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CBEYOND, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Please read the following discussion together with our Condensed Consolidated Financial Statements and the related notes and other financial information included elsewhere in this periodic report and our Annual Report on Form 10-K. The discussion in this periodic report contains forward-looking statements that involve risks and uncertainties, such as statements of our plans, objectives, expectations, and intentions. The cautionary statements made in this report should be read as applying to all related forward-looking statements wherever they appear in this report. Our actual results could differ materially from those discussed here. See "Cautionary Notice Regarding Forward-Looking Statements" elsewhere in this report. Overview Cbeyond is the technology ally for small and mid-sized businesses. We enable our customers to focus on their core business activities by shifting the burden of IT infrastructure management to us. We deliver cloud-based services, communications services, and network connectivity through award-winning enterprise data centers and a private, all-IP enterprise network. Our strategy is based on the belief that small and mid-sized businesses highly value the capabilities and productivity such technologies and services enable, but do not generally have the resources, expertise, or time to purchase and manage them, particularly for the smaller scale of operations typical of our target customers. Founded in 1999, Cbeyond is a technology service provider with a long history of delivering innovative technologies and services to small and mid-sized businesses. We first launched our service offerings in Atlanta in April 2001 and have since expanded our on-net network and service offerings into 13 additional metropolitan markets. Our off-net network, which is managed by third-party network providers, extends the reach of our services across the majority of the United States. Recognizing that our greatest value proposition for customers is when we are able to bring them those technologies and services that are more resource intensive or difficult to obtain and manage, we focus more of our selling and service delivery efforts toward small and mid-sized businesses that are dependent on technology and have complex IT needs. Our research enables us to define and quantify a segment of the small-business customer market called the "technology-dependent" customer. Technology-dependent customers have the following characteristics: • The bulk of their employees use personal computers on the job; • They have knowledge workers who need to share data from a centralized source; • They have remote workers who need to access data on the go; • They need symmetric Metro Ethernet to run their business; • They are often multi-location businesses; and • They have a willingness to consider outsourcing their infrastructure as a way to preserve capital and increase both focus and productivity. In connection with our focus on technology-dependent customers, we defined certain of our technology-dependent customers as "Cbeyond 2.0" customers. Cbeyond 2.0 customers are those customers that we provide network access at speeds of 10 Mbps and higher, or certain cloud-based services, such as virtual servers, physical servers, or cloud PBX services. In addition, we designate customers using our MPLS service as Cbeyond 2.0 customers. We refer to all other customers as Cbeyond 1.0 customers. Although Cbeyond 1.0 customers also frequently purchase cloud-based services from us, we delineate between Cbeyond 1.0 and Cbeyond 2.0 based on how pervasive or significant we believe such services are to a customer's operation. Specifically, we consider the cloud-based services that qualify a customer as Cbeyond 2.0 as infrastructure-as-a-service in nature. We believe the distinction is important because infrastructure services are generally longer-term in nature, generate higher revenues, and provide a gateway for software-as-a-service products. We estimate that almost one-half of our customers are technology-dependent, but are not currently considered Cbeyond 2.0 customers because either they do not currently utilize cloud-based solutions or advanced network services, or they obtain these services from other providers. We believe this makes them strong prospects to become Cbeyond 2.0 customers. During the three months ended March 31, 2014, we generated $24.5 million, or 22.5% of revenue from Cbeyond 2.0 customers, which represents a 78.1% increase over the amount recognized from Cbeyond 2.0 customers during the three months ended March 31, 2013. In early 2012, we announced our plan to realign our distribution channels by building a new direct sales group dedicated to managing both existing and new technology-dependent customers, reducing our traditional direct sales force, and consolidating certain offices. Since our initial realignment actions, we have made and continue to make adjustments to our distribution channels and service organizations based on the experience gained in targeting technology-dependent customers. 14-------------------------------------------------------------------------------- Table of Contents In January 2014, we implemented a workforce reduction plan to rebalance our resources to support the continued implementation of this strategy and to address the current financial impacts of our transformation, including reducing expenses to offset a portion of expected revenue declines and the compression of margins. This workforce reduction plan affected approximately 100 employees and resulted in $2.3 million of realignment charges recognized in the first quarter of 2014. During the first quarter of 2014, we also closed or downsized certain branch offices, incurring approximately $0.3 million in losses under non-cancelable office leases. We have incurred cumulative realignment costs of $6.9 million as of March 31, 2014. On April 19, 2014, the Company entered into a definitive agreement to be acquired by Birch Communications, Inc. Under the terms of the agreement, which was unanimously approved by the Company's Board of Directors on April 19, 2014, the Company's stockholders will receive between $9.97 and $10.00 per share in cash, in a transaction valued at approximately $323.4 million. The exact amount that the Company's stockholders will receive will be based on the actual number of shares of the Company's common stock (including restricted stock) and stock options outstanding at the effective time of the transaction, which will be determined, in part, by stock transactions relating to previously granted stock awards to employees that occur after April 19, 2014. In connection with the transaction, Birch has obtained debt financing commitments from PNC Bank, National Association, PNC Capital Markets LLC and Jefferies Finance LLC. The transaction is subject to approval by the Company's stockholders, receipt of regulatory approvals and other customary closing conditions, and is expected to close in the third quarter of 2014. Revenue (in thousands) Three months ended March 31, Change from Previous Period 2014 2013 Dollars Percent 1.0 customer revenue $ 84,074 $ 106,214 $ (22,140 ) (20.8 )% 2.0 customer revenue 24,463 13,732 $ 10,731 78.1 % Total revenue $ 108,537 $ 119,946 $ (11,409 ) (9.5 )% Our focus on realigning our sales force to acquire higher-value customers has resulted in a lower number of new customers than we have achieved historically. Because of this, in recent periods, customer churn has exceeded new customer growth, resulting in a decline in customers and total revenue. We expect similar trends in the near-term until our realignment results in Cbeyond 2.0 customer revenue growth exceeding the revenue from churned Cbeyond 1.0 customers. Our revenue growth strategy includes offering service bundles that are increasingly oriented toward higher-value, technologically sophisticated solutions; however, a significant portion of our revenue base is derived from providing traditional telecommunications services. For the one-half of our existing customer base that we do not consider technology-dependent, traditional telecommunications services will continue to be our primary source of revenue. To support the higher bandwidth needs of technology-dependent customers, we are acquiring fiber network assets in multiple markets primarily under 20-year capital leases, including agreements for the indefeasible rights of use (or "IRU") of certain fiber network assets. During the three months ended March 31, 2014 and 2013, we took delivery of fiber assets with future minimum capital lease obligations of $1.2 million and $3.0 million, respectively. The cash outlays for these obligations are financed through fiber providers and will be payable by us as capital lease obligations. In addition to our fiber capital lease obligations, we have outstanding construction orders for fiber assets with future minimum lease payments of $10.7 million, for which we have obtained BAAs. As of March 31, 2014, we have placed additional construction orders that total $20.5 million for which we have not yet obtained BAAs. We do not expect to be able to obtain BAAs for every order placed. Therefore, we expect a portion of these orders may never be constructed. Additional construction orders may be placed under these contracts in the future. We currently include all revenue from customers who purchase network access from us within our average monthly revenue per customer location (or "ARPU") calculation. Thus, revenue from customers who purchase cloud-based services independent of network access is excluded from ARPU. After considering all cloud-based services, we believe that Cbeyond 2.0 customers currently provide a significantly higher ARPU than that of our Cbeyond 1.0 customers. We have not determined the revenue metrics that best represent the results of the consolidated business or the results from customers that purchase cloud-based services independent of network access. We have focused our sales efforts on customers that purchase both network and cloud-based services based on the belief that these services, when combined, offer the greatest value proposition to customers and allow us significantly greater control over the quality of services. Therefore, revenue from non-network customers has not grown as quickly as revenue from customers who purchase both network and cloud-based services from us. Given the significant revenue opportunities that we believe exist from non-network customers, we will begin actively selling certain cloud-based services, such as cloud PBX with mobile services, independent of network access. We expect that in the next few quarters these efforts will begin to result in higher revenue growth from non-network customers than in prior periods. 15-------------------------------------------------------------------------------- Table of Contents Calculation of ARPU (Dollar amounts in thousands, except ARPU) Three months ended March 31, 2014 2013 Total revenue $ 108,537 $ 119,946 Revenue from non-network customers $ (3,746 ) $ (3,650 ) (A) Network access customer revenue $ 104,791 $ 116,296 (B) Average network access customers 52,841 59,063 ARPU (A / B / number of months in period) $ 661 $ 656 As we accelerate sales of cloud-based services to both new and existing technology-dependent customers, we expect our revenue to include an increasing proportion of higher ARPU Cbeyond 2.0 customers. Our concentrated focus on technology-dependent customers has resulted in a net decline in customers in recent periods. Longer-term, we expect that ARPU will increase as our customer mix becomes more oriented to those who are technology-dependent and are using our services to satisfy their technology needs. In addition, we expect that our future capital expenditures and operating expenses will continue to be more focused on selling to these types of customers. Operating expenses will include the cost of revenue to support a higher bandwidth Metro Ethernet network and the selling expenses of a more focused and consultative sales force. Capital expenditures will include the costs of building out a higher bandwidth network, additional hosting infrastructure, and product development. Our chief operating decision maker uses Adjusted EBITDA and Free Cash Flow on a consolidated basis, accompanied by disaggregated revenue information by service offering, to assess the financial performance of the business. We believe Adjusted EBITDA and Free Cash Flow are important performance metrics for evaluating our ability to generate cash that can potentially be used by the business for capital investments, acquisitions, reduction of debt, or potential payment of dividends or share repurchases. We have also designed our corporate bonus plan to include Adjusted EBITDA as a component. Management believes that Adjusted EBITDA data should be available to investors so that investors have the same data that management employs in assessing operations. EBITDA is a non-GAAP financial measure commonly used by investors, financial analysts, and ratings agencies. EBITDA is generally defined as net income (loss) before interest, income taxes, depreciation, and amortization. However, we use Adjusted EBITDA, also a non-GAAP financial measure, to further exclude, when applicable, non-cash share-based compensation; public offering or acquisition-related transaction costs; purchase accounting adjustments; gains, losses, and other costs associated with asset dispositions; and non-operating income or expense. Adjusted EBITDA may exclude charges for employee severances, asset or facility impairments, other exit activity costs associated with a management directed plan (including realignment costs), and costs associated with our strategic review. We define Free Cash Flow as Adjusted EBITDA less cash capital expenditures. For purposes of calculating Free Cash Flow, we distinguish capital expenditures that require the up-front outlay of cash from those where payment is deferred on a longer-term basis. This distinction is driven primarily by the significant investments we are making to lease fiber network assets that generally have an expected useful life of 20 years, which is substantially longer than our typical asset lives. We believe this distinction is warranted and appropriate since these investments are expected to yield meaningful positive cash flows in future periods when the debt and lease payments occur. These favorable future cash flows will result from fiber infrastructure replacing a portion of the access and transport circuits previously leased from ILECs. Reconciliation of Capital Expenditures (in thousands) Three months ended March 31, 2014 2013 Cash capital expenditures (1) $ 12,929 $ 12,434 Non-cash capital expenditures: Fiber capital lease assets 1,242 3,017 Total capital expenditures $ 14,171 $ 15,451 (1) Represents cash purchases of property and equipment per the Condensed Consolidated Statements of Cash Flows. Adjusted EBITDA decreased $3.9 million, or 18.8% during the three months ended March 31, 2014 over the comparable period in 2013. The decline in Adjusted EBITDA reflects the decline in our customer base to whom we provide traditional telecommunications services, partially offset by an increase in revenue from Cbeyond 2.0 customers, a reduction in cost of revenue caused by recent changes in the way we assess telecommunication-related fees, and a lower average number of employees. 16-------------------------------------------------------------------------------- Table of Contents Reconciliation of Free Cash Flow and Adjusted EBITDA to Net loss (in thousands) Three months ended March 31, 2014 2013 Free Cash Flow $ 3,986 $ 8,399 Cash capital expenditures 12,929 12,434 Adjusted EBITDA $ 16,915 $ 20,833 Depreciation and amortization (16,191 ) (17,605 ) Non-cash share-based compensation (2,713 ) (2,979 ) Realignment costs (1) (2,631 ) (467 ) Strategic review costs (2) (710 ) - Costs associated with asset disposition (3) (100 ) - Interest expense, net (232 ) (153 ) Loss before income taxes (5,662 ) (371 ) Income tax expense (263 ) (185 ) Net loss $ (5,925 ) $ (556 ) (1) During the three months ended March 31, 2014, $2.6 million of realignment costs are included in Selling, general and administrative expense as compared to $0.5 million for the comparable period in 2013. See Note 5 to the Condensed Consolidated Financial Statements . (2) Amounts related to our strategic review primarily include fees incurred with bankers and advisors. (3) During the three months ended March 31, 2014, we incurred $0.1 million of costs related to our fiber dispute discussed in Note 10 to the Condensed Consolidated Financial Statements . Revenue Our revenue is disaggregated into Network, Voice and Data or Managed Hosting and Cloud. Managed Hosting and Cloud includes virtual servers, physical servers, and cloud PBX services to customers and distribution channels that are not limited by geographical location. Our focus is to provide these services to Network access customers; however, certain customers purchase these cloud-based services independent of network access. Managed Hosting and Cloud also includes other services, such as virtual receptionist, Microsoft® Exchange hosting, Web hosting, and fax-to-email, that are purchased by Network access customers in quantities that exceed those included in their bundled service package. We seek to sell our bundled service offerings through three-year contracts, but also offer one-year and two-year contracts at generally higher prices. As a result, customer churn rates impact our projected future revenue streams. We define customer churn rate for a given month as the number of Network access customers disconnected in that month divided by the total number of Network access customers at the beginning of that month. Due to differences in ARPU between Cbeyond 1.0 customers and Cbeyond 2.0 customers, we believe a unit-based churn metric may become less meaningful than it has been historically. In the future, we may transition to a revenue-based churn metric that will be applicable to all revenue, including revenue from customers that purchase cloud-based services independent of network access. Although not a significant source of our Network, Voice and Data revenue, we charge other communications companies for terminating calls to our customers on our network. Terminating access charges have historically grown at a slower rate than our customer base due to reductions in access rates on interstate calls as mandated by the Federal Communications Commission. These rate reductions are expected to continue in the future. We also charge our customers fees to recover a portion of the costs we incur to comply with regulations. Cost of Revenue Our cost of revenue represents costs directly related to the operation of our network and includes payments for access circuits, interconnection and transport fees, customer circuit installation costs, fees paid for Web hosting services, collocation rents and other facility costs, telecommunications-related taxes and fees, and the cost associated with our mobile offering. Cost of revenue associated with our cloud-based services includes licensing fees for the required operating systems, broadband service and access fees, and power for our data center facilities. The primary component of cost of revenue consists of the access fees paid to local telephone companies for circuits we lease on a monthly basis to provide connectivity to our customers. These access circuits link our customers to our network equipment located in a collocation facility, which we also generally lease from local telephone companies. 17-------------------------------------------------------------------------------- Table of Contents Historically, most of the circuits we leased have been T1s, which are the largest component of our circuit access fees. However, we have converted many of our existing customer T1 circuits and have begun serving new customers using higher-capacity Metro Ethernet in place of T1 circuits in a number of locations. Although not available to us on a ubiquitous basis in all areas, Ethernet technology provides us with the opportunity to offer a large percentage of our customers' bandwidth at speeds well in excess of T1 circuits while reducing our ongoing operating expenses. Costs related to our fiber network include maintenance and depreciation costs for dark fiber (or fiber provided by third parties and operated by us) and access fees for lit fiber (or fiber both provided and operated by third parties). We have experienced increases in access costs due to serving customers with higher-capacity Metro Ethernet and expect these increases to continue as we expand the number of such customers, particularly where we obtain these high bandwidth circuits through third parties. Cost of revenue also includes transport costs, which are primarily the costs we incur with ILECs for traffic between central offices where we have collocation equipment, traffic between our collocations and other wire centers, and intercity traffic between our markets. Another significant component of our cost of revenue is the cost associated with our mobile offering. These costs include usage-based charges, monthly recurring base charges, or some combination thereof, depending on the type of mobile product in service, and the cost of mobile equipment sold to our customers. The cost of mobile devices typically exceeds our selling price due to the highly competitive marketplace and traditional pricing practices for mobile services. We believe these costs are offset over time by the long-term profitability of our service contracts. We routinely negotiate and receive telecommunication billing recoveries from various local telephone companies to resolve prior errors in billing, including the effect of price decreases retroactively applied upon the adoption of new rates as mandated by regulatory bodies. We also receive payments from local telephone companies in the form of performance penalties that are assessed by state regulatory commissions based on the local telephone companies' performance in the delivery of circuits and other services. Because of the many factors that impact the amount and timing of telecommunication billing recoveries, we are often unable to estimate the outcome of these situations. Accordingly, we generally recognize telecommunication billing recoveries as offsets to cost of revenue when the ultimate resolution and amount are known and verifiable. These items do not follow any predictable trends and often result in variances when comparing the amounts received over multiple periods. In the future, through systematic improvements in process applications, and after gaining further historical experience, we may be able to more reliably estimate the outcome of telecommunication billing recoveries prior to being known and verifiable, which could result in earlier recognition of these recoveries. Selling, General and Administrative Expense Our selling, general and administrative expense consist of salaries and related costs for employees and other costs related to sales and marketing, engineering, IT, billing, regulatory, administrative, collections, legal, and accounting functions. In addition, bad debt expense and share-based compensation expense are included in selling, general and administrative expenses. Our selling, general and administrative expense includes both fixed and variable costs. Fixed costs include the cost of staffing certain corporate functions such as IT, marketing, administrative, billing and engineering, and other associated costs, such as office rent, legal and accounting fees, property taxes, and recruiting. Variable costs include commissions; bonuses; marketing materials; the cost of provisioning and customer activation staff, which varies with the level of new customer installations; and the cost of customer care and technical support staff, which varies with the level of total customers on our network and the complexity of our product offering. Also included in selling, general and administrative expense are realignment costs. These costs are related to our strategic shift to directly focus our selling and service delivery efforts toward the customers within our target market of technology-dependent small and mid-sized businesses that have complex IT needs. Realignment costs primarily relate to employee severances and facility exit costs. 18-------------------------------------------------------------------------------- Table of Contents Results of Operations Revenue (Dollar amounts in thousands, except ARPU) For the three months ended March 31, 2014 2013 Change from previous period % of % of Dollars Revenue Dollars Revenue Dollars Percent Revenue Network, Voice and Data $ 99,903 92.0 % $ 113,352 94.5 % $ (13,449 ) (11.9 )% Managed Hosting and Cloud 8,634 8.0 % 6,594 5.5 % 2,040 30.9 % Total revenue 108,537 119,946 (11,409 ) (9.5 )% Cost of revenue 36,556 33.7 % 38,788 32.3 % (2,232 ) (5.8 )% Gross profit (exclusive of depreciation and amortization): $ 71,981 66.3 % $ 81,158 67.7 % $ (9,177 ) (11.3 )% Network access customer data: Customer locations at period end 51,923 58,434 (6,511 ) (11.1 )% ARPU $ 661 $ 656 $ 5 0.8 % Average monthly churn rate 1.7 % 1.6 % 0.1 % Total revenue decreased in the three months ended March 31, 2014 compared to the three months ended March 31, 2013 due to a decline in the number of customers. Our realignment of distribution channels to focus on higher-value customers resulted in fewer new customers than churned customers. The increase in Managed Hosting and Cloud revenue is largely due to our focus on technology-dependent customers and sales of our cloud-based service offerings. Our focus on realigning our sales force to acquire higher-value customers has resulted in a lower number of new customers than we have achieved historically. Because of this, in recent periods, customer churn has exceeded new customer growth, resulting in a decline in customers and total revenue. We expect similar trends in the near-term until our realignment results in Cbeyond 2.0 customer revenue growth exceeding the revenue from churned Cbeyond 1.0 customers. ARPU increased $5, or 0.8%, in the three months ended March 31, 2014 compared to the comparable period in 2013. The increase in ARPU is due to an increasing proportion of higher ARPU, technology-dependent customers, partially offset by pricing pressure relating to our lower ARPU, Cbeyond 1.0 customers. Longer-term, we expect that our focus on technology-dependent customers, or Cbeyond 2.0 customers, and new product launches will continue to benefit ARPU. This expectation is evident by the current shift we are seeing between Network, Voice and Data revenue, which declined 11.9% in the three months ended March 31, 2014 compared to the comparable period in 2013, and Managed Hosting and Cloud revenue, which increased 30.9% in the three months ended March 31, 2014 compared to the comparable period in 2013. These results reflect the growth of our flagship cloud offerings, TotalCloud Phone System and TotalCloud Data Center. Our average customer churn rate was 1.7% in the three months ended March 31, 2014, representing a slight increase over the three months ended March 31, 2013, but consistent with recent periods. The increase from 1.6% in the three months ended March 31, 2013 is primarily attributable to price competition for smaller communications-centric customers and a reduced emphasis on retaining lower-ARPU, communications-centric customers from whom we do not expect to be able to generate acceptable profit margins in the future. This shift in focus on retaining high-quality revenues rather than the number of customers served may result in a continued elevation of customer churn rates in the near-term. 19-------------------------------------------------------------------------------- Table of Contents Cost of Revenue (Dollar amounts in thousands) For the three months ended March 31, 2014 2013 Change from previous period % of % of Dollars Revenue Dollars Revenue Dollars Percent Cost of revenue (exclusive of depreciation and amortization): Circuit access fees $ 18,363 16.9 % $ 18,207 15.2 % $ 156 0.9 % Other cost of revenue 9,793 9.0 % 11,170 9.3 % (1,377 ) (12.3 )% Transport cost 5,823 5.4 % 6,220 5.2 % (397 ) (6.4 )% Mobile cost 3,336 3.1 % 4,212 3.5 % (876 ) (20.8 )%Telecommunications cost recoveries (759 ) (0.7 )% (1,021 ) (0.9 )% 262 (25.7 )% Total cost of revenue $ 36,556 33.7 % $ 38,788 32.3 % $ (2,232 ) (5.8 )% Cost of revenue decreased in the three months ended March 31, 2014 compared to the three months ended March 31, 2013, largely as a result of changes in the way we assess telecommunication-related fees and from serving fewer mobile subscribers. These reductions were partially offset by higher circuit costs attributable to delivering higher bandwidth circuits to our customers. Circuit access fees, or line charges, represent the largest single component of cost of revenue. These costs primarily relate to the usage of circuits that connect our equipment at network points of collocation to our equipment located at our customers' premises. Changes in circuit access fees have historically correlated to changes in the number of customers, but there are a number of influences in recent periods that have reduced the level of correlation. We are experiencing increases in access costs as we provide higher bandwidth to our customers. As we serve more technology-dependent customers with higher bandwidth needs, we expect access costs to initially increase. We are able to generate much higher revenue from these customers due to the breadth and type of services enabled by higher bandwidth. In the longer term, as we are able to meaningfully leverage our own fiber network we expect our access costs on a per-customer basis to decline, and we expect an increase in our depreciation expense as a significant portion of our fiber network assets are acquired under capital leases. Other cost of revenue includes components such as long distance charges, installation costs to connect new circuits, the cost of local interconnection with ILECs' networks, Internet access costs, the cost of third-party service offerings we provide to our customers, costs to deliver our cloud-based services, and certain taxes and fees. The decrease in other cost of revenue in the three months ended March 31, 2014 compared to the three months ended March 31, 2013 relates primarily to recent changes in the way we assess telecommunication-related fees, which reduces the amount of universal service fund charges. We expect these savings to continue in future periods. The decrease in transport costs is primarily due to our efforts to optimize our network by regrooming and consolidating transport circuits. Longer-term, as we continue to optimize our network and leverage our fiber network, we expect transport costs on a per-customer basis to decline, partially offset by an increase in depreciation related to our fiber network. Mobile costs decreased both in amount and as a percentage of revenue in the three months ended March 31, 2014 compared to the three months ended March 31, 2013. The primary driver of this decrease is a reduction in mobile subscribers, resulting in lower mobile service costs as well as lower shipments of mobile devices. We expect the average cost of our mobile devices to increase as a result of us offering the iPhone beginning in the fourth quarter of 2013. In 2014, we will begin actively selling an integrated bundle of cloud PBX and mobile services to customer prospects nationwide. In the next few quarters this may begin to result in higher shipments of mobile devices 20-------------------------------------------------------------------------------- Table of Contents Selling, General and Administrative and Other Operating Expenses (Dollar amounts in thousands) For the three months ended March 31, 2014 2013 Change from previous period % of % of Dollars Revenue Dollars Revenue Dollars Percent Selling, general and administrative (exclusive of depreciation and amortization) Salaries, wages and benefits (exclusive of share-based compensation) $ 32,994 30.4 % $ 39,425 32.9 % $ (6,431 ) (16.3 )% Share-based compensation 2,713 2.5 % 2,979 2.5 % (266 ) (8.9 )% Marketing cost 1,205 1.1 % 529 0.4 % 676 127.8 % Realignment costs 2,631 2.4 % 467 0.4 % 2,164 463.4 % Strategic review costs 710 0.7 % - - 710 nm Other selling, general and administrative 20,967 19.3 % 20,371 17.0 % 596 2.9 % Total SG&A $ 61,220 56.4 % $ 63,771 53.2 % $ (2,551 ) (4.0 )% Other operating expenses: Depreciation and amortization 16,191 14.9 % 17,605 14.7 % (1,414 ) (8.0 )% Total other operating expenses $ 16,191 14.9 % $ 17,605 14.7 % $ (1,414 ) (8.0 )% Other data: Average employees 1,366 1,662 (296 ) (17.8 )% Selling, general and administrative expense decreased $2,551 in the three months ended March 31, 2014 compared to the prior year primarily due to a lower average number of employees, partially offset by higher realignment costs and our review of strategic alternatives to increase shareholder value. Salaries, wages and benefits decreased $6,431 in the three months ended March 31, 2014 compared to the prior year due to a lower average number of employees and a decrease in commissions. We reduced the size of our traditional direct sales force in both 2012 and 2013 while adding a new sales force comprised of more experienced professionals dedicated to Cbeyond 2.0 opportunities. In 2014, we further reduced our workforce to rebalance our resources to support the continued implementation of our strategic realignment. Increased spending on lead generation services resulted in a $676 increase in marketing costs during the three months ended March 31, 2014 compared to 2013. These services will assist our sales force in focusing their sales and marketing efforts on qualified potential customers. Share-based compensation expense decreased $266 during the three months ended March 31, 2014 compared to 2013, primarily due to a decline in the fair value of awards granted based on lower share prices in recent periods. As our share price has declined, we have experienced decreases in our share-based compensation expense related to the vesting of higher valued awards granted in prior years. Costs incurred relating to our strategic realignment and other reorganization efforts resulted in $2.6 million and $0.5 million of selling, general and administrative expense in the three months ended March 31, 2014 and March 31, 2013, respectively. Realignment costs in the three months ended March 31, 2014 consisted of $2.3 million for employee severances and benefits and $0.3 million for losses under non-cancelable office leases. In 2013, realignment costs consisted of $0.5 million for employee severances and benefits. Strategic review costs primarily include fees incurred with bankers and advisors that assisted our Strategy Committee. Other selling, general and administrative expenses primarily include professional fees, outsourced services, rent and other facilities costs, maintenance, recruiting fees, travel and entertainment costs, property taxes, and bad debt expense. Other selling, general and administrative expense during the three months ended March 31, 2014 was higher than 2013 due to consulting and outsourced services relating to business process reviews, redesign, and outsourcing; an increase in hardware and software maintenance; and legal fees related to our fiber dispute discussed in Note 10 to the Condensed Consolidated Financial Statements . 21-------------------------------------------------------------------------------- Table of Contents Bad debt expense was $1.1 million, or 1.0% of revenue, during the three months ended March 31, 2014 compared to $0.9 million, or 0.8% of revenue, during the three months ended March 31, 2013. This represents a slight increase in bad debt expense over the prior year but is consistent with recent periods. These increases were partially offset by declines in recruiting fees. Depreciation and amortization decreased 8.0% during the three months ended March 31, 2014 compared to the three months ended March 31, 2013, primarily due to our recent investments in longer-lived fiber network assets and a gradual decline in total capital expenditures in recent periods. Operating Loss For the three months ended March 31, 2014 and 2013, our operating loss was $5.4 million and $0.2 million, respectively. The operating loss during the three months ended March 31, 2014 was primarily driven by a $9.2 million reduction in gross profit which reflects the decline in our customer base to whom we provide traditional telecommunications services, partially offset by an increase in revenue from Cbeyond 2.0 customers and a reduction in cost of revenue caused by recent changes in the way we assess telecommunication-related fees. Selling, general and administrative expenses declined $2.6 million primarily due to a lower average number of employees, partially offset by higher realignment costs and our review of strategic alternatives to increase shareholder value. Interest and Income Taxes (Dollar amounts in thousands) For the three months ended March 31, 2014 2013 Change from previous period % of % of Dollars Revenue Dollars Revenue Dollars Percent Interest expense, net $ (232 ) (0.2 )% $ (153 ) (0.1 )% $ (79 ) 51.6 % Income tax expense (263 ) (0.2 )% (185 ) (0.2 )% (78 ) 42.2 % Total $ (495 ) $ (338 ) $ (157 ) 46.4 % We recognize our 2014 interim period income tax expense based on our year-to-date effective tax rate because our estimated annual tax rate fluctuates significantly from only slight variances in estimated annual income. The three months ended March 31, 2014 income tax expense primarily relates to the tax goodwill amortization that will likely remain non-deductible for book purposes and state income tax expense levied by Texas, which imposes a gross receipts-based tax due regardless of profit levels. This tax is not dependent upon levels of pre-tax income and has a significant influence on our effective tax rate. Liquidity and Capital Resources (Dollar amounts in thousands) |