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CBEYOND, INC. - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) You should read the following discussion together with our Consolidated Financial Statements and the related notes and other financial information included elsewhere in this periodic report and our Annual Report on Form 10-K. The discussion in this periodic report contains forward-looking statements that involve risks and uncertainties, such as statements of our plans, objectives, expectations and intentions. The cautionary statements made in this report should be read as applying to all related forward-looking statements wherever they appear in this report. Our actual results could differ materially from those discussed here. See "Cautionary Notice Regarding Forward-Looking Statements" elsewhere in this report. In this report, Cbeyond, Inc. and its subsidiary are referred to as "we," "our," "us," the "Company" or "Cbeyond." Overview We first launched our service offering in Atlanta in April 2001 and have since expanded service into 13 additional metropolitan markets. From inception, our strategy has been to package big-business technologies and services for small and mid-sized companies in convenient and affordable bundles that they generally could not obtain from any other single supplier. This strategy is based on the belief that small and mid-sized businesses highly value the capabilities and productivity such technologies and services enable, but do not generally have the resources, expertise, or time to purchase and manage them, particularly for the smaller scale of operations typical of our target customers. Our initial service offering conveniently bundled local and long-distance voice services with T1 Internet access with a higher level of quality and at a lower price than our customers could obtain by purchasing these services separately. Over time, we began adding new technologies and services to our bundles as they became available, including mobile voice and data, email, voicemail, Web hosting, secure backup and file sharing, fax-to-email, virtual private network, desktop security, Microsoft® Exchange, mobile workforce management, virtual receptionist, MPLS, Metro Ethernet broadband Internet access, and other IT and communications services. Understanding the capital and operating efficiencies, as well as enhanced data security, that off-premise computing could bring to our customers, we acquired MaximumASP and Aretta in late 2010 to expand our IT services into cloud computing with virtual and physical cloud servers and cloud PBX. During 2012, we completed the full integration of the operations of MaximumASP and Aretta into our existing operations under common functional leadership. Subsequent to these acquisitions, we began offering professional services to assist customers with their transition to cloud-based services and have expanded these services to additional one-time services, such as MPLS network design, and recurring services, such as remote monitoring. Our four product families include TotalNetwork, TotalVoice, TotalCloud, and TotalAssist, which reflect our service offerings that have evolved over time. Recognizing that our greatest value proposition for customers is when we are able to bring them those technologies and services that are more resource intensive or difficult to obtain and manage, we focus more of our selling and service delivery efforts toward small and mid-sized businesses that are dependent on technology and have complex IT needs. Our research enables us to define and quantify a segment of the small-business customer market called the "technology-dependent" customer. Technology-dependent customers have the following characteristics: • The bulk of their employees use personal computers on the job; • They have knowledge workers who need to share data from a centralized source; • They have remote workers who need to access data on the go; • They need symmetric Metro Ethernet to run their business; • They are often multi-location businesses; and • They have a willingness to consider outsourcing their infrastructure as a way to preserve capital and increase both focus and productivity. We announced this strategy in early 2012 and accelerated efforts to realign our distribution channels by building a new direct sales group dedicated to managing both existing and new technology-dependent customers, reducing our traditional direct sales force, and consolidating certain offices. This strategic realignment resulted in $2.9 million of expense during 2012. We expect to complete the realignment during the first half of 2013 and incur approximately $0.5 million of additional realignment charges. In connection with our focus on technology-dependent customers, we defined certain of our technology-dependent customers as "Cbeyond 2.0" customers. Cbeyond 2.0 customers are those customers that we provide network access at speeds in excess of 10 Mbps or certain cloud-based services, such as virtual servers, physical servers, or cloud PBX services. In addition, we designate customers using our MPLS service as Cbeyond 2.0 customers. We refer to all other customers as Cbeyond 1.0 customers. Although Cbeyond 1.0 customers also frequently purchase cloud-based services from us, we delineate between Cbeyond 1.0 and Cbeyond 2.0 based on how pervasive or significant we believe such services are to a customer's 25-------------------------------------------------------------------------------- Table of Contents operation. Specifically, we consider the cloud-based services that qualify a customer as Cbeyond 2.0 as infrastructure-as-a-service in nature. We believe the distinction is important because infrastructure services are generally longer-term in nature, generate higher revenues and provide a gateway for software-as-a-service products. Our cloud-based services that do not qualify a customer as being designated Cbeyond 2.0 include products such as virtual receptionist, Microsoft® Exchange hosting, Web hosting, and fax-to-email, among others. Depending on the product, we host these types of services for between 5% and 80% of our customers and have been hosting such services for most of our existence, which gives us significant experience in operating in a cloud computing environment. These cloud-based services are typically included within our bundled services, but customers purchase additional quantities to meet their specific needs. Charges for additional services outside of our bundled package grew 15.5% during the current year, from $6.1 million in 2011 to $7.0 million in 2012. We estimate that almost one-half of our customers are technology-dependent, but are not currently considered Cbeyond 2.0 customers because either they do not currently utilize cloud-based solutions or advanced network services, or they obtain these services from other providers. We believe this makes them strong prospects to become Cbeyond 2.0 customers. During the fourth quarter of 2012, we generated $11.4 million, or 9.5%, of revenue from Cbeyond 2.0 customers, which represents a 66.5% increase over the amount recognized during the first quarter of 2012. We did not start tracking the comprehensive Cbeyond 2.0 customer base until 2012, and thus we do not have comparable and meaningful prior year Cbeyond 2.0 customer revenue data. We currently include all revenue from customers who purchase network access from us (or "Network access customers") within our average monthly revenue per customer location (or "ARPU") calculation. Thus, revenue from customers who purchase cloud-based services independent of network access is excluded from ARPU. After considering all cloud-based services, we believe that Cbeyond 2.0 customers currently provide over 60% higher ARPU than that of our Cbeyond 1.0 customers and we expect that percentage to grow over time. We have not yet determined the revenue metrics that best represent the results of the consolidated business or the results from customers that purchase cloud-based services independent of network access. We focus our sales efforts on customers that purchase both network and cloud-based services since we believe that these services, when combined, offer the greatest value proposition to customers and allows us significantly more control over the quality of service. Therefore, we do not expect revenue from customers that only purchase cloud-based services to grow as quickly as revenue from customers who purchase both network access and cloud services from us. Year ended December 31, 2012 2011 2010 Calculation of ARPU (Dollar amounts in thousands, except ARPU): Total revenue $ 487,966 $ 485,422 $ 451,965 Cloud only revenue (13,581 ) (12,793 ) (1,784 ) (A) Network access customer revenue (1) $ 474,385 $ 472,629 $ 450,181 (B) Average Network access customers 60,931 59,571 53,588 ARPU (A / B / number of months in period) $ 649 $ 661 $ 700 (1) During the third quarter of 2012 we began including revenue from certain cloud-based services provided to Network access customers within the ARPU calculation that were not previously included. We have recast all historical disclosures of ARPU for all periods presented in this Form 10-K to conform to the current presentation. As we accelerate sales of cloud-based services to both new and existing technology-dependent Network access customers, we expect our revenue to include an increasing proportion of higher ARPU Cbeyond 2.0 customers. Our concentrated focus on technology-dependent customers was expected to result in little to no net growth in customers in 2012 and we expect this to continue in the near term; however, we expect that in the longer-term our ARPU and customer additions will increase as our customer mix becomes more oriented to those who are technology-dependent and are using our services to satisfy their technology needs. In addition, we expect that our future capital expenditures and operating expenses will continue to be more focused on selling to these types of customers. Operating expenses will include the cost of revenue to support a higher bandwidth Metro Ethernet network and the selling expenses of a more focused and consultative sales force. Capital expenditures will include the costs of building out a higher bandwidth network, additional hosting infrastructure, and product development. During the first quarter of 2012, we executed agreements to provide optical fiber access in multiple markets through long-term capital leases of fiber infrastructure assets, including agreements for the indefeasible rights of use (or "IRU") of certain fiber network assets. Upon execution of these agreements, we took delivery of fiber assets and incurred future minimum capital lease obligations of $2.4 million. This obligation was partially satisfied in May 2012 through a $2.0 million lump sum payment directly funded by our Fiber Loan. During the remainder of 2012, we took delivery of additional fiber assets with 26-------------------------------------------------------------------------------- Table of Contents future minimum capital lease obligations of $4.3 million. The cash outlays for all obligations arising from our fiber assets will be either directly funded by our Fiber Loan or financed through fiber providers and will be payable by us through 2018 either as debt or capital lease obligations. Under these agreements, we have building access agreements (or "BAAs") and outstanding construction orders for fiber assets with expected future minimum lease payments of $6.2 million. These commitments are not recognized on the balance sheet as of December 31, 2012 because they are contingent upon third parties completing construction and our testing and acceptance of the fiber assets. As of December 31, 2012, we have placed additional construction orders that total $11.5 million for which we have not yet obtained building access agreements. We do not expect to be able to obtain building access agreements for every order placed. Therefore, we expect a portion of these orders may never be constructed. Additional construction orders may be placed under these contracts in the future. Through June 30, 2012, we were organized into three reportable segments: Core Managed Services Established Markets, Core Managed Services Emerging Markets, and Cloud Services. Beginning in late 2011 and continuing into the third quarter of 2012, we integrated substantially all administrative and operating functions of our former Cloud Services segment into the administrative and operating functions of our former Core Managed Services segments. Sales and marketing functions have also been combined as we focus on selling integrated service bundles that include our cloud-based services. Due to the advanced stage of our integration, during the third quarter of 2012, our CODM shifted his focus towards a product-oriented structure rather than a geographic basis and began reviewing financial results on a consolidated basis accompanied by disaggregated revenue information by product line. Accordingly, we revised our reportable segments to one reportable segment during the third quarter to reflect this change, which we expect to continue for the foreseeable future. Our CODM uses Adjusted EBITDA and Free Cash Flow to assess the financial performance of the business at a consolidated level. We believe these are important performance metrics for evaluating our ability to generate cash that can potentially be used by the business for capital investments, acquisitions, reduction of debt, or potential payment of dividends or share repurchases. We have also designed our corporate bonus compensation plan to include Free Cash Flow as a component. Management believes that Adjusted EBITDA data should be available to investors so that investors have the same data that management employs in assessing operations. EBITDA is a non-GAAP financial measure commonly used by investors, financial analysts and ratings agencies. EBITDA is generally defined as net income (loss) before interest, income taxes, depreciation and amortization. However, we use Adjusted EBITDA, also a non-GAAP financial measure, to further exclude, when applicable, non-cash share-based compensation, public offering or acquisition-related transaction costs, purchase accounting adjustments, gains or losses on asset dispositions, and non-operating income or expense. On a less frequent basis, Adjusted EBITDA may exclude charges for employee severances, asset or facility impairments, and other exit activity costs associated with a management directed plan (collectively referred to as realignment costs). Historically, we have defined Free Cash Flow as Adjusted EBITDA less total capital expenditures. During the first quarter of 2012, we refined our definition of capital expenditures for purposes of calculating Free Cash Flow to distinguish capital expenditures that require the up-front outlay of cash from those where payment is deferred on a longer-term basis. This distinction is driven primarily by the significant investments we are making to lease fiber network assets that have an expected useful life of 20 years, which is substantially longer than our typical asset lives. We believe this distinction is warranted and appropriate since these investments are expected to yield meaningful positive cash flows in future periods when the debt and lease payments occur. These favorable future cash flows will result from fiber infrastructure replacing a portion of the access and transport circuits we currently lease from incumbent local exchange carriers. We have recast all historical disclosures of capital expenditures as well as Free Cash Flow for all periods presented in this Form 10-K to be consistent with this delineation between cash and non-cash capital expenditures. Year ended December 31, 2012 2011 2010 Reconciliation of Capital Expenditures (in thousands) Cash capital expenditures (1) 61,605 77,604 61,962 Non-cash capital expenditures: Fiber capital lease assets 6,742 - - Equipment capital lease assets 1,591 - - Leasehold improvements - 87 870 Total capital expenditures 69,938 77,691 62,832 (1) Represents cash purchases of property and equipment per the Consolidated Statement of Cash Flows. 27-------------------------------------------------------------------------------- Table of Contents Adjusted EBITDA was $94.2 million in 2012, an 18% increase over 2011. Free Cash Flow was $32.6 million in 2012 compared to $2.6 million in 2011. The growth in Adjusted EBITDA and Free Cash Flow is primarily attributable to a reduction in capital expenditure subsequent to our copper-based Metro Ethernet conversion efforts in 2011 and lower operating costs as a result of our strategic realignment. Year ended December 31, 2012 2011 2010 Reconciliation of Free Cash Flow and Adjusted EBITDA to Net loss (in thousands) Free Cash Flow $ 32,640 $ 2,559 $ 10,973 Cash capital expenditures 61,605 77,604 61,962 Adjusted EBITDA 94,245 80,163 72,935 Depreciation and amortization (74,023 ) (69,895 ) (59,304 ) Non-cash share-based compensation (13,140 ) (14,149 ) (15,591 ) MaximumASP purchase accounting adjustments (1) - 516 (213 ) Transaction costs - (154 ) (755 ) Realignment costs (2) (2,236 ) - - Interest expense, net (577 ) (500 ) (279 ) Other income, net - 1,211 1,867 Income (loss) before income taxes 4,269 (2,808 ) (1,340 ) Income tax expense (6,591 ) (5,176 ) (314 ) Net loss $ (2,322 ) $ (7,984 ) $ (1,654 ) (1) These adjustments include the effect of adjusting acquired deferred revenue and the contingent consideration to fair value. These adjustments affect period-to-period financial performance comparability in periods subsequent to the acquisition and are not indicative of changes in underlying results of operations. We may have similar adjustments in future periods if we have any new acquisitions. (2) During 2012, $2.2 million of realignment costs are included in Selling, general and administrative expense and $0.7 million are included in Depreciation and amortization. Revenue Our revenue is disaggregated into Network, Voice and Data or Managed Hosting and Cloud. Managed Hosting and Cloud includes virtual servers, physical servers, and cloud PBX services to customers and distribution channels that are not limited by geographical location. Our focus is to provide these services to Network access customers; however, certain customers purchase these cloud-based services independent of network access. Managed Hosting and Cloud also includes other services, such as virtual receptionist, Microsoft® Exchange hosting, Web hosting, and fax-to-email, that are purchased by Network access customers in quantities that exceed those included in their bundled service package. We seek to sell our services through three-year contracts, but also offer one-year and two-year contracts at generally higher prices. As a result, customer churn rates impact our projected future revenue streams. We define customer churn rate for a given month as the number of Network access customers disconnected in that month divided by the total number of Network access customers at the beginning of that month. Due to differences in ARPU between Cbeyond 1.0 customers and Cbeyond 2.0 customers, we believe a unit-based churn metric is likely to become less meaningful than it has been historically. In the future, we intend to transition to a revenue-based churn metric that will be applicable to all revenue, including revenue from customers that purchase cloud-based services independent of network access. Although not a significant source of our Network, Voice and Data revenue, we charge other communications companies for terminating calls to our customers on our network. Terminating access charges have historically grown at a slower rate than our customer base due to reductions in access rates on interstate calls as mandated by the Federal Communications Commission. These rate reductions are expected to continue in the future. Cost of Revenue Our cost of revenue represents costs directly related to the operation of our network and includes payments for access circuits, interconnection and transport fees, customer circuit installation costs, fees paid for Web hosting services, collocation rents and other facility costs, telecommunications-related taxes and fees, and the cost of mobile handsets. Cost of revenue associated with our cloud-based services includes licensing fees for the required operating systems, broadband service and access fees, and power for our data center facilities. 28-------------------------------------------------------------------------------- Table of Contents The primary component of cost of revenue consists of the access fees paid to local telephone companies for high capacity circuits we lease on a monthly basis to provide connectivity to our customers. These access circuits link our customers to our network equipment located in a collocation facility, which we also lease from local telephone companies. Historically, most of the high capacity circuits we leased have been T1's, which are the largest component of our circuit access fees. However, we are converting many of our existing customer T1 circuits and have begun serving new customers using Metro Ethernet in place of T1 circuits in a number of locations. Although not available to us on an ubiquitous basis in all areas, Ethernet technology provides us with the opportunity to offer a large percentage of our customers' bandwidth at speeds well in excess of T1 circuits while reducing our ongoing operating expenses. We substantially completed our copper-based Metro Ethernet customer conversion project in 2011 and in 2012 we shifted our focus to our optical fiber access initiative. Costs related to our fiber network include lease payments and maintenance costs for dark fiber (or fiber provided by third parties operated by us) and access fees for lit fiber (or fiber operated by third parties). We expect these costs to increase in 2013 as we expand our fiber network. A rising component of cost of revenue is transport cost, which is primarily the cost we incur with ILECs for traffic between central offices where we have collocation equipment, traffic between wire centers without our presence and our collocations, and intercity traffic between our markets. These costs have increased in the near term as we have built additional collocations to support our Metro Ethernet initiative; however, we expect that the increased transport costs will be offset by greater reductions in future access fees resulting from our investment in Ethernet technology, which provides significantly lower operating expenses than traditional T1 technology. Another significant component of our cost of revenue is the cost associated with our mobile offering. These costs include usage-based charges, monthly recurring base charges, or some combination thereof, depending on the type of mobile product in service and the cost of mobile equipment sold to our customers. The cost of mobile devices typically exceeds our selling price due to the highly competitive marketplace and traditional pricing practices for mobile services. We believe these costs are offset over time by the long-term profitability of our service contracts. We routinely negotiate and receive telecommunication cost recoveries from various local telephone companies to resolve prior errors in billing, including the effect of price decreases retroactively applied upon the adoption of new rates as mandated by regulatory bodies. We also receive payments from local telephone companies in the form of performance penalties that are assessed by state regulatory commissions based on the local telephone companies' performance in the delivery of circuits and other services. Because of the many factors that impact the amount and timing of telecommunication cost recoveries, we are often unable to estimate the outcome of these situations. Accordingly, we generally recognize telecommunication cost recoveries as offsets to cost of revenue when the ultimate resolution and amount are known and verifiable. These items do not follow any predictable trends and often result in variances when comparing the amounts received over multiple periods. In the future, through systematic improvements in process applications, and after gaining further historical experience, we may be able to more reliably estimate the outcome of telecommunication cost recoveries prior to being known and verifiable, which could result in earlier recognition of these recoveries. Selling, General and Administrative Expense Our selling, general and administrative expense consist of salaries and related costs for employees and other costs related to sales and marketing, engineering, information technology, billing, regulatory, administrative, collections, legal, and accounting functions. In addition, bad debt expense and share-based compensation expense are included in selling, general and administrative expenses. Our selling, general and administrative expense includes both fixed and variable costs. Fixed costs include the cost of staffing certain corporate functions such as IT, marketing, administrative, billing and engineering, and associated costs, such as office rent, legal and accounting fees, property taxes, and recruiting costs. Variable costs include commissions; bonuses; marketing materials; the cost of provisioning and customer activation staff, which varies with the level of installation of new customers; and the cost of customer care and technical support staff, which varies with the level of total customers on our network; and the complexity of our product offering. Reclassifications Reclassifications have been made to the 2011 and 2010 Revenue table within Item 7 herein to present our revenue on a product-line basis, separating Network, Voice and Data from Managed Hosting and Cloud. Reclassifications have also been made to ARPU within Item 7 herein to include revenue from certain cloud-based services provided to Network access customers within the calculation that were not previously included. Such reclassifications were made to conform to the current year presentation. 29-------------------------------------------------------------------------------- Table of Contents Consolidated Results of Operations Year Ended December 31, 2012 Compared to Year Ended December 31, 2011 Revenue (Dollar amounts in thousands, except ARPU) For the year ended December 31, 2012 2011 Change from Previous Period % of % of Dollars Revenue Dollars Revenue Dollars PercentRevenue: Network, Voice and Data $ 463,289 94.9 % $ 464,659 95.7 % $ (1,370 ) (0.3 )% Managed Hosting and Cloud 24,677 5.1 % 20,763 4.3 % 3,914 18.9 % Total revenue 487,966 485,422 2,544 0.5 % Cost of revenue 158,582 32.5 % 161,306 33.2 % (2,724 ) (1.7 )% Gross margin (exclusive of depreciation and amortization) $ 329,384 67.5 % $ 324,116 66.8 % $ 5,268 1.6 % Network access customer data: Customer locations at period end 59,692 62,169 (2,477 ) (4.0 )% ARPU $ 649 $ 661 $ (12 ) (1.8 )% Average monthly churn rate 1.6 % 1.4 % 0.2 % Total revenue slightly increased during 2012 compared to 2011 due to our efforts to realign our distribution channels by building a new direct sales group dedicated to technology-dependent customers and reducing our traditional direct sales force. This focus on our realignment and on higher-value customers resulted in lower new customer acquisition by our sales force than we have achieved historically. Because of this, customer churn exceeded new customer growth and resulted in a decline in customers. The revenue impact of the decline in customers was largely offset by increases in fees we charge our customers to recover certain regulatory costs. We expect these regulatory charges to have a continuing benefit in future periods. The impact of such fees in 2013 will be more significant as compared to 2012. Managed Hosting and Cloud revenue increased in 2012 largely due to the introduction of additional cloud-based service offerings. We expect revenue growth to return as our Cbeyond 2.0 sales force increases in number and productivity, and as we refine and expand our catalog of products targeted to technology-dependent customers and further expand our Metro Ethernet network. ARPU declined 1.8% for 2012, compared to 2011, which is an improvement over the 5.6% decline for 2011 compared to 2010. The decline in ARPU is primarily due to existing customers converting to lower priced packages, decreased charges for usage above levels of voice minutes included in our packages, customers reducing the number of additional lines and services with incremental charges, and a decline in the number of customers utilizing our mobile services. We believe the decline is also related to the economic conditions faced by our customers and continued competitive pressures from alternate communications providers, such as cable companies. These negative factors were primarily offset by the increases noted above. ARPU may continue to decline in the short-term for the reasons noted above; however, we anticipate that our focus on selling sophisticated solutions to technology-dependent customers will decrease the rate of decline by increasing the proportion of new, higher ARPU, technology-dependent customers. Longer-term, we expect that our focus on technology-dependent customers, or Cbeyond 2.0 customers, and new product launches will increasingly benefit ARPU. This expectation is evident by the current shift we are seeing between Network, Voice and Data revenue, which declined 0.3% in 2012, and Managed Hosting and Cloud revenue, which increased 18.9% in 2012. These results reflect the launch of our flagship cloud offerings, TotalCloud Phone System and TotalCloud Data Center, during the fourth quarter of 2012. Our average customer churn rate was 1.6% for 2012, representing a slight increase over prior periods. The increase from 1.4% for 2011 is primarily attributable to price competition for smaller communications-centric customers. 30-------------------------------------------------------------------------------- Table of Contents Cost of Revenue (Dollar amounts in thousands) For the year ended December 31, 2012 2011 Change from Previous Period % of % of Dollars Revenue Dollars Revenue Dollars PercentCost of revenue (exclusive of depreciation and amortization): Circuit access fees $ 72,669 14.9 % $ 72,549 14.9 % $ 120 0.2 % Other cost of revenue 44,661 9.2 % 47,298 9.7 % (2,637 ) (5.6 )% Transport cost 25,735 5.3 % 24,355 5.0 % 1,380 5.7 % Mobile cost 18,506 3.8 % 22,358 4.6 % (3,852 ) (17.2 )% Telecommunications cost recoveries (2,989 ) (0.6 )% (5,254 ) (1.1 )% 2,265 (43.1 )% Total cost of revenue $ 158,582 32.5 % $ 161,306 33.2 % $ (2,724 ) (1.7 )% The principal drivers of the overall decrease in cost of revenue are the reduction in installation costs from fewer new customer installations and reduced costs related to the copper-based Metro Ethernet conversion project, which was substantially complete at the end of 2011, and a reduction in mobile-related costs. These cost reductions were partially offset by higher circuit costs attributable to delivering higher bandwidth circuits to our customers, and costs relating to additional collocation facilities added to support the Metro Ethernet expansion. Circuit access fees, or line charges, represent the largest single component of cost of revenue. These costs primarily relate to our lease of circuits connecting our equipment at network points of collocation to our equipment located at our customers' premises. The increase in circuit access fees has historically correlated to changes in the number of customers, but there are a number of influences in recent periods that have reduced the level of correlation. We are realizing expected cost savings from our Metro Ethernet conversion initiative, but are also experiencing increases as we provide higher bandwidth to our customers. A portion of our cost savings relates to a reduction in direct and indirect costs associated with migrating customers to Metro Ethernet technology from $2.9 million in 2011 to $0.4 million in 2012. As we serve more technology-dependent customers with higher bandwidth needs, we expect access costs to initially increase. These customers, however, will also generate much higher revenue due to the breadth and type of services enabled by higher bandwidth. Over time, as we increasingly leverage our own fiber assets we expect our access costs on a per-customer basis to decline. Other cost of revenue includes components such as long distance charges, installation costs to connect new circuits, the cost of local interconnection with ILECs' networks, Internet access costs, the cost of third-party service offerings we provide to our customers, costs to deliver our cloud-based services, and certain taxes and fees. Other cost of revenue decreased in 2012 compared to 2011, primarily due to a decrease in new customer installations and a reduction of approximately $1.7 million in costs related to the copper-based Metro Ethernet conversion project, which was substantially completed in 2011. Transport cost is a rising component of cost of revenue and has risen at a rate outpacing customer growth as we build additional collocations to support our Metro Ethernet initiative. This trend will continue for the near-term. Longer-term, we expect transport costs to decline given the cost profile of Ethernet access versus traditional T1 access. As a percentage of revenue, mobile costs decreased during 2012 compared to 2011. Primary drivers of this decrease include a reduction in mobile service costs and mobile device costs due to lower volume. The reduction in shipments relates to the decrease in new customers and a decrease in the rate of new customers electing mobile services. Though we do not currently anticipate significant changes in the percentage of customers using our mobile services in the future, we have been selling more recent and competitive mobile device models. As such, we do not anticipate mobile costs will continue to decline from current levels in the long term. 31-------------------------------------------------------------------------------- Table of Contents Selling, General and Administrative and Other Operating Expenses (Dollar amounts in thousands) For the year ended December 31, 2012 2011 Change from Previous Period % of % of Dollars Revenue Dollars Revenue Dollars Percent Selling, general and administrative (exclusive of depreciation and amortization): Salaries, wages and benefits (exclusive of share-based compensation) $ 152,265 31.2 % $ 160,074 33.0 % $ (7,809 ) (4.9 )% Share-based compensation 13,140 2.7 % 14,149 2.9 % (1,009 ) (7.1 )% Marketing cost 2,343 0.5 % 2,739 0.6 % (396 ) (14.5 )%Acquisition related benefit - - % (426 ) (0.1 )% 426 (100.0 )% Realignment costs 2,236 0.5 % - - % 2,236 nm Other selling, general and administrative 80,531 16.5 % 81,204 16.7 % (673 ) (0.8 )% Total SG&A $ 250,515 51.3 % $ 257,740 53.1 % $ (7,225 ) (2.8 )% Other operating expenses: Depreciation and amortization 74,023 15.2 % 69,895 14.4 % 4,128 5.9 % Total other operating expenses $ 74,023 15.2 % $ 69,895 14.4 % $ 4,128 5.9 % Other data: Average employees 1,675 1,957 (282 ) (14.4 )% Selling, general and administrative expense decreased during 2012 compared to 2011, primarily due to a lower number of average employees, partially offset by realignment costs. Salaries, wages and benefits decreased during 2012 compared to the prior year due to a lower number of average employees as a result of our strategic realignment, which resulted in a workforce reductions during the first and second quarters of 2012. The savings that resulted from our strategic realignment were partially offset throughout the remainder of the year as we continued to invest in our Cbeyond 2.0 sales force and staffing our operations to support our focus on technology-dependent customers. Salaries, wages and benefits was also affected by higher employee bonus expense in 2012 compared to 2011. Share-based compensation expense decreased during 2012 compared to 2011, primarily due to a decline in the fair value of awards granted based on lower share prices in recent periods. As our share price has declined, we have experienced decreases in our share-based compensation expense related to the full vesting of higher historical valued awards granted. This is partially offset by increased share-based compensation costs related to our 2012 corporate bonus plan as all corporate employees now receive 20% of their bonus in shares. Marketing costs decreased in 2012 compared to 2011 due to lower advertising and promotional activity as we reduced costs while focusing on our strategic realignment. This decline is not expected to continue in the future as we focus on technology-dependent customers. The strategic realignment, which was announced in early 2012, resulted in $2.2 million of selling, general and administrative expense in 2012. This expense primarily consisted of $1.4 million for employee severances and benefits, and $0.7 million for losses under non-cancelable office leases. Other selling, general and administrative expenses primarily include professional fees, outsourced services, rent and other facilities costs, maintenance, recruiting fees, travel and entertainment costs, property taxes, and bad debt expense. The decrease in this category of costs is primarily due to streamlining operations as part of our strategic realignment effort and stronger overall cost controls due to slowing revenue growth. This decrease is not expected to continue in the future as we focus on serving technology-dependent customers. Bad debt expense was $5.7 million, or 1.2% of revenue, compared to $6.5 million, or 1.3% of revenue, during 2012 and 2011, respectively. The increase in depreciation and amortization in 2012 compared to 2011 relates primarily to a 11.0% increase in depreciable fixed assets over the prior period. In addition, we recognized $0.7 million of accelerated depreciation in 2012 for certain long-lived assets at offices which were consolidated as part of the strategic realignment. 32-------------------------------------------------------------------------------- Table of Contents Other Income (Expense) and Income Taxes (Dollar amounts in thousands) For the year ended December 31, 2012 2011 Change from Previous Period % of % of Dollars Revenue Dollars Revenue Dollars Percent Interest expense, net $ (577 ) (0.1 )% $ (500 ) (0.1 )% $ (77 ) 15.4 % Other income, net - - % 1,211 0.2 % (1,211 ) (100.0 )% Income tax expense (6,591 ) (1.4 )% (5,176 ) (1.1 )% (1,415 ) 27.3 % Total $ (7,168 ) (1.5 )% $ (4,465 ) (0.9 )% $ (2,703 ) nm The majority of our interest expense in 2012 and 2011 relates to commitment fees under our Credit Facility. Accordingly, interest expense was slightly higher in 2012 due to an increase in our Credit Facility from $40.0 million to $75.0 million. As we continue to draw on our Fiber Loan and incur capital lease obligations, we expect to incur increased interest expense. During 2011, we recognized other income of $1.2 million, which primarily relates to adjusting liabilities of our former captive leasing subsidiaries upon the expiration of various statutory periods (see Note 17 to the Consolidated Financial Statements ). The 2012 income tax expense primarily relates to the increase in our valuation allowance against our net deferred tax asset, utilization of net operating loss carryforwards to offset taxable income, and state income taxes payable in markets in which we do not have net operating loss carryforwards. Included in state income tax expense are gross receipts based taxes levied by Texas that are due regardless of income levels. Since this tax is not dependent upon levels of income, it has a significant influence on our effective tax rate. Additionally, income tax expense reflects amounts associated with share-based transactions, which are described in Note 11 to the Consolidated Financial Statements . Our net deferred tax assets, before valuation allowance, totaled approximately $37.2 million and $39.7 million at December 31, 2012 and 2011, respectively, and primarily relate to net operating loss carryforwards. In evaluating our ability to realize our deferred income tax assets, we consider all available positive and negative evidence, including our historical operating results, ongoing tax planning and forecasts of future taxable income. Our evaluation led us to increase our valuation allowance in the fourth quarter of 2012 by $3.3 million, resulting in additional income tax expense. Our deferred tax assets are now fully reserved by the valuation allowance. In addition to our fully reserved net deferred tax assets, we have a deferred tax liability of $0.8 million, which relates to tax amortization for goodwill. 33-------------------------------------------------------------------------------- Table of Contents Consolidated Results of Operations Year Ended December 31, 2011 Compared to Year Ended December 31, 2010 Revenue (Dollar amounts in thousands, except ARPU) For the year ended December 31, 2011 2010 Change from Previous Period % of % of Dollars Revenue Dollars Revenue Dollars PercentRevenue: Network, Voice and Data $ 464,659 95.7 % $ 445,898 98.7 % $ 18,761 4.2 % Managed Hosting and Cloud 20,763 4.3 % 6,067 1.3 % 14,696 242.2 % Total revenue 485,422 451,965 33,457 7.4 % Cost of revenue 161,306 33.2 % 146,507 32.4 % 14,799 10.1 % Gross margin (exclusive of depreciation and amortization) $ 324,116 66.8 % $ 305,458 67.6 % $ 18,658 6.1 % Network access customer data: Customer locations at period end 62,169 56,972 5,197 9.1 % ARPU $ 661 $ 700 $ (39 ) (5.6 )% Average monthly churn rate 1.4 % 1.4 % - % Total revenue increased in 2011 compared to 2010 primarily due to an increase in the average number of Network access customers, offset by a reduction in ARPU. Managed Hosting and Cloud services contributed an additional $14.7 million in revenue in 2011 primarily due to the inclusion of our acquisitions of MaximumASP and Aretta for a full twelve months in 2011. This is compared to 2010, which included approximately two months of results given the timing of our acquisitions. The decline in ARPU was primarily due to the lower prices of the new packages introduced in 2010, existing customers converting to lower priced packages, decreased charges for usage above levels of voice minutes included in our packages, customers reducing the number of additional lines and services with incremental charges, and decreased adoption of our mobile services. We believe the decline is related to the effects of the ongoing current economic conditions on customers and the continued increased competitive pressures from alternate providers, such as cable companies. This downward pressure has been partially offset by the value delivered through selling additional service offerings. Cost of Revenue (Dollar amounts in thousands) For the year ended December 31, 2011 2010 Change from Previous Period % of % of Dollars Revenue Dollars Revenue Dollars Percent Cost of revenue (exclusive of depreciation and amortization): Circuit access fees $ 72,549 14.9 % $ 64,726 14.3 % $ 7,823 12.1 % Other cost of revenue 47,298 9.7 % 40,005 8.9 % 7,293 18.2 % Transport cost 24,355 5.0 % 20,301 4.5 % 4,054 20.0 % Mobile cost 22,358 4.6 % 26,712 5.9 % (4,354 ) (16.3 )% Telecommunications cost recoveries (5,254 ) (1.1 )% (5,237 ) (1.2 )% (17 ) 0.3 % Total cost of revenue $ 161,306 33.2 % $ 146,507 32.4 % $ 14,799 10.1 % The principal driver of the overall increase in cost of revenue is customer growth. The inclusion of our acquisitions for a full year in 2011 contributed an additional $3.2 million of costs. Cost of revenue directly associated with migrating customers to copper-based Metro Ethernet totaled $2.8 million during 2011. In addition, indirect costs we attribute to our copper-based Metro Ethernet conversion initiative totaled $1.8 million in 2011. Circuit access fees, or line charges, represent the largest component of cost of revenue. These costs primarily relate to our lease of circuits connecting our equipment at network points of collocation to our equipment located at our customers' premises. The increase in circuit access fees has historically correlated to the increase in the number of customers. However, we have experienced increased costs as we have expanded in certain markets with higher access fees and sold additional bandwidth to existing customers. Circuit access fees also include $1.1 million of direct conversion expenses related to copper- 34-------------------------------------------------------------------------------- Table of Contents based Metro Ethernet conversions and $1.8 million of certain indirect costs in 2011. These indirect costs related to inefficiencies in our circuit disconnect process and other unanticipated costs identified during the third quarter that we attributed to our copper-based Metro Ethernet initiative and do not expect to reoccur in the future. Circuit access fees increased as a percentage of revenue primarily due to a decrease in ARPU. We expect circuit access fees as a percentage of revenue to stabilize over time as we convert customers to Metro Ethernet, which we expect will reduce operating costs, and as ARPU stabilizes. Other cost of revenue principally includes long distance charges, installation costs to connect new circuits, the cost of local interconnection with the local telephone companies' networks, Internet access costs, the cost of third-party service offerings we provide to our customers, costs to deliver our cloud-based services, and certain taxes and fees. Other cost of revenue increased as a percentage of revenue in 2011 compared to 2010 primarily due to customer growth outpacing revenue growth. In addition, we experienced a $1.7 million increase in installation costs during 2011 relating to the copper-based Metro Ethernet initiative. Transport cost is a rising component of cost of revenue and has risen at a rate outpacing customer growth as we build additional collocations to support our Metro Ethernet initiative. This trend will continue for the near-term. Longer-term, we expect transport costs to decline on a per-customer basis given the cost profile of Ethernet access versus traditional T1 access. As a percentage of revenue, mobile costs decreased in 2011 compared to 2010. The primary drivers of this decrease are reductions in service costs due to lower negotiated rates and mobile device costs due to lower volumes. The reduction in shipments stems from a lower percentage of new customers electing mobile services primarily due to a reduction in our use of promotional and other incentives. Selling, General and Administrative and Other Operating Expenses (Dollar amounts in thousands) For the year ended December 31, 2011 2010 Change from Previous Period % of % of Dollars Revenue Dollars Revenue Dollars Percent Selling, general and administrative (exclusive of depreciation and amortization): Salaries, wages and benefits (exclusive of share-based compensation) $ 160,074 33.0 % $ 150,205 33.2 % $ 9,869 6.6 % Share-based compensation 14,149 2.9 % 15,591 3.4 % (1,442 ) (9.2 )% Marketing cost 2,739 0.6 % 3,440 0.8 % (701 ) (20.4 )% Acquisition related (benefit) expense (426 ) (0.1 )% 755 0.2 % (1,181 ) (156.4 )% Other selling, general and administrative 81,204 16.7 % 79,091 17.5 % 2,113 2.7 % Total SG&A $ 257,740 53.1 % $ 249,082 55.1 % $ 8,658 3.5 % Other operating expenses: Depreciation and amortization 69,895 14.4 % 59,304 13.1 % 10,591 17.9 % Total other operating expenses $ 69,895 14.4 % $ 59,304 13.1 % $ 10,591 17.9 % Other data: Average employees 1,957 1,814 143 7.9 % Selling, general and administrative expenses increased in 2011 compared to 2010, primarily due to increased employee salaries, wages and benefits. The inclusion of our acquisitions for a full year in 2011 contributed an additional $7.9 million of costs. Total selling, general and administrative expenses also includes $2.9 million in employee costs and other expenses associated with migrating customers to copper-based Metro Ethernet during 2011. The overall increase in selling, general and administrative expenses is partially offset by certain decreased expenses, including bad debt expense and share-based compensation. Higher employee costs, which include salaries, wages, benefits, and other compensation paid to our direct sales representatives and sales agents, related to the additional employees necessary to staff newer markets and serve the growth in customers. We also incurred approximately $5.5 million more in compensation costs in 2011 due to employees at acquired entities who were with us for the full year. Overall, the increase in salaries, wages and benefits over the prior respective period was consistent with the growth in the average number of employees. As a percentage of revenue, employee costs during 2011 remained consistent with the prior period. During the third and fourth quarters of 2011, management recommended and the Board of Directors approved to reduce the accrued payout level under our 2011 corporate incentive plan based on management's assessment that the quality of results warranted a lower achievement level than expected under the plan's 35-------------------------------------------------------------------------------- Table of Contents parameters. We believed this amendment to the plan better aligned management's compensation with the interests of stockholders. These actions resulted in a $1.8 million reduction to employee costs during 2011. Share-based compensation expense decreased overall and as a percentage of revenue in 2011 compared to 2010, primarily due to a decline in the fair value of awards granted based on lower share prices in recent periods. As our share price has declined, we have experienced decreases in our share-based compensation expense related to the full vesting of higher historical valued awards granted. Additionally, during the third quarter of 2011, the vesting of certain non-employee performance awards was no longer considered probable. Marketing costs decreased in 2011 compared to 2010 primarily due to lower advertising and promotional activity as we reduced costs while focusing on our strategic realignment. Acquisition related (benefit) expense during 2011 includes a $0.6 million fair value adjustment to reduce our contingent consideration liability related to the MaximumASP acquisition based on actual revenue achievement. In 2010, acquisition related (benefit) expense primarily includes direct transaction costs associated with our acquisitions, which includes accounting, legal, and other professional fees. Other selling, general and administrative expenses primarily include professional fees, outsourced services, rent and other facilities costs, maintenance, recruiting fees, travel and entertainment costs, property taxes, and bad debt expense. The increase in this category of costs was primarily due to the addition of new and expanded operations needed to keep pace with the growth in customers. The improvement as a percentage of revenue is partially attributable to improved bad debt expense over the prior year and stronger overall cost controls as we scale back overhead growth due to slowing revenue growth. Bad debt expense was $6.5 million, or 1.3% of total revenue in 2011, compared to $7.5 million, or 1.7% of revenues in 2010. This decline was primarily from stronger cash collections and more stringent credit policies in place during 2011. The increase in depreciation and amortization in 2011 compared to 2010 relates primarily to a 23.6% increase in capital expenditures during 2011 compared to 2010. In addition, we recognized $3.4 million of depreciation and amortization in 2011 from assets acquired through our acquisitions in late 2010. Other Income (Expense) and Income Taxes (Dollar amounts in thousands) For the year ended December 31, 2011 2010 Change from Previous Period % of % of Dollars Revenue Dollars Revenue Dollars Percent Interest expense, net $ (500 ) (0.1 )% $ (279 ) (0.1 )% $ (221 ) 79.2 % Other income, net 1,211 0.2 % 1,867 0.4 % (656 ) (35.1 )% Income tax expense (5,176 ) (1.1 )% (314 ) (0.1 )% (4,862 ) 1,548.4 % Total $ (4,465 ) (0.9 )% $ 1,274 0.3 % $ (5,739 ) (450.5 )% The majority of our interest expenses in 2011 and 2010 relate to commitment fees under our Credit Facility. Accordingly, interest expense was higher in 2011 due to the increase in our Credit Facility from $25.0 million to $40.0 million early in 2010 and then to $75.0 million early in 2011. We had no amounts outstanding under our Credit Facility as of December 31, 2011. During 2011 and 2010, we recognized other income of $1.2 million and $1.9 million, respectively, which primarily relates to adjusting liabilities of our former captive leasing subsidiaries upon the expiration of various statutory periods (see Note 17 to the Consolidated Financial Statements ). In 2011, we recorded income tax expense despite having a pre-tax loss of $2.8 million due to income taxes in states with gross receipts-based taxes, which are due regardless of profit levels, the write-off of certain deferred tax assets associated with share-based transactions (see Note 11 to the Consolidated Financial Statements ), and an increase in our valuation allowance against our net deferred tax asset. We also recorded income tax expense in 2010 on a pre-tax loss of $1.3 million. Since gross receipts-based taxes are not dependent upon levels of pre-tax income and because we are near break-even at a pre-tax level, these taxes have a significant influence on our effective tax rate. As the operating results for the markets in these states become proportionately less significant to the consolidated results and as consolidated pre-tax income increases, the impact of these gross receipts-based taxes on our effective tax rate will decline. We recorded income tax expense in 2011 related to increases in the deferred tax asset valuation allowance of approximately $3.6 million. In 2010, income tax expense was benefited by $0.6 million due to reductions in the valuation allowance. Our net deferred tax assets, before valuation allowance, totaled approximately $39.7 million and $42.2 million at December 31, 2011 and 2010, respectively, and primarily relate to net operating loss carryforwards. We maintain a valuation allowance, which reduces our net deferred income tax assets to the amount that is more likely than not to be realized. As of December 31, 2011, our valuation allowance was $35.0 million. In evaluating our ability to realize our deferred income tax assets we consider all available positive and negative evidence, including our historical operating results, ongoing tax planning 36-------------------------------------------------------------------------------- Table of Contents and forecasts of future taxable income. Our evaluation led us to increase our valuation allowance by $4.2 million in the fourth quarter of 2011, resulting in additional income tax expense. Liquidity and Capital Resources (Dollar amounts in thousands): Change from Previous Period For the year ended December 31, Dollars Percent 2012 2011 2010 2012 v 2011 2011 v 2010 2012 v 2011 2011 v 2010 Cash Flows: Net cash provided by operating activities $ 89,291 $ 75,874 $ 79,149 $ 13,417 $ (3,275 ) 17.7 % (4.1 )% Net cash used in investing activities (65,260 ) (78,784 ) (92,619 ) 13,524 13,835 (17.2 )% (14.9 )% Net cash (used in) provided by financing activities (1,932 ) (14,942 ) 576 13,010 (15,518 ) (87.1 )% nm Net increase (decrease) in cash and cash equivalents $ 22,099 $ (17,852 ) $ (12,894 ) $ 39,951 $ (4,958 ) (223.8 )% 38.5 % As of December 31, 2012, we have $30.6 million of cash and cash equivalents held in our operating bank accounts, $2.0 million outstanding under the Fiber Loan, and no amounts outstanding under our revolving line of credit. We currently have no plans to draw against the Credit Facility for short-term needs. We substantially completed our copper-based Metro Ethernet customer conversion project in 2011 and have shifted our focus to our optical fiber access initiative. During 2012, we executed multiple agreements to provide optical fiber access in several markets. We expect to incur costs of between $35 million and $40 million through 2014 associated with the initial phase of this initiative. The Fiber Loan, secured under our amended and restated Credit Facility, provides us up to $10.0 million to finance the purchase of fiber network assets from a third party. During 2012, we made cash payments for share repurchases and acquisition-related consideration, which are not expected to occur on a frequent basis. In addition, during 2012, we reduced our communications-centric, or Cbeyond 1.0, sales force in order to reinvest in teams focused on delivering services to technology-dependent customers. This realignment resulted in cash payments of $1.0 million for employee severances and benefits and $0.5 million for other costs. These reductions in personnel resulted in a significant temporary increase in Free Cash Flow. Although we anticipate that Free Cash Flow will remain positive in the foreseeable future, by the fourth quarter of 2012 the expense savings were largely offset by the growth in staffing for our Cbeyond 2.0 sales channels. Accordingly, we expect lower levels of Adjusted EBITDA and Free Cash Flow throughout 2013. We believe that cash on hand, cash generated from operating activities, and cash available under our Credit Facility will be sufficient to fund capital expenditures, debt and capital lease obligations, operating expenses, and other cash requirements associated with future growth. While we do not anticipate a need for additional access to capital or new financing aside from our Credit Facility and related Fiber Loan, we monitor the capital markets and may access those markets if our business prospects or plans change resulting in a need for additional capital, or if additional capital required can be obtained on favorable terms. Cash Flows from Operating Activities Our operating cash flows result primarily from cash received from our customers, offset by cash payments for circuit access fees, employee compensation (less amounts capitalized related to internal use software that are reflected as cash used in investing activities), and operating leases. Cash received from our customers generally corresponds to our revenue. Because our credit terms are typically less than one month, our receivables settle quickly. Changes to our operating cash flows have historically been driven primarily by changes in operating income and changes to the components of working capital, including changes to receivable and payable days. Operating cash flows may fluctuate favorably or unfavorably depending on the timing of significant vendor payments. Operating cash flows increased by $13.4 million in 2012 primarily due to the reduction in our traditional Cbeyond 1.0 sales force in connection with our strategic realignment efforts, which temporarily lowered our operating costs. Operating cash flows decreased in 2011 compared to 2010 primarily due to a greater net loss, resulting in $6.3 million of reduced cash flows, higher bonus payments of $1.2 million, which are paid annually during the first quarter, and lease payment escalations for our facilities over that of the prior year. As previously discussed, during 2011 we also incurred $4.6 million of direct and indirect costs of our copper-based Metro Ethernet conversion initiative. 37-------------------------------------------------------------------------------- Table of Contents Cash Flows from Investing Activities Our principal cash investments are purchases of property and equipment, which fluctuate depending on the growth in customers in our existing markets, the timing and number of facility and network additions needed to expand existing markets and upgrade our network, enhancements and development costs related to our operational support systems in order to offer additional applications and services to our customers, and increases to the capacity of our data centers as our customer base and the product portfolio expand. We believe that capital efficiency is a key advantage of the IP-based network technology that we employ. Cash flows used in investing activities decreased in 2012 primarily due to a reduction in cash capital expenditures as we substantially completed the copper-based Metro Ethernet initiative in 2011. We continue to invest in Metro Ethernet through optical fiber access to reduce operating expenses and provide higher bandwidth and additional services to our customers. Our cash capital expenditures decreased from $77.6 million in 2011 to $61.6 million in 2012. During 2012, we also acquired $6.7 million of fiber network assets and $1.6 million of servers and computer equipment through capital lease arrangements that did not require an initial outlay of cash. We also paid $5.0 million in deferred acquisition consideration related to our acquisitions of MaximumASP and Aretta in 2012 compared to $1.2 million in 2011. We closed these acquisitions in 2010 and paid closing date consideration of $30.6 million, net of cash acquired. Additionally, during 2012, we transferred $1.3 million of cash formerly classified as restricted cash into our operating account. Cash Flows from Financing Activities Cash flows from financing activities relate to activity associated with employee stock option exercises, vesting of restricted shares, financing costs associated with the amendments to our Credit Facility, repurchases of common stock, and principal payments on capital leases. During the first quarter of 2012, we borrowed $4.3 million against our Credit Facility, most of which was used to settle acquisition-related contingent consideration. We repaid this borrowing during the second quarter of 2012. As of December 31, 2012, we had no amounts outstanding under our Credit Facility and $2.0 million outstanding under our Fiber Loan. We also repurchased 0.3 million shares for $2.0 million during 2012 and 1.3 million shares for $13.0 million during 2011 under the $15.0 million repurchase program authorized by our Board of Directors in May 2011. Commitments The following table summarizes our commitments as of December 31, 2012: Payments Due by Period Less than 1 More than 5 Contractual Obligations Total Year 1 to 3Years 3 to 5 years Years Capital lease obligations (1) $ 6,603 $ 1,739 $ 2,678 $ 2,186 $ - Fiber lease commitments (2) 6,170 1,097 1,602 1,602 1,869 Operating lease obligations (3) 41,180 10,994 19,495 7,674 3,017 Circuit commitments (4) 14,565 7,874 6,527 164 - Purchase obligations (5) 15,484 2,685 1,282 1,429 10,088 Long-term debt payments (6) 2,000 - 571 1,143 286 Anticipated interest payments (7) 1,679 340 640 600 99 Total $ 87,681 $ 24,729 $ 32,795 $ 14,798 $ 15,359 (1) Capital leases are presented on our balance sheet at the net present value of the future minimum lease payments. Capital lease obligations presented above include payments of both principal and interest. (2) Fiber lease commitments represent outstanding construction orders for fiber network assets for which we have obtained building access agreements. These commitments are not recognized on our balance sheet because they are contingent upon third parties completing construction and our testing and acceptance of the assets. (3) Operating lease obligations include future minimum lease payments under our non-cancelable operating leases with an initial term in excess of one year and fees to landlords under building access agreements to procure access to multi-tenant office buildings. (4) Circuit commitments include minimum lease agreements for customer circuits from ILECs. (5) Purchase obligations represent an estimate of open purchase orders and contractual obligations in the ordinary course of business for which we have not received the goods or services. Also included are contractual maintenance fees related to our leased fiber network. (6) Long-term debt payments represent principal payments under our Fiber Loan. (7) Anticipated interest payments represent commitment fees related to our Credit Facility. In February 2013, we entered into an agreement with a vendor that includes estimated minimum purchase commitments of $3.0 million in 2013, $4.9 million in 2014, $5.4 million in 2015, and $1.8 million in 2016. 38-------------------------------------------------------------------------------- Table of Contents Credit Facility We are party to a credit agreement with Bank of America (or "Credit Facility"), which provides for a $75.0 million secured revolving line of credit and a $10.0 million senior secured delayed draw term loan (or "Fiber Loan"). Our Credit Facility is available to finance working capital, capital expenditures, and other general corporate purposes. As of December 31, 2012, $1.3 million of the revolving line of credit was utilized for letters of credit and we had $73.7 million in remaining availability. Additionally, we had $2.0 million outstanding under the Fiber Loan at an annual interest rate of 2.0% and had remaining availability of $8.0 million. On March 31, 2012, we entered into the sixth amendment of the Credit Facility to increase the allowable capital lease amounts under the agreement from $10.0 million to $30.0 million. On May 2, 2012, we amended and restated our Credit Facility to provide the $10.0 million Fiber Loan. On March 4, 2013, we entered into the first amendment to the amended and restated Credit Facility to increase the allowable capital lease and permitted acquisitions amounts from $30.0 million to $60.0 million. We also amended the financial covenants of the Credit Facility, replacing the covenants requiring us to maintain minimum levels of Adjusted EBITDA and maximum levels of annual capital expenditures with a covenant requiring us to maintain a minimum fixed charge coverage ratio. Additionally, we extended the maturity date of the Credit Facility (including the Fiber Loan) to May 2, 2018 and extended the draw period of the Fiber Loan to December 31, 2014. Fiber Loan principal payments are due in quarterly installments as early as June 2014 through the maturity date of May 2, 2018. The following description of the Credit Facility briefly summarizes the terms and conditions that are material to us. Interest and Fees The interest rates applicable to loans under the Credit Facility are floating interest rates that, at our option, will equal a London Interbank Offered Rate (or "LIBOR") or an alternate base rate plus, in each case, an applicable margin. The current base rate is a fluctuating interest rate equal to the higher of (a) the prime rate of interest per annum publicly announced from time to time by Bank of America, as administrative agent, as its prime rate in effect at its principal office in New York City; (b) the overnight federal funds rate plus 0.50%; and (c) the Eurodollar base rate plus 1.0%. The interest periods of the Eurodollar loans are one, two, three or six months, at our option. The amended applicable margins for LIBOR loans or alternate base rate loans are 1.75% and 0.75%, respectively. In addition, we are required to pay to Bank of America a commitment fee for unused commitments at a per annum rate of 0.40%. Security The Credit Facility is secured by all assets of Cbeyond Communications, LLC (or "LLC") and is guaranteed by Cbeyond, Inc. All assets of the consolidated entity reside with LLC. In addition, Cbeyond, Inc. has no operations other than those conducted by LLC. Accordingly, all income and cash flows from operations are generated by and belong to LLC and all assets appearing on the Consolidated Financial Statements secure the Credit Facility. In addition, the credit agreement contains certain restrictive covenants that effectively prohibit us from paying cash dividends. Covenants and Other Matters Under the terms of the amended and restated Credit Facility, we are subject to certain financial covenants and restrictive covenants, which limit, among other items, our ability to incur additional indebtedness, make investments, pay cash dividends, sell or acquire assets, and grant security interests in our assets. The credit agreement also contains certain customary negative covenants, representations and warranties, affirmative covenants, notice provisions, indemnification and events of default, including change of control, cross-defaults to other debt, and judgment defaults. Through the maturity date of the Credit Facility, we are required to maintain a consolidated leverage ratio less than or equal to 1.5 to 1.0. We are also required to maintain a consolidated fixed charge coverage ratio greater than or equal to 1.2 to 1.0. As of December 31, 2012, we are in compliance with all applicable covenants. Off-Balance Sheet Arrangements We have no off-balance sheet arrangements that have, or are reasonably likely to have, a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors. 39-------------------------------------------------------------------------------- Table of Contents Critical Accounting Policies and Estimates We prepare the Consolidated Financial Statements in accordance with GAAP, which requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures in our Consolidated Financial Statements and accompanying notes. We believe that of our significant accounting policies, which are described in Note 2 to the Consolidated Financial Statements included herein, those discussed below involve a higher degree of judgment and complexity and are therefore considered critical. While we have used our best estimates based on the facts and circumstances available to us at the time, different estimates reasonably could have been used in the current period, or changes in the accounting estimates that we used are reasonably likely to occur from period to period, which may have a material impact on the presentation of our financial condition and results of operations. Although we believe that our estimates, assumptions, and judgments are reasonable, they are based upon information presently available. Actual results may differ significantly from these estimates under different assumptions, judgments or conditions. Software Development We capitalize the salaries and payroll-related costs of employees and consultants who devote time to the development of certain internal-use software projects. We monitor software development projects to ensure that only those costs relating to development activities; including software design and configuration, coding, installation, testing, and parallel processing; are capitalized. Determining the phase of software development or enhancement that is eligible for capitalization requires judgment, which may affect the amount and timing of both the related capitalization and subsequent depreciation. If a project constitutes an enhancement to previously developed software, we assess whether the enhancement is significant and creates additional functionality to the software, thus resulting in capitalization. All other software development costs are expensed as incurred. We amortize capitalized software development costs over estimated useful lives of the software. Allowance for Doubtful Accounts We have established an allowance for doubtful accounts through charges to selling, general and administrative expenses. The allowance is established based upon the amount we ultimately expect to collect from customers and is estimated based on a number of factors, including a specific customer's ability to meet its financial obligations to us, as well as general factors, such as the length of time the receivables are past due, historical collection experience, and the general economic environment. Customer accounts are generally considered delinquent when payments are forty-five days past due and the service disconnection process begins. Customer accounts are typically written off against the allowance sixty to ninety days after service disconnection, when our direct collection efforts cease. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, or if economic conditions worsened, additional allowances may be required in the future, which could have a material effect on our financial condition and results of operations. If we made different judgments or utilized different estimates for any period, material differences in the amount and timing of our expenses could result. Share-Based Compensation In accordance with ASC 718, Stock Compensation, we account for shared-based compensation expense using the fair value recognition provisions of ASC 718. Share-based compensation expense is measured at the grant date based on the fair value of the award as calculated by the lattice trinomial option-pricing model and is recognized as expense on a straight-line basis over the requisite service period, after estimating the effect of forfeitures. Option valuation models involve input assumptions that are subjective, and hence, may result in an option value that is not equal to that of the fair value observed in a market transaction between a willing buyer and willing seller. Additionally, estimated forfeiture rates are based on historical data, and may not be indicative of future forfeiture behavior. Valuation Allowances for Deferred Tax Assets We provide for the effect of income taxes on our financial position and results of operations in accordance with ASC 740, Income Taxes. Under this accounting pronouncement, income tax expense is recognized for the amount of income taxes payable or refundable for the current year and for the change in net deferred tax assets or liabilities resulting from events that are recorded for financial reporting purposes in a different reporting period than recorded in the tax return. We made assumptions, judgments, and estimates to determine our current provision for income taxes and also our deferred tax assets and liabilities and any valuation allowance to be recorded against our net deferred tax assets. Our judgments, assumptions, and estimates relative to the current provision for income tax take into account current tax laws, our interpretation of current tax laws, and allowable deductions. Changes in tax law or our interpretation of tax laws could materially impact the amounts provided for income taxes in our financial position and results of operations. Our assumptions, judgments, and estimates relative to the value of our net deferred tax assets take into account predictions of the amount and category of future taxable income. Actual operating results and the underlying amount and category of income or 40-------------------------------------------------------------------------------- Table of Contents loss in future years could render our current assumptions, judgments, and estimates of recoverable net deferred taxes inaccurate, thus materially impacting our financial position and results of operations. Our valuation allowance for our net deferred tax asset is designed to take into account the uncertainty surrounding the realization of our net operating losses and our other deferred tax assets. Recently Issued Accounting Standards For information about recently issued accounting standards, refer to Note 4 to our Consolidated Financial Statements . Item 7A. Quantitative and Qualitative Disclosures About Market Risk Interest Rate Risk Our variable-rate borrowings under our Credit Facility are subject to fluctuations in interest expense and cash flows. Management actively monitors this exposure when present. At December 31, 2012, we utilized $2.0 million of our Fiber Loan. A 100 basis point increase in market interest rates would have resulted in an increase in pre-tax interest expense of less than $0.1 million. As we continue to draw on our Fiber Loan, our sensitivity to interest rate risk will increase. As of December 31, 2012, our cash and cash equivalents were held in non-interest bearing bank accounts. We do not enter into any interest rate instruments for trading purposes. 41-------------------------------------------------------------------------------- Table of Contents |