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BROADVIEW NETWORKS HOLDINGS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the Unaudited Condensed Consolidated Financial Statements and Notes to the Unaudited Condensed Consolidated Financial Statements included elsewhere in this quarterly report and our Form 10-K for the year ended December 31, 2011 filed with the Securities and Exchange Commission (the "SEC"). Certain information contained in the discussion and analysis set forth below and elsewhere in this quarterly report, including information with respect to our plans and strategies for our business and related financing, includes forward-looking statements that involve risk and uncertainties. In evaluating such statements, existing and prospective investors should specifically consider the various factors identified in this quarterly report that could cause results to differ materially from those expressed in such forward-looking statements, including matters set forth in our Form 10-K for the year ended December 31, 2011 filed with the SEC. Many of the amounts and percentages presented in this discussion and analysis have been rounded for convenience of presentation, and all amounts included in tables are presented in thousands. Overview We are a leading communications and IT solutions provider to small and medium sized business ("SMB") and large business, or enterprise customers nationwide, with a historical focus on markets across 10 states throughout the Northeast and Mid-Atlantic United States, including the major metropolitan markets of New York, Boston, Philadelphia, Baltimore and Washington, D.C. We offer a comprehensive product portfolio and deliver an end-to-end communications solution to our customers, with a focus on addressing complex infrastructure, productivity and security needs through a combination of products and services. We have provided cloud-based communications services in our Northeast and Mid-Atlantic markets since 2006 and have provided these services nationwide since late 2009. For the three months ended September 30, 2012, approximately 91% of our total revenue was generated from retail end users in a wide array of industries, including professional services, health care, education, manufacturing, real estate, retail, automotive, non-profit groups and others. For the same period, approximately 9% of our total revenue was generated from wholesale, carrier access and other sources. For the three months ended September 30, 2012, we generated revenues of $82.6 million and Adjusted EBITDA of $14.8 million. See the section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations - Adjusted EBITDA Presentation." For the nine months ended September 30, 2012, and the years ended December 31, 2011 and 2010, we recorded operating income of $4.5 million, $27.5 million and $20.8 million, respectively. For the nine months ended September 30, 2012 and the years ended December 31, 2011 and 2010, we recorded net losses of $26.7 million, $11.9 million and $18.8 million, respectively. Although we expect to continue to have net losses for the foreseeable future, we continue to search for ways of increasing operating efficiencies that could potentially offset continued pressures on revenue and margin. Our business is subject to several macro trends, some of which negatively affect our operating performance. Among these negative trends are lower wireline voice usage per customer, which translates into less usage-based revenue and lower unit pricing for certain services. In addition, we continue to face other industry-wide trends including rapid technology changes and overall increases in competition from existing large competitors such as Verizon Communications, Inc. ("Verizon") and established cable operators, competitive local exchange carriers ("CLECs") and newer entrants such as Voice Over Internet Protocol ("VoIP"), wireless and other service providers. These factors are partially mitigated by several positive trends. These include a more stable customer base, increasing revenue per customer due to the trend of customers buying more products from us as we deploy new technology and expand our offerings, higher contribution margins for our VoIP services, a focus on larger customers and an overall increase in demand for data, managed and cloud-based services. Although our overall revenue has declined since 2008, we have partially mitigated the impact of the revenue decline on our overall operating results by reducing costs of revenue and selling, general and administrative ("SG&A") costs, the achievement of operating efficiencies throughout the organization and by the net effect of non-recurring gains and losses. As of September 30, 2012, we had approximately 190 sales, sales management and sales support employees, including approximately 140 quota-bearing representatives in all sales channels, the majority of whom target SMB and enterprise customers located within the footprint of our switching centers and approximately 260 colocations. We also offer our cloud-based solutions, including our OfficeSuite® VoIP solution, on a nationwide basis and have chosen our agent sales channel as our primary distribution channel for nationwide sales. We recently began using alternate channels including web-based, search engine marketing and distribution partners in addition to our traditional channels. We focus our sales efforts on communications intensive multi-location business customers who purchase multiple products. These customers generally purchase higher margin services in multi-year contracts, and consequently maintain higher retention rates. We believe that the lack of focus from the incumbent local exchange carriers ("ILECs") and cable companies on the SMB segment has created a sustainable growth opportunity and have focused our strategies on providing SMB customers with a competitive communications solution. 14-------------------------------------------------------------------------------- Table of Contents We focus our business strategy on providing services based on our T-1 and Ethernet-based products, as well as our cloud-based services, which we believe offer greater value to customers, increase customer retention and provide revenue growth opportunities for us. Historically, the Company's revenue was dominated by off-net, voice revenue from smaller customers. We have transitioned a large percentage of our revenue base to T-1- and IP-based products and cloud-based communications services. For the three months ended September 30, 2012, revenue from these accounts represented 76% of our retail revenue with 16% of retail revenue generated by cloud-based communications services, 45% of retail revenue generated by other T-1- and IP-based products, and 15% of retail revenue generated by traditional voice services provided to those T-1- and IP-based accounts. For the same period, T-1- and IP-based products represented approximately 81% of new retail sales, with typical incremental gross profit margins in excess of 60%. Cloud-based services, including cloud-based computing services, represented approximately 40% of new retail sales while other T-1- and IP-based products represented 41% of new retail sales. From the first quarter of 2009 to the third quarter of 2012, cloud-based products and services have grown at a 28% compounded annual growth rate ("CAGR"). Our facilities-based network encompasses approximately 3,000 route miles of metro and long-haul fiber and approximately 260 colocations. We have agreements in place with approximately 400 lit buildings that allow us to colocate our network equipment in order to reduce our last-mile cost. Our network architecture pairs the strength of a traditional infrastructure with IP and Multiprotocol Label Switching ("MPLS") platforms. These platforms, in conjunction with our software development expertise and proprietary technology, allow us to offer a product line that includes advanced, converged services, such as our cloud-based solutions, virtual private networks ("VPNs") and complex multi-location services, on a cost effective basis. Our network topology incorporates metro Ethernet over Copper ("EoC") access technology, enabling us to provide multi-megabit data services through copper loops to customers from selected major metropolitan colocations, resulting in lower costs and higher margins. In addition, we are able to deliver our cloud-based communications services nationwide utilizing partner carriers for last-mile access. A significant portion of our customer base has been migrated to our IP- and MPLS-based infrastructure, which enhances the performance of our network. As of September 30, 2012, approximately 78% of our total installed lines were provisioned on-net. Voluntary Reorganization Under Chapter 11 and Other Events On the Petition Date, we filed voluntary petitions for reorganization under Chapter 11 of the Code in the Court in order to effectuate the Plan. On October 3, 2012, the Court entered an order confirming the Plan. Upon consummation of the Plan, the significant financial effects of the emergence will include: • cancellation of all existing equity interests including capital stock, options, warrants or other rights to purchase the Company's existing capital stock; • recapitalization of the Company with the authorization of 19,000,000 shares of Common Stock and 1,000,000 shares of preferred stock; • holders of the Notes will receive their pro rata share of 97.5% of newly issued Common Stock (subject to dilution by the exercise of warrants and equity pursuant to a management incentive plan) and $150 million of New Notes; • holders of the existing preferred stock will receive their pro rata share of (i) 2.5% of newly issued Common Stock (subject todilution by the exercise of warrants and equity pursuant to a management incentive plan), and (ii) two tranches of eight-year warrants to acquire shares of newly issued Common Stock representing, in the aggregate, up to 15.0% of the Company's outstanding capital stock following the restructuring (subject to dilution as described above); • execution of the Exit Facility; • repayment of $15.9 million of principal and accrued interest under the DIP Credit Facility; and • cancelation of the Notes totaling approximately $316.2 million, which includes accrued interest. The Plan does not contain any significant compromise and settlement agreement, other than those identified in this report. Under the Plan, general unsecured creditors, vendors, customers and employees will not be negatively impacted and our obligations to these groups are expected to be paid in full in accordance with their original terms. In connection with the Plan, we will cancel all existing equity interests in the Company, including capital stock, options, warrants and other rights to purchase existing capital stock and will recapitalize the Company with the authorization of 19,000,000 shares of Common Stock and 1,000,000 shares of Preferred Stock. 15-------------------------------------------------------------------------------- Table of Contents From the Petition Date to the Effective Date, we have operated the business as "debtors-in-possession" under the jurisdiction of the Court and in accordance with the applicable provisions of the Code and the orders of the Court. At September 30, 2012, we recorded $316.2 million of liabilities subject to compromise, which consists entirely of the principal of the Notes plus accrued interest. In addition, we recorded a reorganization expense of $1.4 million for the three and nine months ended September 30, 2012, which consisted entirely of professional fees. While we continue to believe that our projections and the underlying assumptions contained in the Disclosure Statement that was distributed and publicly filed in connection with the Restructuring and our solicitation of the Plan are reasonable for its long-term forecast, the potential impact of the pre-petition and bankruptcy period resulting from the Restructuring is difficult to estimate and may have a negative effect on our results of operations for the remainder of 2012 and into 2013. In addition, the potential impact of Hurricane Sandy is difficult to predict, but may also provide negative impacts on the Company's results. In both cases, these are expected to be short term in nature and not affect our long-term views of overall business prospects. The areas most likely to be affected include, but are not limited to: • new sales and customer churn directly related to the negative image of our Restructuring and the storm; and • incremental capital and operating costs required due to the storm such as overtime, duplicate network costs and replacement network equipment. 16-------------------------------------------------------------------------------- Table of Contents Results of Operations The following table sets forth, for the periods indicated, certain financial data as a percentage of total revenues. Three Months Ended September 30, Nine Months Ended September 30, 2012 2011 2012 2011 Revenues: Voice and data services 90.6 % 86.9 % 89.0 % 86.5 % Wholesale 7.1 % 6.2 % 6.7 % 6.0 % Access 0.2 % 4.8 % 2.3 % 5.4 % Total network services 97.9 % 97.9 % 98.0 % 97.9 % Other 2.1 % 2.1 % 2.0 % 2.1 % Total revenues 100.0 % 100.0 % 100.0 % 100.0 % Operating expenses: Network services 48.5 % 46.2 % 47.5 % 46.0 % Other cost of revenues 0.8 % 0.7 % 0.8 % 0.9 % Selling, general and administrative 41.7 % 35.7 % 39.3 % 35.1 % Depreciation and amortization 11.0 % 10.7 % 10.7 % 10.3 % Total operating expenses 102.0 % 93.3 % 98.3 % 92.3 % Income from operations (2.0 )% 6.7 % 1.7 % 7.7 % Reorganization items (1.7 )% - % (0.6 )% - %Interest expense, net of interest income (11.5 )% (10.2 )% (11.1 )% (10.1 )% Other Income - % - % - % 0.1 % Loss before provision for income taxes (15.2 )% (3.5 )% (10.0 )% (2.3 )% Provision for income taxes (0.4 )% (0.4 )% (0.4 )% (0.4 )% Net loss (15.6 )% (3.9 )% (10.4 )% (2.7 )% Key Components of Results of Operations Revenues Our revenues, as detailed in the table above, consist primarily of network services revenues, which consist primarily of voice and data managed and cloud-based services, wholesale services and access services. Voice and data services consist of local dial tone, long distance and data services, as well as managed and cloud-based services. Wholesale services consist of voice and data services, data collocation services and transport services. Access services includes carrier access and reciprocal compensation revenue, which consists primarily of usage charges that we bill to other carriers to originate and terminate their calls from and to our customers. Network services revenues represents a predominantly recurring revenue stream linked to our retail and wholesale customers. For the nine months ended September 30, 2012 approximately 89.0% of our total revenue was generated from retail customer voice and data products and services. Revenue from data and integrated voice/data products, including cloud-based services and T-1/T-3 and other managed services has been trending to an increasing percentage of our overall revenue over the past several years, while voice revenues have been declining primarily due to the decline in revenue from traditional voice services, or Plain Old Telephone Services ("POTS"). In recent quarters, we have experienced a reduction in the quarterly rate of decline of our POTS revenues. Since June 30, 2010, our average quarterly rate of decline was 3.8% as compared to the 5.7% average quarterly rate of decline experienced during the quarters from April 1, 2009 to June 30, 2010, when the combined effects of the recession and our shift in product focus most impacted our results. Our cloud-based revenues have grown from the first quarter of 2009 to the third quarter of 2012 at a 28% CAGR. As a result, the average quarterly decline in our core voice and data revenue, which excludes certain ancillary voice and data revenue components, has improved over the past several quarters with an average quarterly decrease of $1.4 million in the nine months ended September 30, 2012 as compared to an average quarterly decrease of $1.8 million in 2011, $2.4 million in 2010 and a peak sequential decrease of $4.7 million in the quarter ended June 30, 2009. Our cloud-based products and services comprised approximately 16% of our retail revenue and approximately 40% of new retail sales for the three months ended September 30, 2012. We continue to focus on cloud-based, data and managed services as growth 17-------------------------------------------------------------------------------- Table of Contents opportunities as we expect the industry to trend toward lower usage components of legacy products such as long distance and local usage. This lower usage is primarily driven by trends toward customers using more online and wireless communications. Cost of Revenues (exclusive of depreciation and amortization) Our network services cost of revenues consist primarily of the cost of operating our network facilities. Determining our cost of revenues requires significant estimates. The network components for our facilities-based business include the cost of: • leasing local loops and digital T-1 lines which connect our customers to our network; • leasing high capacity digital lines that connect our switching equipment to our colocations; • leasing high capacity digital lines that interconnect our network with the ILECs; • leasing space, power and terminal connections in the incumbent local exchange carrier central offices for colocating our equipment; • signaling system network connectivity; and • Internet transit and peering, which is the cost of delivering Internet traffic from our customers to the public Internet. The costs to obtain local loops, digital T-1 lines and high capacity digital interoffice transport facilities from the ILECs vary by carrier and state and are regulated under federal and state laws. We do not anticipate any significant changes in Verizon local loop, digital T-1 line or high capacity digital interoffice transport facility rates in the near future. Except for our lit buildings, within our footprint we obtain local loops, T-1 lines and interoffice transport capacity from the ILECs. We obtain interoffice facilities from carriers other than the ILECs, where possible, in order to lower costs and improve network redundancy; however, in most cases, the ILECs are our only source for local loops and T-1 lines. Our off-net network services cost of revenues consist of amounts we pay to Verizon, FairPoint Communications, Inc. ("FairPoint") and AT&T, Inc. ("AT&T") pursuant to our commercial agreements with them. Rates for such services are prescribed in the commercial agreements and available for the term of the agreements. The FairPoint agreement operates on a month-to-month basis. The Verizon and AT&T commercial agreements expire in January 2013 and December 2014, respectively. The Verizon commercial agreement contains certain minimum purchase obligations, which we have met in all of the years we were under the agreement. Our network services cost of revenues include the fees we pay for long distance, data and other services. We have entered into long-term wholesale purchasing agreements for these services. Some of the agreements contain significant termination penalties and/or minimum usage volume commitments. In the event we fail to meet minimum volume commitments, we may be obligated to pay underutilization charges. Gross Profit (exclusive of depreciation and amortization) Gross profit (exclusive of depreciation and amortization), referred to herein as "gross profit", as presented in this Management's Discussion and Analysis of Financial Condition and Results of Operations, represents income from operations, before depreciation and amortization and SG&A. Gross profit is a non-GAAP financial measure used by our management, together with financial measures prepared in accordance with GAAP such as revenue, cost of revenue, and income from operations to assess our historical and prospective operating performance. The following table sets forth, for the periods indicated, a reconciliation of gross profit to income from operations as income from operations is calculated in accordance with GAAP: Three Months Ended September 30, Nine Months Ended September 30, 2012 2011 2012 2011 Income (loss) from operations $ (1,639 ) $ 6,290 $ 4,501 $ 22,031 Depreciation and amortization 9,006 9,941 27,564 29,709 Selling, general and administrative 34,467 33,360 101,351 100,942 Gross profit $ 41,834 $ 49,591 $ 133,416 $ 152,682 Percentage of total revenue 50.7 % 53.1 % 51.7 % 53.1 % Gross profit is not a financial measurement prepared in accordance with GAAP. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Key Components of Result of Operations - Gross Profit (exclusive of depreciation and amortization)" in our Form 10-K for the year ended December 31, 2011 for our reasons for including gross profit data in this quarterly report and for material limitations with respect to the usefulness of this measurement. 18-------------------------------------------------------------------------------- Table of Contents Selling, General and Administrative SG&A is comprised primarily of salaries and related expenses, software development expenses, occupancy costs, sales and marketing expenses, commission expenses, bad debt expense, billing expenses, professional services expenses, including non-recurring fees in connection with the Restructuring and insurance expenses. Determining our allowance for doubtful accounts receivable requires significant estimates. In determining the proper level for the allowance we consider factors such as historical collections experience, the aging of the accounts receivable portfolio and economic conditions. We perform a credit review process on each new significant customer that involves reviewing the customer's current service provider bill and payment history, matching customers with national databases for delinquent customers and, in some cases, requesting credit reviews through Dun & Bradstreet Corporation. Depreciation and Amortization Our depreciation and amortization expense currently includes depreciation for network related voice and data equipment, fiber, back-office systems, third party conversion costs, furniture, fixtures, leasehold improvements, office equipment and computers and amortization of intangibles associated with mergers, acquisitions and software development costs. Reorganization Items Our expenses that result from Chapter 11 reorganization activities and Restructuring are reported as reorganization items in our consolidated condensed statements of operations. Our reorganization expenses consisted entirely of professional fees. Adjusted EBITDA Presentation Adjusted EBITDA as presented in this Management's Discussion and Analysis of Financial Condition and Results of Operations, represents net loss before depreciation and amortization, interest income and expense, provision for income taxes, severance and related separation costs, costs associated with an early lease termination, professional fees related to strategic initiatives, post-petition reorganization items and costs associated with a carrier settlement. Adjusted EBITDA is not a measure of financial performance under GAAP. Adjusted EBITDA is a non-GAAP financial measure used by our management, together with financial measures prepared in accordance with GAAP such as net loss, income (loss) from operations and revenues, to assess our historical and prospective operating performance. The following table sets forth, for the periods indicated, a reconciliation of adjusted EBITDA to net loss as net loss is calculated in accordance with GAAP: Three Months Ended September 30, Nine Months Ended September 30, 2012 2011 2012 2011 Net loss $ (12,876 ) $ (3,699 ) $ (26,658 ) $ (7,762 ) Add back non-EBITDA items included in net loss: Depreciation and amortization 9,006 9,941 27,564 29,709 Interest expense, net of interest income 9,454 9,606 28,762 28,903 Provision for income taxes 355 382 969 1,073 EBITDA 5,939 16,230 30,637 51,923 Severance and related separation costs 1 31 372 266 Professional fees related to strategic initiatives(1) 4,675 100 9,787 175 Reorganization items 1,428 - 1,428 - Costs associated with carrier settlement 2,800 - 2,800 - Costs associated with early termination of lease - 955 - 955 Other income - - - (183 ) Adjusted EBITDA $ 14,843 $ 17,316 $ 45,024 $ 53,136 Percentage of total revenues 18.0 % 18.5 % 17.4 % 18.5 % (1) During the three months ended June 30, 2012, management determined that costs associated with refinancing efforts should be written off. These costs, totaling $1,630, were included in other assets on our condensed consolidated balance sheet at December 31, 2011. 19-------------------------------------------------------------------------------- Table of Contents Adjusted EBITDA is not a financial measurement prepared in accordance with GAAP. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Key Components of Results of Operations - Adjusted EBITDA Presentation" in our Form 10-K for the year ended December 31, 2011 for our reasons for including Adjusted EBITDA data in this quarterly report and for material limitations with respect to the usefulness of this measurement. Three Months Ended September 30, 2012 Compared to Three Months Ended September 30, 2011 Set forth below is a discussion and analysis of our results of operations for the three months ended September 30, 2012 and 2011. The following table provides a breakdown of components of our gross profit for the three months ended September 30, 2012 and 2011: Three Months Ended September 30, 2012 2011 % of Total % of Total Amount Revenues Amount Revenues % Change Revenues: Network services $ 80,868 97.9 % $ 91,506 97.9 % (11.6 )% Other 1,719 2.1 % 1,938 2.1 % (11.3 )% Total revenues 82,587 100.0 % 93,444 100.0 % (11.6 )% Cost of revenues: Network services 40,088 48.5 % 43,173 46.2 % (7.1 )% Other 665 0.8 % 680 0.7 % (2.2 )% Total cost of revenues 40,753 49.3 % 43,853 46.9 % (7.1 )% Gross profit: Network services 40,780 49.4 % 48,333 51.7 % (15.6 )% Other 1,054 1.3 % 1,258 1.4 % (16.2 )% Total gross profit $ 41,834 50.7 % $ 49,591 53.1 % (15.6 )% Revenues Revenues for the three months ended September 30, 2012 and 2011 were as follows: Three Months Ended September 30, 2012 2011 % of Total % of Total Amount Revenues Amount Revenues % Change Revenues: Voice and data services $ 74,861 90.6 % $ 81,161 86.9 % (7.8 )% Wholesale 5,870 7.1 % 5,829 6.2 % 0.7 % Access 137 0.2 % 4,516 4.8 % (97.0 )% Total network services 80,868 97.9 % 91,506 97.9 % (11.6 )% Other 1,719 2.1 % 1,938 2.1 % (11.3 )% Total revenues $ 82,587 100.0 % $ 93,444 100.0 % (11.6 )% Revenues from voice and data services decreased $6.3 million or 7.8% between 2011 and 2012. Within voice and data services, revenues from core voice and data services, excluding cloud-based services, decreased $8.8 million, or 12.5%; revenues from cloud-based services increased $2.2 million, or 22.4%; and ancillary voice and data revenues increased by $0.3 million or 20.1%. The decrease in non-cloud core services was due to: i) line churn which while improving in recent quarters still exceeds line additions, ii) lower usage revenue per customer, iii) lower prices per unit for certain traditional services and iv) a lower number of lines and customers. Wholesale revenues were unchanged. Access revenue decreased by $4.4 million or 97.0%. Of this decrease, $2.8 million was a result of a one-time settlement of access charges with another carrier, which was recorded during the three months ended September 30, 2012. In addition our access revenues decreased due to several factors, including: decreasing levels of traffic to which access charges are applicable, including decreases in retail voice customer traffic, lower per-minute rates charged to carriers as a result of FCC-mandated rate decreases and the impact of increased disputes related to access charges. 20-------------------------------------------------------------------------------- Table of Contents Other revenues decreased $0.2 million or 11.3% between 2011 and 2012. Other revenues include data cabling, service installation and wiring and phone systems sales and installation, which continued to decline due to the economic environment. Cost of Revenues (exclusive of depreciation and amortization) Cost of revenues were $40.8 million for the three months ended September 30, 2012, a decrease of 7.1% from $43.9 million for the same period in 2011, primarily due to our overall decline in revenue. The decrease is also due to the identification and elimination of inefficiencies in our operation platform and negotiated savings with our vendors. Our costs consist primarily of those incurred from other providers and those incurred from the cost of our network. Costs where we purchased services or products from third party providers comprised $31.2 million or 76.6% of our total cost of revenues for the three months ended September 30, 2012 compared to $33.5 million, or 76.4%, for the three months ended September 30, 2011. The most significant components of our costs purchased from third party providers consist of costs related to our Verizon wholesale advantage contract, unbundled network element loop ("UNE-L") costs and T-1 costs, which totaled $6.6 million, $4.0 million and $10.8 million, respectively, for the three months ended September 30, 2012. Combined, these costs decreased by 9.1% between 2011 and 2012. These costs totaled $7.7 million, $4.5 million and $11.2 million, respectively, for the three months ended September 30, 2011. Gross Profit (exclusive of depreciation and amortization) Gross profit was $41.8 million for the three months ended September 30, 2012, a decrease of 15.6% from $49.6 million for the same period in 2011. The decrease in gross profit is primarily due to the decline in revenue. As a percentage of revenues, gross profit decreased to 50.7% in 2012 from 53.1% in 2011. This decrease in gross profit as a percentage of revenue in 2012 is due primarily to a settlement of disputed access revenue that occurred in 2012 that resulted in lower revenue without a corresponding reduction in cost of revenue. The impact of the settlement decreased gross profit by 1.6%. We are focusing sales initiatives towards increasing the amount of cloud-based services and T-1-based services, as we believe that these initiatives will produce incrementally higher margins than those currently reported from traditional voice services. In addition, as we continue to drive additional cost saving initiatives, including provisioning customers to our on-net facilities, identifying additional inaccuracies in billing from existing carriers, renegotiating existing agreements and executing new agreements with additional vendors, we believe that our gross profit as a percentage of revenue will improve over time. Selling, General and Administrative SG&A expenses were $34.5 million, 41.7% of revenues, for the three months ended September 30, 2012, an increase of 3.3% from $33.4 million, 35.7% of revenues, for the same period in 2011. This increase is primarily due to the net effect of i) increased professional fees of $4.5 million, which includes $1.6 million of non-recurring write-offs of discontinued refinancing costs and $3.1 million of other professional fees incurred in connection with the ongoing Restructuring, ii) decreased employee costs of $1.0 million that is primarily a result of reduced employee head count compared to the same period in 2011, iii) decreased property lease and utilities of $1.0 million primarily due to restructured and discontinued leases and iv) decreased commissions of $0.6 million that is primarily a result of reduced quota-bearing representatives. Depreciation and Amortization Depreciation and amortization expense was $9.0 million for the three months ended September 30, 2012, a decrease of 9.4% from $9.9 million for the same period in 2011. This decrease in depreciation and amortization expense was a result of decreased purchases of $1.7 million and a reduction in the monthly amortization expense on the customer base assets. Amortization expense included in our results of operations for customer base intangible assets for the three months ended September 30, 2012 was $0.9 million, a decrease of $0.4 million from $1.3 million included in our results of operations during the same period in 2011. 21-------------------------------------------------------------------------------- Table of Contents Interest Interest expense was $9.5 million for the three months ended September 30, 2012, a decrease of 1.6% from $9.6 million for the same period in 2011. The decrease was primarily due to lower interest expense as a result of having a lower average outstanding debt balance for the three months ended September 30, 2012 compared to the same period in 2011. The lower average debt balance is due to reduced borrowings under our DIP Credit Facility. In addition, upon entering into Chapter 11, pursuant to an agreement with our Note holders, we began accruing and paying interest to our Note holders at a rate of 10.5% rather than at our historical rate of 11.375%. Our effective annual interest rates for the three months ended September 30, 2012 and 2011 are as follows: Three Months Ended September 30, 2012 2011 Interest expense $ 9,467 $ 9,625 Weighted average debt outstanding $ 318,985 $ 322,360 Effective interest rate 11.87 % 11.94 % Nine Months Ended September 30, 2012 Compared to Nine Months Ended September 30, 2011 Set forth below is a discussion and analysis of our results of operations for the nine months ended September 30, 2012 and 2011. The following table provides a breakdown of components of our statements of operations for the nine months ended September 30, 2012 and 2011: Nine Months Ended September 30, 2012 2011 % of Total % of Total Amount Revenues Amount Revenues % Change Revenues: Network services $ 252,757 98.0 % $ 281,231 97.9 % (10.1 )% Other 5,277 2.0 % 6,169 2.1 % (14.5 )% Total revenues 258,034 100.0 % 287,400 100.0 % (10.2 )% Cost of revenues: Network services 122,636 47.5 % 132,260 46.0 % (7.3 )% Other 1,982 0.8 % 2,458 0.9 % (19.4 )% Total cost of revenues 124,618 48.3 % 134,718 46.9 % (7.5 )% Gross profit: Network services 130,121 50.5 % 148,971 51.9 % (12.7 )% Other 3,295 1.2 % 3,711 1.2 % (11.2 )% Total gross profit $ 133,416 51.7 % $ 152,682 53.1 % (12.6 )% 22-------------------------------------------------------------------------------- Table of Contents Revenues Revenues for the nine months ended September 30, 2012 and 2011 were as follows: Nine Months Ended September 30, 2012 2011 % of Total % of Total Amount Revenues Amount Revenues % Change Revenues: Voice and data services $ 229,610 89.0 % $ 248,691 86.5 % (7.7 )% Wholesale 17,381 6.7 % 17,386 6.0 % - % Access 5,766 2.3 % 15,154 5.4 % (62.0 )% Total network services 252,757 98.0 % 281,231 97.9 % (10.1 )% Other 5,277 2.0 % 6,169 2.1 % (14.5 )% Total revenues $ 258,034 100.0 % $ 287,400 100.0 % (10.2 )% Revenues from voice and data services have decreased $19.1 million or 7.7% between 2011 and 2012. Within voice and data services, revenues from core voice and data services, excluding cloud-based services, decreased $26.4 million, or 12.2%; revenues from cloud-based services increased $6.9 million, or 25.6%; and ancillary voice and data revenues increased by $0.4 million. The decrease in non-cloud core services was due to: i) line churn which, while improving in recent quarters, still exceeds line additions, ii) lower usage revenue per customer, iii) lower prices per unit for certain traditional services and iv) a lower number of lines and customers. Wholesale revenues were unchanged. Our carrier access revenues decreased $9.4 million or 61.9%, which is partially due to one-time settlements that occurred in 2012 and 2011. In addition, access revenues decreased due to several factors, including: decreasing levels of traffic to which access charges are applicable, including decreases in retail voice customer traffic, lower per-minute rates charged to carriers as a result of FCC-mandated rate decreases, and the impact of increased disputes related to access charges. Our other revenues decreased $0.9 million or 14.5% between 2011 and 2012. Other revenues include data cabling, service installation and wiring and phone systems sales and installation, which continued to decline due to the economic environment. Cost of Revenues (exclusive of depreciation and amortization) Cost of revenues were $124.6 million for the nine months ended September 30, 2012, a decrease of 7.5% from $134.7 million for the same period in 2011 primarily due to our overall decline in revenue. The decrease is also due to the identification and elimination of inefficiencies in our operating platforms and negotiations of lower costs from our vendors. Our costs consist primarily of those incurred from other providers and those incurred from the cost of our network. Costs where we purchased services or products from third party providers comprised $95.4 million, or 76.5% of our total cost of revenues for the nine months ended September 30, 2012 and $103.7 million, or 77.0%, in the nine months ended September 30, 2011. The most significant components of our costs purchased from third party providers consist of costs related to our Verizon wholesale advantage contract, UNE-L costs and T-1 costs, which totaled $20.9 million, $12.4 million and $32.5 million, respectively, for the nine months ended September 30, 2012. Combined, these costs decreased by 8.2% between 2011 and 2012. These costs totaled $23.6 million, $14.0 million and $34.0 million, respectively, for the nine months ended September 30, 2011. We have experienced a decrease in these costs where we purchased services or products from third parties primarily due to our effective migration of lines to lower cost platforms. Gross Profit (exclusive of depreciation and amortization) Gross profit was $133.4 million for the nine months ended September 30, 2012, a decrease of 12.6% from $152.7 million for the same period in 2011. The decrease in gross profit is primarily due to the decline in revenue. As a percentage of revenues, gross profit decreased to 51.7% in 2012 from 53.1% in 2011. This decrease in gross profit as a percentage of revenue in 2012 is due primarily to a settlement of access revenue that occurred in 2012 that resulted in lower revenue and a settlement of access revenue that occurred in 2011 that resulted in additional revenue, neither of which had corresponding impact on cost of revenue. The impact of the settlement in 2012 decreased gross profit by 0.5%. The impact on the settlement in 2011 increased gross profit by 0.2%. We are focusing sales initiatives towards increasing the amount of cloud-based services and T-1-based services, as we believe that these initiatives will produce incrementally higher margins than those currently reported from traditional voice services. In addition, as we continue to drive additional cost saving initiatives, including provisioning customers to our on-net facilities, identifying additional inaccuracies in billing from existing carriers, renegotiating existing agreements and executing new agreements with additional vendors, we believe that our gross profit as a percentage of revenue will improve over time. 23-------------------------------------------------------------------------------- Table of Contents Selling, General and Administrative SG&A expenses were $101.4 million, 39.3% of revenues, for the nine months ended September 30, 2012, a decrease of 0.5% from $100.9 million, 35.1% of revenues, for the same period in 2011. This increase is primarily due to the net effect of i) increased professional fees of $9.6 million, which includes $1.6 million of non-recurring write-offs of discontinued refinancing costs and $8.2 million of other professional fees incurred in connection with the ongoing Restructuring, ii) decreased employee costs of $4.5 million that is primarily a result of reduced employee head count compared to the same period in 2011, iii) decreased commissions of $2.1 million that is a result of reduced quota-bearing representatives and decreased new sales activity, and iv) decreased other miscellaneous activities of $2.5 million. We continue to look for additional cost savings in various categories including headcount and professional services. Depreciation and Amortization Depreciation and amortization costs were $27.6 million for the nine months ended September 30, 2012, a decrease of 7.1% from $29.7 million for the same period in 2011. This decrease in depreciation and amortization expense was a result in decreased purchases of $8.3 million and a reduction in the monthly amortization expense on the customer base assets. Amortization expense included in our results of operations for customer base intangible assets for the nine months ended September 30, 2012 was $2.6 million, a decrease of $1.2 million from $3.8 million included in our results of operations during the same period in 2011. Interest Interest expense was $28.8 million for the nine months ended September 30, 2012, a decrease of 0.5% from $29.0 million for the same period in 2011. The decrease was due to a reduced rate of interest on our Notes and lower debt outstanding, partially offset by fees associated with Revolving Credit Facility and DIP Credit Facility. Upon entering into Chapter 11, pursuant to an agreement with our Note holders, we began accruing and paying interest to our Note holders at a rate of 10.5% rather than at our historical rate of 11.375%. Our effective annual interest rates for the nine months ended September 30, 2012 and 2011 are as follows: Nine Months Ended September 30, 2012 2011 Interest expense $ 28,805 $ 28,958 Weighted average debt outstanding $ 319,539 $ 322,693 Effective interest rate 12.02 % 11.96 % 24-------------------------------------------------------------------------------- Table of Contents Off-Balance Sheet Arrangements We have no special purpose or limited purpose entities that provide off-balance sheet financing, liquidity, or market or credit risk support, and we do not currently engage in hedging, research and development services, or other relationships that expose us to any liabilities that are not reflected on the face of our financial statements. We previously maintained standby letters of credit under the Revolving Credit Facility. During the three months ending June 30, 2012, we collateralized those letters of credit with cash. Liquidity and Capital Resources As a result of the Plan, the reduction in our overall debt is expected to lower interest expense by approximately $18.4 million annually, which will provide for lower leverage and more financial flexibility. With a more appropriate capital structure to support management's strategic plan and business objectives, we will have greater financial flexibility and liquidity to pursue cloud-based and other growth opportunities. Contemporaneous with the Petition Date, we entered into the DIP Credit Facility. Borrowings under the DIP Credit Facility were used to purchase $13.9 million of investments. Unused portions of the DIP Credit Facility are subject to availability under a borrowing base and compliance with certain covenants. Our principal sources of liquidity are cash from operations, cash, cash equivalents, investment securities and capital lease line. As of September 30, 2012, we had cash and cash equivalents of $17.3 million compared to $22.9 million as of December 31, 2011. We had investment securities of $13.9 million and $13.6 million as of September 30, 2012 and December 31, 2011, respectively. Upon emergence from Chapter 11, our short-term liquidity requirements will consist of interest on the New Notes, capital expenditures, and working capital. As of September 30, 2012 we had $2.8 million of capital lease obligations outstanding under our capital lease lines. As of September 30, 2012, we had $15.9 million of outstanding borrowings under our DIP Credit Facility. Outstanding borrowings under the DIP Credit Facility will become due and payable as a condition to emergence from Chapter 11 and the consummation of the Plan, following which we will enter into the Exit Facility. Our cash and cash equivalents are being held in several large financial institutions, although most of our balances exceed the Federal Deposit Insurance Corporation insurance limits. For the nine months ended September 30, 2012, the Company incurred capital expenditures of $16.4 million. Fixed and success-based capital expenditures will continue to be a significant use of liquidity and capital resources. A significant majority of our planned capital expenditures are "success-based" expenditures, meaning that they are directly linked to new revenue. Disputes We are involved in a variety of disputes with multiple carrier vendors relating to billings of approximately $19,020 as of September 30, 2012. While we hope to resolve these disputes through negotiation, we may be compelled to arbitrate these matters. We believe we have accrued an amount appropriate to settle all remaining disputed charges. However, it is possible that the actual settlement of any remaining disputes may differ from our reserves and that we may settle at amounts greater than the estimates. We believe we will have sufficient cash on hand to fund any differences between our expected and actual settlement amounts. In the event that disputes are not resolved in our favor and we are unable to pay the vendor charges in a timely manner, the vendor may deny us access to the network facilities that we require to serve our customers. If the vendor notifies us of an impending "embargo" of this nature, we may be required to notify our customers of a potential loss of service, which may cause a substantial loss of customers. It is not possible at this time to predict the outcome of these disputes. 25-------------------------------------------------------------------------------- Table of Contents Nine Months Ended September 30, 2012 Compared to Nine Months Ended September 30, 2011 Cash Flows from Operating Activities Cash provided by operating activities was $13.6 million for the nine months ended September 30, 2012, compared to $9.3 million for the same period in 2011. During the nine months ended September 30, 2012 we paid $18.0 million in interest expense on the Notes compared to $34.1 million during the same period in 2011. This increase in operating cash flow was partially offset by paying $8.2 million in professional fees related to the Restructuring during 2012. Cash Flows from Investing Activities Cash used in investing activities was $16.2 million for the nine months ended September 30, 2012, compared to cash used in investing activities of $24.3 million for the same period in 2011. This was primarily due to a decrease of $8.3 million in capital expenditures during nine months ended September 30, 2012 as compared to the same period in 2011. Cash Flows from Financing Activities Cash flows used in financing activities was $3.0 million for the nine months ended September 30, 2012. Cash used in financing activities was insignificant for the nine months ended September 30, 2011. The change in cash flows from financing activities was primarily due to repayments on the Revolving Credit Facility, net of borrowings under our DIP Credit Facility, of$1.2 million, which occurred during 2012. In addition, net repayments on our capital lease financings were $1.2 million for the nine months ended September 30, 2012. There were no such net repayments during the corresponding period in 2011. Application of Critical Accounting Policies and Estimates The preparation of the condensed consolidated financial statements in accordance with GAAP requires us to make judgments, estimates and assumptions regarding uncertainties that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities and the reported amounts of revenues and expenses. We use historical experience and all available information to make these judgments and estimates and actual results could differ from those estimates and assumptions that are used to prepare our financial statements at any given time. Despite these inherent limitations, management believes that Management's Discussion and Analysis of Financial Condition and Results of Operations and the accompanying condensed consolidated financial statements and notes provide a meaningful and fair perspective of our financial condition and our operating results for the current period. For more information, see our Form 10-K for the year ended December 31, 2011. Other Matters At September 30, 2012, we had NOLs available totaling approximately $218.6 million, which begin to expire in 2019. As of September 30, 2012, we have provided a full valuation allowance against the net deferred tax asset, of which the NOLs are the primary component, because we do not believe it is more likely than not that this asset will be realized. If we achieve profitability, the net deferred tax assets may be available to offset future income tax liabilities. Upon emergence from chapter 11, it is likely that our NOLs will be further limited. 26-------------------------------------------------------------------------------- Table of Contents |