the voting equity interests and all of the non-voting equity interests of the Company and GTTA in their respective non-United States subsidiaries.

Concurrent with entering into the Note Purchase Agreement, Silicon Valley Bank and BIA entered into an Intercreditor and Subordination Agreement which governs, among other things, ranking and collateral access for the respective lenders.

Warrant

On June 6, 2011, pursuant to the Purchase Agreement, the Company issued to BIA a warrant (the “Warrant”) to purchase from the Company 634,648 shares of the Company’s common stock, at an exercise price equal to $1.144 per share (as adjusted from time to time as provided in the Warrant). Upon a change of control (as defined in the Purchase Agreement) or the repayment of the Notes prior to the maturity date of the Notes, the holder of the Warrant shall have the option to require the Company to repurchase the Warrant from the holder at a price equal to the value of the Warrant on the date of such change of control or repayment.  The Company evaluated the down round ratchet feature embedded in the Warrant and after considering ASC 480, Distinguishing Liabilities from Equity, which establishes standards for how an issuer classifies and measures in its statement of financial position certain financial instruments with characteristics of both liabilities and equity, and ASC 815,   Derivatives and Hedging, the Company concluded the warrants should be treated as a derivative and recorded a liability for the amount of $427,000.  At September 30, 2011, the warrant liability was marked to market which resulted in a gain of $38,000 for the three and nine months then ended.  The balance of the warrant liability was $389,000 at September 30, 2011, which is included in other long-term liabilities.
 
Subordinated Notes

On February 8, 2010, the Company completed a units offering (“February 2010 Units”) in which it sold 500 units consisting of debt and common stock at a purchase price of $10,000 per unit, resulting in $5.0 million of proceeds to the Company.  Each unit consisted of 2,970 shares of the Company’s common stock, and $7,000 in principal amount of the Company’s subordinated promissory notes due February 8, 2012.  The subordinated promissory notes were issued at a discount to face value of $0.2 million and the discount is being amortized, into interest expense, over the life of the notes. Interest on the subordinated promissory notes accrues at 10% per annum.  Accrued but unpaid interest was $138,000 as of September 30, 2011.

The proceeds from the February 2010 Units were to be applied by the Company to finance a portion of the purchase price under an asset purchase agreement with Global Capacity. On April 30, 2010, the asset purchase agreement with Global Capacity expired without consummation of the acquisition.  On May 13, 2010, investors representing $1.5 million in aggregated principal amount of the Company’s subordinated promissory notes and $0.9 million of the Company’s common stock waived the right to receive their refund and elected to retain some or all of their subordinated promissory notes. In May 2011, $1.4 million of the February 2010 Units subordinated notes were amended to mature in four equal installments on March 31, June 30, September 30 and December 31, 2013, and are included in long-term debt as of September 30, 2011. The remaining  $0.1 million of the February 2010 Units subordinated notes are included in short-term debt as of September 30, 2011.
 
 
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On December 31, 2010, the Company completed a financing transaction in which it issued 212 Units, valued at $10,000 per unit (“December 2013 Units”).  Each unit consisted of 5,000 shares of the Company’s common stock, and $5,000 in principal amount of the Company’s subordinated promissory notes due December 31, 2013.  The subordinated promissory notes were issued at a discount to face value of $0.2 million and the discount is being amortized, into interest expense, over the life of the notes.  In total, the Company issued 1,060,000 shares of the Company’s common stock and $1.1 million in principal amount of subordinated promissory notes.

On February 16, 2011, the Company and the holders of the December 2013 Units amended the offering solely to increase the aggregate principal amount available for issuance from $1.1 million to $1.6 million. On February 16, 2011, the Company also completed a financing transaction in which it issued 40 Units, at a purchase price of $10,000 per Unit, for gross proceeds of $0.4 million. Each Unit was comprised of 5,000 shares of the Company’s common stock, and $5,000 in principal amount of subordinated promissory notes.  The subordinated promissory notes were issued at a discount to face value of $47,000 and the discount is being amortized, into interest expense, over the life of the notes.

As of September 30, 2011, the subordinated notes payable had a balance of $2.5 million. The balance includes notes totaling $1.9 million due to a related party, Universal Telecommunications, Inc. H. Brian Thompson, the Company’s Executive Chairman of the Board of Directors, is also the head of Universal Telecommunications, Inc., his own private equity investment and advisory firm. Also, included in the balance is $0.2 million of the notes held by officers and directors of the Company.

Promissory Note and Capital Lease

As part of the December 2009 acquisition, the Company assumed approximately $0.6 million in capital lease obligations payable in monthly installments through April 2011 and issued approximately $0.3 million in subordinated seller notes to the sellers, due in monthly installments and payable in full by October 2010.  The Company paid in full both the subordinated seller notes and the capital lease obligations as of September 30, 2011.

As part of the June 2011 acquisition of PacketExchange, the Company assumed a promissory note of approximately $0.7 million.

Liquidity Assessment

Cash provided by operating activities for the nine months ended September 30, 2011 was $0.4 million. Cash used in operating activities for the nine months ended September 30, 2010, was $3.3 million.

Net cash used in investing activities for the nine months ended September 30, 2011 was $15.1 million, consisting primarily of the $14.6 million of cash used, net of cash acquired, in the acquisition of PacketExchange.  Net cash used in investing activities for the nine months ended September 30, 2010 was $135,000.
 
Cash provided by financing activities was approximately $15.2 million for the nine months ended September 30, 2011, primarily consisting of the $14.5 million, net of acquisition fees, in funds raised for the acquisition of PacketExchange.  Cash flows provided by financing activities were $5.8 million for the nine months ended September 30, 2010.

Management monitors cash flow and liquidity requirements. Based on the Company’s cash and cash equivalents, the Silicon Valley Bank credit facility, and analysis of the anticipated working capital requirements, Management believes the Company has sufficient liquidity to fund the business and meet its contractual obligations. The Company’s current planned cash requirements for 2011 are based upon certain assumptions, including its ability to manage expenses, integrate its recent acquisition and grow revenue from services arrangements. In connection with the activities associated with the services, the Company expects to incur expenses, including provider fees, employee compensation and consulting fees, professional fees, sales and marketing, insurance and interest expense. Should the expected cash flows not be available, management believes it would have the ability to revise its operating plan and make reductions in expenses.

The Company believes that cash currently on hand, expected cash flows from future operations and existing borrowing capacity are sufficient to fund operations for the next twelve months, including the scheduled repayment, of indebtedness pursuant to the Silicon Valley Bank Term Loan, the BIA Note, and certain subordinated credit facilities. If our operating performance differs significantly from our forecasts, we may be required to reduce our operating expenses and curtail capital spending, and we may not remain in compliance with our debt covenants.  In addition, if the Company were unable to fully fund its cash requirements through operations and current cash on hand, the Company would need to obtain additional financing through a combination of equity and subordinated debt financings and/or renegotiation of terms of its existing debt.  If any such activities become necessary, there can be no assurance that the Company would be successful in obtaining additional financing or modifying its existing debt terms.
 
 
22

 
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Sensitivity

Interest due on the Company’s loans is based upon the applicable stated fixed contractual rate with the lenders. Interest earned on the Company’s bank accounts is linked to the applicable base interest rate. For the nine months ended September 30, 2011 and 2010, the Company had interest expense, net of interest income, of approximately $1.6 million and $1.1 million, respectively. The Company believes that its results of operations are not materially affected by changes in interest rates.

Exchange Rate Sensitivity

Approximately 29% of the Company’s revenues for the nine months ended September 30, 2011 are derived from services provided outside of the United States. As a consequence, a material percentage of the Company’s revenues are billed in British Pounds Sterling or Euros. Since we operate on a global basis, we are exposed to various foreign currency risks. First, our consolidated financial statements are denominated in U.S. Dollars, but a significant portion of our revenue is generated in the local currency of our foreign subsidiaries. Accordingly, changes in exchange rates between the applicable foreign currency and the U.S. Dollar will affect the translation of each foreign subsidiary’s financial results into U.S. Dollars for purposes of reporting consolidated financial results.

In addition, because of the global nature of our business, we may from time to time be required to pay a supplier in one currency while receiving payments from the underlying customer of the service in another currency. Although it is the Company’s general policy to pay its suppliers in the same currency that it will receive cash from customers, where these circumstances arise with respect to supplier invoices in one currency and customer billings in another currency, the Company’s gross margins may increase or decrease based upon changes in the exchange rate. Such factors did not have a material impact on the Company’s results in the nine months ended September 30, 2011.
 
ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

The Company’s management carried out an evaluation required by Rule 13a-15 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), under the supervision of and with the participation of its Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), of the effectiveness of our disclosure controls and procedures as defined in Rule 13a-15 and 15d-15 under the Exchange Act (“Disclosure Controls”).

Based on our evaluation, our CEO and CFO concluded that our disclosure controls and procedures are designed at a reasonable assurance level and are effective to provide reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our CEO and CFO, as appropriate, to allow timely decisions regarding required disclosure.

The CEO and the CFO, with assistance from other members of management, have reviewed the effectiveness of our disclosure controls and procedures as of September 30, 2011 and, based on their evaluation, have concluded that the disclosure controls and procedures were effective as of such date.
 
Changes in Internal Control over Financial Reporting

There have not been any changes in the Company’s internal control over financial reporting during the quarter ended September 30, 2011 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
 
 
23

 

Limitations on the Effectiveness of Controls

Management, including our CEO and CFO, does not expect that Disclosure Controls and internal controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by management override of the controls.

The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, a control may become inadequate because of changes in conditions or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and may not be detected.
 
PART II – Other Information

ITEM 1. LEGAL PROCEEDINGS

The Company is subject to legal proceedings, claims and litigation arising in the ordinary course of business. Although the outcome of these matters is currently not determinable, GTT believes it has adequate provisions for any such matters and we do not expect that the ultimate costs to resolve these matters will have a material adverse impact on our financial condition, results of operations or cash flows.
 
ITEM 1A. RISK FACTORS

The Company operates in a rapidly changing environment that involves a number of risks, some of which are beyond its control. In addition to the other information set forth in this report, the reader should carefully consider the factors discussed in Part I, “Item 1A.  Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, which could materially affect our business, financial condition or future results.  Additional risks and uncertainties not presently known to us, which we currently deem to be immaterial or which are similar to those faced by other companies in this industry or business in general, may also affect our business, financial condition and/or operating results.  If any of these risks or uncertainties actually occur, our business, financial condition and operating results would likely suffer. We do not believe that the risks and uncertainties described in the Risk Factors included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, have materially changed other than as set forth below.
  
Risks Relating to Our Business and Operations

We depend on several large customers, and the loss of one or more of these customers, or a significant decrease in total revenues from any of these customers, would likely reduce our revenue and income.

For the nine months ended September 30, 2011, our five largest customers accounted for approximately 19% of our total service revenues. If we were to lose all of the underlying services from one or more of our large customers, or if one or more of our large customers were to significantly reduce the services purchased from us or otherwise renegotiate the terms on which services are purchased from us, our revenues could decline and our results of operations would suffer.

If our customers elect to terminate their agreements with us, our business, financial condition and results of operations may be adversely affected.

Our services are sold under agreements that generally have initial terms of between one and three years. Following the initial terms, these agreements generally automatically renew for successive month-to-month, quarterly, or annual periods, but can be terminated by the customer without cause with relatively little notice during a renewal period. In addition, certain government customers may have rights under federal law with respect to termination for convenience that can serve to minimize or eliminate altogether the liability payable by that customer in the event of early termination. Our customers may elect to terminate their agreements as a result of a number of factors, including their level of satisfaction with the services they are receiving, their ability to continue their operations due to budgetary or other concerns, and the availability and pricing of competing services. If customers elect to terminate their agreements with us, our business, financial condition, and results of operation may be adversely affected.
 
 
24

 
 
Competition in the industry in which we do business is intense and growing, and our failure to compete successfully could make it difficult for us to add and retain customers or increase or maintain revenues.

The markets in which we operate are rapidly evolving and highly competitive. We currently or potentially compete with a variety of companies, including some of our transport suppliers, with respect to their products and services, including global and regional telecommunications service providers such as AT&T, British Telecom, NTT, Level 3, Qwest and Verizon, among others.

The industry in which we operate is consolidating, which is increasing the size and scope of our competitors. Competitors could benefit from assets or businesses acquired from other carriers or from strategic alliances in the telecommunications industry. New entrants could enter the market with a business model similar to ours. Our target markets may support only a limited number of competitors. Operations in such markets with multiple competitive providers may be unprofitable for one or more of such providers. Prices in the data transmission and internet access business have declined in recent years and may continue to decline.

Many of our potential competitors have certain advantages over us, including:

 
substantially greater financial, technical, marketing, and other resources, including brand or corporate name recognition;

 
substantially lower cost structures, including cost structures of facility-based providers who have reduced debt and other obligations through bankruptcy or other restructuring proceedings;

 
larger client bases;

 
longer operating histories;

 
more established relationships in the industry; and

 
larger geographic presence.
 
 Our competitors may be able to use these advantages to:

 
develop or adapt to new or emerging technologies and changes in client requirements more quickly;

 
take advantage of acquisitions and other opportunities more readily;

 
enter into strategic relationships to rapidly grow the reach of their networks and capacity;

 
devote greater resources to the marketing and sale of their services;

 
adopt more aggressive pricing and incentive policies, which could drive down margins; and

 
expand their offerings more quickly.

If we are unable to compete successfully against our current and future competitors, our revenues and gross margins could decline and we would lose market share, which could materially and adversely affect our business.

We might require additional capital to support business growth, and this capital might not be available on favorable terms, or at all.

Our operations or expansion efforts may require substantial additional financial, operational, and managerial resources. As of September 30, 2011, we had approximately $7.0 million in cash and cash equivalents and current liabilities $20.5 million greater than current assets. We may have insufficient cash to fund our working capital or other capital requirements and may be required to raise additional funds to continue or expand our operations. 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. Our ability to sell assets or raise additional equity or debt capital will depend on the condition of the capital and credit markets and our financial condition at such time. Accordingly, additional capital may not be available to us, or may only be available on terms that adversely affect our existing stockholders, or that restrict our operations. For example, if we raise additional funds through issuances of equity or convertible debt securities, our existing stockholders could suffer dilution, and any new equity securities we issue could have rights, preferences, and privileges superior to those of holders of our common stock. Also, if we were forced to sell assets, there can be no assurance regarding the terms and conditions we could obtain for any such sale, and if we were required to sell assets that are important to our current or future business, our current and future results of operations could be materially and adversely affected. We have granted security interests in substantially all of our assets to secure the repayment of our indebtedness maturing in 2012 and 2016, and if we are unable to satisfy our obligations the lenders could foreclose on their security interests.

 
25

 

Because our business consists primarily of reselling telecommunications network capacity purchased from third parties, the failure of our suppliers and other service providers to provide us with services, or disputes with those suppliers and service providers, could affect our ability to provide quality services to our customers and have an adverse effect on our operations and financial condition.

The majority of our business consists of integrating and reselling network capacity purchased from facility-based telecommunications carriers. Accordingly, we will be largely dependent on third parties to supply us with services. Occasionally in the past, our operating companies have experienced delays or other problems in receiving services from third party providers. Disputes also arise from time to time with suppliers with respect to billing or interpretation of contract terms. Any failure on the part of third parties to adequately supply us or to maintain the quality of their facilities and services in the future, or the termination of any significant contracts by a supplier, could cause customers to experience delays in service and lower levels of customer care, which could cause them to switch providers. Furthermore, disputes over billed amounts or interpretation of contract terms could lead to claims or legal action against us, some of which if resolved against us could have an adverse impact on our results of operations and/or financial condition. Suppliers may also attempt to impose onerous terms as part of purchase contract negotiations. To the extent that key suppliers were to attempt to impose such provisions as part of future contract negotiations, such developments could have an adverse impact on the company’s operations. Finally, some of our suppliers are potential competitors. We cannot guarantee that we will be able to obtain use of facilities or services in a timely manner or on terms acceptable and in quantities satisfactory to us. 
 
Industry consolidation may affect our ability to obtain services from suppliers on a timely or cost-efficient basis.

A principal method of connecting with our customers is through local transport and last mile circuits we purchase from incumbent carriers such as AT&T and Verizon, or competitive carriers such as Time Warner Telecom, XO, or Level 3. In recent years, AT&T, Verizon, and Level 3 have acquired competitors with significant local and/or long-haul network assets. Industry consolidation has occurred on a lesser scale as well through mergers and acquisitions involving regional or smaller national or international competitors. Generally speaking, we believe that a marketplace with multiple supplier options for transport access is important to the long-term availability of competitive pricing, service quality, and carrier responsiveness. It is unclear at this time what the long-term impact of such consolidation will be, or whether it will continue at the same pace as it has in recent years; we cannot guarantee that we will continue to be able to obtain use of facilities or services in a timely manner or on terms acceptable and in quantities satisfactory to us from such suppliers.

We may occasionally have certain sales commitments to customers that extend beyond the Company’s commitments from its underlying suppliers.

The Company’s financial results could be adversely affected if the Company were unable to purchase extended service from a supplier at a cost sufficiently low to maintain the Company’s margin for the remaining term of its commitment to a customer. While the Company has not encountered material price increases from suppliers with respect to continuation or renewal of services after expiration of initial contract terms, the Company cannot be certain that it would be able to obtain similar terms and conditions from suppliers. In most cases where the Company has faced any price increase from a supplier following contract expiration, the Company has been able to locate another supplier to provide the service at a similar or reduced future cost; however, the Company’s suppliers may not provide services at such cost levels in the future.
 
 
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We may make purchase commitments to vendors for longer terms or in excess of the volumes committed by our underlying customers.

The Company attempts to match its purchase of network capacity from its suppliers and its service commitments from its customers. However, from time to time the Company has obligations to its suppliers that exceed the duration of the Company’s related customer contracts or that are for capacity in excess of the amount for which it has Customer commitments. This could arise based upon the terms and conditions available from the Company’s suppliers, from an expectation of the Company that we will be able to utilize the excess capacity, as a result of a breach of a customer’s commitment to us, or to support fixed elements of the Company’s network. Under any of these circumstances, the Company would incur the cost of the network capacity from its supplier without having corresponding revenues from its customers, which could result in a material and adverse impact on the Company’s operating results.

The networks on which we depend may fail, which would interrupt the network availability they provide and make it difficult to retain and attract customers.

Our customers depend on our ability to provide network availability with minimal interruption. The ability to provide this service depends in part on the networks of third party transport suppliers. The networks of transport suppliers may be interrupted as a result of various events, many of which they cannot control, including fire, human error, earthquakes and other natural disasters, disasters along communications rights-of-way, power loss, telecommunications failures, terrorism, sabotage, vandalism, or the financial distress or other event adversely affecting a supplier, such as bankruptcy or liquidation.

We may be subject to legal claims and be liable for losses suffered by customers due to our inability to provide service. If our network failure rates are higher than permitted under the applicable customer contracts, we may incur significant expenses related to network outage credits, which would reduce our revenues and gross margins. Our reputation could be harmed if we fail to provide a reasonably adequate level of network availability, and in certain cases, customers may be entitled to seek to terminate their contracts with us in case of prolonged or severe service disruptions or other outages.  
 
System disruptions could cause delays or interruptions of our service due to terrorism, natural disasters and other events beyond our control, which could cause us to lose customers or incur additional expenses.

Our success depends on our ability to provide reliable service. Although we have attempted to design our network services to minimize the possibility of service disruptions or other outages, in addition to risks associated with third party provider networks, our services may be disrupted by problems on our own systems, including events beyond our control such as terrorism, computer viruses, or other infiltration by third parties that affect our central offices, corporate headquarters, network operations centers, or network equipment. Such events could disrupt our service, damage our facilities, and damage our reputation. In addition, customers may, under certain contracts, have the ability to terminate services in case of prolonged or severe service disruptions or other outages. Accordingly, service disruptions or other outages may cause us to, among other things, lose customers and could harm our results of operations.

If the products or services that we market or sell do not maintain market acceptance, our results of operations will be adversely affected.

Certain segments of the telecommunications industry are dependent on developing and marketing new products and services that respond to technological and competitive developments and changing customer needs. We cannot assure you that our products and services will gain or obtain increased market acceptance. Any significant delay or failure in developing new or enhanced technology, including new product and service offerings, could result in a loss of actual or potential market share and a decrease in revenues.

The communications market in which we operate is highly competitive; we could be forced to reduce prices, may lose customers to other providers that offer lower prices and have problems attracting new customers.

The communications industry is highly competitive and pricing for some of our key service offerings, such as our dedicated IP transport services, have been generally declining. If our costs of service, including the cost of leasing underlying facilities, do not decline in a similar fashion, we could experience significant margin compression, reduction of profitability and loss of business.

If carrier and enterprise connectivity demand does not continue to expand, we may experience a shortfall in revenues or earnings or otherwise fail to meet public market expectations.

The growth of our business will be dependent, in part, upon the increased use of carrier and enterprise connectivity services and our ability to capture a higher proportion of this market. Increased usage of enterprise connectivity services depends on numerous factors, including:

 
the willingness of enterprises to make additional information technology expenditures;
 
 
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the availability of security products necessary to ensure data privacy over the public networks;

 
the quality, cost, and functionality of these services and competing services;

 
the increased adoption of wired and wireless broadband access methods;

 
the continued growth of broadband-intensive applications; and

 
the proliferation of electronic devices and related applications.

Our long sales and service deployment cycles require us to incur substantial sales costs that may not result in related revenues.

Our business is characterized by long sales cycles, which are often in the range of 45 days or more, between the time a potential customer is contacted and a customer contract is signed. Furthermore, once a customer contract is signed, there is typically an extended period of between 30 and 120 days before the customer actually begins to use the services, which is when we begin to realize revenues. As a result, we may invest a significant amount of time and effort in attempting to secure a customer, which investment may not result in near term, if any, revenues. Even if we enter into a contract, we will have incurred substantial sales-related expenses well before we recognize any related revenues. If the expenses associated with sales increase, if we are not successful in our sales efforts, or if we are unable to generate associated offsetting revenues in a timely manner, our operating results could be materially and adversely affected.
 
 Because much of our business is international, our financial results may be affected by foreign exchange rate fluctuations.

Approximately 29% of our revenue comes from countries outside of the United States. As such, other currencies, particularly the Euro and the British Pound Sterling, can have an impact on the Company’s results (expressed in U.S. Dollars). Currency variations also contribute to variations in sales in impacted jurisdictions. Accordingly, fluctuations in foreign currency rates, most notably the strengthening of the dollar against the euro and the pound, could have a material impact on our revenue growth in future periods. In addition, currency variations can adversely affect margins on sales of our products in countries outside of the United States and margins on sales of products that include components obtained from suppliers located outside of the United States.

Because much of our business is international, we may be subject to local taxes, tariffs, or other restrictions in foreign countries, which may reduce our profitability.

Revenues from our foreign subsidiaries, or other locations where we provide or procure services internationally, may be subject to additional taxes in some foreign jurisdictions. Additionally, some foreign jurisdictions may subject us to additional withholding tax requirements or the imposition of tariffs, exchange controls, or other restrictions on foreign earnings. Any such taxes, tariffs, controls, and other restrictions imposed on our foreign operations may increase our costs of business in those jurisdictions, which in turn may reduce our profitability.

If our goodwill or amortizable intangible assets become further impaired we may be required to record a significant charge to earnings.

Under generally accepted accounting principles, 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 reduced future cash flow estimates, a decline in stock price and market capitalization, and slower growth rates in our industry. During the nine months ended September 30, 2011 and the year ended December 31, 2010, the Company recorded no impairment to goodwill and amortizable intangible assets. We may be required to record a significant charge to earnings 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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The ability to implement and maintain our databases and management information systems is a critical business requirement, and if we cannot obtain or maintain accurate data or maintain these systems, we might be unable to cost-effectively provide solutions to our customers.

To be successful, we must increase and update information in our databases about network pricing, capacity, and availability. Our ability to provide cost-effective network availability and access cost management depends upon the information we collect from our transport suppliers regarding their networks. These suppliers are not obligated to provide this information and could decide to stop providing it to us at any time. Moreover, we cannot be certain that the information that these suppliers share with us is accurate. If we cannot continue to maintain and expand the existing databases, we may be unable to increase revenues or to facilitate the supply of services in a cost-effective manner.

Furthermore, we are in the process of reviewing, integrating, and augmenting our management information systems to facilitate management of client orders, client service, billing, and financial applications. Our ability to manage our businesses could be materially adversely affected if we fail to successfully and promptly maintain and upgrade the existing management information systems.

If we are unable to protect our intellectual property rights, competitors may be able to use our technology or trademarks, which could weaken our competitive position.

We own certain proprietary programs, software, and technology. However, we do not have any patented technology that would preclude competitors from replicating our business model; instead, we rely upon a combination of know-how, trade secret laws, contractual restrictions, and copyright, trademark and service mark laws to establish and protect our intellectual property. Our success will depend in part on our ability to maintain or obtain (as applicable) and enforce intellectual property rights for those assets, both in the United States and in other countries. Although our Americas operating company has registered some of its service marks in the United States, we have not otherwise applied for registration of any marks in any other jurisdiction. Instead, with the exception of the few registered service marks in the United States, we rely exclusively on common law trademark rights in the countries in which we operate.  
 
 
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We may file applications for patents, copyrights and trademarks as our management deems appropriate. We cannot assure you that these applications, if filed, will be approved, or that we will have the financial and other resources necessary to enforce our proprietary rights against infringement by others. Additionally, we cannot assure you that any patent, trademark, or copyright obtained by us will not be challenged, invalidated, or circumvented, and the laws of certain foreign countries may not protect intellectual property rights to the same extent as do the laws of the United States or the member states of the European Union. Finally, although we intend to undertake reasonable measures to protect the proprietary assets of our combined operations, we cannot guarantee that we will be successful in all cases in protecting the trade secret status of certain significant intellectual property assets. If these assets should be misappropriated, if our intellectual property rights are otherwise infringed, or if a competitor should independently develop similar intellectual property, this could harm our ability to attract new clients, retain existing customers, and generate revenues.
 
Intellectual property and proprietary rights of others could prevent us from using necessary technology to provide our services or otherwise operate our business.

We utilize data and processing capabilities available through commercially available third-party software tools and databases to assist in the efficient analysis of network engineering and pricing options. Where such technology is held under patent or other intellectual property rights by third parties, we are required to negotiate license agreements in order to use that technology. In the future, we may not be able to negotiate such license agreements at acceptable prices or on acceptable terms. If an adequate substitute is not available on acceptable terms and at an acceptable price from another software licensor, we could be compelled to undertake additional efforts to obtain the relevant network and pricing data independently from other, disparate sources, which, if available at all, could involve significant time and expense and adversely affect our ability to deliver network services to customers in an efficient manner.

Furthermore, to the extent that we are subject to litigation regarding the ownership of our intellectual property or the licensing and use of others’ intellectual property, this litigation could:

 
be time-consuming and expensive;

 
divert attention and resources away from our daily business;

 
impede or prevent delivery of our products and services; and

 
require us to pay significant royalties, licensing fees, and damages.

Parties making claims of infringement may be able to obtain injunctive or other equitable relief that could effectively block our ability to provide our services and could cause us to pay substantial damages. In the event of a successful claim of infringement, we may need to obtain one or more licenses from third parties, which may not be available at a reasonable cost, if at all. The defense of any lawsuit could result in time-consuming and expensive litigation, regardless of the merits of such claims, and could also result in damages, license fees, royalty payments, and restrictions on our ability to provide our services, any of which could harm our business.

We continue to evaluate merger and acquisition opportunities and may purchase additional companies in the future, and the failure to integrate them successfully with our existing business may adversely affect our financial condition and results of operations.

We continue to explore merger and acquisition opportunities, and we may face difficulties if we acquire other businesses in the future, including:

 
integrating the personnel, services, products and technologies of the acquired businesses into our existing operations;

 
retaining key personnel of the acquired businesses;

 
failing to adequately identify or assess liabilities of acquired businesses;

 
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failing to achieve the synergies, revenue growth and other expected benefits we used to determine the purchase price of the acquired businesses;

 
failing to realize the anticipated benefits of a particular merger and acquisition;

 
incurring significant transaction and acquisition-related costs;

 
incurring significant amounts of additional debt;

 
creating significant contingent earn-out obligations and other financial liabilities;

 
incurring unanticipated problems or legal liabilities;

 
being subject to business uncertainties and contractual restrictions while an acquisition is pending that could adversely affect our business; and

 
diverting our management’s attention from the day-to-day operation of our business.

These difficulties could disrupt our ongoing business and increase our expenses. As of the date of this Form 10-Q, we have no agreement or memorandum of understanding to enter into any acquisition transaction.

In addition, our ability to complete acquisitions may depend, in part, on our ability to finance these acquisitions, including both the costs of the acquisition and the cost of the subsequent integration activities. Our ability may be constrained by our cash flow, the level of our indebtedness, restrictive covenants in the agreements governing our indebtedness, conditions in the securities and credit markets and other factors, most of which are generally beyond our control. If we proceed with one or more acquisitions in which the consideration consists of cash, we may use a substantial portion of our available cash to complete such acquisitions, thereby reducing our liquidity. If we finance one or more acquisitions with the proceeds of indebtedness, our interest expense and debt service requirements could increase materially. Thus, the financial impact of future acquisitions, including the costs to pursue acquisitions that do not ultimately close, could materially affect our business and could cause substantial fluctuations in our quarterly and yearly operating results.

We may experience difficulties integrating the recently acquired business of PacketExchange, which could adversely affect our financial condition and results of operations.

On June 6, 2011 we acquired PacketExchange. The success of this acquisition will depend in part on our success in integrating this business with our own. If we are unable to meet the challenges involved in successfully integrating the operations of PacketExchange or if we are otherwise unable to realize the anticipated benefits of this acquisition, our results of operations and financial condition could be seriously harmed. In addition, the overall integration of the acquired business will require substantial attention from our management, which could further harm our results of operations and financial condition.

The challenges involved in integrating the business of PacketExchange include:

 
integrating the company’s operations, processes, people, technologies, products and services;

 
coordinating and integrating sales and marketing functions;

 
demonstrating to the PacketExchange customers and suppliers that the acquisition will not result in adverse changes in business focus, products or service (including customer satisfaction);

 
assimilating and retaining the key personnel; and

 
consolidating administrative infrastructures and eliminating duplicative operations and administrative functions.