TMCnet News
CBEYOND, INC. - 10-Q - 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 Condensed 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 $0.5 million and $2.3 million of expense during the three months ended March 31, 2013 and 2012, respectively. We have incurred cumulative realignment costs of $3.4 million through March 31, 2013 and expect to complete our realignment during the second quarter of 2013. 13-------------------------------------------------------------------------------- Table of Contents 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 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. Revenue for additional cloud-based services outside of a bundled package was $1.7 million during the three months ended March 31, 2013 and 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 three months ended March 31, 2013, we generated $13.7 million of revenue from Cbeyond 2.0 customers, which represents a 99.8% increase over the amount recognized during the three months ended March 31, 2012. Our revenue growth strategy includes offering service bundles that are increasingly oriented toward higher-value, technologically sophisticated solutions, however, a significant portion of our revenue base is derived from providing traditional telecommunications services. For the one-half of our existing customer base that we do not consider technology-dependent, traditional telecommunications services will continue to be our primary source of revenue. Our shift in strategy to focus on revenue growth from technology-dependent customers also includes an adjustment to our pricing philosophy for traditional telecommunications services to adapt to the competitive pricing environment for such services. More specifically, beginning in late 2011, we began adopting our competitors' practice of charging fees to recover a portion of the regulatory costs incurred to provide traditional telecommunications services. Since that time, we have gradually increased those fees to levels comparable to what we have seen in the market. 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 70% higher ARPU than that of our Cbeyond 1.0 customers and we expect that percentage to continue to grow over time. We have not 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. Three months ended March 31, 2013 2012 Calculation of ARPU Total revenue $ 119,946 $ 123,843 Cloud only revenue (3,650 ) (3,245 ) (A) Network access customer revenue (1) 116,296 120,598 (B) Average Network access customers 59,063 62,317 ARPU (A / B / number of months in period) $ 656 $ 645 (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-Q to conform to the current presentation. 14-------------------------------------------------------------------------------- Table of Contents 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 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 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. We took delivery of additional fiber assets with future minimum capital lease obligations of $4.3 million during the remainder of 2012. During the first quarter of 2013, we took delivery of additional fiber assets with future minimum capital lease obligations of $3.0 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. We have building access agreements and outstanding construction orders for fiber assets with expected future minimum lease payments of $6.0 million. These commitments are not recognized on the balance sheet as of March 31, 2013 because they are contingent upon third parties completing construction and our testing and acceptance of the fiber assets. As of March 31, 2013, we have placed additional construction orders that total $14.3 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 will never be constructed. Additional construction orders may be placed under these contracts in the future. Our chief operating decision maker uses Adjusted EBITDA and Free Cash Flow on a consolidated basis, accompanied by disaggregated revenue information by product line, to assess the financial performance of the business. We believe Adjusted EBITDA and Free Cash Flow 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 plan to include Adjusted EBITDA 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). We define Free Cash Flow as Adjusted EBITDA less cash capital expenditures. For purposes of calculating Free Cash Flow, we 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 generally 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. Three months ended March 31, 2013 2012Reconciliation of Capital Expenditures (in thousands) Cash capital expenditures (1) $ 12,434 $ 14,836 Non-cash capital expenditures: Fiber capital lease assets 3,017 2,400 Total capital expenditures $ 15,451 $ 17,236 (1) Represents cash purchases of property and equipment per the Condensed Consolidated Statements of Cash Flows. 15-------------------------------------------------------------------------------- Table of Contents Adjusted EBITDA was $20.8 million during the three months ended March 31, 2013, a 9.3% decrease over the comparable period in 2012. Free Cash Flow was $8.4 million during the three months ended March 31, 2013 compared to $8.1 million during the comparable period in 2012. The decline in Adjusted EBITDA reflects the decline in our customer base to whom we provide traditional telecommunications services, partially offset by an increase in fees we charge to our customers to recover the cost of regulatory compliance, and an increase in Cbeyond 2.0 revenue. Results during the three months ended March 31, 2013 also include the costs associated with our fully staffed new direct sales group focused on technology-dependent customers. Three months ended March 31, 2013 2012 Reconciliation of Free Cash Flow and Adjusted EBITDA to Net income (loss) (Dollar amounts in thousands) Free Cash Flow $ 8,399 $ 8,138 Cash capital expenditures 12,434 14,836 Adjusted EBITDA $ 20,833 $ 22,974 Depreciation and amortization (17,605 ) (18,876 ) Non-cash share-based compensation (2,979 ) (3,783 ) Realignment costs (1) (467 ) (1,640 ) Interest expense, net (153 ) (127 ) Income tax (expense) benefit (185 ) 258 Net loss $ (556 ) $ (1,194 ) (1) During the three months ended March 31, 2013 and 2012, $467 and $1,640 of realignment costs are included in Selling, general and administrative expense and $0 and $682 are included in Depreciation and amortization, respectively. 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 may become less meaningful than it has been historically. In the future, we may 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. We charge our customers fees to recover a portion of the costs we incur to comply with federal regulations. Prior to 2012 these regulatory recovery fees were insignificant, but we have since increased them to levels comparable to what we have seen in the market. 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. 16-------------------------------------------------------------------------------- Table of Contents The primary component of cost of revenue consists of the access fees paid to local telephone companies for 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 generally lease from local telephone companies. Historically, most of the circuits we leased have been T1's, which are the largest component of our circuit access fees. However, we have converted many of our existing customer T1 circuits and have begun serving new customers using higher-capacity 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 maintenance costs for dark fiber (or fiber provided by third parties and operated by us) and access fees for lit fiber (or fiber both provided and operated by third parties). We have experienced increases in access costs associated with higher-capacity Metro Ethernet and expect these increases to continue 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 billing 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 billing recoveries, we are often unable to estimate the outcome of these situations. Accordingly, we generally recognize telecommunication billing 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 billing 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 other 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; 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 three months ended March 31, 2012 Revenue table within Item 2 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 2 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 presentation for the three months ended March 31, 2013. 17-------------------------------------------------------------------------------- Table of Contents Results of Operations Revenue (Dollar amounts in thousands, except ARPU) For the three months ended March 31, 2013 2012 Change from previous period % of % of Dollars Revenue Dollars Revenue Dollars Percent Revenue Network, Voice and Data $ 113,352 94.5 % $ 118,087 95.4 % $ (4,735 ) (4.0 )% Managed Hosting and Cloud 6,594 5.5 % 5,756 4.6 % 838 14.6 % Total revenue 119,946 123,843 (3,897 ) (3.1 )% Cost of revenue 38,788 32.3 % 40,484 32.7 % (1,696 ) (4.2 )% Gross margin (exclusive of depreciation and amortization): $ 81,158 67.7 % $ 83,359 67.3 % $ (2,201 ) (2.6 )% Network access customer data: Customer locations at period end 58,434 62,465 (4,031 ) (6.5 )% ARPU $ 656 $ 645 $ 11 1.7 % Average monthly churn rate 1.6 % 1.5 % 0.1 % Network, Voice and Data revenue decreased in the three months ended March 31, 2013 compared to the three months ended March 31, 2012 due to our strategic efforts to realign our distribution channels. Our focus on the strategic realignment and on higher-value customers has resulted in lower new customers than we have achieved historically. Because of this, in recent periods customer churn has exceeded new customer growth resulting in a decline in customers. The revenue impact of the decline in customers was partially offset by an increase in fees we charge our customers to recover certain regulatory costs. Regulatory recovery charges increased $3.6 million and $5.6 million in the three months ended March 31, 2013 compared to the three months ended December 31, 2012 and March 31, 2012, respectively. We expect these higher regulatory recovery charges to have a continuing benefit in future periods. We do not believe that the increase in fees during the first quarter of 2013 significantly impacted customer churn. The increase in Managed Hosting and Cloud revenue is largely due to the introduction of additional cloud-based service offerings. We expect growth in total revenue to return as ARPU increases, churn declines, the productivity of our Cbeyond 2.0 sales force increases, and as we refine and expand our catalog of products targeted to technology-dependent customers and further expand our Metro Ethernet network. ARPU increased $11, or 1.7%, in the three months ended March 31, 2013 compared to the three months ended March 31, 2012. Excluding regulatory recovery charges, ARPU decreased 0.4% and 3.2% in the three months ended March 31, 2013 compared to the three months ended December 31, 2012 and March 31, 2012, respectively. Our focus on selling sophisticated solutions to technology-dependent customers has decreased 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 4.0% year-over-year and Managed Hosting and Cloud revenue, which increased 14.6% year-over-year. 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% in the three months ended March 31, 2013, representing a slight increase over the three months ended March 31, 2012, but consistent with more recent periods. The increase is primarily attributable to price competition for smaller communications-centric customers. 18-------------------------------------------------------------------------------- Table of Contents Cost of Revenue (Dollar amounts in thousands) For the three months ended March 31, 2013 2012 Change from previous period % of % of Dollars Revenue Dollars Revenue Dollars Percent Cost of revenue (exclusive of depreciation and amortization): Circuit access fees $ 18,207 15.2 % $ 18,067 14.6 % $ 140 0.8 % Other cost of revenue 11,170 9.3 % 11,524 9.3 % (354 ) (3.1 )% Transport cost 6,220 5.2 % 6,546 5.3 % (326 ) (5.0 )% Mobile cost 4,212 3.5 % 4,918 4.0 % (706 ) (14.4 )%Telecommunications billing recoveries (1,021 ) (0.9 )% (571 ) (0.5 )% (450 ) 78.8 % Total cost of revenue $ 38,788 32.3 % $ 40,484 32.7 % $ (1,696 ) (4.2 )% The principal drivers of the overall decrease in cost of revenue are the reduction in installation costs from fewer new customer installations, a reduction in mobile subscribers, an increase in telecommunication billing recoveries, and the overall reduced costs of serving fewer Network access customers. These reductions were partially offset by higher circuit costs attributable to delivering higher bandwidth circuits to our customers, and higher costs relating to premium mobile devices. Circuit access fees, or line charges, represent the largest single component of cost of revenue. These costs primarily relate to the usage of circuits that connect 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 continuing to realize cost savings from our Metro Ethernet conversion initiative, but are also experiencing increases in access costs as we provide higher bandwidth to our customers. 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 the three months ended March 31, 2013 compared to the three months ended March 31, 2012, primarily due to a decrease in new customer installations. The decrease in transport costs was primarily driven by the decline in Network access customers. Longer-term, as we continue to optimize our network and augment it with Metro Ethernet access, we expect transport costs to decline given the cost profile of Metro Ethernet compared to traditional T1 access. As a percentage of revenue, mobile costs decreased during the three months ended March 31, 2013 compared to the three months ended March 31, 2012. The primary driver of this decrease is a reduction in mobile service costs. We have also experienced a reduction in shipments related to the decrease in new customers. However, this has been offset by the cost of more recently launched competitive mobile device models. We do not anticipate significant changes in the percentage of customers using our mobile services in the future, therefore we do not anticipate that mobile costs will continue to decline from current levels in the long term. 19-------------------------------------------------------------------------------- Table of Contents Selling, General and Administrative and Other Operating Expenses (Dollar amounts in thousands) For the three months ended March 31, 2013 2012 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 (excluding share-based compensation) $ 39,425 32.9 % $ 39,839 32.2 % $ (414 ) (1.0 )% Share-based compensation 2,979 2.5 % 3,783 3.1 % (804 ) (21.3 )% Marketing cost 529 0.4 % 713 0.6 % (184 ) (25.8 )% Realignment cost 467 0.4 % 1,640 1.3 % (1,173 ) (71.5 )% Other selling, general and administrative 20,371 17.0 % 19,833 16.0 % 538 2.7 % Total SG&A $ 63,771 53.2 % $ 65,808 53.1 % $ (2,037 ) (3.1 )% Other operating expenses: Depreciation and amortization 17,605 14.7 % 18,876 15.2 % (1,271 ) (6.7 )% Total other operating expenses $ 17,605 14.7 % $ 18,876 15.2 % $ (1,271 ) (6.7 )% Other data: Average employees 1,662 1,783 (121 ) (6.8 )% Selling, general and administrative expense decreased during the three months ended March 31, 2013 compared to the three months ended March 31, 2012, primarily due to a lower average number of employees and a reduction in realignment costs. Salaries, wages and benefits decreased during the three months ended March 31, 2013 compared to that of the prior year, but increased as a percentage of revenue. The decrease is due to a lower number of average employees as a result of our strategic realignment, which resulted in a reduction to our workforce. The majority of the savings that resulted from our strategic realignment is offset by the continuing investment in our Cbeyond 2.0 sales force and staffing of operations to support our increase in technology-dependent customers. Share-based compensation expense decreased in amount and as a percentage of revenue during the three months ended March 31, 2013 compared to the three months ended March 31, 2012, 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. The strategic realignment, which was announced in early 2012, resulted in $1.6 million of selling, general and administrative expense for the three months ended March 31, 2012. During the three months ended March 31, 2013 we recognized $0.5 million of employee severances and medical benefits. We expect to complete our realignment during the second quarter of 2013. 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 is primarily due to higher consulting and outsourced services relating to our change in strategy. Bad debt expense was $0.9 million, or 0.8% of total revenue, compared to $1.6 million, or 1.3% of total revenue during the three months ended March 31, 2013 and 2012, respectively. The reduction is primarily related to lower revenue, improved customer collections consistent with our tighter credit policies, and improving economic conditions. The decrease in depreciation and amortization for the three months ended March 31, 2013 compared to the three months ended March 31, 2012 relates primarily to a decrease in net depreciable fixed assets over the prior period. In addition, we recognized $0.7 million of accelerated depreciation during the three months ended March 31, 2012 on certain long-lived assets at offices which were consolidated as part of the strategic realignment. 20-------------------------------------------------------------------------------- Table of Contents Other Expense and Income Taxes (Dollar amounts in thousands) For the three months ended March 31, 2013 2012 Change from previous period % of % of Dollars Revenue Dollars Revenue Dollars Percent Interest expense, net $ (153 ) (0.1 )% $ (127 ) (0.1 )% $ (26 ) 20.5 % Income tax (expense) benefit (185 ) (0.2 )% 258 0.2 % (443 ) nm Total $ (338 ) (0.3 )% $ 131 0.1 % $ (469 ) nm We recognize our 2013 interim period income tax expense based on our year-to-date effective tax rate because our estimated annual tax rate fluctuates significantly from only slight variances in estimated annual income. The three months ended March 31, 2013 income tax expense primarily relates to the tax goodwill amortization that will likely remain non-deductible for book purposes and state income tax expense levied by Texas, which imposes a gross receipts-based tax due regardless of profit levels. This tax is not dependent upon levels of pre-tax income and has a significant influence on our effective tax rate. Liquidity and Capital Resources (Dollar amounts in thousands): |