TMCnet News
ZAYO GROUP LLC - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) Information contained in this Annual Report on Form 10-K (this "Report"), in other filings by Zayo Group, LLC ("we" or "us"), with the Securities and Exchange Commission (the "SEC") in press releases and in presentations by us or our management that are not historical by nature constitute "forward-looking statements," which can be identified by the use of forward-looking terminology such as "believes," "expects," "plans," "intends," "estimates," "projects," "could," "may," "will," "should," or "anticipates," or the negatives thereof, other variations thereon or comparable terminology, or by discussions of strategy. No assurance can be given that future results expressed or implied by the forward-looking statements will be achieved and actual results may differ materially from those contemplated by the forward-looking statements. Such statements are based on management's current expectations and beliefs, and are subject to a number of risks and uncertainties that could cause actual results to differ materially from those expressed or implied by the forward-looking statements. These risks and uncertainties include, but are not limited to, those relating to our financial and operating prospects, current economic trends, future opportunities, ability to retain existing customers and attract new ones, our acquisition strategy and ability to integrate acquired companies and assets, outlook of customers, reception of new products and technologies, and strength of competition and pricing. Other factors and risks that may affect our business and future financial results are detailed in our SEC filings, including, but not limited to, those described under "Item 1A: Risk Factors" and in this "Management's Discussion and Analysis of Financial Condition and Results of Operations." We caution you not to place undue reliance on these forward-looking statements, which speak only as of their respective dates. We undertake no obligation to publicly update or revise forward-looking statements to reflect events or circumstances after the date of this Report or to reflect the occurrence of unanticipated events, except as may be required by law. The following discussion and analysis should be read together with our audited consolidated financial statements and the related notes appearing elsewhere in this Report. Amounts presented in this Item 7 are rounded. As such, rounding differences could occur in period-over-period changes and percentages reported throughout this Item 7. Overview Introduction We are a large and fast growing provider of bandwidth infrastructure in the United States and Europe. Our products and services enable mission-critical, high-bandwidth applications, such as cloud-based computing, video, mobile, social media, machine-to-machine connectivity, and other bandwidth-intensive applications. Key products include leased dark fiber, fiber to cellular towers and small cell sites, dedicated wavelength connections, Ethernet and IP connectivity and other high-bandwidth offerings. We provide our services over a unique set of dense metro, regional, and long-haul fiber networks and through our interconnect-oriented datacenter facilities. Our fiber networks and datacenter facilities are critical components of the overall physical network architecture of the Internet and private networks. Our customer base includes some of the largest and most sophisticated consumers of bandwidth infrastructure services, such as wireless service providers; telecommunications service providers; financial services companies; social networking, media, and web content companies; education, research, and healthcare institutions; and governmental agencies. We typically provide our bandwidth infrastructure services for a fixed monthly recurring fee under contracts that vary between one and twenty years in length. As of June 30, 2014, we had more than $4.6 billion in revenue under contract with a weighted average remaining contract term of approximately 43 months. We operate our business with a unique focus on capital allocation and financial performance with the ultimate goal of maximizing equity value for our stockholders. Our core values center on partnership, alignment, and transparency with our three primary constituent groups-employees, customers, and stockholders. We are a wholly-owned subsidiary of Zayo Group Holdings, Inc., a Delaware corporation ("Holdings"), which is in turn wholly owned by Communications Infrastructure Investments, LLC, a Delaware limited liability company ("CII"). Our fiscal year ends June 30 each year, and we refer to the fiscal year ended June 30, 2012 as "Fiscal 2012," the fiscal year ended June 30, 2013 as "Fiscal 2013," and the fiscal year ended June 30, 2014 as "Fiscal 2014." 25-------------------------------------------------------------------------------- Table of Contents Our Segments We use the management approach to determine the segment financial information that should be disaggregated and presented. The management approach is based on the manner by which management has organized the segments within the Company for making operating decisions, allocating resources, and assessing performance. As of June 30, 2014, we have two reportable segments as described below: Physical Infrastructure. Through our Physical Infrastructure segment, we provide raw bandwidth infrastructure to customers that require more control of their internal networks. These services include dark fiber, mobile infrastructure (fiber-to-the-tower and small cell), and colocation and interconnection. Dark fiber is a physically separate and secure, private platform for dedicated bandwidth. We lease dark fiber pairs (usually two to 12 total fibers) to our customers, who "light" the fiber using their own optronics. Our mobile infrastructure services provide direct fiber connections to cell towers, small cells, hub sites, and mobile switching centers. Our datacenters offer colocation and interconnection services to our customers, who then house and power computing and networking equipment for the purpose of aggregating and distributing data, voice, Internet, and video traffic. The contract terms in our Physical Infrastructure segment generally range from three to twenty years. Lit Services. Our Lit Services segment provides bandwidth infrastructure solutions over our metro, regional, and long-haul fiber networks where we use optronics to light the fiber and our customers pay us for access based on the amount and type of bandwidth they purchase. Our lit services include wavelength, Ethernet, IP, and SONET services. We target customers who require a minimum of 10G of bandwidth across their networks. The contract terms in this segment typically range from two to five years. Factors Affecting Our Results of Operations Business Acquisitions We were founded in 2007 with the investment thesis of building a bandwidth infrastructure platform to take advantage of the favorable Internet, data, and wireless growth trends driving the demand for bandwidth infrastructure, and to be an active participant in the consolidation of the industry. These trends have continued in the years since our founding, despite volatile economic conditions, and we believe that we are well positioned to continue to capitalize on those trends. We have built a significant portion of our network and service offerings through 32 acquisitions to date. As a result of the growth of our business from these acquisitions, and capital expenditures and the increased debt used to fund those investing activities, our results of operations for the respective periods presented and discussed herein are not comparable. Significant Acquisitions AboveNet, Inc. ("AboveNet") On July 2, 2012, we acquired 100% of the outstanding capital stock of AboveNet, a public company listed on the New York Stock Exchange, for total consideration of approximately $2,212.5 million in cash, net of $139.1 million of cash acquired. At the closing, each outstanding share of AboveNet common stock was converted into the right to receive $84 in cash. AboveNet was a provider of bandwidth infrastructure and network-neutral colocation and interconnection services, primarily to large corporate enterprise clients and communication carriers, including Fortune 1000 and FTSE 500 companies in the United States and Europe. AboveNet's commercial strategy was consistent with ours, which was to focus on leveraging its infrastructure assets to provide bandwidth infrastructure services to a select set of customers with high-bandwidth demands. AboveNet provided physical infrastructure and lit services over its dense metropolitan, regional, national, and international fiber networks. It also operated a Tier 1 IP network with direct and indirect (through peering arrangements) connectivity in many of the most important bandwidth centers and peering exchanges in the U.S. and Europe. Its product set was highly aligned with our own, consisting primarily of dark fiber, wavelengths, Ethernet, IP, and colocation services. AboveNet had also built a very strong base of business with enterprise clients, particularly within the financial services sector. The acquisition of AboveNet added approximately 20,600 new route miles and approximately 2,500,000 fiber miles to our network and added connections to approximately 4,000 on-net buildings, including more than 2,600 enterprise locations, many of which housed some of the largest corporate users of network services in the world. AboveNet's metropolitan networks typically contained 432, and in some cases 864, fiber strands in each cable. This high fiber count allowed AboveNet to add new 26-------------------------------------------------------------------------------- Table of Contents customers in a timely and cost-effective manner by focusing incremental construction and capital expenditures on the laterals that connect to the customer premises. AboveNet's metropolitan networks served 17 markets in the U.S., with strong network footprints in a number of the largest metro markets, including Boston, Chicago, Los Angeles, New York, Philadelphia, San Francisco, Seattle, and Washington, D.C. It also served four metro markets in Europe: London, Amsterdam, Frankfurt, and Paris. These locations also included many private datacenters and hub locations that were important for AboveNet's customers. AboveNet used under-sea capacity on the Trans-Atlantic undersea telecommunications network and other trans-Atlantic cables to provide connectivity from the U.S. to Europe. The results of the acquired AboveNet business are included in our operating results beginning July 2, 2012. 360networks Holdings (USA) Inc. ("360networks") On December 1, 2011, we acquired 100% of the equity of 360networks. We paid the purchase consideration of approximately $317.9 million, net of approximately $0.7 million in cash acquired and net of an assumed working capital deficiency of approximately $26.4 million. The acquired 360networks business operated approximately 19,800 route miles of intercity and metropolitan fiber network across 21 states and British Columbia. 360networks' intercity network interconnected over 70 markets across the central and western United States. In addition to its intercity network, 360networks operated over 800 route miles of metropolitan fiber networks across 25 markets, including Seattle, Denver, Colorado Springs, Omaha, Sacramento, and Salt Lake City. The results of the acquired 360networks business are included in our operating results beginning December 1, 2011. Geo Networks Limited ("Geo") On May 16, 2014, we acquired all of the outstanding shares of Geo, which is a London-based dark fiber provider. The purchase consideration of £174 million ($292.3 million), net of approximately £8.2 million ($13.7 million) in cash acquired, was paid with a combination of cash on hand and available funds drawn on our $250 million revolving credit facility. Geo owns and operates a high capacity fiber network in the United Kingdom, providing dark fiber and co-location services to a variety of high-bandwidth sectors including media companies, service providers, financial services, datacenters, and gaming organizations. The acquisition added over 2,100 route miles to our European network and additional connectivity to 587 on-net buildings. The results of the acquired Geo business are included in our operating results beginning May 16, 2014. Summary of Business Acquisitions The table below summarizes the dates and purchase prices (which are net of cash acquired and includes assumption of debt and capital leases) of all acquisitions and asset purchases through June 30, 2014. 27-------------------------------------------------------------------------------- Table of Contents Acquisition Date Acquisition Cost (in thousands) Memphis Networx July 31, 2007 $ 9,173 PPL Telecom August 24, 2007 46,301 Indiana Fiber Works September 28, 2007 22,601 Onvoy November 7, 2007 69,962 Voicepipe November 7, 2007 2,800 Citynet Fiber Networks February 15, 2008 99,238 Northwest Telephone May 30, 2008 5,181 CenturyTel Tri-State Markets July 22, 2008 2,700 Columbia Fiber Solutions September 30, 2008 12,091 CityNet Holdings Assets September 30, 2008 3,350 Adesta Assets September 30, 2008 6,430 Northwest Telephone California May 26, 2009 15 FiberNet September 9, 2009 96,571 AGL Networks July 1, 2010 73,666 Dolphini Assets September 20, 2010 235 American Fiber Systems October 1, 2010 114,141 360networks December 1, 2011 317,891 MarquisNet December 31, 2011 13,581 Arialink May 1, 2012 17,129 AboveNet July 2, 2012 2,210,043 FiberGate August 31, 2012 118,335 USCarrier October 1, 2012 16,092 FTS December 14, 2012 109,700 Litecast December 31, 2012 22,160 Core NAP May 31, 2013 7,080 Corelink August 1, 2013 16,128 Access October 1, 2013 40,068 FiberLink October 2, 2013 43,137 CoreXchange March 4, 2014 17,503 Geo May 16, 2014 292,332 Less portion of acquisition costs spun off to OVS, ZEN and ZPS (89,165 ) Total $ 3,716,469 We completed each of the acquisitions described above, with the exception of Voicepipe and Corelink, with cash raised through combinations of equity issuances and the incurrence of debt. We acquired Voicepipe from certain existing CII equity holders in exchange for CII preferred units, and we acquired Corelink with a combination of cash and CII preferred units. During Fiscal 2013, the results of the operations of ZPS are presented in a single caption entitled, "Earnings from discontinued operations, net of income taxes" on our consolidated statements of operations. All discussions contained in this "Management's Discussion & Analysis of Financial Conditions and Results of Operations" relate only to our results of operations from continuing operations. Recently Closed Acquisitions On July 1, 2014, we acquired a 96% equity interest in Neo Telecoms ("Neo"), a Paris-based bandwidth infrastructure company, for a purchase price of €57.2 million ($79.3 million based on the foreign currency exchange rate on that date). The purchase price was funded with cash on hand available from the proceeds of the Sixth Amendment to our Term Loan Facility. The acquisition of Neo added over 300 route miles of owned Paris metro fiber and approximately 540 on-net buildings to our 28-------------------------------------------------------------------------------- Table of Contents network. Neo also operates nine colocation centers across France, offering more than 36,000 square feet of datacenter space. The Paris and regional network throughout France will be integrated into our existing European network connecting London, Frankfurt, and Amsterdam and the U.S. The results of the acquired Neo business are not included in our operating results presented herein, as the acquisition closed July 1, 2014. On July 1, 2014, we acquired Colo Facilities Atlanta ("AtlantaNAP"), a data center and managed services provider in Atlanta, for a purchase price of $52.5 million. The purchase price was paid with cash on hand. The acquisition of AtlantaNAP added approximately 72,000 square feet of total data center space, including 42,000 square feet of conditioned colocation space. The results of the acquired AtlantaNAP business are not included in our operating results presented herein, as the acquisition closed July 1, 2014. Debt and Equity Financing We had total indebtedness (excluding capital lease obligations) of $3,240.1 million and $2,830.7 million as of June 30, 2014 and 2013, respectively. As of June 30, 2014, our indebtedness consisted of $750.0 million aggregate principal amount of 8.125% senior secured first-priority notes due 2020 (the "Senior Secured Notes"), $500.0 million of 10.125% senior unsecured notes due 2020 (the "Senior Unsecured Notes," and together with the Senior Secured Notes, the "Notes"), and a $1,990.1 million senior secured term loan facility (the "Term Loan Facility"). The interest rate on the Term Loan Facility is floating based on LIBOR (subject to a floor of 1.0%) plus the applicable margin and was 4.00% and 4.50% as of June 30, 2014 and 2013, respectively. We also have a $250 million senior secured revolving credit facility (the "Revolver"), which was undrawn as of June 30, 2014. On May 16, 2014, we entered into a Sixth Amendment (the "Sixth Amendment") to the credit agreement governing the Term Loan Facility and Revolver (the "Credit Agreement"). The Sixth Amendment increased the Company's Term Loan Facility by $275.0 million. The $275.0 million add-on was priced at 99.5%. No other terms of the Credit Agreement were amended. In August 2012, we entered into interest rate swap agreements with an aggregate notional value of $750.0 million and a maturity date of June 30, 2017. The contracts state that we pay a 1.67% fixed rate of interest for the term of the agreement, which began June 30, 2013. The counterparties pay to us the greater of actual LIBOR or 1.25%. We entered into the swap arrangements to reduce the risk of increased interest costs associated with potential future increases in LIBOR rates. As of June 30, 2014, the estimated fair value of the interest rate swaps was a liability of $2.0 million. Substantial Capital Expenditures During Fiscal 2014, 2013, and 2012, we invested, net of stimulus grant reimbursements, $360.8 million, $323.2 million, and $124.1 million, respectively, in capital expenditures primarily to expand our fiber network to support new customer contracts. We expect to continue to make significant capital expenditures in future periods. During Fiscal 2013 and 2012, we received a total of $9.3 million and $22.8 million, respectively, in grant money from the National Telecommunications and Information Administration's Broadband Technology Opportunities Program ("BTOP") for reimbursement of property and equipment expenditures. We did not receive any grant money during the year ended June 30, 2014. The BTOP program is intended to support the deployment of broadband infrastructure, encourage sustainable adoption of broadband service, and develop and maintain a nationwide public map of broadband service capability and availability, under which recipients are required to comply with certain operational and reporting requirements as it relates to these broadband infrastructure assets. The Company has accounted for these funds as a reduction of the cost of its fiber optic network. 29-------------------------------------------------------------------------------- Table of Contents Critical Accounting Policies and Estimates This discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States ("GAAP"). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue, expenses and related disclosures. We base our estimates on historical results which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We evaluate these estimates on an ongoing basis. Actual results may differ from these estimates under different assumptions or conditions. We have accounting policies that involve estimates such as the allowance for doubtful accounts, revenue reserves, useful lives of long-lived assets, fair value of our common and preferred units issued as compensation, accruals for estimated tax and legal liabilities, accruals for exit activities associated with real estate leases, accruals for customer disputes and valuation allowance for deferred tax assets. We have identified the policies below, which require the most significant judgments and estimates to be made in the preparation of our consolidated financial statements, as critical to our business operations and an understanding of our results of operations. Revenue and Trade Receivables We recognize revenue derived from leasing fiber optic telecommunications infrastructure and the provision of telecommunications and colocation services when the service has been provided and when there is persuasive evidence of an arrangement, the fee is fixed or determinable and collection of the receivable is reasonably assured. Taxes collected from customers and remitted to government authorities are excluded from revenue. Approximately 95% of revenue is billed in advance on a fixed-rate basis. The remainder of revenue is billed in arrears on a transactional basis determined by customer usage. The Company often bills customers for upfront charges, which are non-refundable. These charges relate to down payments or prepayments for future services and are influenced by various business factors including how the Company and customer agree to structure the payment terms. If the upfront payment made by a customer provides no benefit to the customer beyond the contract term, the upfront charge is deferred and recognized as revenue ratably over the contract term. If the upfront payment provides benefit to the customer beyond the contract term, the charge is recognized as revenue over the estimated life of the customer relationship. Revenue attributable to leases of dark fiber pursuant to IRUs are accounted for in the same manner as the accounting treatment for sales of real estate with property improvements or integral equipment. This accounting treatment typically results in the deferral of revenue for the cash that has been received and the recognition of revenue ratably over the term of the agreement (generally up to 20 years). Revenue is recognized at the amount expected to be realized, which includes billing and service adjustments. During each reporting period, we make estimates for potential future sales credits to be issued in respect of current revenue, related to service interruptions and customer disputes, which are recorded as a reduction in revenue. We analyze historical credit activity when evaluating our credit reserve requirements. We reserve for known service interruptions as incurred. We review customer disputes and reserve against those we believe to be valid claims. The determination of the customer dispute credit reserve involves significant judgment, estimations and assumptions. We defer recognition of revenue until cash is collected on certain components of revenue, principally contract termination charges and late fees. We estimate the ability to collect our receivables by performing ongoing credit evaluations of our customers' financial condition, and provide an allowance for doubtful accounts based on expected collection of our receivables. Our estimates are based on assumptions and other considerations, including payment history, credit ratings, customer financial performance, industry financial performance and aging analysis. Stock-Based Compensation We account for our stock-based compensation in accordance with the provisions of ASC 718-Compensation: Stock Compensation, which requires stock compensation to be recorded as either liability or equity awards based on the terms of the grant agreement. The CII common units granted to employees were considered to be stock-based compensation with terms that required the awards to be classified as liabilities due to cash settlement features. As such, we accounted for these awards as a liability and re-measured the liability to its fair value at each reporting date until the date of settlement, which requires the use of significant judgments and estimates. At each reporting period, we adjust the value of the vested portion of our liability awards to their fair value. The preferred units of CII granted to certain employees and directors were considered to be stock-based compensation with terms that required the awards to be classified as equity. As such, we accounted for these awards as 30-------------------------------------------------------------------------------- Table of Contents equity, which required us to determine the fair value of the award on the grant date and amortize the related expense over the vesting period of the award. We used a third party valuation firm to assist in the valuation of the CII common units at each reporting period and the CII preferred units when granted. In developing a value for these units, a two-step valuation approach was used. In the first step, we estimated the value of our equity through an analysis of valuations associated with various future potential liquidity scenarios. The second step involved allocating these values across our capital structure. The valuation was conducted in consideration of the guidance provided in the American Institute of Certified Public Accountants ("AICPA") Practice Aid "Valuation of Privately-Held Company Equity Securities Issued as Compensation" and with adherence to the Uniform Standards of Professional Appraisal Practice set forth by the Appraisal Foundation. We allocate value to each class of stock using the Probability Weighted Expected Return Method ("PWERM"). The unit value was based on a probability-weighted present value of expected future proceeds to our shareholders, considering each potential liquidity scenario available to us as well as preferential rights of each security. The potential scenarios that we considered within the PWERM framework were remaining a private company with the same ownership, a sale or merger, and an initial public offering ("IPO"). The PWERM utilizes a variety of assumptions regarding the likelihood of a certain scenario occurring, if the event involves a transaction, the potential timing of such an event, and the potential valuation that each scenario might yield. We more heavily weighted the valuation estimate associated with an IPO as compared to remaining a private entity with the same ownership, with the least weight applied to the company sale assumption. Within the PWERM framework, management also considered various liquidation possibilities, including an IPO and a sale or merger. In each of these scenarios, a distribution is established around the estimated exit dates and valuations of each scenario. Future valuation figures are based upon corresponding market data for comparable companies in comparable scenarios. These include publicly-traded valuation statistics and acquisition valuation statistics for comparable companies in the IPO scenario and sale/merger scenario, respectively. Valuation statistics are combined with expectations regarding our future economic performance to produce future valuation estimates. Estimates are then discounted to the present using our estimated cost of equity as the discount rate. In the scenario where the Company remains private, or status quo scenario, we estimated our total equity value using a discounted cash flow approach, which involved developing a projected free cash flow, estimating an appropriate risk adjusted present value discount rate, calculating the present value of our projected free cash flows, and calculating a terminal value. There were several inputs that were required to develop an estimate of the enterprise value under the status quo scenario, including forecasted earnings, discount rate, and the terminal multiple and/or the capitalization factor. We have developed a forecast of our revenues and EBITDA through June 30, 2019. Our forecasted revenues and EBITDA are based on our business operations as of the balance sheet date. If a material acquisition has occurred or has a high probability of occurring subsequent to the balance sheet date, the forecast utilized in the valuation reflects the pro forma results of operations of the combined entities. The next step in the income approach was to estimate a discount rate that most appropriately reflected our cost of capital, which we estimated to be 10.53% as of June 30, 2014. In determining this discount rate, we utilized a weighted average cost of capital ("WACC") utilizing the Capital Asset Pricing Model ("CAPM") build-up method. This method derived the cost of equity in part from the volatility (risk) statistics suggested by the Guideline Public Companies in the form of their five year historical betas. We included certain incremental risk premiums specific to us to account for the fact that we have historically depended on outside investment to operate and have a history of substantial volatility in earnings and cash flows. Based on our projections and estimated discount rate, we calculated the present value of our future cash flows. In order to estimate the enterprise value, we added to the estimated discounted cash flows an estimated terminal value. The H-Model reflected us as a going concern after the projection period by assuming that free cash flows grow at a supernormal rate starting in July 2019 and linearly taper to a long-term growth rate consistent with estimated inflation over a period of five years. These assumptions were used to construct a capitalization factor that was applied directly to the terminal year free cash flow, producing a terminal value specific to the H-Model Method. Both terminal values were converted into a present value through discounting by our WACC. The terminal value was estimated utilizing the "H-Model" method and "Observed Market Multiple" method. Next, the Observed Market Multiple method assumed we would be sold at the end of the forecast period. To develop a terminal multiple, we observed prevailing valuations associated with the Guideline Public Companies and the acquisitions of Guideline Public Companies. A terminal EBITDA multiple was selected to calculate the terminal value under this methodology. After adding the present value of free cash flows and terminal value for each scenario, we weighted the H-Model method at 75% and the Observed Market Multiple method at 25% to calculate a final enterprise value under the status quo scenario. Based on these scenarios, management calculated the probability-weighted expected return to all of the equity holders. The resulting enterprise valuation was then allocated across our capital structure. Upon a liquidation of CII, or upon a non-liquidating distribution, the holders of common units would share in the proceeds after the CII preferred unit holders received their unreturned capital contributions and their priority return (6% per annum). After the preferred unreturned capital 31-------------------------------------------------------------------------------- Table of Contents contributions and the priority return were satisfied, the remaining proceeds were allocated on a scale ranging from 85% to the Class A preferred unit holders and 15% to the common unit holders to 80% to the preferred unit holders and 20% to the common unit holders depending upon the return multiple to the preferred unit holders, also known as a waterfall allocation. The value attributable to each class of shares was then discounted in order to account for the lack of marketability of the units. In determining the appropriate lack of marketability discount, we evaluated both empirical and theoretical approaches to arrive at a composite range that we believed indicated a reasonable spectrum of discounts for each of the valuation techniques utilized. The empirical methods we evaluated relied on datasets procured from observed transactions in interests in the public domain that are perceived to incorporate pricing information related to the marketability (or lack thereof) of the interest itself. These empirical methods included IPO Studies and Restricted Stock Studies. Theoretical models utilized in our analysis formed the primary basis for the discount for lack of marketability, and included the Finnerty Average-Strike Put, the Asian Protective Put and the Black-Scholes-Merton Protective Put. The following table reflects the estimated value of the Class A, B, C D, E, F, G, H, I, J, and K common units as of June 30, 2014, 2013, 2012: Estimated fair value as of June 30, Common Units 2014 2013 2012 (estimated value per unit) Class A $ 2.47 $ 1.50 $ 0.92 Class B 2.22 1.34 0.81 Class C 1.92 1.14 0.68 Class D 1.86 1.10 0.65 Class E 1.62 0.95 0.55 Class F 1.44 0.75 0.49 Class G 0.82 0.46 n/a Class H 0.70 0.38 n/a Class I 0.45 n/a n/a Class J 0.33 n/a n/a Class K 0.29 n/a n/a Determining the fair value of share-based awards at the grant date and subsequent reporting dates requires judgment. If actual results differ significantly from these estimates, stock-based compensation expense and the Company's results of operations could be materially impacted. Property and Equipment We record property and equipment acquired in connection with a business combination at their estimated fair values on the acquisition date. See "-Critical Accounting Policies and Estimates: Acquisitions-Purchase Price Allocation." Purchases of property and equipment are stated at cost, net of depreciation. Major improvements are capitalized, while expenditures for repairs and maintenance are expensed when incurred. Costs incurred prior to a capital project's completion are reflected as construction-in-progress and are part of network infrastructure assets. Depreciation begins once the property and equipment is available and ready for use. Certain internal direct labor costs of constructing or installing property and equipment are capitalized. Capitalized direct labor reflects a portion of the salary and benefits of certain field engineers and other employees that are directly related to the construction and installation of network infrastructure assets. We have contracted with third party contractors for the construction and installation of the majority of our fiber network. Depreciation and amortization is provided on a straight-line basis over the estimated useful lives of the assets, with the exception of leasehold improvements, which are amortized over the lesser of the estimated useful lives or the term of the lease. 32-------------------------------------------------------------------------------- Table of Contents Estimated useful lives of our property and equipment in years are as follows: Land N/A Buildings improvements and site improvements 15 to 20 Furniture, fixtures and office equipment 3 to 7 Computer hardware 3 to 5 Software 3 Machinery and equipment 5 to 7 Fiber optic equipment 8 Circuit switch equipment 10 Packet switch equipment 5 Fiber optic network 15 to 20 Construction in progress N/A We perform periodic internal reviews to estimate useful lives of our property and equipment. Due to rapid changes in technology and the competitive environment, selecting the estimated economic life of telecommunications property and equipment requires a significant amount of judgment. Our internal reviews take into account input from our network services personnel regarding actual usage, physical wear and tear, replacement history, and assumptions regarding the benefits and costs of implementing new technology that factor in the need to meet our financial objectives. When property and equipment is retired or otherwise disposed of, the cost and accumulated depreciation is removed from the accounts, and resulting gains or losses are reflected in operating income. From time to time, we are required to replace or re-route existing fiber due to structural changes such as construction and highway expansions, which is defined as a "relocation." In such instances, we fully depreciate the remaining carrying value of network infrastructure removed or rendered unusable, and capitalize the new fiber and associated construction costs of the relocation placed into service, which is reduced by any reimbursements received for such costs. To the extent that the relocation does not require the replacement of components of our network, and only involves the act of moving our existing network infrastructure, as-is, to another location, the related costs are expensed as incurred. Interest costs are capitalized for all assets that require a period of time to get them ready for their intended use. This policy is based on the premise that the historical cost of acquiring an asset should include all costs necessarily incurred to bring it to the condition and location necessary for its intended use. In principle, the cost incurred in financing expenditures for an asset during a required construction or development period is itself a part of the asset's historical acquisition cost. The amount of interest costs capitalized for qualifying assets is determined based on the portion of the interest cost incurred during the assets' acquisition periods that theoretically could have been avoided if expenditures for the assets had not been made. The amount of interest capitalized in an accounting period is calculated by applying the capitalization rate to the average amount of accumulated expenditures for the asset during the period. The capitalization rates used to determine the value of interest capitalized in an accounting period is based on our weighted average effective interest rate for outstanding debt obligations during the respective accounting period. We periodically evaluate the recoverability of our long-lived assets and evaluate such assets for impairment whenever events or circumstances indicate that the carrying amount of such assets may not be recoverable. Impairment is determined to exist if the estimated future undiscounted cash flows are less than the carrying value of such assets. We consider various factors to determine if an impairment test is necessary. The factors include: consideration of the overall economic climate, technological advances with respect to equipment, our strategy, and capital planning. Since our inception, no event has occurred nor has there been a change in the business environment that would trigger an impairment test for our property and equipment assets. Deferred Tax Assets Deferred tax assets arise from a variety of sources, the most significant being: tax losses that can be carried forward to be utilized against taxable income in future years; and expenses recognized in our income statement but disallowed in our tax return until the associated cash flow occurs. We record a valuation allowance to reduce our deferred tax assets to the amount that is expected to be recognized. The amount of deferred tax assets recorded on our consolidated balance sheets is influenced by management's assessment of our future taxable income with regard to relevant business plan forecasts, the reversal of deferred tax balances, and reasonable tax planning strategies. At each balance sheet date, existing assessments are reviewed and, if necessary, revised to reflect changed 33-------------------------------------------------------------------------------- Table of Contents circumstances. In a situation where recent losses have been incurred, the relevant accounting standards require convincing evidence that there will be sufficient future taxable income. In connection with several of our acquisitions, we have acquired significant net operating loss carryforwards ("NOLs"). The Tax Reform Act of 1986 contains provisions that limit the utilization of NOLs if there has been an "ownership change" as described in Section 382 of the Internal Revenue Code. Upon acquiring a company that has NOLs, we prepare an assessment to determine if we have a legal right to use the acquired NOLs. In performing this assessment we follow the regulations within the Internal Revenue Code Section 382: Net Operating Loss Carryovers Following Changes in Ownership. Any disallowed NOLs acquired are written-off in purchase accounting. A valuation allowance is required for deferred tax assets if, based on available evidence, it is more-likely-than-not that all or some portion of the asset will not be realized due to the inability to generate sufficient taxable income in the period and/or of the character necessary to utilize the benefit of the deferred tax asset. When evaluating whether it is more-likely-than-not that all or some portion of the deferred tax asset will not be realized, all available evidence, both positive and negative, that may affect the realizability of deferred tax assets is identified and considered in determining the appropriate amount of the valuation allowance. We continue to monitor our financial performance and other evidence each quarter to determine the appropriateness of our valuation allowance. If we are unable to meet our taxable income forecasts in future periods we may change our conclusion about the appropriateness of the valuation allowance which could create a substantial income tax expense in our consolidated statement of operations in the period such change occurs. As of June 30, 2014, we had a cumulative federal (U.S.) NOL carryforward balance of $ 1,073.9 million. During the year ending June 30, 2014, we utilized $298.0 million of NOL carryforwards that were available to offset future taxable income. During the year ending June 30, 2013, we generated $90.6 million of NOL carryforwards that are available to offset future taxable income and we added $1,008.8 million to our NOL carryforward balance as a result of NOL carryforwards acquired from the AboveNet acquisition. Our NOL carryforwards, if not utilized to reduce taxable income in future periods, will expire in various amounts beginning in 2020 and ending in 2032. As a result of Internal Revenue Service regulations, we are currently limited to utilizing a maximum of $614 million of acquired NOL carryforwards during Fiscal 2014; however, to the extent that we do not utilize $614 million of our acquired NOL carryforwards during a fiscal year, the difference between the $614 million maximum usage and the actual NOLs usage is carried over to the next calendar year. Of our $1,073.9 million NOL carryforwards balance, $938.6 million of these NOL carryforwards were acquired in acquisitions. The deferred tax assets recognized at June 30, 2014 have been based on future profitability assumptions over a five-year horizon. The analysis of our ability to utilize our NOL balance is based on our forecasted taxable income. The forecasted assumptions approximate our best estimates, including market growth rates, future pricing, market acceptance of our products and services, future expected capital investments, and discount rates. Although our forecasted income includes increased taxable earnings in future periods, flat earnings over the period in which our NOL carryfowards are available would result in full utilization of our current unreserved NOL carryforwards. Goodwill and Purchased Intangibles We review goodwill and indefinite-lived intangible assets for impairment at least annually in April, or more frequently if a triggering event occurs between impairment testing dates. Intangible assets arising from business combinations, such as acquired customer contracts and relationships (collectively "customer relationships"), are initially recorded at fair value. We amortize customer relationships primarily over an estimated life of ten to twenty years using the straight-line method, as this method approximates the timing in which we expect to receive the benefit from the acquired customer relationship assets. Goodwill represents the excess of the purchase price over the fair value of the net identifiable assets acquired in a business combination. Our impairment assessment begins with a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. The qualitative assessment includes comparing the overall financial performance of the reporting units against the planned results used in the last quantitative goodwill impairment test. Additionally, each reporting unit's fair value is assessed in light of certain events and circumstances, including macroeconomic conditions, industry and market considerations, cost factors, and other relevant entity- and reporting unit-specific events. If it is determined under the qualitative assessment that it is more likely than not that the fair value of a reporting unit is less than its carrying value, then a two-step quantitative impairment test is performed. Under the first step, the estimated fair value of the reporting unit is compared with its carrying value (including goodwill). If the fair value of the reporting unit exceeds its carrying value, step two does not need to be performed. If the estimated fair value of the reporting unit is less than its carrying value, an indication of goodwill impairment exists for the reporting unit and the enterprise must perform step two of the 34-------------------------------------------------------------------------------- Table of Contents impairment test (measurement). Under step two, an impairment loss is recognized for any excess of the carrying amount of the reporting unit's goodwill over the implied fair value of that goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit in a manner similar to a purchase price allocation in acquisition accounting. The residual fair value after this allocation is the implied fair value of the reporting unit goodwill. Fair value of the reporting unit under the two-step assessment is determined using a discounted cash flow analysis. The selection and assessment of qualitative factors used to determine whether it is more likely than not that the fair value of a reporting unit exceeds the carrying value involves significant judgments and estimates. Our impairment assessment for indefinite-lived intangible assets involves comparing the estimated fair value of indefinite-lived intangible assets to their respective carrying values. To the extent the carrying value of indefinite-lived intangible assets exceeds the fair value, the Company will recognize an impairment loss for the difference. Intangible assets with finite useful lives are amortized over their respective estimated useful lives and reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. We recorded no impairment charges for goodwill or intangibles during the years ended June 30, 2014, 2013, or 2012. Acquisitions - Purchase Price Allocation We apply the acquisition method of accounting to account for business combinations. The cost of an acquisition is measured as the aggregate of the fair values at the date of exchange of the assets given, liabilities incurred, and equity instruments issued. Identifiable assets, liabilities, and contingent liabilities acquired or assumed are measured separately at their fair value as of the acquisition date. The excess of the cost of the acquisition over our interest in the fair value of the identifiable net assets acquired is recorded as goodwill. If our interest in the fair value of the identifiable net assets acquired in a business combination exceeds the cost of the acquisition, a gain is recognized in earnings on the acquisition date only after we have reassessed whether we have correctly identified all of the assets acquired and all of the liabilities assumed. For certain of our larger acquisitions, we engage outside appraisal firms to assist in the fair value determination of identifiable intangible assets such as customer relationships, tradenames, property and equipment and any other significant assets or liabilities. We adjust the preliminary purchase price allocation, as necessary, after the acquisition closing date through the end of the measurement period (up to one year) as we finalize valuations for the assets acquired and liabilities assumed. The determination and allocation of fair values to the identifiable assets acquired and liabilities assumed is based on various assumptions and valuation methodologies requiring considerable management judgment. The most significant variables in these valuations are discount rates, terminal values, the number of years on which to base the cash flow projections, and the assumptions and estimates used to determine cash inflows and outflows or other valuation techniques (such as replacement cost). We determine which discount rates to use based on the risk inherent in the related activity's current business model and industry comparisons. Terminal values are based on the expected life of products, forecasted life cycle and forecasted cash flows over that period. Although we believe that the assumptions applied in the determination are reasonable based on information available at the date of acquisition, actual results may differ from the estimated or forecasted amounts and the difference could be material. Background for Review of Our Results of Operations Revenue Our revenue is comprised predominately of monthly recurring revenue ("MRR"). MRR is related to an ongoing service that is generally fixed in price and paid by the customer on a monthly basis. We also report monthly amortized revenue ("MAR"), which represents the amortized portion of previously collected upfront charges to customers. Upfront charges are typically related to IRUs structured as pre-payments rather than monthly recurring payments (though we structure IRUs as both prepaid and recurring, largely dependent on the customers' preference) and installation fees. The last category of revenue we report is other revenue. Other revenue includes credits and adjustments, termination revenue, construction services, and equipment sales. Our consolidated reported revenue in any given period is a function of our beginning revenue under contract and the impact of organic growth and acquisition activity. Our organic activity is driven by net new sales ("bookings"), gross installed revenue ("installs") and churn processed ("churn") as further described below. Net New Sales. Bookings are the dollar amount of orders recorded as MRR and MAR in a period that have been signed by the customer and accepted by our service delivery organization. The dollar value of bookings is equal to the monthly recurring price that the customer will pay for the services and/or the monthly amortized amount of the revenue that we will recognize for those services. To the extent a booking is cancelled by the customer prior to it being 35-------------------------------------------------------------------------------- Table of Contents installed, it is subtracted from the total bookings number in the period that it is cancelled. Bookings do not immediately impact revenue until they are installed (gross installed revenue). Gross Installed Revenue. Installs are the amount of MRR and MAR for services that have been installed, tested, accepted by the customer, and entered into the billing system in a given period. Installs include new services, price increases, and upgrades. Churn Processed. Churn is any negative change to MRR and MAR. Churn includes disconnects, negative price changes, and disconnects associated with upgrades or replacement services. For each period presented, disconnects associated with attrition and upgrades are the drivers of churn, accounting for more than 80% of negative changes in MRR and MAR while price changes account for less than 20%. Monthly churn is also presented as a percentage of MRR and MAR ("churn percentage"). Given the size and amount of acquisitions we have completed, we have estimated the revenue growth rate associated with our organic activity in each period reported. Our estimated organic growth rate is calculated by adding an estimate of the acquired companies' revenue for the reporting period prior to the date of inclusion in our results of operations, and then calculating the growth rate between the two reported periods. The estimate of acquired annual revenue is based on the acquired companies' revenues for the most recent quarter prior to close (including estimated purchase accounting adjustments) multiplied by four, except in the case of AboveNet, which is based upon publicly reported revenue for the full period from June 30, 2011 to June 30, 2012. If, in calculating our estimated organic growth rates, we were to use the actual revenue results for the four quarters preceding the closing of each of our acquisitions, including AboveNet, our estimated organic growth rates would be higher than the estimated organic growth rates presented. If we were to use acquired annualized revenue, calculated by taking each acquired company's revenues for the most recent quarter prior to the closing of such acquisition and multiplying by four, including for AboveNet, our estimated organic growth rates would be lower than the estimated organic growth rates presented. Operating Costs Our operating costs consist primarily of third-party network service costs and colocation facility costs. Third-party network service costs result from our leasing of certain network facilities, primarily leases of circuits and dark fiber, from carriers to augment our owned infrastructure, for which we are generally billed a fixed monthly fee. Our colocation facility costs include rent and license fees paid to the landlords of the buildings in which our zColo business operates, along with the utility costs to power those facilities. While increases in demand for our services will drive additional operating costs in our business, consistent with our strategy of leveraging our owned infrastructure assets, we expect to primarily utilize our existing network infrastructure or build new network infrastructure to meet the demand. In limited circumstances, we will augment our network with additional circuits or services from third-party providers. Third-party network service costs include the upfront cost of the initial installation of such circuits. We have excluded depreciation and amortization expense from our operating costs. Selling, General, and Administrative Expenses Our selling, general, and administrative ("SG&A") expenses include compensation and benefits expenses, network operations expenses, other SG&A expenses, transaction costs and stock-based compensation. Compensation and benefits expenses include salaries, wages, incentive compensation and benefits. Employee-related costs that are directly associated with network construction, service installations and development of business support systems are capitalized rather than expensed in SG&A. After compensation and benefits and stock-based compensation, network operations expenses are the largest components of our SG&A expenses. Network operations expenses include all of the non-personnel related expenses of maintaining our network infrastructure, including contracted maintenance fees, right-of-way costs, rent for cellular towers and other places where fiber is located, pole attachment fees, and relocation expenses. Other SG&A expenses include expenses such as property tax, franchise fees, travel, office expense, and maintenance expense on colocation facilities. Transaction costs include expenses associated with professional services (i.e., legal, accounting, regulatory, etc.) rendered in connection with acquisitions or disposals (including spin-offs), travel expense, severance expense incurred on the date of acquisition or disposal, and other direct expenses incurred that are associated with signed and/or closed acquisitions or disposals. Our stock-based compensation expense contains two components, common unit awards classified as liabilities and, to a lesser extent, preferred unit awards classified as equity. For the CII common units granted to employees and directors, we recognize an expense equal to the fair value of all of those common units that vest during the period plus the change in fair 36-------------------------------------------------------------------------------- Table of Contents value of previously vested units, and record a liability in respect of those amounts. When the CII preferred units are initially granted, we recognize no expense. We use the straight line method, over the vesting period, to amortize the fair value of those units, as determined on the date of grant. Subsequent changes in the fair value of the preferred units granted to members of management and directors do not affect the amount of expense we recognize. Refer to "Selected Historical Consolidated Financial Information" for additional financial information for the indicated periods. 37-------------------------------------------------------------------------------- Table of Contents Refer to Item 6. Selected Financial Data for financial information discussed herein. Year Ended June 30, 2014 Compared to the Year Ended June 30, 2013 Revenue Year ended June 30 2014 2013 $ Variance % Variance (in thousands) Segment and consolidated revenue: Physical Infrastructure $498,235 $ 416,277 $ 81,958 20 % Lit Services 608,675 573,335 35,340 6 % Eliminations - (1,527 ) 1,527 (100 )% Consolidated $1,106,910 $ 988,085 $ 118,825 12 % Our total revenue increased by $118.8 million, or 12%, from $988.1 million for Fiscal 2013 to $1,106.9 million for Fiscal 2014. The increase in revenue was driven by our organic growth as well as the timing of our Fiscal 2013 and Fiscal 2014 acquisitions. Our organic growth was driven by installs that exceeded churn over the course of both periods, resulting from continued strong demand for bandwidth infrastructure services broadly across our service territory and customer industry verticals. Further underlying revenue drivers included: • Bookings grew significantly, increasing from $17.6 million to $21.7 million in combined MRR and MAR. This growth was driven by increased customer demand for our services, our growing fiber and datacenter footprint (from both organic investments and acquisitions), and our salesforce's improved effectiveness in selling on this base of assets. The total contract value associated with this period's bookings was approximately $1.7 billion. • Installs grew by approximately $1.4 million from Fiscal 2013 to Fiscal 2014, but trailed the increase in bookings, which included more infrastructure-related services with longer booking to install time intervals. Examples included several FTT sales and a large dark fiber sale to tw telecom. • The monthly churn percentage decreased slightly from 1.4% to 1.3% between Fiscal 2013 and Fiscal 2014. Multiple Fiscal 2013 and Fiscal 2014 acquisitions impacted revenue growth between the two periods. The six Fiscal 2013 acquisitions were completed at various times throughout the year, although the largest (AboveNet) closed on July 2, 2012 and was fully included in our annual results for the year ended June 30, 2014 and 2013 and therefore was not a contributor to the period-over-period acquisition growth. The other acquisitions were included in our results of operations for only part of the year ended June 30, 2013 compared to their inclusion for Fiscal 2014. The five Fiscal 2014 acquisitions were completed on August 1, 2013, October 1, 2013, October 2, 2013, March 4, 2014, and May 16, 2014 and were included in our year ended June 30, 2014 results for approximately eleven, nine, nine, four, and one month(s), respectively. The Fiscal 2014 acquisitions represented smaller acquisitions of dark fiber and colocation-only providers, with the exception of Geo, which was a larger acquisition of a European-based dark fiber and wavelength services provider completed in the fourth quarter of Fiscal 2014. Physical Infrastructure. Revenues from our Physical Infrastructure segment increased by $81.9 million, or 20%, from $416.3 million for Fiscal 2013 to $498.2 million for Fiscal 2014. Dark fiber is the largest Strategic Product Group within the segment and benefited from continuing growth in infrastructure demand. Our FTT and zColo products also contributed to the segment's growth. All of the Fiscal 2014 acquisitions impacted the Physical Infrastructure segment revenues as FiberLink (dark fiber) and CoreLink and CoreXchange (both colocation) were Physical Infrastructure-only businesses and Geo was primarily Physical Infrastructure (dark fiber). Lit Services. Revenues from our Lit Services segment increased by $35.4 million, or 6%, from $573.3 million for Fiscal 2013 to $608.7 million for Fiscal 2014. Growth was strongest in the segment's Ethernet and IP Strategic Product Groups, driven by customer demand and increased effectiveness in marketing these products. Wavelength revenue growth was dampened by churn, including price concessions we proactively offered in exchange for customer contract extensions. SONET is a legacy product, and its revenue 38-------------------------------------------------------------------------------- Table of Contents declined between the two periods, consistent with our expectations. The Lit Services period-over-period revenue results were primarily influenced by the carryover impacts from the Fiscal 2013 acquisitions, as the Fiscal 2014 acquisitions mostly impacted the Physical Infrastructure segment. The following table reflects the stratification of our revenues during these periods. The substantial majority of our revenue continued to come from recurring payments from customers under contractual arrangements. Year ended June 30, 2014 2013 (in thousands) Monthly recurring revenue $ 1,025,878 93 % $ 933,818 95 % Monthly amortized revenue 54,081 5 % 42,331 4 % Other revenue 26,951 2 % 11,936 1 % Total revenue $ 1,106,910 100 % $ 988,085 100 % Operating Costs, Excluding Depreciation and Amortization Year ended June 30 2014 2013 $ Variance % Variance (in thousands) Segment and consolidated operating costs, excluding depreciation and amortization: Physical Infrastructure $44,879 $ 37,146 $ 7,733 21 % Lit Services 96,546 99,449 (2,903 ) (3 )% Consolidated $141,425 $ 136,595 $ 4,830 4 % As a percentage of revenue 13% 14% Our operating costs, excluding depreciation and amortization, increased by $4.8 million, or 4% from $136.6 million for Fiscal 2013 to $141.4 million for Fiscal 2014. The increase in consolidated operating costs was primarily due to increased facility costs related to the colocation acquisitions, partially offset by cost savings, as planned network related synergies were realized. Operating costs as a percentage of total revenue decreased from 14% to 13% as a result of cost reductions and because our incremental revenue typically has less third-party network service costs associated with it than the existing base of revenue. Physical Infrastructure. Physical Infrastructure operating costs increased by $7.8 million, or 21%, from $37.1 million for Fiscal 2013 to $44.9 million for Fiscal 2014. The increase in operating costs was primarily a result of the acquisitions of CoreNAP, Corelink, and CoreXchange in Fiscal 2013 and Fiscal 2014. Lit Services. Lit Services operating costs decreased by $2.9 million, or 3%, from $99.4 million for Fiscal 2013 to $96.5 million for Fiscal 2014. The decrease in operating costs was primarily due to realized network-related cost synergies related to our acquisitions, and, to a lesser extent, ongoing off-net circuit cost reduction projects. Selling, General and Administrative Expenses The table below sets forth the components of our selling, general and administrative ("SG&A") expenses during the years ended June 30, 2014 and 2013: 39-------------------------------------------------------------------------------- Table of Contents Year ended June 30, 2014 2013 $ Variance % Variance (in thousands)Compensation and benefits expenses $ 121,314 $ 118,325 $ 2,989 3 % Network operations expenses 130,481 119,850 10,631 9 % Other SG&A expenses 61,575 60,603 972 2 % Transaction costs 4,495 14,204 (9,709 ) (68 )% Stock-based compensation 253,361 105,048 148,313 141 % Total SG&A expenses $ 571,226 $ 418,030 $ 153,196 37 % Compensation and Benefits Expenses. Compensation and benefits expenses increased by $3.0 million, or 3%, from $118.3 million for Fiscal 2013 to $121.3 million for Fiscal 2014. The increase in compensation and benefits reflected the increase in headcount during Fiscal 2014 to support our growing business, including certain employees retained from businesses acquired since June 30, 2013, and employer matching of employee 401(k) contributions beginning in the fourth quarter of Fiscal 2014. This was partially offset by a reduction in bonus payout as the average payout for the year ended June 30, 2013 was approximately 130% of target as compared to approximately 100% of target for the year ended June 30, 2014. Headcount as of the end of the respective periods was: June 30, June 30, 2014 2013 Physical Infrastructure 861 584 Lit Services 623 546 Total 1,484 1,130 Network Operations Expenses. Network operations expenses increased by $10.6 million, or 9%, from $119.9 million for Fiscal 2013 to $130.5 million for Fiscal 2014. The increase principally reflected the growth of our network assets and the related expenses of operating that expanded network. Our total network route miles increased approximately 7% from 75,839 miles at June 30, 2013 to 80,861 miles at June 30, 2014. Other SG&A. Other SG&A expenses increased by $1.0 million, or 2%, from $60.6 million for Fiscal 2013 to $61.6 million for Fiscal 2014. The increase was primarily the result of additional expenses attributable to our Fiscal 2013 and Fiscal 2014 acquisitions, which were partially offset by the receipt of $3.8 million in connection with an escrow settlement relating to the 360networks acquisition during the second quarter of Fiscal 2014. Transaction Costs. Transaction costs decreased by $9.7 million, or 68%, from $14.2 million for Fiscal 2013 to $4.5 million for Fiscal 2014. The decrease was due to higher transaction-related costs in the first quarter of Fiscal 2013 associated with the AboveNet acquisition, partially offset by the transaction-related costs associated with the Geo and Neo acquisitions in Fiscal 2014. Stock-Based Compensation. Stock-based compensation expense increased by $148.4 million, or 141%, from $105.0 million for Fiscal 2013 to $253.4 million for Fiscal 2014. The stock-based compensation expense associated with the common units is impacted by both the estimated value of the common units and the number of common units vesting during the period. The following table reflects the estimated fair value of the common units during the relevant periods impacting the stock-based compensation expense for the years ended June 30, 2014 and 2013. 40-------------------------------------------------------------------------------- Table of Contents Estimated fair value as of June 30, Common Units 2014 2013 2012 (estimated value per unit) Class A $ 2.47 $ 1.50 $ 0.92 Class B 2.22 1.34 0.81 Class C 1.92 1.14 0.68 Class D 1.86 1.10 0.65 Class E 1.62 0.95 0.55 Class F 1.44 0.75 0.49 Class G 0.82 0.46 n/a Class H 0.70 0.38 n/a Class I 0.45 n/a n/a Class J 0.33 n/a n/a Class K 0.29 n/a n/a Depreciation and Amortization Depreciation and amortization expense increased by $13.7 million, or 4%, from $322.7 million for Fiscal 2013 to $336.4 million for Fiscal 2014. The increase was primarily the result of depreciation related to capital expenditures since June 30, 2013 and acquisition-related growth. Total Other Expense, Net The table below sets forth the components of our total other expense, net for the years ended June 30, 2014 and 2013. Year ended June 30, 2014 2013 (in thousands) Interest expense $ (203,508 ) $ (202,464 ) Loss on extinguishment of debt (1,911 ) (77,253 ) Other income, net 5,039 326 Total other expense, net $ (200,380 ) $ (279,391 ) Interest Expense. Interest expense increased by $1.0 million, or 1%, from $202.5 million for Fiscal 2013 to $203.5 million for Fiscal 2014. The increase was primarily a result of additional interest expense related to the $150.0 million and $275.0 million add-ons to our Term Loan Facility during the second and fourth quarters of Fiscal 2014, respectively. Also contributing to the increase in interest expense was the impact of changes in market value of our interest rate swaps during the year ended June 30, 2014 as compared to the year ended June 30, 2013. The change in market value was additional interest expense of $4.7 million for the year ended June 30, 2014 as compared to a reduction in interest expense of $2.6 million for the year ended June 30, 2013, representing a year over year increase in interest expense of $7.3 million. These increases were partially offset by a decrease in interest expense resulting from the amendments to our Credit Agreement during the second and third quarters of Fiscal 2013 and second quarter of Fiscal 2014 to lower the interest rates on our Term Loan Facility and Revolver, in addition to quarterly principal payments on our Term Loan Facility, which reduced our outstanding debt obligations. Loss on Extinguishment of Debt. In connection with the debt refinancing activities during Fiscal 2014, we recognized an expense of $1.9 million associated with debt extinguishment costs, including a cash expense of $0.9 million associated with the payment of third party costs and non-cash expenses of $1.0 million, consisting of $0.7 million associated with the write-off of unamortized debt issuance costs and $0.3 million associated with the write-off of the net unamortized discount on the extinguished debt balances. In connection with the debt refinancing activities during the Fiscal 2013, we incurred an expense of $77.3 million associated with debt extinguishment costs, including a cash expense of $43.1 million associated with the payment of early redemption fees and other third party expenses on our previous indebtedness and non-cash expenses, including $34.2 million associated with the write-off of unamortized debt issuance costs and unamortized discounts. 41-------------------------------------------------------------------------------- Table of Contents Other Income, Net. Other income, net increased by $4.7 million from $0.3 million for Fiscal 2013 to $5.0 million for Fiscal 2014. Other income, net consists primarily of unrealized foreign currency gain related to the re-measurement of intercompany loans between our domestic and foreign subsidiaries. Provision for Income Taxes Income tax expense increased over the prior year by $61.8 million, from an income tax benefit of $24.0 million for Fiscal 2013 to an income tax expense of $37.8 million for Fiscal 2014. Our provision for income taxes included both the current provision and a provision for deferred income tax expense resulting from timing differences between tax and financial reporting accounting bases. We were unable apply our NOLs to the income of our subsidiaries in some states and thus our state income tax expense was higher than the expected blended rate. In addition, as a result of our stock-based compensation and certain transaction costs not being deductible for income tax purposes, our effective tax rate was higher than the statutory rate. The following table reconciles an expected tax provision based on a statutory federal tax rate applied to our earnings before income tax to our actual provision for income taxes (in thousands): Year ended June 30, 2014 2013 Expected benefit at statutory rate $ (49,859 ) $ (59,046 ) Increase due to: Non-deductible stock-based compensation 96,342 35,576 State income taxes, net of federal benefit (6,519 ) (2,201 ) Transactions costs not deductible for tax purposes 759 1,257 State NOL adjustment - 2,788 Foreign tax rate differential 991 (2,264 ) Change in effective tax rate (286 ) - Change in valuation allowance 1,284 - Reversal of uncertain tax positions, net (2,600 ) - Other, net (2,263 ) (156 ) Provision/(benefit) for income taxes $ 37,849 $ (24,046 ) Year Ended June 30, 2013 Compared to the Year Ended June 30, 2012 Revenue Year ended June 30 2013 2012 $ Variance % Variance (in thousands) Segment and consolidated revenue: Physical Infrastructure $ 416,277 $ 157,419 $ 258,858 164 % Lit Services 573,335 224,624 $ 348,711 155 % Eliminations (1,527 ) - (1,527 ) 100 % Consolidated $ 988,085 $ 382,043 $ 606,042 159 % Our total revenue increased by $606.0 million, or 159%, from $382.0 million for Fiscal 2012 to $988.1 million for Fiscal 2013. The increase in revenue was driven primarily by our Fiscal 2012 and 2013 acquisitions and organic growth. Our organic growth was driven by installs that exceeded churn in both periods, resulting from strong demand for bandwidth infrastructure services broadly across our geographic markets and customer verticals. Further underlying organic activity drivers during the period included: • Bookings increased from $8.5 million in Fiscal 2012 to $17.6 million in Fiscal 2013 in combined MRR and MAR. This growth was primarily driven by the addition of the AboveNet fiber assets, select salespeople and customer relationships used to market our services across a broader set of assets. Our bookings grew over the course of Fiscal 42-------------------------------------------------------------------------------- Table of Contents 2013, with each quarter's results exceeding the prior. The total contract value associated with Fiscal 2013 bookings was approximately $1 billion. • Installs increased from $7.4 million in Fiscal 2012 to $18.3 million in Fiscal 2013, and were the primary driver of our organic revenue growth. This install activity was directly correlated to our bookings; however, there was a natural time delay between booking and the associated install. We believe our ability to install bookings on a timely basis improved throughout the year as we completed the integration activities associated with the Fiscal 2012 acquisitions and substantially integrated the AboveNet acquisition. • The monthly churn percentage increased slightly from 1.3% for Fiscal 2012 to 1.4% for Fiscal 2013, with total churn increasing from $4.9 million to $13.4 million. This Fiscal 2013 churn percentage remained within our expected range. However, following our acquisition of AboveNet, we proactively renegotiated services with former AboveNet customers in order to significantly extend the average remaining contract life of our services and revenue. These actions often required some price concession to our customers (which had a resulting churn impact) in exchange for a longer term. The three Fiscal 2012 acquisitions were completed on December 1, 2011, December 31, 2011 and May 1, 2012 and therefore were included in our results of operations for seven, six and two months, respectively, in Fiscal 2012 compared to a full twelve months in Fiscal 2013. The most significant acquisition in Fiscal 2012 was 360networks. The acquisition of 360networks added substantial metro and regional network assets in the Western U.S. The six Fiscal 2013 acquisitions were completed at various times throughout the year with the largest, AboveNet, closing on July 2, 2012 and being included in our Fiscal 2013 results of operations for the entire twelve month period. The AboveNet acquisition significantly expanded our metro fiber assets in some of largest U.S. metro markets plus London, and provided important new customer relationships and product capabilities that we applied across our combined networks. The acquisition of AboveNet had the impact of more than doubling our previous revenue run rate. Physical Infrastructure. Revenues from our Physical Infrastructure segment increased by $258.9 million, or 164%, from $157.4 million for Fiscal 2012 to $416.3 million for Fiscal 2013. We estimate that organic revenue growth for the Physical Infrastructure. This was influenced by the increasing importance of bandwidth for our customers (in volume and criticality), and, in select cases, reflects a shift from lit services to physical infrastructure products. This is evidenced by strong bookings and install activity on large FTT projects for many of the major wireless carriers. The six Fiscal 2013 acquisitions were disproportionately weighted towards Physical Infrastructure products, and therefore acquisitions had a larger impact on this segment. Each of our Fiscal 2012 acquisitions were also heavily weighted towards Physical Infrastructure products. Lit Services. Revenues from our Lit Services segment increased by $348.7 million, or 155%, from $224.6 million for Fiscal 2012 to $573.3 million for Fiscal 2013. This growth was supported by new geographies and routes, as well as enhanced Ethernet and IP capabilities that were acquired through the AboveNet acquisition. AboveNet's large base of wavelength and Ethernet customers was the primary contributor to the Lit Services inorganic growth. The following table reflects the stratification of our revenues during these periods. The substantial majority of our revenue continued to come from recurring payments from customers under contractual arrangements (MRR). Year ended June 30, 2013 2012 (in thousands) Monthly recurring revenue $ 933,818 95 % $ 357,417 94 % Monthly amortized revenue 42,331 4 % 13,785 4 % Other revenue 11,936 1 % 10,841 2 % Total revenue $ 988,085 100 % $ 382,043 100 % 43-------------------------------------------------------------------------------- Table of Contents Operating Costs, Excluding Depreciation and Amortization Year ended June 30 2013 2012 $ Variance % Variance (in thousands) Segment and consolidated operating costs, excluding depreciation and amortization: Physical Infrastructure $ 37,146 $ 21,677 $ 15,469 71 % Lit Services 99,449 60,904 38,545 63 % Consolidated $136,595 $ 82,581 $ 54,014 65 % As a percentage of revenue 14% 22% Our operating costs, excluding depreciation and amortization, increased by $54.0 million, or 66%, from $82.6 million for Fiscal 2012 to $136.6 million for Fiscal 2013. The increase in consolidated operating costs primarily related to our Fiscal 2012 and Fiscal 2013 acquisitions, and additional network costs incurred in order to support new customer contracts entered into subsequent to June 30, 2012. Operating costs as a percentage of total revenue decreased from 22% to 14% principally due to the shift in product mix (namely the increased percentage of dark fiber) associated with the July 2, 2012 acquisition of AboveNet. Also, as a result of the acquisition of AboveNet and its status as a Tier 1 settlement-free peering partner, we were able to eliminate IP transit costs that we previously incurred by the Company. Physical Infrastructure. Physical Infrastructure operating costs increased by $12.2 million, or 56%, from $21.7 million for Fiscal 2012 to $33.9 million for Fiscal 2013. As a percentage of revenue physical infrastructure operating costs decreased materially reflecting the higher proportion of acquired dark fiber with little to no associated network costs. Lit Services. Lit Services operating costs increased by $35.7 million, or 59%, from $60.9 million for Fiscal 2012 to $96.6 million for Fiscal 2013. As a percentage of revenue, Lit Services operating costs also decreased significantly. While the acquired AboveNet Lit Services did have associated network expenses, the proportion of those expenses to revenue was lower for AboveNet than the Company. Selling, General and Administrative Expenses The table below sets forth the components of our SG&A expenses during the years ended June 30, 2013 and 2012. Year ended June 30, 2013 2012 $ Variance % Variance (in thousands) Compensation and benefits expenses $ 118,325 $ 47,102 $ 71,223 151 % Network operations expenses 119,850 37,097 82,753 223 % Other SG&A expenses 60,603 20,866 39,737 190 % Transaction costs 14,204 6,630 7,574 114 % Stock-based compensation 105,048 26,253 78,795 300 % Total SG&A expenses $ 418,030 $ 137,948 $ 280,082 203 % Compensation and Benefits Expenses. Compensation and benefits expenses increased by $71.2 million, or 151%, from $47.1 million for Fiscal 2012 to $118.3 million for Fiscal 2013. The compensation and benefits increase reflects the increased number of employees resulting from the AboveNet acquisition and to a lesser extent employees hired during the year to support our growing business as well as employees retained from other Fiscal 2013 acquisitions. A majority of the increase to our headcount occurred on July 2, 2012 as a result of hiring certain former employees of AboveNet. 44-------------------------------------------------------------------------------- Table of Contents Head count as of the end of the respective periods was: June 30, June 30, 2013 2012 Physical Infrastructure 584 225 Lit Services 546 275 Total 1,130 500 Network Operations Expenses. Network operations expenses increased by $82.8 million, or 223%, from $37.1 million for Fiscal 2012 to $119.9 million for Fiscal 2013. The increase principally reflected the growth of our network assets and the related expenses of operating that expanded network. Our total network route miles increased approximately 63% from 46,504 miles at June 30, 2012 to 75,839 miles at June 30, 2013, primarily due to the acquisition of AboveNet. Also contributing to the increase was a one-time charge of $6.6 million related to lease termination costs associated with exit activities initiated for unutilized technical facilities space recognized during the fourth quarter of Fiscal 2013. Other SG&A. Other SG&A expenses increased by $39.7 million, or 190%, from $20.9 million for Fiscal 2012 to $60.6 million for the Fiscal 2013. The increase was principally a result of additional expenses attributable to our Fiscal 2013 and Fiscal 2012 acquisitions. In addition, during the fourth quarter of Fiscal 2013, we recognized a one-time charge of $3.6 million related to lease termination costs associated with exit activities initiated for unutilized office space. Transaction Costs. Transaction costs increased by $7.6 million, or 114%, from $6.6 million for Fiscal 2012 to $14.2 million for Fiscal 2013. This increase was primarily due to the AboveNet acquisition. Stock-Based Compensation. Stock-based compensation expenses increased by $78.7 million, or 300%, from $26.3 million for Fiscal 2012 to $105.0 million for Fiscal 2013. The stock-based compensation expense associated with the common units was impacted by both the estimated value of the common units and the number of common units vesting during the period. The following table reflects the estimated fair value of the common units during the relevant periods impacting the stock-based compensation expense for the years ended June 30, 2013 and 2012. Estimated fair value as of June 30, (estimated value per unit) Common Units of CII 2013 2012 2011 Class A $ 1.50 $ 0.92 $ 0.81 Class B 1.34 0.81 0.58 Class C 1.14 0.68 0.33 Class D 1.10 0.65 0.31 Class E 0.95 0.55 0.23 Class F 0.75 0.49 n/a Class G 0.46 n/a n/a Class H 0.38 n/a n/a The increase in the value of the common units in the current period was primarily a result of our organic growth since June 30, 2012, cost synergies realized and expected to be realized from our prior acquisitions and a reduction to the discount rate utilized in the Company's valuation of the common units resulting from our reduced financing costs. We recognize changes in the fair value of the common units through increases or decreases in stock-based compensation expense and adjustments to the related stock-based compensation liability. The stock-based compensation liability associated with the common units was $158.5 million and $54.4 million as of June 30, 2013 and June 30, 2012, respectively. The liability was impacted by changes in the estimated value of the common units, number of vested common units, and distributions made to holders of the common units. In December 2011, CII and the preferred unit holders of CII authorized a non-liquidating distribution to common unit holders of up to $10.0 million. The eligibility for receiving proceeds from the distribution was determined by the liquidation preference of the unit holder. Receiving proceeds from the authorized distribution was at the election of the common unit holder. As a condition of the early distribution, common unit holders electing to receive an early distribution received 85% of the amount 45-------------------------------------------------------------------------------- Table of Contents that they would otherwise be entitled to receive if the distribution were in connection with a liquidating distribution. The common unit holders electing to receive the early distribution retained all of their common units and are entitled to receive future distributions only to the extent such future distributions are in excess of the non-liquidating distribution, excluding the 15% discount. During Fiscal 2012, $9.1 million was distributed to CII's common unit holders. Common unit holders electing to receive the early distribution forfeited $1.6 million in previously recognized stock-based compensation, which was recorded as a reduction to the stock-based compensation liability during Fiscal 2012. Depreciation and Amortization Depreciation and amortization expense increased by $237.7 million, or 280%, from $85.0 million for Fiscal 2012 to $322.7 million for Fiscal 2013. The increase was a result of the substantial increase to our property and equipment and intangible assets since June 30, 2012, principally a result of our Fiscal 2012 and Fiscal 2013 acquisitions and capital expenditures since June 30, 2012. Total Other Expense, Net The table below sets forth the components of our total other expense, net for the years ended June 30, 2013 and 2012. Year ended June 30, 2013 2012 (in thousands) Interest expense $ (202,464 ) $ (50,720 ) Loss on extinguishment of debt (77,253 ) - Impairment of cost method investment - (2,248 ) Other income, net 326 123 Total other expense, net $ (279,391 ) $ (52,845 ) Interest expense. Interest expense increased by $151.8 million, or 299%, from $50.7 million for Fiscal 2012 to $202.5 million for Fiscal 2013. The increase was a result of our increased indebtedness during Fiscal 2013 as compared to Fiscal 2012, partially offset by a decrease in our weighted-average interest rate from Fiscal 2012 to Fiscal 2013. Loss on extinguishment of debt. In connection with the repayment of our previously existing term loan and revolver and redemption of our $350.0 million outstanding aggregate principal amount of previously issued notes in July 2012 (the "Debt Refinancing Activities") and the subsequent re-pricing transactions completed during the second and third quarters of Fiscal 2013 related to our Term Loan Facility and Revolver (the "Second and Fourth Amendments"), we recorded a loss on extinguishment of debt totaling $77.3 million during Fiscal 2013. In connection with the Debt Refinancing Activities, discussed above, we recognized an expense of $65.0 million associated with debt extinguishment costs, including a cash expense of $39.8 million associated with the payment of early redemption fees on our previous indebtedness and non-cash expenses of $17.0 million associated with the write-off of our unamortized debt issuance costs and $8.1 million associated with the write off of the net unamortized discount on the extinguished debt balances. In connection with the Second and Fourth Amendments, we recognized a loss on extinguishment of debt of $12.3 million. The loss consisted of a cash expense of $2.0 million associated with the payment of an early call premium paid to certain creditors and other third party expenses and $10.3 million associated with the write-off of unamortized debt issuance costs and discounts. Impairment of cost method investment. In connection with the October 1, 2010 acquisition of American Fiber Systems, we acquired an ownership interest in USCarrier. As of June 30, 2012, we owned 55% of the outstanding Class A membership units and 34% of the outstanding Class B membership units. On August 15, 2012, we entered into an agreement to acquire the remaining equity interest in USCarrier. As a result of certain disputes with the board of managers of USCarrier, we were unable to exercise control or significant influence over USCarrier's operating and financial policies and as a result we accounted for this investment utilizing the cost method of accounting from the date of the AFS acquisition, at which time the investment was recorded at fair value, through June 30, 2012. Based upon the agreed upon purchase price of the remaining equity interests, we determined the fair value of our ownership interest in USCarrier as of June 30, 2012 to be $12.8 million and recognized an impairment of $2.2 million during the quarter ended June 30, 2012. Provision for Income Taxes We recorded a benefit for income taxes of $24.0 million during Fiscal 2013 as compared to a provision for income taxes of $29.6 million during Fiscal 2012. Our provision for income taxes included both the current and deferred provision for income tax expense resulting from timing differences between tax and financial reporting accounting bases. We were unable to 46-------------------------------------------------------------------------------- Table of Contents combine our NOLs for application to the income of our subsidiaries in some states and thus our state income tax expense was higher than the expected blended rate. During Fiscal 2013, we dissolved certain acquired legal entities, which resulted in the loss of state NOLs that were generated by those entities. The loss of these NOLs resulted in a decrease in the benefit for income taxes of $2.8 million for Fiscal 2013. In addition, as a result of our stock-based compensation and certain transaction costs not being deductible for income tax purposes, our effective tax rate was higher than the statutory rate. The following table reconciles our expected tax provision based on the statutory federal tax rate applied to our earnings before income taxes to our actual provision/(benefit) for income taxes: Year ended June 30, 2013 2012 (in thousands) Expected (benefit)/provision at statutory rate $ (59,046 ) $ 8,298 Increase due to: Non-deductible stock-based compensation 35,576 8,685 State income taxes, net of federal (benefit)/provision (2,201 ) 5,184 Transactions costs not deductible for tax purposes 1,257 1,416 State NOL adjustment 2,788 - Foreign tax rate differential (2,264 ) - Provision for uncertain tax positions, net - 5,808 Change in effective tax rate - 459 Other, net (156 ) (293 ) (Benefit)/provision for income taxes $ (24,046 ) $ 29,557 Adjusted EBITDA We define Adjusted EBITDA as earnings from continuing operations before interest, income taxes, depreciation and amortization ("EBITDA") adjusted to exclude acquisition or disposal-related transaction costs, losses on extinguishment of debt, stock-based compensation, unrealized foreign currency gains on an intercompany loan, and impairment of cost method investment. We use Adjusted EBITDA to evaluate operating performance, and this financial measure is among the primary measures used by management for planning and forecasting for future periods. We believe that the presentation of Adjusted EBITDA is relevant and useful for investors because it allows investors to view results in a manner similar to the method used by management and facilitates comparison of our results with the results of other companies that have different financing and capital structures. We also monitor Adjusted EBITDA because our subsidiaries have debt covenants that restrict their borrowing capacity that are based on a leverage ratio, which utilizes a modified EBITDA, as defined in our Credit Agreement and Indenture. The modified EBITDA is consistent with our definition of Adjusted EBITDA; however, it includes the pro forma Adjusted EBITDA of and expected cost synergies from the companies acquired by us during the quarter for which the debt compliance certification is due. Adjusted EBITDA results, along with other quantitative and qualitative information, are also utilized by management and our compensation committee for purposes of determining bonus payouts to employees. Adjusted EBITDA has limitations as an analytical tool and should not be considered in isolation from, or as a substitute for, analysis of our results from operations and operating cash flows as reported under GAAP. For example, Adjusted EBITDA: does not reflect capital expenditures, or future requirements for capital and major maintenance expenditures or contractual commitments; does not reflect changes in, or cash requirements for, our working capital needs; does not reflect interest expense, or the cash requirements necessary to service the interest payments, on our debt; and does not reflect cash required to pay income taxes. Our computation of Adjusted EBITDA may not be comparable to other similarly titled measures computed by other companies because all companies do not calculate Adjusted EBITDA in the same fashion. 47-------------------------------------------------------------------------------- Table of Contents Reconciliations from segment and consolidated Adjusted EBITDA to net earnings/(loss) are as follows: For the year ended June 30, 2014 Physical Corp/ Infrastructure Lit Services eliminations Total (in millions) Segment and consolidated Adjusted EBITDA $ 325.6 $ 326.7 $ - $ 652.3 Interest Expense (121.8 ) (81.2 ) (0.5 ) (203.5 ) Depreciation and amortization expense (205.0 ) (131.4 ) - (336.4 ) Transaction costs (2.8 ) (1.0 ) (0.7 ) (4.5 ) Stock-based compensation (163.4 ) (90.0 ) - (253.4 ) Loss on extinguishment of debt (1.1 ) (0.8 ) - (1.9 ) Unrealized foreign currency translation gains - - 4.7 4.7 (Loss)/earnings from continuing operations before provision for income tax (168.5 ) 22.2 3.6 (142.6 ) Provision for income taxes - - (37.8 ) (37.8 ) Net (loss)/earnings $ (168.5 ) $ 22.2 $ (34.2 ) $ (180.5 ) For the year ended June 30, 2013 Physical Corp/ Infrastructure Lit Services eliminations Total (in millions) Segment and consolidated Adjusted EBITDA $ 276.2 $ 278.4 $ (1.6 ) $ 553.0 Interest Expense (119.0 ) (83.5 ) - (202.5 ) Depreciation and amortization expense (183.6 ) (139.1 ) - (322.7 ) Transaction costs (7.2 ) (7.0 ) - (14.2 ) Stock-based compensation (46.4 ) (58.7 ) - (105.0 ) Loss on extinguishment of debt (45.1 ) (32.2 ) - (77.3 ) Unrealized foreign currency translation gains - - 0.1 0.1 (Loss)/earnings from continuing operations before provision for income tax (125.0 ) (42.1 ) (1.5 ) (168.6 ) Benefit for income taxes - - 24.0 24.0 Earnings from discontinued operations, net of income taxes - - 1.8 1.8 Net (loss)/earnings $ (125.0 ) $ (42.1 ) $ 24.3 $ (142.8 ) For the year ended June 30, 2012 Corp/ Physical Infrastructure Lit Services eliminations Total (in millions) Segment and consolidated Adjusted EBITDA $ 101.1 $ 92.1 $ 1.3 $ 194.5 Interest Expense (23.2 ) (27.5 ) - (50.7 ) Depreciation and amortization expense (38.5 ) (46.4 ) - (85.0 ) Transaction costs (2.2 ) (4.4 ) - (6.6 ) Stock-based compensation (13.6 ) (12.7 ) - (26.3 ) Impairment of cost method investment - (2.2 ) - (2.2 ) (Loss)/earnings from continuing operations before provision for income tax 23.5 (1.1 ) 1.3 23.7 Provision for income taxes - - (29.5 ) (29.5 ) Net (loss)/earnings $ 23.5 $ (1.1 ) $ (28.2 ) $ (5.8 ) 48-------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources Our primary sources of liquidity have been cash provided by operations, equity contributions, and borrowings. Our principal uses of cash have been for acquisitions, capital expenditures, and debt service requirements. See "Cash Flows" below. We anticipate that our principal uses of cash in the future will be for acquisitions, capital expenditures, working capital, and debt service. We have financial covenants under the Indentures governing our Notes and our Credit Agreement that, under certain circumstances, restrict our ability to incur additional indebtedness. The Indentures governing our Notes limit any increase in our secured indebtedness (other than certain forms of secured indebtedness expressly permitted under the Indentures) to a pro forma secured debt ratio of 4.5 times our previous quarter's annualized modified EBITDA and limit our incurrence of additional indebtedness to a total indebtedness ratio of 5.25 times our previous quarter's annualized modified EBITDA. The Credit Agreement similarly limits our incurrence of additional indebtedness. See Note 9 - Long Term Debt - Debt Covenants to our audited consolidated financial statements for more information on our financial covenants. As of June 30, 2014, we had $292.6 million in cash and cash equivalents and a working capital surplus of $193.2 million. Cash and cash equivalents consist of amounts held in bank accounts and highly-liquid U.S. treasury money market funds. Additionally, as of June 30, 2014, we had $243.6 million available under our Revolver. Our capital expenditures, net of stimulus grants, increased by $37.6 million, or 12%, during the year ended June 30, 2014 as compared to the year ended June 30, 2013, from $323.2 million to $360.8 million, respectively. The increase in capital expenditures is a result of meeting the needs of our larger customer base resulting from our acquisitions and organic growth. We expect to continue to invest in our network for the foreseeable future. These capital expenditures, however, are expected to primarily be success-based; that is, in most situations, we will not invest the capital until we have an executed customer contract that supports the investment. As part of our corporate strategy, we continue to be regularly involved in discussions regarding potential acquisitions of companies and assets. We expect to fund such acquisitions with cash from operations, debt (including available borrowings under our $250.0 million Revolver), equity contributions, and available cash on hand. Cash Flows We believe that our cash flow from operating activities, in addition to cash and cash equivalents currently on-hand, will be sufficient to fund our operating activities and capital expenditures for the foreseeable future, and in any event for at least the next 12 to 18 months. Given the generally volatile global economic climate, no assurance can be given that this will be the case. We regularly consider acquisitions and additional strategic opportunities, including large acquisitions, which may require additional debt or equity financing. The following table sets forth the components of our cash flow for the years ended June 30, 2014, 2013, and 2012. Year Ended June 30, 2014 2013 2012 (In thousands) Net cash provided by operating activities $ 560,297 $ 393,321 $ 167,630 Net cash used in investing activities (754,098 ) (2,795,942 ) (475,410 ) Net cash provided by financing activities 397,249 2,334,041 433,079 Cash Flows from Operating Activities of Continuing Operations Cash flows from operating activities of continuing operations increased by $167.1 million, or 42%, from $393.3 million for Fiscal 2013 to $560.3 million for Fiscal 2014. Cash flows from operating activities during the year ended June 30, 2014 represents the loss from continuing operations of $180.5 million, plus the add backs of non-cash items deducted in the determination of net loss, principally depreciation and amortization of $336.4 million, loss on extinguishment of debt of $1.9 million, stock-based compensation expense of $253.4 million, provision for bad debts of $1.9 million, additions to deferred revenue of $163.8 million, non-cash interest expense of $22.1 million and change in the deferred tax provision of $24.7 million, less amortization of deferred revenue of $53.9 million, minus the net change in working capital components. Cash flows from operating activities during the year ended June 30, 2013 represents the loss from continuing operations of 49-------------------------------------------------------------------------------- Table of Contents $144.6 million, plus the add backs of non-cash items deducted in the determination of net loss, principally depreciation and amortization of $322.7 million, stock-based compensation expense of $105.1 million, losses on extinguishment of debt of $77.3 million, additions to deferred revenue of $42.3 million and non-cash interest expense of $12.3 million, less amortization of deferred revenue of $61.5 million and the change in deferred tax provision of $25.7 million, plus the net change in working capital components. The increase in cash flows from operating activities during the year ended June 30, 2014 as compared to the year ended June 30, 2013 is primarily a result of additional earnings from our organic growth, cost synergies realized from our acquisitions and interest expense savings from our refinancings. Cash flows from operating activities of continuing operations increased by $225.7 million, or 135%, from $167.6 million for Fiscal 2012 to $393.3 million for Fiscal 2013. Cash flows from operating activities during the year ended June 30, 2012 represents our net loss from continuing operations of $5.9 million, plus the add back to our net loss of non-cash items deducted in the determination of net loss, principally depreciation and amortization of $85.0 million, additions to deferred revenue of $55.0 million, non-cash interest expense of $4.8 million, the change in deferred tax provision of $31.1 million and non-cash stock-based compensation expense of $26.3 million, less amortization of deferred revenue of $13.8 million, minus the change in working capital components. The increase in cash flows from operating activities during the year ended June 30, 2013 as compared to the year ended June 30, 2012 is primarily a result of additional earnings from our organic growth and cost synergies realized from our acquisitions. Cash Flows from Investing Activities of Continuing Operations We used cash in investing activities of continuing operations of $754.1 million, $2,795.9 million, and $475.4 million during the years ended June 30, 2014, 2013, and 2012, respectively. During the year ended June 30, 2014, our principal uses of cash for investing activities were $360.8 million in additions to property and equipment, $0.3 million for Corelink, $40.1 million for the acquisition of Access, $43.1 million for the acquisition of FiberLink, $17.5 million for the acquisition of CoreXchange, and $292.3 million for the acquisition of Geo. During the year ended June 30, 2013, our principal uses of cash for investing activities were $2,212.5 million for the acquisition of AboveNet, $118.3 million for the acquisition of FiberGate, $16.1 million for the acquisition of USCarrier, $109.7 million for the acquisition of First Telecom, $22.2 million for the acquisition of Litecast, $7.0 million for the acquisition of Core NAP, and $323.2 million in additions to property and equipment, net of stimulus grant reimbursements. Partially offsetting the net cash used in investing activities during the year ended June 30, 2013 was purchase consideration of $2.7 million returned from our acquisitions of MarquisNet and Arialink. During the year ended June 30, 2012, our principal uses of cash for investing activities were $317.9 million for the acquisition of 360networks, $15.5 million for our acquisition of MarquisNet, $17.9 million for the acquisition of Arialink, and $124.1 million in additions to property and equipment, net of stimulus grant reimbursements. Cash Flows from Financing Activities of Continuing Operations Our cash provided by financing activities was $397.2 million, $2,334.0 million and $433.1 million during the years ended June 30, 2014, 2013, and 2012, respectively. Our cash flows from financing activities during the year ended June 30, 2014 primarily consist of $618.6 million from the proceeds from long-term debt offset by $213 million in principal payments on long-term debt obligations, $7.9 million in principal payments on capital leases, and $4.9 million in debt issuance costs during Fiscal 2014. Our cash flows from financing activities during the year ended June 30, 2013 primarily consist of $3,189.3 million from the proceeds from long-term debt, $345.0 million in equity contributions from CII and $22.7 million in net transfers of cash out of restricted cash accounts. These cash inflows were partially offset by $83.1 million in debt issuance costs, $1,058.6 million in principal repayments on long-term debt obligations, $72.1 million in early redemption fees on debt extinguishments, and $1.9 million in principal payments on capital leases during Fiscal 2013. Our cash flows from financing activities during the year ended June 30, 2012 consist of $335.6 million from the proceeds from long-term borrowings, and $134.8 million in equity contributions from CII. This cash inflow was partially offset by $11.7 million in debt issuance costs, $1.6 million in principal repayments on long-term debt obligations, $22.8 million in net transfers of cash to restricted cash accounts, and $1.2 million in principal payments on capital leases during Fiscal 2012. 50-------------------------------------------------------------------------------- Table of Contents Contractual Cash Obligations The following table represents a summary of our estimated future payments under contractual cash obligations as of June 30, 2014 for continuing operations. Changes in our business needs, cancellation provisions, changing interest rates and other factors may result in actual payments differing from these estimates. We cannot provide certainty regarding the timing and amounts of these future payments. Less More Than 1 Than 5 Total Year 1-3 Years 3-5 Years Years (in thousands) Long-term debt (principal and interest) $ 4,368,768 $ 217,956 $ 433,656 $ 420,836 $ 3,296,320 Operating leases 854,084 96,492 149,107 110,602 497,883 Purchase obligations 157,105 157,105 - - - Capital leases (principal and interest) 31,948 4,012 7,982 6,778 13,176 Total $ 5,411,905 $ 475,565 $ 590,745 $ 538,216 $ 3,807,379 Our operating leases and purchase commitments include expected payments for our operating facilities, network services and capacity, communications equipment, and maintenance obligations. Our purchase commitments are primarily success-based, meaning that before we commit resources to expand our network, we have a signed customer contract that will provide us with an attractive return on the required capital. The contractual long-term debt payments, above, include an estimate of future interest expense based on the interest rates in effect on our floating rate debt obligations as of the most recent balance sheet date. Cash payments for interest, net of capitalized interest, which are reflected in our cash flows from operating activities, during the year ended June 30, 2014 were $175.3 million and represent 31% of our cash flows from operating activities before interest expense. We also made cash payments related to principal payments on our debt obligations of $25.9 million (exclusive of the impact of refinancing transactions), which are reflected in our cash flows from financing activities, and represent 5% of our cash flows from operating activities. 51-------------------------------------------------------------------------------- Table of Contents Off-Balance Sheet Arrangements We do not have any special purpose or limited purpose entities that provide off-balance sheet financing, liquidity, or market or credit risk support and we do not engage in leasing, hedging, or other similar activities that expose us to any significant liabilities that are not reflected in our audited consolidated financial statements, or disclosed in Note 15-Commitments and Contingencies to our audited consolidated financial statements, or in the Future Contractual Obligations table included above. Recently Issued Accounting Pronouncements Discontinued Operations On April 10, 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2014-08-Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity. The amendments in the ASU change the criteria for reporting discontinued operations for all public and nonpublic entities. The amendments also require new disclosures about discontinued operations and disposals of components of an entity that do not qualify for discontinued operations reporting. The ASU is effective prospectively for disposals (or classifications as held-for-sale) that occur within annual periods beginning on or after December 15, 2014, and interim periods within those annual periods, for public entities, with early adoption permitted for disposals (or classifications as held-for-sale) that have not been reported in financial statements previously issued or available for issuance. The Company has not yet adopted the guidance under this ASU. Revenue Recognition On May 28, 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers, which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The ASU will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. The new standard is effective for us on or after July 1, 2017. Early application is not permitted. The standard permits the use of either the retrospective or cumulative effect transition method. We are evaluating the effect that ASU 2014-09 will have on our consolidated financial statements and related disclosures. We have not yet selected a transition method nor have we determined the effect of the standard on our ongoing financial reporting. 52-------------------------------------------------------------------------------- Table of Contents |