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MITEL NETWORKS CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion of the financial condition and results of operations of the Company should be read in conjunction with the unaudited interim consolidated financial statements and accompanying notes included elsewhere in this Quarterly Report on Form 10-Q ("Report") and our audited annual financial statements included in our Transition Report on Form 10-K for the eight months ended December 31, 2013 ("Annual Report"). All amounts are expressed in U.S. dollars unless otherwise noted. Certain information contained in this Report, including information regarding future financial results, performance and plans, expectations, and objectives of management, constitute forward-looking information within the meaning of Canadian securities laws and forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. We refer to all of these as forward-looking statements. Statements that include the words "may," "will," "should," "could," "target," "outlook," "estimate," "continue," "expect," "intend," "plan," "predict," "potential," "believe," "project," "anticipate" and similar statements of a forward-looking nature, or the negatives of those statements, identify forward-looking statements. In particular, this Report contains forward-looking statements pertaining to, among other matters: the company's ability to achieve or sustain profitability in the future; fluctuations in quarterly and annual revenues and operating results; fluctuations in foreign exchange rates; general global economic conditions; our business strategy; our plans and objectives for future operations; our industry; our future economic performance, profitability and financial condition; the costs of operating as a public company; our R&D expenditures; our ability to successfully implement our restructuring plans; our ability to successfully integrate the acquisition of Aastra Technologies Limited ("Aastra") and realize certain synergies; our ability to successfully implement and achieve our business strategies successfully; intense competition; our reliance on channel partners for a significant component of our sales; and our dependence upon a small number of outside contract manufacturers to manufacture our products. Forward-looking statements are subject to a variety of known and unknown risks, uncertainties, assumptions and other factors that could cause actual events or results to differ from those expressed or implied by the forward-looking statements. These statements reflect our current views with respect to future events and are based on assumptions and subject to risks and uncertainties. We operate in a very competitive and rapidly changing environment. New risks emerge from time to time. In making these statements we have made certain assumptions. While we believe our plans, intentions, expectations, assumptions and strategies reflected in these forward-looking statements are reasonable, we cannot assure you that these plans, intentions, expectations assumptions and strategies will be achieved. Our actual results, performance or achievements could differ materially from those contemplated, expressed or implied by the forward-looking statements contained in this Report as a result of various factors, including the risks and uncertainties discussed elsewhere in this Report and in our Annual Report. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the cautionary statements set forth in this Report. Except as required by law, we are under no obligation to update any forward-looking statement, whether as a result of new information, future events or otherwise. Please refer to the section entitled "Risk Factors" included in our Annual Report for a further discussion of risk and uncertainties affecting our business and financial results. Overview Mitel is a global provider of business communications and collaboration software and services. Our communication solutions meet the needs of customers in over 100 countries. On January 31, 2014, Mitel completed the acquisition of Aastra, as described below. In conjunction with the transaction, the Company reorganized its business into two new business units: Premise and Cloud. 22-------------------------------------------------------------------------------- Premise The Premise segment sells and supports products and services for premise-based customers. This includes the Company's premise-based IP and TDM telephony platforms, desktop devices and unified communications and collaboration ("UCC") and contact centre applications that are deployed on the customer's premise. Premise-based sales are typically sold as an initial sale of hardware and software, with ongoing recurring revenue from hardware and software maintenance and other managed services that we also offer. Cloud The Cloud segment sells and supports products that are deployed in a cloud environment. The Cloud segment is comprised of a retail offering and a wholesale offering. The retail cloud offering, branded MiCloud, provides hosted cloud and related services directly to the end user. The Company is typically paid a monthly recurring fee for these services, which include UCC applications, voice and data telecommunications and desktop devices. The wholesale offering, branded Powered by Mitel, enables service providers to provide a range of hosted communications offerings to their end customers. The hosted offering include hosted PBX, voice and video calling, SIP Trunking, voice and video mail, call center, audio conferencing and video and web collaboration services. The wholesale cloud offering is also sold to large enterprise customers who run their own data centers in private cloud or hybrid cloud networks with management provided by Mitel, or one of Mitel's channel partners. Revenue in the wholesale cloud offering is billed either as monthly recurring fees or as an upfront sale of hardware and software. Significant Events and Recent Developments: Acquisition of Aastra - January 2014 On January 31, 2014, Mitel completed the acquisition of Aastra. Aastra was a global provider of unified communications and collaboration software, solutions and services with annual revenues of approximately CAD $600 million for the year ended December 31, 2013, of which approximately 75% were generated in Europe. Mitel acquired all of the outstanding Aastra common shares in exchange for $80.0 million cash as well as the issuance of 44.2 million Mitel common shares. In conjunction with the acquisition, Mitel refinanced its existing credit facilities with a $355.0 million term loan and an undrawn revolving facility of $50.0 million. Acquisition of Oaisys - March 2014 On March 4, 2014, Mitel completed the acquisition of Oaisys, a leading developer of integrated call recording and quality management solutions. The acquisition of Oaisys further strengthens Mitel's position in the growing contact center market. The cost of the acquisition is estimated to be $7.9 million consisting of $5.9 million of cash and expected contingent consideration of $2.0 million. Acquisition of prairieFyre - June 2013 On June 17, 2013, we completed the acquisition of prairieFyre Software Inc. ("prairieFyre"), a global provider of contact center, business analytics, and workforce optimization software and services. The acquisition provides us with a cornerstone development platform to address increasing demand for cloud-based contact center solutions. Our net cash cost for the acquisition was $20.0 million for a 100% equity ownership interest in prairieFyre. As a highly integrated original equipment manufacturer ("OEM"), substantially all of prairieFyre's revenues were derived from Mitel and our channel partners. As a result, upon acquisition, substantially all of prairieFyre's revenues are eliminated against Mitel's cost of sales, resulting in an increase in our consolidated gross margin and gross margin percentage. prairieFyre's operations have been included in the consolidated results of operations since the date of acquisition. Sale of DataNet - March 2013 In March 2013, we completed the sale of our DataNet business, which distributed a wide variety of third-party telephony and data products and related services. As a result, the operating results of DataNet have been reported as discontinued operations on the consolidated statement of operations up to the time of sale. 23 -------------------------------------------------------------------------------- Refinancing of Credit Agreement - February 2013 In February 2013, we completed a refinancing of our senior long-term debt by entering into new credit agreements, consisting of an undrawn $40.0 million first lien revolving credit facility, a $200.0 million first lien term loan and an $80.0 million second lien term loan (the "February 2013 Credit Facilities"). Proceeds of $276.4 million from the February 2013 Credit Facilities (net of original issue discount of $3.6 million), along with $36.4 million of cash on hand, were used to repay the remaining $174.0 million outstanding first lien term loan and $130.0 million outstanding second lien term loan, as well as fees and expenses related to the transaction. In January 2014 we refinanced our credit facilities in connection with the acquisition of Aastra, as described above. Operating Results Total revenue for the three months ended March 31, 2014 was $241.5 million compared to $143.1 million for the three months ended March 31, 2013. The revenue increase was primarily due to the acquisition of Aastra on January 31, 2014, which contributed $89.3 million of revenues. Excluding Aastra, revenue increased by $9.1 million primarily due to continued growth in the cloud segment. Our operating income for the three months ended March 31, 2014 was $1.7 million compared to $11.0 million for the three months ended March 31, 2013. The decrease in operating income was largely driven by higher special charges and restructuring costs incurred as a result of the Aastra acquisition, which offset the increased gross margin from higher revenues. Comparability of Periods Our functional currency is the U.S. dollar and our consolidated financial statements are prepared with U.S. dollar reporting currency using the current rate method. With the acquisition of Aastra, a significant portion of our revenue is now earned in Euros. Changes in foreign-exchange rates from period to period can have a significant impact on our results of operations and financial position, which may also make the comparability of periods complex. The results of acquisitions are included in our results from operations from the date of acquisition. In addition, we have incurred various costs related to acquisitions and the integration of those acquisitions, which have been recorded in special charges and restructuring costs, as described below. Selected Consolidated Financial Data The following table sets forth our comparative results of operations, both in dollars and as a percentage of total revenues: Three months ended March 31, 2014 2013 Change % of % of Amounts Revenue Amounts Revenue Amount % (in millions, except percentages and per share amounts) Revenues $ 241.5 $ 143.1 $ 98.4 68.8 Cost of revenues 112.1 46.4 % 62.3 43.5 % 49.8 79.9 Gross margin 129.4 53.6 % 80.8 56.5 % 48.6 60.1 Expenses: Selling, general and administrative 88.2 36.5 % 54.5 38.1 % 33.7 61.8 Research and development 26.3 10.9 % 13.8 9.6 % 12.5 90.6 Special charges and restructuring costs 13.2 5.5 % 1.4 1.0 % 11.8 + Loss on litigation settlement - - 0.1 0.1 % (0.1 ) + 127.7 52.9 % 69.8 48.8 % 57.9 83.0 Operating income from continuing operations 1.7 0.7 % 11.0 7.7 % (9.3 ) + Interest expense (5.9 ) (2.4 )% (5.4 ) (3.8 )% (0.5 ) 9.3 Debt retirement costs (14.7 ) (6.1 )% (2.6 ) (1.8 )% (12.1 ) + Other income 0.1 - 0.1 0.1 % - - Income (loss) from operations, before taxes (18.8 ) (7.8 )% 3.1 2.2 % (21.9 ) + Income tax recovery (expense) 5.2 2.2 % (1.8 ) (1.3 )% 7.0 + Net income (loss) from continuing operations (13.6 ) (5.6 )% 1.3 0.9 % (14.9 ) + Net loss from discontinued operations - - (3.0 ) (2.1 )% 3.0 + Net loss $ (13.6 ) (5.6 )% $ (1.7 ) (1.2 )% $ (11.9 ) + Adjusted EBITDA, a non-GAAP measure $ 35.6 14.7 % $ 23.0 16.1 % $ 12.6 54.8 + The comparison is not meaningful. 24 -------------------------------------------------------------------------------- Net loss per common share-Basic Net loss per common share from continuing operations $ (0.16 ) $ 0.02 Net loss per common share from discontinued operations $ - $ (0.05 ) Net loss per common share $ (0.16 ) $(0.03 ) Net loss per common share-Diluted Net loss per common share from continuing operations $ (0.16 ) $ 0.02 Net loss per common share from discontinued operations $ - $ (0.05 ) Net loss per common share $ (0.16 ) $(0.03 ) Weighted-average number of common shares outstanding Basic 83.5 53.7 Diluted 83.5 56.2 Adjusted Earnings Before Interest, Taxes, Depreciation and Amortization ("Adjusted EBITDA") The following table presents a reconciliation of Adjusted EBITDA to net income, the most directly comparable U.S. GAAP measure: Three months ended March 31 2014 2013 (in millions) Net loss $ (13.6 ) $ (1.7 ) Net loss from discontinued operations - 3.0 Net income (loss) from continuing operations (13.6 ) 1.3 Adjustments: Interest expense 5.9 5.4 Income tax expense (recovery) (5.2 ) 1.8 Amortization and depreciation 16.2 8.9 Debt retirement costs 14.7 2.6 Foreign exchange loss 0.3 0.5 Special charges and restructuring costs 13.2 1.4 Stock-based compensation 1.3 1.1 Loss on litigation settlement - 0.1 Acquisition accounting for deferred revenue(1) 2.8 - Adjusted EBITDA from continuing operations 35.6 23.1 Adjusted EBITDA from discontinued operations(2) - (0.1 ) Adjusted EBITDA $ 35.6 $ 23.0 (1) In accordance with the fair value provisions applicable to the accounting for business combinations, acquired deferred revenue relating to the Aastra acquisition was recorded on the opening balance sheet at an amount that was lower than the historical carrying value. Although this purchase accounting requirement has no impact on the Company's business or cash flow, it adversely impacts the Company's reported GAAP revenue in the reporting periods following the acquisition. In order to provide investors with financial information that facilitates comparison of results, the Company provides non-GAAP financial measures which exclude the impact of the acquisition accounting adjustments. The Company believes that this non-GAAP financial adjustment is useful to investors because it allows investors to compare reports of financial results of the Company as the revenue reduction related to acquired deferred revenue will not recur when similar software maintenance and service contracts are recorded in future periods. 25 -------------------------------------------------------------------------------- (2) The reconciliation from net loss from discontinued operations to Adjusted EBITDA from discontinued operations for the three months ended March 31, 2013 consists of special charges and restructuring costs of $1.6 million, non-cash impairment of goodwill of $1.9 million and an income tax recovery of $0.6 million. We define Adjusted EBITDA as net income (loss), adjusted for the items as noted in the above tables. Adjusted EBITDA is not a measure calculated in accordance with U.S. GAAP. Adjusted EBITDA should not be considered as an alternative to net income, income from operations or any other measure of financial performance calculated and presented in accordance with U.S. GAAP. We prepare Adjusted EBITDA to eliminate the impact of items that we do not consider indicative of our core operating performance. We encourage you to evaluate these adjustments and the reasons we consider them appropriate, as well as the material limitations of non-GAAP measures and the manner in which we compensate for those limitations. We use Adjusted EBITDA: • as a measure of operating performance; • for planning purposes, including the preparation of our annual operating budget; • to allocate resources to enhance the financial performance of our business; and • in communications with our board of directors concerning our financial performance. We believe that the use of Adjusted EBITDA provides consistency and comparability of, and facilitates, period to period comparisons, and also facilitates comparisons with other companies in our industry, many of which use similar non-GAAP financial measures to supplement their U.S. GAAP results. We believe Adjusted EBITDA may also be useful to investors in evaluating our operating performance because securities analysts use Adjusted EBITDA as a supplemental measure to evaluate the overall operating performance of companies. Our investor and analyst presentations also include Adjusted EBITDA. However, we also caution you that other companies in our industry may calculate Adjusted EBITDA or similarly titled measures differently than we do, which limits the usefulness of Adjusted EBITDA as a comparative measure. Moreover, although Adjusted EBITDA is frequently used by investors and securities analysts in their evaluations of companies, Adjusted EBITDA and similar non-GAAP measures have limitations as analytical tools, and you should not consider them in isolation or as a substitute for an analysis of our results of operations as reported under U.S. GAAP. Some of the limitations of Adjusted EBITDA are that it does not reflect: • interest income or interest expense; • cash requirements for income taxes; • foreign exchange gains or losses; • cash payments made in connection with litigation settlements; • significant cash payments made in connection with special charges and restructuring costs; • employee stock-based compensation; and • cash requirements for the replacement of assets that have been depreciated or amortized. 26 -------------------------------------------------------------------------------- We compensate for the inherent limitations associated with using Adjusted EBITDA through disclosure of such limitations, presentation of our financial statements in accordance with U.S. GAAP and reconciliation of Adjusted EBITDA to the most directly comparable U.S. GAAP measure, net income (loss). Results of Operations Revenues The following table sets forth revenues by business segment in dollars and as a percentage of total revenues: Three months ended March 31, 2014 2013 Change % of % of Revenues Revenues Revenues Revenues Amount % (in millions, except percentages) Premise segment - product revenues $ 159.8 66.2 % $ 87.1 60.9 % $ 72.7 83.5 Premise segment - service revenues 55.9 23.1 % 42.7 29.8 % 13.2 30.9 Cloud segment - product revenues 6.7 2.8 % 1.2 0.8 % 5.5 458.3 Cloud segment - recurring service revenues 19.1 7.9 % 12.1 8.5 % 7.0 57.9 $ 241.5 100.0 % $ 143.1 100.0 % $ 98.4 68.8 Revenues increased across all segments as a result of the acquisitions made in the last twelve months and, in particular, the acquisition of Aastra in January 2014. In addition, our revenues were favorably impacted by a general strengthening of foreign currencies when compared against the U.S. dollar. In particular, the British pound sterling and Euro were stronger against the U.S. dollar by an average of 5.2% and 3.1%, respectively in the first quarter of 2014 when compared to the first quarter of 2013. Revenue for the first quarter of 2014 includes a reduction in revenue of $2.8 million (first quarter of 2013-nil) relating to purchase accounting. In accordance with the fair value provisions applicable to the accounting for business combinations, acquired deferred revenue relating to the Aastra acquisition was recorded on the opening balance sheet at an amount that was lower than the historical carrying value. Although this purchase accounting adjustment has no impact on the Company's business or cash flow, it adversely impacts the Company's reported GAAP revenue in the reporting periods following the acquisition. Based on the fair value of deferred revenue recorded in the initial purchase price allocation, we expect that revenue will be adversely affected by a total of $10.3 million over the next two years. Excluding the results of acquisitions, premise segment product revenues increased by $4.1 million, or 4.7%, to $91.2 million as a result of increased volumes in the U.S. and Canada as well as the favorable impact of foreign exchange rates, as described above, while cloud segment product revenues increased by $4.6 million to $5.8 million as both new and existing customers transition to the cloud. Excluding the results of acquisitions, premise segment service revenues decreased by $5.0 million, or 11.6%, to $37.8 million while cloud segment recurring service revenues increased by $5.3 million, or 44.1%, to $17.4 million. The decrease in premise segment service revenues and increase in cloud segment recurring service revenues largely reflects existing customers transitioning from a premise solution to a cloud solution. Gross Margin The following table sets forth gross margin, both in dollars and as a percentage of revenues: Three months ended March 31, 2014 2013 Change Gross % of Gross % of Absolute Margin Revenues Margin Revenues Amount % (in millions, except percentages) Premise segment - product gross margin $ 95.3 59.6 % $ 58.0 66.6 % $ 37.3 (7.0 ) Premise segment - service gross margin 21.6 38.6 % 16.4 38.4 % 5.2 0.2 Cloud segment - product gross margin 3.2 47.8 % 0.8 66.7 % 2.4 (18.9 ) Cloud segment - recurring service gross margin 9.3 48.7 % 5.6 46.3 % 3.7 2.4 $ 129.4 53.6 % $ 80.8 56.5 % $ 48.6 (2.9 ) 27 -------------------------------------------------------------------------------- In the first quarter of 2014, overall gross margin percentage decreased by an absolute 2.9% to 53.6% compared to 56.5% for the first quarter of 2013 primarily as a result of the acquisition of Aastra, which contributed $39.6 million of gross margin, a gross margin percentage of 44.3%, to the first quarter of 2014. Excluding the effect of the Aastra acquisition, Mitel gross margin percentage increased by an absolute 2.5% to 59.0%, primarily due to the acquisition of prairieFyre in June 2013. Excluding the effect of the acquisition of Aastra, premise segment product gross margin percentage increased by an absolute 2.0%, to 68.6% primarily as a result of the acquisition of prairieFyre in June 2013, while cloud segment product gross margin percentage decreased to 45.5% as the cloud segment was in its early stages in the first quarter of 2013. Excluding the effect of the acquisition of Aastra, premise segment service gross margin percentage increased by an absolute 4.7% to 43.1%, primarily as a result of the acquisition of prairieFyre in June 2013, while cloud segment recurring service gross margin percentage increased by an absolute 1.7% to an absolute 48.0% due to the mix of services provided. Operating Expenses Selling, General and Administrative ("SG&A") SG&A expenses decreased to 36.5% of revenues in the first quarter of 2014 from 38.1% in the first quarter of 2013, an increase of $33.7 million in absolute dollars. The increase in absolute dollars is primarily due to acquisitions made in the last 12 months. Our SG&A expenses for the first quarter of 2014 included certain non-cash charges, most significantly $11.3 million (first quarter of 2013-$5.6 million) for the amortization of acquired intangible assets. In addition, SG&A expenses included $1.3 million (first quarter of 2013-$1.1 million) of non-cash compensation expenses associated with employee stock options. Excluding acquisitions made in the last 12 months, SG&A expenses remained relatively consistent at 38.0% of revenues compared to 38.1% in the first quarter of 2013, largely due to increased spending on sales growth initiatives being offset by savings from restructuring initiatives. Research and Development ("R&D") R&D expenses in the first quarter of 2014 increased to 10.9% of revenues compared to 9.6% of revenues for the first quarter of 2013, an increase of $12.5 million in absolute dollars. The increase was largely driven by acquisitions made in the last twelve months. Excluding acquisitions made in the last 12 months, R&D expenses remained relatively consistent at 9.6% of revenues compared to 9.5% of revenues in the first quarter of 2013. Our R&D expenses in absolute dollars can fluctuate depending on the timing and number of development initiatives in any given quarter. R&D expenses as a percentage of revenues is highly dependent on revenue levels and could vary significantly depending on actual revenues achieved. Special Charges and Restructuring Costs We recorded special charges and restructuring costs of $13.2 million in the first quarter of 2014, primarily relating to the acquisition and integration of Aastra. The costs consisted of $2.2 million of employee-related charges, $1.1 million of facility-related charges, $4.9 million of integration-related charges as well as $5.0 million of acquisition-related charges. The employee-related charges consisted of termination and related costs related to headcount reductions of approximately 50 people, primarily in North America. Facility-related charges consisted primarily of lease termination obligations for facilities, primarily in North America. Integration-related charges include professional fees and incidental costs relating to the integration of Aastra. Acquisition-related charges consisted primarily of legal and advisory fees incurred to close the Aastra acquisition in January 2014. We recorded special charges and restructuring costs of $1.4 million in the first quarter of 2013. The charges primarily relate to headcount reductions and additional lease termination obligations as we reduced our cost structure. We may take additional restructuring actions in the future to reduce our operating expenses and gain operating efficiencies. The timing and potential amount of such actions will depend on several factors, including future revenue levels and opportunities for operating efficiencies identified by management. Operating Income from Continuing Operations We reported operating income from continuing operations of $1.7 million in the first quarter of 2014 compared to $11.0 million in the first quarter of 2013. The decrease in operating income was driven by higher special charges and restructuring costs, which was partially offset by higher revenues and gross margin in the legacy Mitel business. Operating income from acquisitions was approximately nil as adverse effects from purchase price allocation adjustments to revenue of $2.8 million and amortization of acquired intangible assets of $5.7 million largely offset income from operations. 28-------------------------------------------------------------------------------- Non-Operating Expenses Interest Expense Interest expense was $5.9 million in the first quarter of 2014 compared to $5.4 million in the first quarter of fiscal 2013. The increase in interest expense was due to the refinancing of our credit facilities in conjunction with the acquisition of Aastra in January 2014 as higher debt levels to finance the acquisition were partially offset by a lower interest rate margin and a lower LIBOR floor on the refinanced debt (4.25% and 1.00%, respectively at March 31, 2014 compared to 5.75% and 1.25% at March 31, 2013). Debt retirement costs For the first quarter of 2014, we recorded debt retirement costs of $14.7 million relating to the refinancing of our debt in January 2014. These costs consisted of $10.0 million of unamortized debt issue costs and unamortized original issue discount, $4.2 million of prepayment fees relating to repaying our prior credit facilities and $0.5 million of other costs relating to the refinancing. For the first quarter of 2013, we recorded debt retirement costs of $2.6 million relating to the refinancing our debt in February 2013. These costs consisted of $2.6 million of unamortized debt issue costs and unamortized original issue discount relating to repaying our prior credit facilities. Income tax expense For the first quarter of 2014, we recorded a net income tax recovery of $5.2 million compared to an expense of $1.8 million for the first quarter of 2013. The income tax recovery in the first quarter of 2014 was primarily due to a tax recovery on certain non-recurring items primarily related to the Aastra acquisition. The tax recovery in the first quarter of 2013 was primarily driven by the expected effective tax rate for the year. Net Income (Loss) from Continuing Operations Our net loss from continuing operations for the first quarter of fiscal 2014 was $13.6 million compared to net income from continuing operations of $1.3 million in the first quarter of fiscal 2013. The higher net loss from continuing operations was primarily due to higher debt retirement costs and lower operating income, as described above. Net Loss from Discontinued Operations Net loss from discontinued operations consists of the operations of DataNet, which was sold in March 2013. Further information on the sale of DataNet can be found under Item 7 of our Annual Report. Net Loss Our net loss for the first quarter of 2014 was $13.6 million compared to a net loss of $1.7 million in the first quarter of 2013. The higher net loss was due to the higher net loss from continuing operations, as described above. Other Comprehensive Income (Loss) Other comprehensive loss for the first quarter of 2014 includes a loss of $7.7 million related to pension liability adjustments. At March 31, 2014, the pension valuation from December 31, 2013 for our U.K. pension plan was updated for actual investment performance and certain changes in assumptions. The increase in pension liability and corresponding other comprehensive loss was primarily due to an increase in the accrued benefit obligation from a decrease in the discount rate from 4.7% at December 31, 2013 to 4.6% at March 31, 2014. The discount rate assumption was determined on a consistent basis and reflects prevailing rates available on high-quality, fixed income debt instruments. Other comprehensive loss for the first quarter of 2013 includes a loss of $19.5 million related to pension liability adjustments as the U.K. pension plan's valuation was updated for actual investment performance and certain changes in assumptions. 29 -------------------------------------------------------------------------------- Adjusted EBITDA Adjusted EBITDA, a non-GAAP measure, was $35.6 million in the first quarter of 2014 compared to $23.0 million in the first quarter of 2013, an increase of $12.6 million. This increase was driven primarily by higher gross margin from the legacy Mitel business as well contributions from acquisitions made in the last 12 months. For a definition and explanation of Adjusted EBITDA and why we believe it is useful in evaluating our financial condition, as well as a reconciliation of Adjusted EBITDA to the most directly comparable GAAP measure net income, see "Selected Consolidated Financial Data - Adjusted EBITDA" elsewhere in this Report. Cash Flows Below is a summary of comparative results of cash flows and a discussion of the results for the three months ended March 31, 2014 and March 31, 2013. Three months ended March 31, 2014 2013 Change (in millions) Net cash provided by (used in) Operating activities $ 26.8 $ 9.7 $ 17.1 Investing activities (9.4 ) (1.6 ) (7.8 ) Financing activities 77.4 (37.2 ) 114.6 Effect of exchange rate changes on cash and cash equivalents 1.0 (1.7 ) 2.7 Increase (decrease) in cash and cash equivalents $ 95.8 $ (30.8 ) $ 126.6 Cash Provided by Operating Activities Net cash generated from operating activities in the first quarter of 2014 was $26.8 million compared to $9.7 million in the first quarter of 2013. The increase was due to favorable changes in non-cash operating assets of $13.6 million in the first quarter of 2014 compared to unfavorable changes in the first quarter of 2013 of $5.0 million. Cash Used in Investing Activities Net cash used for investing activities was $9.4 million in the first quarter of 2014 compared to $1.6 million in the first quarter of 2013. The cash used in investing activities for the first quarter of 2014 includes $6.2 million for the January 2014 acquisition of Aastra (cash paid of $80.0 million, net of cash acquired of $79.4 million) and the March 2014 acquisition of Oaisys (cash paid of $5.9 million net of cash acquired of $0.3 million). The first quarters of 2014 and 2013 also include additions to property, plant and equipment of $3.2 million and $1.6 million, respectively. Cash Used in Financing Activities Net cash provided by financing activities in the first quarter of 2014 was $77.4 million compared to cash used in financing activities of $37.2 million during the first quarter of 2013. The cash from financing activities in the first quarter of 2014 consisted primarily of net proceeds from the January 2014 refinancing. The proceeds from the new credit facility of $353.2 million, net of repayments of the prior credit facilities as well as fees and costs related to the refinancing. The use of cash in the first quarter of 2013 consisted primarily of a net repayment of long-term debt as a result of the February 2013 refinancing. Effect of exchange rate changes on cash Our overall cash position was also impacted by exchange rate changes during the period, which increased cash by $1.0 million during the first quarter of 2014 (first quarter of 2013-$1.7 million decrease). Liquidity and Capital Resources As of March 31, 2014, our liquidity consisted primarily of cash and cash equivalents of $136.0 million and an undrawn $50.0 million revolving facility. At March 31, 2014, we had $354.1 million outstanding under our secured credit facilities, consisting of a term loan due 2020. At December 31, 2013 we had $258.5 million outstanding under our then-existing credit facilities consisting of a first lien term loan due 2019 and second lien term loan due 2020. 30 -------------------------------------------------------------------------------- On January 31, 2014, in conjunction with the acquisition of Aastra, we refinanced our credit facilities. The new credit facilities consist of a $355.0 million term loan and a $50.0 million revolving facility (the "January 2014 Credit Facilities"). Proceeds of $353.2 million (net of original discount of $1.8 million), along with cash on hand, were used to repay the remaining $258.5 million outstanding on the prior credit facilities, the $80.0 million of cash consideration paid for the acquisition of Aastra, as well as fees and expenses in connection with the refinancing and the acquisition of Aastra. The undrawn $50.0 million revolving credit facility bears interest at LIBOR plus 4.25%, or, at the option of the Company, a base rate plus an applicable margin, and matures in January 2019. The Company may borrow Canadian dollars under the revolving credit facility. Such borrowings bear interest at the Canadian prime rate plus an applicable margin. The $355.0 million term loan bears interest at LIBOR (subject to a 1.00% floor) plus 4.25%, or, at the option of the Company, a base rate plus an applicable margin, and matures in January 2020. The term loan requires quarterly principal repayments of 0.25% of the original outstanding principal. We are also required to make annual principal repayments on the term loan based on a percentage of excess cash flow (as defined in the January 2014 Credit Facilities). The annual excess cash flow repayments are required to be paid within 100 days of the end of the fiscal year. The first annual excess cash flow payment is required be paid within 100 days of December 31, 2014. We may prepay the term loan at a premium of 1% over the principal amount within the first six months using proceeds from a refinancing. Otherwise, the term loan can be repaid without premium or penalty. The January 2014 Credit Facilities have customary default clauses, wherein repayment of the credit facilities may be accelerated in the event of an uncured default. The proceeds from the issuance of debt, and proceeds from the sale of Company assets, may also be required to be used, in whole or in part, to make mandatory prepayments under the credit facilities. The January 2014 Credit Facilities contained affirmative and negative covenants, including: (a) periodic financial reporting requirements, (b) a maximum ratio of Consolidated Total Debt (net of up to $50.0 million of unrestricted cash) to the trailing twelve months Earnings before Interest, Taxes, Depreciation and Amortization ("Leverage Ratio"), as specified in the credit facilities, (c) limitations on the incurrence of subsidiary indebtedness and also the borrowers themselves, (d) limitations on liens, (e) limitations on investments and (f) limitations on the payment of dividends. The maximum Leverage Ratio applies to the Company for the period ending June 30, 2014 and for all fiscal quarters thereafter until maturity in January 2020, and is as follows: Maximum Consolidated Fiscal Quarters Ending Leverage Ratio June 30, 2014 through March 31, 2015 3.00:1.00 June 30, 2015 through March 31, 2016 2.50:1.00 June 30, 2016 through March 31, 2017 2.25:1.00 June 30, 2017 and thereafter 2.00:1.00 At March 31, 2014 and December 31, 2013, our cash equivalents consist of short-term, investment-grade commercial paper and government debt. We classify our cash equivalents as current based on their nature and their availability for use in current operations. We believe the overall credit quality of our portfolio is strong, with a majority of our cash equivalents invested in federal government treasury bills of Canada, the U.S. and the U.K. We follow an investment policy where our excess cash is invested in investment-grade commercial paper and government debt, generally with a maturity of less than three months. There is no limit on the investments in the federal governments of Canada, the U.S. or the U.K. We diversify our portfolio by limiting the amount invested in any other single institution. We have defined benefit plans, primarily in the U.K., France and Germany. In addition, we have a multi-employer defined benefit pension plan in Switzerland. Our defined benefit pension plan in the U.K. is in place for a number of our past and present employees in the U.K. The plan has been closed to new members since 2001 and closed to new service since 2012. The plan is partially funded. At March 31, 2014, the plan had an unfunded pension liability of $64.1 million (December 31, 2013-$57.3 million). Contributions to fund the benefit obligations under this plan are based on actuarial valuations, which themselves are based on certain assumptions about the long-term operations of the plan, including the life expectancy of members, the performance of 31 -------------------------------------------------------------------------------- the financial markets and interest rates. The amount of annual employer contributions required to fund the pension deficit annually is determined every three years, in accordance with U.K. regulations and is based on a calendar year. In June 2013, the Company's annual funding requirement to fund the pension deficit for the 2014 calendar year was determined to be $5.4 million (£3.2 million), and will increase at an annual rate of 3% for the calendar years 2015 and 2016. As part of the acquisition of Aastra, we assumed certain unfunded pension obligations related to entities in France and Germany. In France, retirees generally benefit from a lump sum payment upon retirement or departure. In Germany, retirees generally benefit from the receipt of a perpetual annuity at retirement, based on their years of service and ending salary. At March 31, 2014, we had unfunded pension liabilities in France and Germany of $7.8 million and $16.9 million, respectively. We believe we will have sufficient liquidity to support our business operations for the next 12 months. However, we may elect to seek additional funding prior to that time. Our future capital requirements will depend on many factors, including our rate of revenue growth, the timing and extent of spending on restructuring and integration actions, the timing and extent of spending to support product development efforts and expansion of sales and marketing, the timing of introductions of new products and enhancements to existing products, and market acceptance of our products. Additional equity or debt financing may not be available on acceptable terms or at all. In addition, any proceeds from the issuance of debt may be required to be used, in whole or in part, to make mandatory payments under our credit agreements. Contractual Obligations The following table sets forth our contractual obligations as of March 31, 2014: Payments Due by Fiscal Year Last nine 2019 months and Contractual Obligations of 2014 2015 2016 2017 2018 beyond Total (in millions) Long-term debt obligations (1) $ 17.6 $ 22.1 $ 21.9 $ 21.8 $ 21.5 $ 357.2 $ 462.1 Capital lease obligations (2) 4.1 4.8 3.6 1.6 0.1 - 14.2 Operating lease obligations (3) 23.4 23.2 19.8 15.5 13.6 28.0 123.5 Defined benefit pension plan contributions (4) 4.0 5.6 5.7 - - - 15.3 Other (5) 4.5 3.4 - - - - 7.9 Total $ 53.6 $ 59.1 $ 51.0 $ 38.9 $ 35.2 $ 385.2 $ 623.0 (1) Represents the principal and interest payments on our term loan. Interest on our term loan is based on LIBOR plus 4.25% with LIBOR subject to a 1.00% floor. For the purposes of estimating the variable interest, the greater of the average 3-month LIBOR from the last three years (0.3%) and the LIBOR floor (1.00%) has been used. No amounts have been included for potential repayments relating to the annual repayment of excess cash flows as an estimate is not practicable. The first annual repayment of excess cash flows is due 100 days after December 31, 2014. (2) Represents the principal and interest payments for capital lease obligations. Interest rates on these obligations range from 5.3% to 9.0%. (3) Operating lease obligations exclude payments to be received by us under sublease arrangements. (4) Represents the expected contribution to our defined benefit pension plan in the U.K. The amount of annual employer contributions required to fund the U.K. plan's deficit is determined every three years in accordance with U.K. regulations. Future funding requirements after calendar year 2016 are dependent on the unfunded pension liability and the time period over which the deficit is amortized and have been excluded from the table. In addition, no amounts have been included for unfunded pension liabilities in France or Germany. Total cash payments under the pension plans in France and Germany for the year-ended December 31, 2014 are expected to be approximately $1.0 million. (5) Primarily represents payments under an information technology outsourcing agreement. Total contractual obligations listed do not include contractual obligations recorded on the balance sheet as current liabilities, except for those associated with a long-term liability. Contractual obligations also exclude $18.2 million of liabilities relating to uncertain tax positions due to the uncertainty of the timing of any potential payments. Purchase orders or contracts for the purchase of raw materials and other goods and services are not included in the table above. We are not able to determine the aggregate amount of such purchase orders that represent contractual obligations, as purchase orders may represent authorizations to purchase rather than binding agreements. 32 -------------------------------------------------------------------------------- Off-Balance Sheet Arrangements Off-balance sheet arrangements that have material changes from those disclosed in our Annual Report are as follows: Sales-type leases We offer our customers lease financing and other services under our managed services offering. We fund this offering, which we have branded as the TotalSolution® program, in part through the sale to financial institutions of rental payment streams under the leases. Such financial institutions have the option to require us to repurchase such income streams, subject to limitations, in the event of defaults by lease customers and, accordingly, we maintain reserves based on loss experience and past due accounts. In addition, such financial institutions have the option to require us to repurchase such income streams upon any uncured breach by us under the terms of the underlying sale agreements. At March 31, 2014, sold payments remaining unbilled net of lease recourse reserves, which represents the total balance of leases that are not included in our balance sheet, were $80.7 million (December 31, 2013-$87.8 million). Critical Accounting Policies The preparation of our consolidated financial statements and related disclosures in conformity with GAAP requires us to make estimates and assumptions about future events that can have a material impact on the amounts reported in our consolidated financial statements and accompanying notes. The determination of estimates requires the use of assumptions and the exercise of judgment and, as such, actual results could differ from those estimated. Our significant accounting policies are described in note 2 to our audited annual consolidated financial statements included in our Annual Report. The following critical accounting policies have been updated to reflect results to March 31, 2014: Sales-Type Leases, reserves Our total reserve for losses related to the entire lease portfolio, including amounts classified as accounts receivable on our balance sheet, was 3.9% of the ending aggregate lease portfolio as of March 31, 2014 compared to 4.0% at December 31, 2013. The reserve is based on a review of our past write-off experience and a review of the accounts receivable aging as of March 31, 2014. We believe our reserves are adequate to cover future potential write-offs. Should, however, the financial condition of our customers deteriorate in the future, additional reserves in amounts that could be material to the financial statements could be required. Allowance for Doubtful Accounts Our allowance for doubtful accounts is based on our assessment of the collectability of customer accounts. A considerable amount of judgment is required in order to make this assessment, including a detailed analysis of the aging of our accounts receivable, the current creditworthiness of our customers and an analysis of historical bad debts and other adjustments. If there is a deterioration of a major customer's creditworthiness or actual defaults are higher than our historical experience, our estimate of the recoverability of amounts due could be adversely affected. We review in detail our allowance for doubtful accounts on a quarterly basis and adjust the allowance amount estimate to reflect actual portfolio performance and change in future portfolio performance expectations. As of March 31, 2014 and December 31, 2013, the provision represented 5.4% and 4.8% of gross receivables, respectively. Stock-Based Compensation The fair value of the stock options granted is estimated on the grant date using the Black-Scholes option-pricing model for each award, net of estimated forfeitures, and is recognized over the employee's requisite service period, which is generally the vesting period. The assumptions used in the Black-Scholes option-pricing model for the options granted in the first quarter of 2014 are included in note 14 to the unaudited interim consolidated financial statements. For the three months ended March 31, 2014, stock-based compensation expense was $1.3 million (three months ended March 31, 2013-$1.1 million). As of March 31, 2014, there was $6.0 million of unrecognized stock-based compensation expense related to stock option awards (December 31, 2013-$6.0 million). We expect this cost to be recognized over a weighted average period of 2.5 years (December 31, 2013-2.3 years). Recent Accounting Pronouncements Classification of unrecognized tax benefits In July 2013, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2013-11 to include explicit guidance on the financial statement presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss carryforward or a tax credit carryforward exists. The ASU provides 33 -------------------------------------------------------------------------------- amendments to the Income Taxes subtopic of the FASB Accounting Standards Codification ("ASC"), such that generally, unrecognized tax benefits should be presented as a reduction of deferred tax assets created by net operating losses or tax credit carryforwards in the same jurisdiction. We adopted this ASU prospectively in the first quarter of 2014 by presenting certain unrecognized tax benefits as a reduction of deferred tax assets. The adoption did not have a material effect to our consolidated financial statements. Discontinued operations In April 2014, the FASB issued ASU 2014-08 to change the criteria for reporting discontinued operations such that disposals of small groups of assets will no longer qualify for discontinued operations presentation. The ASU provides amendments to the Presentation of Financial Statements and Property, Plant and Equipment subtopics of the FASB ASC. As a result of the ASU, only those disposals of components that represent a strategic shift that has or will have a major effect on the entity's operations will be reported as discontinued operations. We will adopt this ASU prospectively, no later than the first quarter of 2015. |