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CINCINNATI BELL INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Cautionary Statement Concerning Forward-Looking Statements This Quarterly Report on Form 10-Q and the documents incorporated by reference herein contain forward-looking statements regarding future events and results that are subject to the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. All statements, other than statements of historical facts, are statements that could be deemed forward-looking statements. These statements are based on current expectations, estimates, forecasts, and projections about the industries in which we operate and the beliefs and assumptions of our management. Words such as "expects," "anticipates," "predicts," "projects," "intends," "plans," "believes," "seeks," "estimates," "continues," "endeavors," "strives," "may," or variations of such words and similar expressions are intended to identify such forward-looking statements. In addition, any statements that refer to projections of future financial performance, anticipated growth and trends in businesses, and other characterizations of future events or circumstances are forward-looking statements. Readers are cautioned these forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties, which could cause actual results to differ materially and adversely from those reflected in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this Quarterly Report on Form 10-Q and, in particular, the risks discussed under the caption "Risk Factors" in Part II, Item 1A, and those discussed in other documents the Company filed with the Securities and Exchange Commission ("SEC"). Actual results may differ materially and adversely from those expressed in any forward-looking statements. The Company undertakes no obligation to revise or update any forward-looking statements for any reason. Introduction This Management's Discussion and Analysis section provides an overview of Cincinnati Bell Inc.'s financial condition as of March 31, 2013, and the results of operations for the three months ended March 31, 2013 and 2012. This discussion should be read in conjunction with the accompanying Condensed Consolidated Financial Statements and accompanying notes, as well as the Company's Annual Report on Form 10-K for the year ended December 31, 2012. Results for interim periods may not be indicative of results for the full year or any other interim period. Executive Summary The Company is a full-service regional provider of data and voice communications services over wireline and wireless networks and is also a reseller of IT and telephony equipment. On January 24, 2013, we completed the initial public offering ("IPO") of CyrusOne Inc. ("CyrusOne"), which owns and operates our former data center colocation business. CyrusOne conducts its data center business through CyrusOne LP, an operating partnership. After the IPO, we own approximately 1.9 million shares, or 8.6%, of CyrusOne's common stock and are a limited partner in CyrusOne LP, owning approximately 42.6 million, or 66%, of its partnership units. Commencing on January 17, 2014, we may exchange these partnership units into shares of common stock of CyrusOne on a one-for-one basis or for cash at the fair value of a share of CyrusOne common stock, as determined by CyrusOne. Although we effectively own approximately 69% of the economic interests of CyrusOne through our ownership of its common stock and partnership units of CyrusOne LP, we no longer control its operations. Effective January 24, 2013, we no longer include the accounts of CyrusOne in our consolidated financial statements. We now account for our ownership in CyrusOne as an equity method investment. CyrusOne's results of operations and cash flows for the partial month ended January 23, 2013 are included in our consolidated statements of operations, segment results and cash flows for the three months ended March 31, 2013. Our share of CyrusOne's net loss for the period subsequent to the IPO is presented in Loss from CyrusOne equity method investment in our consolidated statement of operations. Due to the change in presentation of CyrusOne, our results of operations for the period ending March 31, 2013 are not comparable to prior periods. Consolidated Results of Operations Service revenue was $270.5 million during the three months ended March 31, 2013, a decrease of $47.5 million, or 15%, compared to the same period in 2012. The decrease was primarily driven by lower data center revenues resulting from excluding CyrusOne's results of operations from our consolidated financial statements subsequent to the completion of its IPO on January 24, 2013. Data center revenue, net of intercompany revenues, was $15.2 million for the period prior to the CyrusOne IPO, which was $35.8 million lower compared to the three months ended March 31, 2012. Also contributing to the Company's decreased service revenue in the three months ended March 31, 2013 were $9.8 million and $2.6 million of lower wireless and wireline service revenues, respectively. 23 -------------------------------------------------------------------------------- Table of Contents Form 10-Q Part I Cincinnati Bell Inc. Product revenue totaled $55.2 million in the three months ended March 31, 2013, an increase of $10.4 million, or 23%, compared to the same period in 2012. The increase was primarily driven by $10.5 million of higher sales of telecommunications and information technology ("IT") hardware. Cost of services was $108.6 million in the three months ended March 31, 2013 compared to $120.4 million in the same period of the prior year, a decrease of $11.8 million, or 10%, that was driven primarily by the IPO of CyrusOne. For the first quarter of 2013, data center cost of services, which represented activity for the partial month prior to the IPO, amounted to $4.8 million, a decrease of $12.5 million compared to the three months ended March 31, 2012. Wireless cost of services decreased by $3.7 million due primarily to lower roaming and network expenses, and the continued implementation of the Company's cost reduction programs. The impact of these lower costs was partially offset by $2.4 million of higher wireline costs, largely associated with the Company's growing Fioptics and business data products, combined with higher payroll and contractor service costs within the IT Services and Hardware segment to support the higher revenue generated from professional services. Cost of products sold was $53.2 million in the three months ended March 31, 2013 compared to $45.4 million in the same period in 2012, an increase of $7.8 million, or 17%. The increase in 2013 primarily reflects increased sales of telecommunications and IT hardware. Selling, general and administrative ("SG&A") expenses were $53.1 million in the three months ended March 31, 2013, a decrease of $10.9 million, or 17%, compared to the same period in 2012. The decreased costs were primarily due to a stock compensation mark-to-market benefit of $5.6 million recognized during the first quarter of 2013 compared to an expense of $2.2 million in the first quarter of 2012. The Company grants stock-based compensation, some of which are cash-settled awards indexed to the Company's stock price. The Company's stock price at March 31, 2013 was $3.26, which decreased compared to the December 31, 2012 stock price of $5.48. The decrease in SG&A was also attributable to the impact of lower overall SG&A expenses due to the IPO of CyrusOne. Depreciation and amortization totaled $50.6 million in the three months ended March 31, 2013, down $0.5 million, or 1%, from the same period in 2012. The decrease was primarily due to $10.4 million of lower depreciation expense due to CyrusOne's IPO, partially offset by $8.5 million of higher depreciation charges associated with shortening the estimated useful lives assigned to the wireless network software. In addition, higher depreciation expense was incurred on new assets placed in service under our Fioptics expansion plan. Transaction-related compensation of $35.5 million in the three months ended March 31, 2013 was associated with the IPO of CyrusOne which was completed on January 24, 2013. In 2010, the Company's Board of Directors approved a long-term incentive program for certain members of management under which payments were contingent upon the completion of a qualifying transaction and attainment of an increase in the equity value of the data center business, as defined in the plan. The completion of the IPO during the quarter resulted in a qualifying transaction requiring payment of compensation to the employees covered under this plan. These payments were made in April 2013. In May 2013, additional compensation payments of $7.0 million were approved by the Board of Directors related to the success of the CyrusOne IPO. Restructuring charges were $2.6 million in the three months ended March 31, 2013, an increase of $1.7 million compared to the same period in 2012. Charges incurred in 2013 were comprised of $1.7 million of expenses related to lease abandonments and $0.9 million of fees to a third party consultant associated with workforce optimization initiatives. Charges incurred in 2012 amounted to $0.9 million and represented severance associated with the elimination of certain management positions, a voluntary termination program, and lease abandonments. A loss on sale or disposal of assets of $2.5 million was incurred in the three months ended March 31, 2013. This loss was primarily attributable to $3.3 million of wireless network equipment removed from service due to upgrades. This equipment had no resale market and has either been disconnected from the existing wireless network, abandoned or demolished. This loss was partially offset by a gain of $0.8 million recognized from sales of copper cabling in the Wireline segment. No such gains or losses were recognized during the same period in 2012. Transaction costs were $0.4 million in the three months ended March 31, 2013, with no such costs incurred in the same period in 2012. Transaction costs represent legal and consulting costs incurred to restructure our legal entities in preparation for CyrusOne's IPO and to prepare CyrusOne to be a real estate investment trust. Interest expense was $47.9 million in the three months ended March 31, 2013 compared to $54.4 million in the same period of 2012, a decrease of $6.5 million, or 12%. The decrease was primarily the result of the redemptions in November 2012 of the 7% Senior Notes due 2015, certain CBT Notes and a portion of the 8 3/8% Senior Notes due 2020, which reduced interest expense by $7.5 million year-over-year. The deconsolidation of CyrusOne in January 2013 also resulted in $1.9 million of lower interest expense that was associated with CyrusOne's other long-term obligations. The impact of these expense 24 -------------------------------------------------------------------------------- Table of Contents Form 10-Q Part I Cincinnati Bell Inc. reductions was partially offset by $2.1 million of higher interest expense incurred on CyrusOne's 6 3/8% Senior Notes due 2022 prior to the IPO and $0.7 million of lower capitalized interest. Loss from CyrusOne equity method investment of $1.9 million in the three months ended March 31, 2013 represents the Company's share of CyrusOne's net loss which, effective with the IPO date of January 24, 2013, is now recorded on the equity method. Other income was $0.3 million in the three months ended March 31, 2013 compared to an expense of $1.5 million in the same period of 2012. The expense incurred in 2012 primarily represented a loss recorded on the termination of a lease financing arrangement. Income tax expense for the three months ended March 31, 2013 was $6.4 million compared to $12.5 million in the same period in 2012. The decrease in tax expense was due primarily to a lower pre-tax income projected for 2013 which led to a lower effective tax rate. For the three months ended March 31, 2013, income tax expense includes a valuation allowance provision of $10.7 million for Texas margin credits which, effective with CyrusOne's IPO on January 24, 2013, are uncertain of being realized before their expiration date. For 2013, the Company expects its effective tax rate to be lower than statutory rates. The Company expects to use federal and state net operating loss carryforwards to substantially defray payment of federal and state tax liabilities in 2013. 25 -------------------------------------------------------------------------------- Table of Contents Form 10-Q Part I Cincinnati Bell Inc. WirelineThe Wireline segment provides local voice, data, long distance, entertainment, VoIP, and other services over its owned and other wireline networks. Local voice services include local telephone service, switched access, and value-added services such as caller identification, voicemail, call waiting, and call return. Data services include high-speed internet using DSL technology and over fiber using its gigabit passive optical network ("GPON"). Data services also provide data transport for businesses, including LAN services, dedicated network access, and metro ethernet and DWDM/optical wave data transport, which primarily are used to transport large amounts of data over private networks. These services are provided to customers in southwestern Ohio, northern Kentucky, and southeastern Indiana through the operations of CBT, an incumbent local exchange carrier ("ILEC") in its operating territory of an approximate 25-mile radius of Cincinnati, Ohio. Outside of the ILEC territory, the Wireline segment provides these services through Cincinnati Bell Extended Territories ("CBET"), which operates as a competitive local exchange carrier ("CLEC") in the communities north of CBT's operating territory including the Dayton, Ohio market. CBET provides voice and data services for residential and business customers on its own network and by purchasing unbundled network elements from the ILEC. The Wireline segment links the Cincinnati and Dayton, Ohio geographies through its Synchronous Optical Fiber Network ("SONET"), which provides route diversity via two separate paths. The Wireline segment also includes long distance, audio conferencing, other broadband services including private line and multi-protocol label switching ("MPLS"). In the three months ended March 31, 2013, the Company continued the expansion of its Fioptics product suite of services, which are fiber-based entertainment, high-speed internet and voice services. During the first quarter of 2013, the Company passed an additional 15,000 residential and business addresses with this product and as of March 31, 2013, had passed a total of 220,000 addresses to which it can provide Fioptics service. Three Months Ended March 31, (dollars in millions) 2013 2012 Change % Change Revenue: Data $ 78.1 $ 76.0 $ 2.1 3 % Voice - local service 59.5 66.0 (6.5 ) (10 )% Long distance and VoIP 26.9 28.9 (2.0 ) (7 )% Entertainment 12.0 7.7 4.3 56 % Other 3.2 3.8 (0.6 ) (16 )% Total revenue 179.7 182.4 (2.7 ) (1 )% Operating costs and expenses: Cost of services and products 71.2 68.8 2.4 3 % Selling, general and administrative 31.0 30.5 0.5 2 % Depreciation and amortization 26.8 25.9 0.9 3 % Restructuring charges 1.4 - 1.4 n/m Gain on sale or disposal of assets (0.8 ) - (0.8 ) n/m Total operating costs and expenses 129.6 125.2 4.4 4 % Operating income $ 50.1 $ 57.2 $ (7.1 ) (12 )% Operating margin 27.9 % 31.4 % (3.5 ) pts Capital expenditures $ 33.8 $ 23.3 $ 10.5 45 % Metrics information (in thousands): Fioptics units passed 220.0 147.0 73.0 50 % High-speed internet subscribers: DSL 199.5 214.4 (14.9 ) (7 )% Fioptics 60.7 42.8 17.9 42 % Total high-speed internet subscribers 260.2 257.2 3.0 1 % Fioptics entertainment subscribers 57.6 42.7 14.9 35 % Local access lines 561.4 608.6 (47.2 ) (8 )% Long distance lines 410.4 439.2 (28.8 ) (7 )% 26-------------------------------------------------------------------------------- Table of Contents Form 10-Q Part I Cincinnati Bell Inc. Wireline, continued Revenue Data revenue consists of Fioptics and digital subscriber line ("DSL") high-speed internet access, data transport, and local area network ("LAN") interconnection services. Data revenue was $78.1 million for the three months ended March 31, 2013, up $2.1 million, or 3%, compared to the same period in 2012. Data transport and LAN services increased $1.2 million year-over-year as a result of increased demand by business customers for higher speed connections. Revenue from Fioptics high-speed internet services in the first quarter of 2013 increased by $1.9 million over the same period in 2012 due largely to increased subscribers. As of March 31, 2013, the Company had 60,700 high-speed internet Fioptics customers, which is a 17,900, or 42%, increase from the March 31, 2012 total of 42,800 subscribers. Partially offsetting these higher revenue items was lower DSL revenue generated in the first quarter of 2013 compared to the first quarter of 2012 due primarily to fewer DSL subscribers. Voice local service revenue includes local service, value added services, digital trunking, switched access and information services. Voice local service revenue was $59.5 million in the three months ended March 31, 2013, down $6.5 million, or 10%, compared to the same period in 2012. The decrease in revenue was primarily driven by fewer local access lines compared to a year ago. Access lines within the segment's ILEC territory decreased by 40,800, or 8%, to 500,800 at March 31, 2013 from 541,600 at March 31, 2012. The Company had 60,600 CLEC access lines at March 31, 2013 compared to 67,000 access lines at March 31, 2012. The segment continues to lose access lines as a result of, among other factors, customers electing to solely use wireless service in lieu of traditional local wireline service, Company-initiated disconnections of customers with credit problems, and customers electing to use service from other providers. Long distance and VoIP revenue was $26.9 million in the three months ended March 31, 2013, down $2.0 million, or 7%, compared to the same period in 2012. The decrease was primarily attributable to $1.2 million of lower long distance revenue that was driven by declining subscriber lines as consumers continue opting to use wireless and VoIP services, combined with lower revenue from audio conferencing services due largely to decreased usage by subscribers. As of March 31, 2013, long distance subscriber lines were 410,400, a 7% decrease from a year ago. Entertainment revenue was $12.0 million in the three months ended March 31, 2013, up $4.3 million, or 56%, compared to the same period in 2012. This increase was largely driven by the growth in Fioptics entertainment revenue which increased by $4.2 million to $11.6 million in 2013, as Fioptics entertainment subscribers grew by 14,900, or 35%, to 57,600 at March 31, 2013 from 42,700 at March 31, 2012. Other revenue was $3.2 million in the three months ended March 31, 2013 compared to $3.8 million generated during the same period in 2012. Costs and Expenses Cost of services and products was $71.2 million in the three months ended March 31, 2013, an increase of $2.4 million, or 3%, compared to the same period in 2012. Contributing to this increase was $3.4 million of higher costs primarily associated with increased Fioptics programming expenses resulting from a broadening subscriber base and higher rates. In addition, contract service costs increased by $3.3 million driven by a decision in late 2012 to bring a portion of our off-shore call center operations back to the United States and higher data connectivity costs. The impact of these cost increases was partially offset by $2.6 million of lower payroll and other costs of providing service driven by reductions in staff and $1.5 million of lower network related costs due largely to decreased customer usage in our audio conferencing and VoIP services. SG&A expenses were $31.0 million in the three months ended March 31, 2013, an increase of $0.5 million, or 2%, compared to the same period in 2012. Payroll-related costs increased by $1.9 million over 2012 driven largely by higher pension costs and increased commissions and bonuses. This increase was partially offset by a decrease in bad debt expense amounting to $1.1 million and lower software, legal and consulting expenses. Depreciation and amortization was $26.8 million in the three months ended March 31, 2013, an increase of $0.9 million compared to a year ago. Assets placed in service in connection with the expansion of our Fioptics network drove the higher depreciation expense in 2013. 27 -------------------------------------------------------------------------------- Table of Contents Form 10-Q Part I Cincinnati Bell Inc. Wireline, continued Restructuring charges of $1.4 million in the three months ended March 31, 2013 were associated with our remaining obligations on abandoned leases. The gain on sale or disposal of assets of $0.8 million in the three months ended March 31, 2013 was primarily associated with the sale of copper cabling that was no longer in use. There were no such charges or gains incurred during the same period in 2012. Capital Expenditures Capital expenditures are incurred to expand our Fioptics product suite, upgrade our DSL network, and to maintain our wireline network. Capital expenditures were $33.8 million for the three months ended March 31, 2013, an increase of $10.5 million, or 45%, compared to the same period in 2012. As of March 31, 2013, the Company is able to provide its Fioptics services to 220,000 residential and business addresses. Given the continued strong demand for this service, in 2013 the Company plans to increase the level of capital investment in the Fioptics service compared to the capital expenditures made in 2012. 28 -------------------------------------------------------------------------------- Table of Contents Form 10-Q Part I Cincinnati Bell Inc. WirelessThe Wireless segment provides advanced digital voice and data communications services through the operation of a regional wireless network in the Company's licensed service territory, which surrounds Cincinnati and Dayton, Ohio and includes areas of northern Kentucky and southeastern Indiana. Although Wireless does not market to customers outside of its licensed service territory, it is able to provide service outside of this territory through roaming agreements with other wireless operators. The segment also sells wireless handset devices and related accessories to support its service business. Three Months Ended March 31, (dollars in millions, except for operating metrics) 2013 2012 Change % Change Revenue: Postpaid service $ 37.5 $ 46.4 $ (8.9 ) (19 )% Prepaid service 11.8 12.7 (0.9 ) (7 )% Equipment and other 4.0 4.6 (0.6 ) (13 )% Total revenue 53.3 63.7 (10.4 ) (16 )%Operating costs and expenses: Cost of services and products 23.5 29.5 (6.0 ) (20 )% Selling, general and administrative 9.8 10.7 (0.9 ) (8 )% Depreciation and amortization 16.0 7.9 8.1 103 % Restructuring charges - 0.5 (0.5 ) n/m Loss on sale or disposal of assets 3.3 - 3.3 n/m Total operating costs and expenses 52.6 48.6 4.0 8 % Operating income $ 0.7 $ 15.1 $ (14.4 ) (95 )% Operating margin 1.3 % 23.7 % (22.4 ) pts Capital expenditures $ 8.2 $ 6.3 $ 1.9 30 % Metrics information: Postpaid ARPU* $51.29 $50.82 $ 0.47 1 % Prepaid ARPU* $26.57 $28.53 $ (1.96 ) (7 )%Postpaid subscribers (in thousands) 236.6 297.7 (61.1 ) (21 )% Prepaid subscribers (in thousands) 148.7 148.7 - 0 % Average postpaid churn 2.6% 2.2% 0.4 pts * The Company has presented certain information regarding monthly average revenue per user ("ARPU") because it believes ARPU provides a useful measure of the operational performance of its Wireless segment. ARPU is calculated by dividing service revenue by the average subscriber base for the period. Revenue Postpaid service revenue was $37.5 million in the three months ended March 31, 2013, a decrease of $8.9 million, or 19%, compared to the same period in 2012. The decrease in postpaid service revenue was primarily the result of a 21% decrease in the Company's postpaid subscribers which drove an overall decrease in voice minutes of use, combined with fewer average minutes of use per subscriber, partially offset by increased data usage. The Company's ability to maintain its subscriber base continues to be challenged by competitive pressure resulting from, among other factors, competitors' premium handsets and competitors' service on new LTE networks. Total postpaid ARPU was $51.29 in the three months ended March 31, 2013, up from $50.82 in the same period in 2012 as the favorable impact on ARPU of increased data usage continued to fully offset the impact of fewer minutes used by postpaid subscribers. At March 31, 2013, the Company had 98,700 postpaid smartphone subscribers, a 5% decrease compared to 104,100 such subscribers at March 31, 2012. As of March 31, 2013, these postpaid smartphone subscribers represented 42% of the total postpaid subscriber base, up from 35% at the end of March 2012. The higher smartphone penetration drove a data ARPU of $18.69 in the three months ended March 31, 2013, up 16% compared to the same period in 2012. 29 -------------------------------------------------------------------------------- Table of Contents Form 10-Q Part I Cincinnati Bell Inc. Wireless, continued Prepaid service revenue was $11.8 million in the three months ended March 31, 2013, a decrease of $0.9 million, or 7%, compared to the same period in 2012. This decrease was largely driven by lower voice rates and fewer minutes used by prepaid subscribers, partially offset by higher data usage by smartphone users. As a result, prepaid ARPU in the three months ended March 31, 2013 decreased to $26.57, down from $28.53 in the same period in 2012. The Company's total prepaid subscribers remained stable at 148,700 at both March 31, 2013 and 2012, while prepaid smartphone subscribers at March 31, 2013 increased to 32,300, up 9,900 or 44% from the same period a year ago. Equipment and other revenue in the three months ended March 31, 2013 was $4.0 million, a decrease of $0.6 million, or 13%, compared to the same period in 2012. Equipment revenue decreased primarily due to continued postpaid subscriber losses which drove fewer activations and upgrades. Costs and Expenses Cost of services and products consists largely of network operation costs, interconnection expenses with other telecommunications providers, roaming expense (which is incurred for subscribers to use their handsets in the territories of other wireless service providers), and cost of handsets and accessories sold. The total cost of services and products was $23.5 million in the three months ended March 31, 2013, reflecting a decrease of $6.0 million, or 20%, compared to the same period of the prior year. This decrease was primarily due to $3.2 million of lower network related costs resulting from renegotiated roaming rates with other wireless carriers, lower network access expenses due to a reduced subscriber base, and the continued impact of the Company's cost containment efforts. Cost of goods sold decreased by an additional $1.2 million over 2012, driven largely by the impact of fewer sales of wireless handsets and lower handset repair costs resulting from a change in suppliers. The continued loss of postpaid subscribers also resulted in $1.0 million of lower handset subsidy costs from fewer activations and upgrades, and a $0.6 million decrease in operating taxes that was primarily driven by lower regulatory revenues. SG&A expenses were $9.8 million in the three months ended March 31, 2013, representing a decrease of $0.9 million, or 8%, compared to the same period of 2012. The decrease primarily reflects $0.5 million of lower advertising costs resulting from the Company's continued cost containment efforts. Other selling and marketing expenses and payroll costs in the first quarter were also lower compared to the same period in 2012 due largely to these cost containment efforts. Depreciation and amortization was $16.0 million in the three months ended March 31, 2013, an increase of $8.1 million compared to the same period in 2012. A change in the estimated useful lives assigned to network software resulted in $8.5 million of higher depreciation expense in the three months ended March 31, 2013. Partially offsetting this increase was lower depreciation expense on a lower asset base due primarily to the impact of fully depreciated and retired assets. Loss on sale or disposal of assets was $3.3 million in the three months ended March 31, 2013, largely the result of wireless network equipment that was removed from service. This equipment had no resale market and has either been disconnected from the existing wireless network, abandoned or demolished. No such losses were incurred during the same period in 2012. Restructuring charges of $0.5 million were incurred in the three months ended March 31, 2012 related to severance and remaining lease obligations associated with the closing of three retail stores. No restructuring costs were incurred during the three month period ended March 31, 2013. Capital Expenditures Capital expenditures were $8.2 million in the three months ended March 31, 2013, an increase of $1.9 million over the same period in 2012. Capital expenditures in the first quarter of 2013 were primarily related to network software upgrades. 30 -------------------------------------------------------------------------------- Table of Contents Form 10-Q Part I Cincinnati Bell Inc. IT Services and Hardware The IT Services and Hardware segment provides a full range of managed IT solutions, including managed infrastructure services, IT and telephony equipment sales, and professional IT staffing services. These services and products are provided in multiple geographic areas including locations in the U.S., Canada and Europe. By offering a full range of equipment and outsourced services in conjunction with the Company's wireline network, the IT Services and Hardware segment provides end-to-end IT and telecommunications infrastructure management designed to reduce cost and mitigate risk while optimizing performance for its customers. Three Months Ended March 31, (dollars in millions) 2013 2012 Change % Change Revenue: Telecom and IT equipment distribution $ 56.9 $ 45.7 $ 11.2 25 % Managed and professional services 27.6 27.5 0.1 0 % Total revenue 84.5 73.2 11.3 15 % Operating costs and expenses: Cost of services and products 69.4 58.7 10.7 18 % Selling, general and administrative 10.7 10.3 0.4 4 % Depreciation and amortization 2.5 1.6 0.9 56 % Total operating costs and expenses 82.6 70.6 12.0 17 % Operating income $ 1.9 $ 2.6 $ (0.7 ) (27 )% Operating margin 2.2 % 3.6 % (1.4 ) pts Capital expenditures $ 1.2 $ 2.2 $ (1.0 ) (45 )% Revenue Revenue from telecom and IT equipment distribution represents the sale, installation, and maintenance of major, branded IT and telephony equipment. Telecom and IT equipment distribution revenue was $56.9 million in the three months ended March 31, 2013, an increase of $11.2 million, or 25%, compared to the same period in 2012. The increase reflects higher equipment sales arising from increased spending primarily from one large customer. Managed and professional services revenue consists of managed VoIP solutions and IT services that include network management, electronic data storage, disaster recovery, and data security management, as well as both long and short-term IT outsourcing and consulting engagements. In the three months ended March 31, 2013, managed and professional services revenue was $27.6 million, comparable to the same period in 2012. Revenue generated from professional services in the first quarter of 2013 grew by 16% primarily from higher customer demand but was offset by a 6% decline in managed services revenue that largely resulted from fewer orders from one of the Company's largest customers. Costs and Expenses Cost of services and products was $69.4 million in the three months ended March 31, 2013, an increase of $10.7 million, or 18%, compared to the same period in 2012. This increase was largely attributable to higher product costs associated with the increased revenue from telecom and IT equipment distribution. SG&A expenses were $10.7 million in the three months ended March 31, 2013, an increase of $0.4 million, or 4%, compared to the first quarter of 2012. The increase is largely due to higher payroll-related expenses and increased sales commissions associated with the higher revenue from professional services and telecom and IT equipment distribution. For the three months ended March 31, 2013, depreciation expense increased $0.9 million compared to 2012 driven by new assets placed in service. Capital Expenditures Capital expenditures were $1.2 million in the three months ended March 31, 2013 compared to $2.2 million in the prior year. Capital expenditures were lower in the first quarter in 2013 due to the timing of spending on equipment to support managed service projects. 31 -------------------------------------------------------------------------------- Table of Contents Form 10-Q Part I Cincinnati Bell Inc. Data Center Colocation Our Data Center Colocation segment provided enterprise customers with outsourced data center operations, including necessary redundancy, security, power, cooling, and interconnection. For the three months ended March 31, 2013, revenues and expenses represent revenues earned and operating expenses incurred during the period January 1, 2013 to January 23, 2013 when CyrusOne's results were included in our consolidated financial statements. Upon completion of the IPO of CyrusOne on January 24, 2013, we no longer control the operations of CyrusOne and now account for our investment in CyrusOne on the equity method. Three Months Ended March 31, (dollars in millions) 2013 2012 Change % Change Revenue $ 15.6 $ 52.6 $ (37.0 ) (70 )% Operating costs and expenses: Cost of services 4.8 17.3 (12.5 ) (72 )%Selling, general and administrative 2.4 6.5 (4.1 ) (63 )% Depreciation and amortization 5.2 15.6 (10.4 ) (67 )% Total operating costs and expenses 12.4 39.4 (27.0 ) (69 )% Operating income $ 3.2 $ 13.2 $ (10.0 ) (76 )% Operating margin 20.5 % 25.1 % (4.6 ) pts Capital expenditures $ 7.7 $ 52.8 $ (45.1 ) (85 )% Data Center Colocation revenues, operating expenses and operating income for the three months ended March 31, 2013 are not comparable to the similar period in 2012 as we no longer include CyrusOne's results in our consolidated financial statements after its IPO completed on January 24, 2013. All variances result from the inclusion of CyrusOne in our consolidated results for only 23 days in 2013 versus for the full quarter in 2012. 32-------------------------------------------------------------------------------- Table of Contents Form 10-Q Part I Cincinnati Bell Inc. Financial Condition, Liquidity, and Capital Resources As of March 31, 2013, the Company had $2,134.0 million of outstanding indebtedness and an accumulated deficit of $3,245.5 million. A significant amount of the Company's indebtedness and accumulated deficit resulted from the purchase and operation of a national broadband business, which was sold in 2003. The Company completed the IPO of CyrusOne on January 24, 2013 and no longer has any obligations related to CyrusOne's indebtedness, including CyrusOne's $525 million 6 3/8% Senior Notes due 2022, capital lease obligations or other financing arrangements. In addition, the Company no longer has access to CyrusOne's $225 million revolving credit facility. The Company's primary source of cash is generated by operations. The Company generated $42.3 million and $23.6 million of cash flows from operations during the three months ended March 31, 2013 and 2012, respectively. As of March 31, 2013, the Company had $237.5 million of short-term liquidity, comprised of $5.1 million of cash and cash equivalents, $200.0 million of undrawn capacity under its corporate credit agreement, and $32.4 million of unused capacity under its receivables facility. The Company's primary uses of cash are for capital expenditures and debt service and, to a lesser extent, to fund pension and retiree medical obligations and preferred stock dividends. The Company believes that its cash on hand, cash generated from operations, and available funding under its credit facilities will be adequate to meet its cash requirements in 2013. In addition, management expects that the Company will continue to have access to the capital markets to refinance debt and other obligations should such a need arise in the near future. As of March 31, 2013, the fair value of our ownership interests in CyrusOne was approximately $1.0 billion. Over the next few years, management intends to sell down the Company's ownership interests in CyrusOne and use such proceeds to repay long-term debt to amounts appropriate for a telecommunications company and for other general corporate purposes. Cash Flows Cash provided by operating activities during the three months ended March 31, 2013 totaled $42.3 million, an increase of $18.7 million compared to the same period in 2012. The cash provided by operating activities in 2013 increased primarily as a result of lower year-over-year payments for working capital requirements. Cash flows used in investing activities during the three months ended March 31, 2013 amounted to $61.9 million, a decrease of $22.7 million compared to $84.6 million used in the same period in 2012. This decrease was primarily due to lower capital expenditures of $33.7 million largely driven by only a partial month of CyrusOne's 2013 capital expenditures being included in our consolidated financial statements. In addition, CyrusOne held cash of $12.2 million at the date of its IPO, which is no longer included in our consolidated financial statements. Cash flows provided by financing activities during the three months ended March 31, 2013 were $1.1 million, compared to cash used in financing activities of $5.8 million during the same period in 2012. For the three months ended March 31, 2013, the Company's cash inflows were primarily comprised of $6.6 million of cash proceeds received from the exercise of stock options and warrants as well as $2.0 million of additional borrowings from the receivables facility. During this period, cash was used primarily to make debt repayments of $3.1 million and to pay $2.6 million of preferred stock dividends. For the same period in 2012, the cash used in financing activities was primarily driven by $4.0 million of debt repayments and a $2.6 million payment for preferred stock dividends. Debt Covenants Credit Facility The credit facility financial covenants require that we maintain certain leverage and interest coverage ratios and limit our cumulative spending on capital expenditures. The facility also contains certain covenants which, among other things, limit the Company's ability to incur additional debt or liens, pay dividends, repurchase Company common stock, sell, transfer, lease, or dispose of assets, and make investments or merge with another company. If the Company was to violate any of its covenants and was unable to obtain a waiver, it would be considered a default. If the Company was in default under its credit facility, no additional borrowings under the credit facility would be available until the default was waived or cured. The Company is in compliance with all of its credit facility covenants. The Company's most restrictive covenants are generally included in its credit facility. In order to continue to have access to the amounts available to it under the revolving credit facility, the Company must remain in compliance with all of the covenants. 33 -------------------------------------------------------------------------------- Table of Contents Form 10-Q Part I Cincinnati Bell Inc. The following table presents the calculations of the most restrictive debt covenant, the Consolidated Total Leverage Ratio, as of and for the twelve months ended March 31, 2013: (dollars in millions) Consolidated Total Leverage Ratio as of March 31, 2013 5.14 Maximum ratio permitted for compliance 7.25 Consolidated Funded Indebtedness additional availability $ 881.4 Consolidated EBITDA clearance over compliance threshold $ 121.6 Definitions and components of these calculations are detailed in our credit agreement and can be found in the Company's Form 8-K filed on November 20, 2012. The Company's ability to make restricted payments (which include share repurchases and common stock dividends) is limited to a total of $15 million given that its Consolidated Total Leverage Ratio, as defined in the credit agreement, exceeds 4.50 to 1.00 as of March 31, 2013. The Company may make restricted payments of $15 million annually when the Consolidated Total Leverage Ratio is less than or equal to 4.50 to 1.00, and this allowance increases to $35 million annually when the Consolidated Total Leverage Ratio is less than or equal to 3.50 to 1.00. There are no limits on restricted payments when the Consolidated Total Leverage Ratio is less than or equal to 3.00 to 1.00. These restricted payment limitations do not impact the Company's ability to make regularly scheduled dividend payments on its 6 3/4% Cumulative Convertible Preferred Stock. Public Bond Indentures Various issuances of the Company's public debt, which include the 8 1/4% Senior Notes due 2017, the 8 3/4% Senior Subordinated Notes due 2018, and the 8 3/8% Senior Notes due 2020, contain covenants that, among other things, limit the Company's ability to incur additional debt or liens, pay dividends or make other restricted payments, sell, transfer, lease, or dispose of assets and make investments or merge with another company. The Company is in compliance with all of its public debt indentures. One of the financial covenants permits the issuance of additional indebtedness up to a 4:00 to 1:00 Consolidated Adjusted Senior Debt to EBITDA Ratio (as defined by the individual indentures). As of March 31, 2013, the Company had exceeded this ratio. The Company is not in default under the terms of the indentures; however, additional indebtedness may only be incurred in specified permitted baskets, including a Credit Agreement basket providing full access to the Corporate revolving credit facility plus an additional $700 million of secured debt. Also, the Company's ability to make restricted payments (which include share repurchases and common stock dividends) is limited to specific allowances. In addition to a $25 million cumulative general allowance, the Company is permitted to make dividend payments on its 6 3/4% Cumulative Convertible Preferred Stock and may repurchase up to $10 million of its common stock per year. Except for the $25 million cumulative general allowance, no other allowances are available for common stock dividend payments. The Company does not believe that this limitation will have a material impact on its operations, liquidity or cash flows in the foreseeable future. When the Company is able to meet this ratio in the future, the aforementioned restrictions on debt incurrence and restricted payments will lapse. Share Repurchase Plan In 2010, the Board of Directors approved a plan for the repurchase of the Company's outstanding common stock in an amount up to $150.0 million. In prior years, the Company repurchased a total of 7.4 million shares at a total cost of $29.8 million and retired 7.3 million of these repurchased shares. The Company did not repurchase any additional shares in the first quarter of 2013. As of March 31, 2013, the Company has the authority to repurchase its common stock with a value of up to $129.2 million under the plan approved by its Board of Directors, subject to satisfaction of the requirements under its bond indentures. Regulatory Matters Refer to the Company's Annual Report on Form 10-K for the year ended 2012 for a complete description of regulatory matters. Contingencies In the normal course of business, the Company is subject to various regulatory and tax proceedings, lawsuits, claims, and other matters. The Company believes adequate provision has been made for all such asserted and unasserted claims in accordance 34 -------------------------------------------------------------------------------- Table of Contents Form 10-Q Part I Cincinnati Bell Inc. with accounting principles generally accepted in the United States. Such matters are subject to many uncertainties and outcomes that are not predictable with assurance. Future Operating Trends Refer to the Company's Annual Report on Form 10-K for the year ended 2012 for a complete description of future operating trends for our business. Critical Accounting Policies The Company's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. Application of these principles requires management to make estimates or judgments that affect the amounts reported in the accompanying condensed consolidated financial statements and information available as of the date of the financial statements. As this information changes, the financial statements could reflect different estimates or judgments. The Company's most critical accounting policies and estimates are described in its Annual Report on Form 10-K for the year ended December 31, 2012. Updates to our critical accounting policies are described below: Investment in CyrusOne - As of January 24, 2013, we completed the IPO of CyrusOne and now own approximately 1.9 million shares, or 8.6%, of CyrusOne's common stock. We are also a limited partner in CyrusOne LP, owning approximately 42.6 million, or 66%, of its partnership units. Effective with the IPO, we no longer control the operations of CyrusOne and account for our investments in CyrusOne using the equity method. Loss from CyrusOne equity method investment of $1.9 million represents our proportionate share of CyrusOne's net loss for the period January 24, 2013 to March 31, 2013. Dividends from CyrusOne reduce our investment. After January 17, 2014, we may exchange our partnership units into cash or common stock of CyrusOne, as determined by CyrusOne, on a one-for-one basis based upon the fair value of a share of CyrusOne common stock. Reviewing the Carrying Values of Long-Lived Assets - The useful lives of plant and equipment are estimated in order to determine the amount of depreciation expense to be recorded during any reporting period. During the three months ended March 31, 2013, we determined that a change was necessary to shorten the estimated useful lives assigned to wireless network software to three years. This change resulted from smartphone-driven technology upgrades, enhancements and projected retirements. For the three months ended March 31, 2013, the increase in depreciation expense associated with this change in estimate amounted to $8.5 million. Accounting for Income Taxes - The Company has state tax credit carryforwards available to offset current and future Texas margin tax. These credits expire in 2026. As we sell down our ownership interest in CyrusOne in the future, we will incur significantly less Texas margin tax. As a result, management concluded that it was more likely than not that these tax credit carryforwards would not be realized prior to their expiration. Accordingly, during the three months ended March 31, 2013, we provided a valuation allowance of $10.7 million to reduce these state tax credit carryforwards to their estimated realizable value. The Company expects to use federal and state net operating loss carryforwards to substantially defray payment of federal and state tax liabilities in 2013. Recently Issued Accounting Standards Refer to Note 1 of the Condensed Consolidated Financial Statements for further information on recently issued accounting standards. The adoption of new accounting standards did not have a material impact on the Company's financial results for the three months ended March 31, 2013. Item 3. Quantitative and Qualitative Disclosures About Market Risk Refer to the Company's Annual Report on Form 10-K for the year ended December 31, 2012 for a description of the Company's market risks. The Company no longer has commodity price risk related to electricity utilized in our former Data Center Colocation segment. There were no other material changes for the period ending March 31, 2013. |