Item 1.
Business
Financial Information
See Part II Item 8 for our financial results and information.
Overview
tw telecom inc. (together with its wholly-owned subsidiaries, “we” or the “Company”) is a leading national provider of managed network services, specializing in business Ethernet, data networking, converged, IP based virtual private network or "IP VPN", Internet access, voice, including voice over Internet Protocol or "VoIP", and network security services to enterprise organizations, including public sector entities, and carriers throughout the U.S., including their global locations. Our revenue is derived from business communication services, including data, high-speed Internet access, network and voice services. Our customers include, among others, enterprise organizations in the financial services, technology and scientific, health care, distribution, manufacturing and professional services industries, public sector entities, system integrators and communications service providers, including ILECs, CLECs, wireless communications companies and cable companies.
Through our subsidiaries, we serve 75 U.S. metropolitan markets with our extensive fiber facilities that are connected by our regional fiber facilities and national IP backbone. As of December 31, 2012, our fiber network spanned approximately 29,000 route miles (including approximately 22,000 metropolitan route miles), connecting to 17,948 buildings served directly by our local fiber facilities. Our fiber networks also connect to over 400 key third party data centers across the country where customers deploy their own equipment or connect to cloud service providers. We continue to extend our fiber footprint within our existing markets by connecting our network into additional locations and to expand our data, voice and IP networking capabilities between our markets, supporting secure end-to-end business Ethernet, IP VPN and converged solutions for customers.
We offer a portfolio of solutions to our customers with predictable and reliable service quality that we believe is industry-leading. We design and deliver scalable and efficient solutions that enable our customers’ complex and evolving business applications. These solutions emphasize our data networking service offerings, which include IP VPN and an expanding portfolio of business Ethernet data products with Class of Service (which allows customers to assign different priorities to various traffic types) and our converged service offerings comprised of data, Internet, voice, security, remote access and managed routers. We also continue to provide a broad range of traditional services including a dedicated network service portfolio with private line, special access and private transport networks, voice services, and secure, high capacity Internet access.
Our principal executive offices are located at 10475 Park Meadows Drive, Littleton, Colorado 80124, and our telephone number is (303) 566-1000. Our Internet address is http://www.twtelecom.com. The information contained on our website is not part of, nor is it incorporated by reference into, this Annual Report on Form 10-K. Our Annual Report on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K, and amendments to these reports are available on our website free of charge, as soon as reasonably practicable after we electronically file such material with, or furnish such material to, the Securities and Exchange Commission. In addition, we intend to disclose on our website, any amendments to or waivers from our Code of Ethics applicable to our principal executive officer, principal financial officer, chief accounting officer, controller and treasurer and other persons performing similar functions within four business days following the date of such amendment or waiver.
We amended our Restated Certificate of Incorporation to change our corporate name from Time Warner Telecom Inc. to tw telecom inc. in March 2008. On July 1, 2008, we began using tw telecom inc. as our name and tw telecom as our brand.
Business Strategy
Our objective is to be the leading national provider of high quality business networking solutions leveraging our integrated network, operational capabilities, dedicated people, local presence, personalized customer experience and advanced support systems to meet the complex and evolving needs of our customers and increase stockholder value. The key elements of our business strategy include the following:
Focus Our Service Offerings to Meet the Complex and Evolving Needs of Our Customers. As the complex needs of our customers evolve and more of their critical applications are divided between their private networks, third party data centers and cloud application providers, we have developed and launched the first two phases of our innovative Intelligent Network and service capabilities (see “Services--Data and Managed Services--Intelligent Network”):
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"Enhanced Management" launched in June 2012, which provides end-to-end visibility into network performance of Ethernet and managed services on a real-time, site-specific basis through our web-based customer portal. Customers are able to establish customized performance thresholds and receive proactive alerts on service performance. These innovative capabilities provide customers a segmented, granular view of their specific service performance information, rather than the aggregate network averages or overall views provided by other carriers; and
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"Dynamic Capacity" launched in August 2012, which enables Ethernet customers to scale their bandwidth on demand or schedule bandwidth availability as needed, paying for the incremental capacity they use. This feature is currently available through our customer portal and we plan to incorporate automation in the future through application interfaces.
We are developing additional functionality to enable customers to manage and prioritize their applications running on our services. Through continuing service innovation, we expect to provide additional intelligent capabilities, automation and other service advancements in the future so that our services will continue to meet our customers' evolving needs.
Capitalize on the Increased Demand for Connectivity Created by the New Information Technology (“IT”) Environment to Enable Customers' IT and Business Strategies. Our enterprise customers are increasingly adopting cloud computing, collaboration, disaster recovery and data center strategies to advance their businesses. We believe that this new IT environment is creating new network demand and opportunities for us. With our Intelligent Network and other advanced service offerings and secure and reliable network connectivity, we are well positioned to provide our customers the flexibility they seek as they are adopting cloud IT strategies to buy services on demand, for as long as they need the service. Our network solutions provide customers the ability to consume network services similarly to how they consume cloud services thus enabling us to capture incremental market share. We plan to continue to further leverage this demand by providing network solutions to the data centers, cloud providers, hosting companies and other participants in this environment and by further automating to enable enterprise customers seeking cloud solutions to more quickly access secure connections to buildings and data centers on our network. We believe that these areas of growing demand have been and will continue to be drivers of our growth.
Deliver a Customer Care Strategy that Differentiates Us from Our Competitors. We approach customer care from the customer’s viewpoint with:
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Our people: We seek to engage all of our employees, whether directly or indirectly, in providing the best possible customer experience. Two-thirds of our employees have customer facing responsibilities, and we have established an internal rewards and recognition program to reward employees for the positive experience they deliver.
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Customized service interaction: We use a coordinated approach that leverages both local resources and our national operating centers to deliver personalized customer service, including providing timely status updates and resolving issues in the shortest possible timeframe. Customers choose the type of service interaction that works best for them: local, national, electronic or live support. In addition, customers can customize their view within our web-based customer portal to quickly locate the information that is most important to them. My Portal is our tool to enable customer knowledge and decision making about their services. Customers can navigate through their account information, network services, trouble tickets, network performance information, order status, billing and payment information either through self-service or with the support of our customer service personnel. We continue to develop additional functionality and enhancements that our customers request and that support our solutions.
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Voice of the customer: We listen to our customers by capturing feedback from customer interactions, customer survey responses and live customer insight panels that provide us with information on our customers' challenges and needs and continually incorporate their feedback to deliver a better overall customer experience to them.
We believe that our ongoing customer experience initiatives have improved our customer loyalty and retention, contributed to reductions in revenue churn and increased sales to existing customers. We plan to continue to innovate to enhance our customers’ experience and ease of doing business with us.
Leverage Our Local Presence on a National Scale with Global Reach. We leverage our local and regional fiber assets and our multi-purpose national Ethernet and IP backbone as well as integrate and manage facilities from other carriers, domestically and globally, to enable our customers to connect to their locations with our network solutions. We have a local presence in our markets with sales, sales engineering, customer support and operational resources, backed by a national organization, to provide personalized service and customized solutions for our customers. These local resources are led by general managers who have accountability for the growth, management and profitability of their local markets.
We believe that our local presence, local and regional fiber-based facilities, and national Ethernet and IP backbone enable us to:
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Offer flexible and scalable products;
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Focus both on selling services in our local markets and providing wide area solutions on a national basis with multi-site and multi-city end-to-end solutions for our regional and national customers;
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Provide a higher quality of service than other competitors;
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Realize a competitive advantage over non-facilities based providers;
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Realize higher margins than carriers that do not operate their own local fiber facilities; and
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Provide a reliable and diverse network.
Enhance Our Multi-Channel Sales Strategy. We have a multi-channel approach to our sales strategy that includes:
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Our direct sales channel, consisting of highly knowledgeable and tenured sales and technical support personnel who focus on medium to large enterprise customers in our local markets. Our direct customer segment sales structure supports local sales, national enterprises, public sector entities and carriers. We continue to expand our direct sales organization, including sales professionals who can more effectively sell our more complex, IT-centric services, and to invest in tools, training and other initiatives to maximize sales productivity;
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Our indirect sales channel that extends our sales coverage in our markets by leveraging our representatives’ customer relationships. We continue to enhance our indirect sales channel in size and scope by adding selected representatives such as value added resellers, cloud providers and system integrators, whose capabilities complement our network service offerings, and expand the portfolio of services available for sale through this channel; and
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Our customer relationship specialists, who focus on sales to our smaller customers and increasing customer retention, freeing our primary sales force to focus on high potential existing and new customers.
Broaden Our Reach and Capabilities to Position Us for Longer-Term Growth and Operational Scale by Employing Our Disciplined Capital Allocation Strategy. Our strategy is to invest for near and long-term growth. We maintain a disciplined approach to capital spending to maximize revenue growth while maintaining attractive rates of return on capital invested to connect customers with our network. We continue to innovate and invest in our business throughout various economic cycles in order to position us for long-term growth. These investments enable us to expand our market opportunity, extend our fiber network and increase both our operational and service capabilities to meet our customers’ growing and complex needs. Elements of our strategy include:
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Success-based investments. The majority of our investments are success-based, driven by customer sales, and include costs to expand our fiber-connected buildings and add equipment and capacity to our network, which must meet certain financial return criteria. In addition to funding current customer opportunities, these investments allow us to reach additional potential customers for future growth. This category of investments is intended to reach their incremental return thresholds within the short to medium term.
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Long-term strategic investments. These investments fund geographic expansions within our markets and adjacent markets, technological advancements of our network and service capabilities for future growth and enhancements to our back office support systems and customer interfaces to increase employee productivity and enhance the customer experience. These investments include fiber construction, strategic fiber purchases, equipment purchases and IT system enhancements for service advancements and automation, among others, all of which have a longer term expected return on investment.
Invest in Our People to Drive the Execution of Our Strategies. We have invested in our highly skilled, professional workforce that we believe allows us to differentiate ourselves from our competitors, innovate our services, advance our customer experience initiatives and make the necessary technological advancements to meet the complex and evolving needs of our customers. We have a multi-faceted approach to ensure our human resources are well aligned, capable and engaged in executing on our strategic business objectives. Elements of our approach include:
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Developing strategies across the organization that prioritize our people investments;
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Enhancing our organizational effectiveness through organizational design, workforce and talent planning, change management and leadership development to maximize employee productivity and engagement;
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Optimizing our talent acquisition efforts through employment marketing, sourcing and recruiting to attract the best talent;
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Developing our talent by providing technical training for sales, operations and engineering resources, leadership and management training and detailed orientation programs to assure that we have skilled employees to remain an industry leader;
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Continually improving employee job performance through various performance management techniques and aligning annual employee goals with our corporate strategies; and
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Providing performance-based compensation designed to incent and engage employees to execute on our business objectives and to create long-term stockholder value.
Services
We deliver a portfolio of scalable, integrated and managed network solutions serving customers’ complex network needs and IT requirements. Our revenue by major service categories for the years ended December 31, 2012, 2011 and 2010 was as follows:
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(1)
See Data and Managed Services--Local Solutions, Wide Area Solutions, Intelligent Network and Internet Services below.
(2)
See Data and Managed Services--Managed Services below. Revenue from the data components of converged services is included in the Data and Internet services revenue category, revenue from the voice components of converged services is included in the Voice services revenue category and revenue from all other components of Managed Services is reflected in the Data and Internet services revenue category.
(3)
See Integrated Services below. Revenue from the voice components of integrated services is included in the Voice services revenue category and revenue from all other components is included in the Data and Internet services revenue category.
(4)
See Voice Services below.
(5)See Network Services below.
(6)
See Intercarrier Services below.
We provide solutions to enterprise customers, ranging from small businesses to Fortune 500 enterprises, city, state and federal government entities, as well as carriers and other communication service providers. We continue to expand our service portfolio to meet our customers’ future networking demands, including new enterprise software applications, data storage, cloud computing, collaboration and security needs. Our primary service offerings are:
Data and Managed Services
Our data services enable customers to connect their locations and internal local area networks together into a single managed solution. From these capabilities, customers have options to manage an array of business and communication applications, including voice, Internet and private network connectivity. We offer the following business Ethernet and managed services:
Local Solutions
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E-Line. A business Ethernet private line and virtual private line service supporting point-to-point and point-to-multipoint customer configurations within our markets, which is highly scalable with speeds up to 10 gigabits per second ("Gbps").
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Switched NLAN. A metropolitan business Ethernet solution that connects multiple locations in speeds up to 10 Gbps. Five Class of Service options are offered that allow customers to prioritize varying types of traffic by their business importance.
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Elite NLAN. A point-to-point metropolitan business Ethernet service which provides dedicated protected Ethernet transport service between two locations at bandwidth speeds up to 10 Gbps.
Wide Area Solutions
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E-Line. A business Ethernet private line and virtual private line service supporting point-to-point and point-to-multipoint customer configurations between our markets, highly scalable with speeds up to 10 Gbps.
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E-Access. A business and carrier Ethernet solution that provides ubiquitous reach across the United States through a single Ethernet connection that scales up to 10 Gbps.
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Extended NLAN. Provides business Ethernet connectivity between most of our markets and is available in either point-to-point or multi-point configurations, generally up to 1 Gbps, and includes Class of Service options.
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Regional Ethernet. Provides point-to-point private lines between select markets with the advantage of Ethernet interfaces.
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IP VPN Services. These services connect multiple customer sites by creating a secure virtual network for the customer within the U.S. and to other countries. Class of Service options are available with premium IP VPN service. Connection speeds are available up to 1 Gbps.
Managed Services
We offer a suite of managed services that complement our data, Internet and converged service offerings. These services allow our customers to reduce the overall management burden of their data systems and IT staff:
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Converged Services fully integrate any combination of communication applications including IP VPN, voice, Internet, security and managed router service into a single managed IP solution available in our 75 core markets and certain additional markets across the U.S. where we can support local voice calling access. This solution is scalable from 1.5 Mbps to 1 Gbps, and enables each communication application to dynamically share all subscribed bandwidth. Class of Service options are available.
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Managed Router. A turnkey solution available with our IP VPN, Internet and converged Services solutions that includes customer premise-based routers that we procure, configure, maintain and manage. The service includes active monitoring and alarming, on-site installation and hardware maintenance.
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Managed Internet. Our managed Internet service provides a turnkey Internet solution that bundles our Internet services with customer premise-based routers that we procure, configure, maintain and manage for the customer. This managed service includes active monitoring and alarming, on-site installation and hardware maintenance.
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Managed Security Services. This service uses security devices placed within our network to establish a firewall to prevent unauthorized traffic from entering a customer’s network. We also offer a managed security solution through equipment placed at the customer’s premises that provides a firewall, in addition to optional secure sockets protocol or SSL, IP VPN, anti-virus, anti-SPAM and content filtration.
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Distributed Denial of Service Mitigation. This service monitors, identifies and mitigates denial of service attacks that flood the target network with high volumes of unauthorized traffic in an attempt to disrupt a customer’s business critical Internet-based applications.
Intelligent Network
We have developed and are continuing to develop service enhancements that provide customers with a new level of visibility and control over their services. The Intelligent Network features that are now available include:
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Enhanced Management. An interactive solution that gives customers detailed, site-specific visibility into the performance of their managed or Ethernet services through our customer portal (see "Customer Care"). Customers gain real-time knowledge of how their network is performing with respect to latency, packet delivery and jitter correlated to their bandwidth utilization, available end-to-end, site-specific and by Class of Service.
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Dynamic Capacity. Enables E-Line Business Ethernet customers to interact with their network and optimize their business by giving them the ability to scale their bandwidth, doubling or tripling capacity, within seconds or scheduled in advance, without service interruption through our customer portal.
Internet Services
Our dedicated high capacity Internet service enables customers to access the Internet and other external networks. We offer a wide range of Internet services with bandwidth speeds ranging from 1.5 Mbps to 10 Gbps transported via Ethernet or traditional Time Division Multiplexing (“TDM”) connectivity. Our Ethernet Internet services are available using Ethernet connections from 2 Mbps to 10 Gbps. Our traditional TDM-based Internet services are available via industry standard transport facilities, with DS-1 to OC-48 connectivity.
Integrated Services
Our bundled integrated offerings enable customers to purchase a full array of access options that combine lines, trunks, long distance, and Internet services to provide an integrated service offering that can dynamically allocate bandwidth for maximum network efficiency, and eliminate the customers' need for multiple vendors.
Network Services
We provide a complete range of network access services with transmission speeds up to 10 Gbps to satisfy our customers’ needs for voice, data, image and video transmission. Each service uses technologically advanced fiber optics and is available as:
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Private Line. Dedicated telecommunications lines connecting various locations of a customer’s operations, suitable for transmitting voice, data and Internet traffic among customer locations.
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Special Access. Dedicated telecommunications lines linking the points of presence (“POPs”) of one or more interexchange carriers (“IXC”), or between enterprise customers and the local POPs of IXCs.
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Transport Arrangements. Dedicated transport between the local exchange carrier (“LEC”) central offices and the IXC POP for voice and data applications.
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Metropolitan and Regional Connectivity. Each transport service is available on our local fiber network and most are available between cities on our inter-city, regional networks.
These services are available in a wide variety of configurations and capacities:
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Private Network Transport Services. A premium quality, fully redundant, and diversely routed service on Synchronous Optical Network (“SONET”) standards that is dedicated to the private use of individual customers with multiple locations.
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SONET Services. Full duplex transmission of digital data on SONET standards allowing multipoint transmission of voice, data or video over protected fiber networks. Available capacities include DS-1, DS-3, STS-1, OC-3, OC-12, OC-48 and OC-192.
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Dense Wavelength Division Multiplexing Services (“DWDM”). High capacity, point-to-point transmission services allowing customers to have access to multiple full-bandwidth channels of 2.5 Gbps and 10 Gbps.
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Collocation Services. We provide secure space with controlled climate and power where customers can locate their equipment to connect to our network in facilities equipped for enterprise IT environmental requirements.
Voice Services
Our voice services provide customers with local and long distance calling capabilities. Our voice services can be provisioned over TDM or as Voice over Internet Protocol (“VoIP”) and include the following:
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Access Trunks. These trunks, typically DS-1, are utilized by private branch exchange (“PBX”) customers that own and operate a switch on their own premises to provide access to the local, regional, and long distance telephone networks.
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Long Distance Service. Provides the capability for customers to place a voice call from one local calling area to another, including international calling, and is offered as a bundle with other voice and converged solutions as well as package plans for various committed levels of usage.
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Local Toll Service. Provides customers with a competitive alternative to ILEC service for intraLATA toll calls.
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Local Telephone Service. Local telephone calling areas are widely defined to provide ease of use for our customers. Additional features include operator and directory assistance services and custom calling features such as call waiting and caller identification.
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Business Access Line Service. Provides customers with quality analog voice grade telephone lines.
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IP Trunks. IP trunks provide voice services over an Ethernet connection and supports IP PBX devices and local and long distance calling to the public switched telephone network (“PSTN”).
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SIP Trunking. Next generation, end-to-end VoIP solution geared towards both medium and large enterprises. We deliver a fully managed solution allowing businesses to avoid both the capital and operating expense of additional local area network equipment enabling them to realize the values of IP telephony.
Intercarrier Services
We are interconnected with other telecommunications carriers, which enables us to originate and terminate long distance calls and terminate local calls for other carriers.
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Switched Access Service. The connection between a long distance carrier’s POP and an end-user’s premises that is provided through the switching facilities of a LEC is referred to as switched access service. Switched access service provides long distance carriers with a switched connection to their customers for the origination and termination of long distance telephone calls or provides large end-users with dedicated access to their carrier of choice. Under our tariffs, we receive per-minute terminating switched access compensation when our network is used for the origination or termination of the carriers’ traffic.
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Local Traffic Termination Services. Pursuant to interconnection agreements with other carriers, we accept traffic that originates on another LEC’s facilities and carry that traffic over our facilities to our customers in order to complete calls. Generally, under applicable regulations, we are entitled to receive compensation-referred to as “reciprocal compensation”-from the originating LECs for those services.
Network and Facilities
Overview. Our integrated network infrastructure combines physical fiber assets and equipment with software-enabled or "logical" capabilities that provide a cost effective platform for the layering of our services and enables us to manage our customers’ needs and to scale our customer service support. Our local, regional and national network utilizes advanced architectures and technologies to deliver high capacity, scalable and resilient network services. Our local markets are interconnected through our IP backbone utilizing multiple standard protocols and operate on fully redundant routers which enable us to deliver services between markets and to the public Internet.
We have designed and constructed our integrated network infrastructure over fiber rings generally using path diversity equipped with electronics that automatically re-route service if a network impairment such as a fiber cut occurs. Our integrated network supports our customers’ application needs through business Ethernet services using state of the art network equipment or optical networking services, leveraging DWDM or SONET technology.
Our VoIP services utilize our packet-based soft switches and media gateways located in our local markets. This equipment is smaller and more cost effective than traditional PSTN end office switches. Our soft switches are interconnected using a VoIP enabled, private IP backbone that operates on our integrated network. Our VoIP network architecture also supports complex disaster recovery services for customers having mission critical voice requirements.
Our integrated network assets and architecture provide the foundation for evolving advanced capabilities that we refer to as the “Intelligent Network” (see "Services--Data and Managed Services--Intelligent Network"). Through the evolution of these capabilities, we are providing customers with the ability to manage their own network services using decision making tools, including network performance information obtained through Enhanced Management and flexible capacity, and planned service offerings to enable customers real time control over the prioritization of their traffic on their services, either manually through our customer portal or using automation through application program interfaces.
Local Market Technical Overview. We serve our customers from central offices that are strategically positioned throughout our local markets. The central offices house the network equipment needed to interconnect customers with each other and with other local exchange, Internet and Ethernet networks. We deploy Ethernet switches, routers, soft switches, media gateways and other electronic network devices in our central offices that are generally configured with redundant electronics and power supplies capable of automatically switching to backup equipment in the event of hardware impairments or failures. This redundancy provides protection to our customers and helps reduce the incidence of service interruptions. We also install and manage our electronics on our customers’ premises to interface with their communications equipment.
Our network is interconnected with multiple ILECs and other carriers for transport and voice services, and our network backbone is connected directly with several external networks to increase our network reach and access. We provide IP VPN service to international locations through arrangements with international network providers and provide a converged VPN solution to our customers’ locations outside of our network through the use of facilities provided by other carriers. We have peering and transit connections with external network vendors that provide our customers exit points from our network to the public Internet. We also have voice peering connections to exchange voice services and features using VoIP-related protocols that are more efficient and offer more capacity and resiliency than traditional TDM trunking connections.
Fiber Lease and License Agreements. We provide a substantial portion of our services entirely on fiber network facilities that we constructed, purchased from other providers or obtained through acquisitions. We also license fiber network facilities through indefeasible rights of use agreements or other similar long term licensing or leasing arrangements (collectively “IRUs”) from other fiber providers. Similarly, our Capacity License Agreements with Time Warner Cable, Comcast Corporation and Bright House Networks, LLC (collectively, the “Cable Operations”), provide us with an exclusive right to use all of the capacity of specified fiber-optic cable owned by the Cable Operations in 23 markets for a term that expires in 2028. The Capacity License Agreements do not restrict us from constructing or licensing fiber-optic capacity from other parties in the markets where we license fiber network facilities from the Cable Operations.
Network.
The following map shows our 75 markets:
Network Monitoring and Management. We provide a single point of contact for our customers and consolidate our systems support and technical expertise for management of our customer and internal networks at our two network operations centers in metropolitan locations near Denver, Colorado and St. Louis, Missouri. These two centers offer capability for redundancy and overlap coverage for our customer networks. We provide 24 hours per day, 7 days a week surveillance and monitoring of networks to achieve a high level of network reliability and performance. Network analysts monitor real-time alarm, status, and performance information for network and customer services, which allows us to react swiftly to repair network or service trouble. We continue to enhance our capabilities and programs that focus on network health and stability and enable us to address network issues before they impact our customers.
Information Technology Solutions. We focus our efforts on creating and deploying applications, systems and technology that optimize our business and increase operational scale through the use of automation and customer self-service portals. We have invested in applications and systems that increase our workforce productivity and decrease manual touch points. This strategy has also enhanced our ability to manage our customers' experience and increased the ease of doing business with us by making information available to our customers in a unified and comprehensive way. We blend the purchase of proven, commercially available software that can be tailored to our business processes, and in-house developed applications that conform to our architectural framework. We select systems that are flexible enough to conform to a rapidly changing environment, while being scalable and easily maintained and enhanced.
We continue to evaluate and implement new technologies and applications to further enhance the integration of our enterprise applications so that data flows efficiently and accurately between applications and manual touch points are minimized. Our systems utilize open system standards and architectures, allowing interoperability with third party systems and applications.
Information Systems Infrastructure. We maintain corporate data centers in Colorado and Texas to support our corporate applications and systems and provide redundancy for our critical corporate applications and systems. Each of our data centers is equipped with state of the art computing capability, storage networks and high availability corporate voice and data services. We use advanced server technology running virtual machine software that has increased computing capacity significantly while reducing environmental and space costs. We host and operate our own corporate private clouds, which provide cost efficient and reliable software and application services for our highly distributed user community. We manage our desktop technology assets, corporate voice and data services centrally to ensure consistency and compatibility between all corporate facilities. Our infrastructure also supports employee mobility and diversity of employee access points to systems to minimize productivity loss due to weather and other potential business interruptions.
We have established a dedicated security team to proactively address the security of our networks and internal and customer-facing systems, employing state of the art systems to detect and protect against intrusions. We also engage all of our employees in our security program though training and communication. The security team also provides input into our new service development process.
Network Development and Application Laboratory. We have a laboratory that is equipped with advanced systems and equipment, including those we use in the operation of our network. The technology lab is designed to provide a self-contained testing and integration environment for the purposes of:
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Verifying the technical and operational integrity of new equipment prior to installation in the network;
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Developing new services and applications;
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Providing a realistic training environment for technicians, engineers, and others;
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Providing a network simulation environment to assist in fault isolation and recovery; and
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Providing a network simulation environment to verify network load, scale, and overlay of our products and services.
Billing Systems. We utilize a single billing system that is interfaced directly into our operational support systems and financial systems for all of our services other than intercarrier compensation. This integrated billing environment increases customer bill accuracy and customer satisfaction. The billing system software is licensed from a billing vendor that develops feature enhancements for us as needed and handles the daily support and maintenance of the system, which operates on our computing hardware. We also utilize a usage collection and management application that gathers network services billing events and usage while creating a real time seamless stream of information that not only provides higher precision usage measurement and revenue tracking, but also provides the foundation for the Intelligent Network services billing.
Green Initiatives. As we replace equipment in our network in the normal course to enable new services we have installed and plan to continue to install new equipment that is cost effective both initially and over the life of the equipment. We ensure that our new equipment is more energy and space efficient as part of our multi-faceted green initiatives. We select new equipment with high efficiency ratings and less cooling consumption that lowers our costs, adds capacity and new capabilities, and takes less space in our central offices, which assists in avoiding costly central office expansions.
In addition to our focus on equipment replacement, we have also concentrated our efforts on energy efficiency in our central offices through remote monitoring of the local environment and automatically controlling cooling systems to minimize utility usage. We have conducted studies of some of our larger facilities in order to identify additional opportunities for energy conservation and enhancing the sustainability of our network. We are working with utility providers and tax authorities to obtain credits and incentives to help fund additional investments to conserve energy and further our green initiatives.
Customers, Sales and Marketing
Customers. We serve both business enterprise and carrier customers. Our enterprise customers include businesses that are data and IT intensive and are primarily in financial services, technology and scientific, health care, distribution, manufacturing and professional services industries, systems integrators and public sector entities. Our carrier customers include ILECs, competitive local exchange carriers (“CLECs”), wireless communications companies and cable companies. As of December 31, 2012, we served approximately 28,000 customers. For the year ended December 31, 2012, enterprise customers represented 79% of total revenue. Our 10 largest customers, primarily carriers, accounted for 18% of our total revenue for the year ended December 31, 2012, and no customer accounted for 5% or more of total revenue. As our enterprise customer revenue continues to grow at a greater rate than our carrier customer revenue, the percentage of our total revenue represented by the carrier customers has been declining.
Sales and Marketing. Our service offerings are part of a comprehensive portfolio of services and solutions designed to support the current and next generation needs of our customers. Our sales and marketing strategy emphasizes our:
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Targeted market strategy focused on key industry verticals and network applications originating from medium and large enterprises in proximity to our metropolitan fiber assets;
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Comprehensive suite of multi-site large bandwidth solutions applying managed and Ethernet technology;
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Intelligent Network capabilities adding visibility into network performance and customer control of bandwidth to our portfolio of data and managed services;
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Continuing to meet ongoing demand and enhancements required from customers for our traditional voice, Internet, converged and transport products;
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Strong customer and product lifecycle management to assure availability of the latest solutions to meet our customers' rapidly changing needs;
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Leading coordinated customer experience strategy, including local support in the customer’s city, a responsive national customer service orientation with strong network management capabilities and customizable self-service tools; and
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Tenured sales professionals and sales engineering professionals with network design capabilities.
We engage in direct local and national sales with specialized sales teams for enterprise, carrier and public sector customers. As of December 31, 2012, we had a total of 574 sales account executives and customer relationship specialists. To expand our sales coverage we continue to hire people strategically targeted at high opportunity markets and industries, and provide tools and training to increase the productivity of our new and existing sales and sales support personnel. Commissions for our direct sales representatives are linked to incremental revenue from services installed. We provide additional incentives for executing service contracts with terms of greater than one year, for certain products and for sales of services provisioned on our fiber facilities. Our customer relationship specialists focus on sales to smaller existing customers and increasing customer retention, freeing our primary sales force to focus on high potential existing and new customers.
Our indirect sales channel further extends our sales coverage by leveraging our representatives’ customer relationships and has increased its contribution to our revenue growth in 2012. This channel enables us to market our entire portfolio of services through experienced outside sales representatives, value added resellers, cloud providers, and systems integrators who provide services and equipment that complement our services, thereby offering customers a complete solution. Our indirect sales representatives are compensated with residual commissions over the life of fixed term contracts and renewals, providing incentives for production and for customer retention through negotiated renewals.
Customer Care
We strive to deliver a consistent, differentiated, valuable customer experience through local and national support. Our local account representatives and customer relationship specialists work with local operations teams, central network operations centers and customer care teams to support our customers. We process customers' requests to order, upgrade or change their services through our coordinated local and national support teams, including customer project personnel who coordinate service installations. Our customer service center is available to all of our customers to answer their questions regarding billing, order status or maintenance concerns. In addition, our network operations centers provide 24 hours per day, 7 days a week trouble reporting and surveillance and monitoring of networks to maintain network reliability and performance (see “Network and Facilities--Network Monitoring and Management”).
Our online customer care self-help platform, MyPortal, offers our customers self-service capabilities that support our customer experience strategy. MyPortal enables customers to easily register and choose various on-line capabilities including the ability to view and pay their bills, view orders, create and view billing disputes, receive scheduled maintenance notifications, advise us of their internal scheduled maintenance activities, create and view trouble tickets, create and view various accounts and enter certain types of service change requests. Customers can also view their own network performance and utilization data on a site and circuit level basis for certain services. MyPortal is the gateway where our customers can obtain the visibility, flexibility and control that the Intelligent Network provides (see "Services--Data and Managed--Intelligent Network").
Competition
We believe that the principal factors affecting competition in our industry are:
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Network capabilities and reach;
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Customer service and experience;
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Network and operational quality;
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Service offerings;
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Ability to provide customer specific solutions;
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Sales strategy;
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Integration of network and IT services;
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Pricing; and
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The regulatory environment.
We compete with other carriers primarily on service offering, network capabilities, service quality and customer service. In addition, we must price our services competitively with both the local market for those services and the market for national solutions. In our industry, technological advances and a competitive market have consistently caused general downward pricing pressure across our service portfolio. Competition varies across local markets and products which deliver national solutions, depending on the number and type of competitors in the market, their capabilities and the customer segment.
Our primary competition is from the ILECs, CLECs and cable companies. The ILECs, primarily AT&T Inc., Verizon Communications, Inc. and CenturyLink Inc., other CLECs and some cable companies offer services substantially similar to some of those we offer and target some of the same customers.
Our competitive strengths include our flexibility in providing customer-specific critical business solutions, our robust data and IP capabilities, our integrated network, our nation-wide footprint of metropolitan markets served with our extensive fiber facilities and building connections that are connected by our regional fiber facilities and national IP backbone, our Intelligent Network capabilities, which we believe represent unique technological advancements, our interconnection with other carriers, network redundancy and disaster recovery capabilities. We believe that our focus on customer service and our operational execution provides us with a competitive advantage over other carriers. Our extensive fiber facilities connecting to multiple buildings in each of our markets and between markets and the depth of our service portfolio also provide us with a competitive advantage over most other CLECs that have limited capabilities to serve carrier POP and data center locations and more limited service offerings.
Consolidation in our industry has resulted in larger and more formidable competitors. We believe that the ILECs have some competitive advantages over us because of their name recognition, technical capabilities, greater financial resources, broader geographic coverage, complementary IT service offerings and potential to bundle and subsidize services of the type we offer with revenue from other services. Cable companies compete with us primarily for business customers that are generally smaller than our target market, and selectively for larger enterprise customers for less complex single market offerings. CLEC competition for smaller customers buying lower speed solutions has increased as a result of their lower cost offerings for solutions provided over existing copper facilities rather than fiber optic facilities.
To the extent we interconnect with and use ILEC networks to service our customers, we depend on the technology and capabilities of the ILECs to meet certain telecommunications needs of our customers and to maintain our service standards. We also use ILEC special access services, unbundled network element (“UNE”) loops, ILEC and other providers' Ethernet loops and ILEC and other carriers’ long haul and local circuits to reach certain customer locations that are not served by our network. Although regulation of ILEC performance standards exists with respect to UNE loops, there is minimal regulatory oversight of the quality of ILEC special access and Ethernet services. We believe that certain ILECs’ lack of investments in their wireline businesses has adversely affected their service delivery intervals and service quality. We also depend on large Internet Service Providers ("ISPs") for Internet peering, which is unregulated, to allow our customers to connect with certain ISPs with which we do not directly connect. We interconnect with other VoIP providers to provide voice solutions outside of our service areas and we rely on carriers with international facilities to provide IP VPN connections in certain international locations. Our ability to compete for customer locations that we do not serve directly on our network is dependent in part on the quality and timeliness of service we receive from these other carriers and our ability to obtain their services at a reasonable cost.
Regulatory environments at the state and federal level differ widely and may have considerable impacts on our costs, opportunities and resulting investment decisions. Some regulatory decisions have or may in the future have negative or positive impacts on our revenue or expense and may favor certain classes of competitors over us (see “Regulatory Environment” below).
Seasonality
We continue to expect business fluctuations to impact sequential quarterly trends in revenue, margins and cash flow. This includes the timing, as well as any seasonality of sales and service installations, usage, rate changes, disputes, settlements, repricing for contract renewals and fluctuations in revenue churn, expenses, capital expenditures and certain taxes and fees. Historically our revenue and expense in the first quarter has been impacted by the slowing of our customers' purchasing activities during the holidays and the resetting of payroll taxes in the new year.
Regulatory Environment
Overview. As a certified competitive telecommunications provider, we are subject to regulation by the Federal Communications Commission (“FCC”), state regulatory authorities and local government agencies. In most areas, we are subject to a less comprehensive set of rules designed for non-dominant or competitive providers.
ILECs typically operate under federal and state rules designed for dominant carriers. As competition has expanded, ILECs have gained some regulatory freedoms at both the federal and state levels. Because the larger ILECs are our major suppliers for local loops and are major competitors, we continue to advocate for meaningful regulatory oversight to promote competition and protect against unreasonable price increases.
Most of the former Regional Bell Operating Companies have sought regulatory freedom from pricing and access requirements applicable to them by requesting that the FCC forebear from regulating many of the products that are used by CLECs like us. To date, the FCC has granted forbearance requests for Ethernet and OC-n high capacity services while denying forbearance requests for all products in a particular geographical area.
More recently, regulators have focused on broadband issues. The FCC delivered its National Broadband Plan (the "Plan") to Congress in March 2010. The Plan sets an ambitious agenda to encourage more private innovation and investment to ensure the universal deployment of broadband. This Plan outlines a number of initiatives that will impact the telecommunications industry including a review of competitive policies and wholesale markets, allocation and management of government controlled assets such as rights of way and poles and reforms to universal service mechanisms. The FCC has opened proceedings for most of the initiatives identified in this Plan, but most are still in process and we cannot predict their impact on us.
Federal Regulation
Special Access. We purchase a substantial amount of special access services from ILECs to expand the reach of our network and also provide special access services to our customers over our fiber facilities in competition with the ILECs. The ILECs have argued before the FCC that the high capacity telecommunications services that they sell, including interstate special access services we buy from them, should no longer be subject to regulations governing price and quality of service. We have advocated that the FCC modify certain of its interstate special access pricing flexibility rules to return these services to price-cap regulation to protect against unreasonable price increases for carriers like us and for regulation of ILEC service quality.
The FCC is reviewing its regulation of special access pricing in a pending proceeding commenced in 2005 that has not yet resulted in proposed rules. In 2012, the FCC suspended the operation of the pricing flexibility triggers, which means that ILECs cannot expand the geographic scope of their capability to raise prices, pending further FCC review. If the special access services we buy from the ILECs were to be further deregulated, ILECs would have a greater ability to continue to increase the price and reduce the service quality of special access services they sell to us but we may eventually experience less pricing pressure on the special access services we sell. If ILEC price reductions were to occur, we would likely experience downward pressure on the prices we charge our customers for special access services and reductions in the prices we pay ILECs for special access services that we purchase. We cannot predict when the FCC will conclude the proceeding on interstate special access pricing regulation or the impact of any such action.
In addition, the FCC has granted ILEC requests for forbearance from regulation of certain Ethernet and OC-n high capacity services offered by the ILECs as special access, with the result that prices we would pay for those services are no longer regulated and can increase. We are seeking to reverse these forbearance requests. In the meantime, we have pursued commercial agreements with the ILECs and other providers for those services.
Intercarrier Compensation and Universal Service Fund. Switched access is a component of intercarrier compensation that long distance carriers are charged to originate and terminate long distance calls using our local network. We also pay switched access charges to other carriers to originate and terminate our customers’ long distance traffic and pay intercarrier compensation to other carriers for traffic that our customers terminate on their facilities. Reciprocal compensation is the other component of intercarrier compensation that represents our charges to LECs for local exchange traffic terminated on our facilities that their customers originate and charges that we pay to LECs for our customers' local exchange traffic terminated on their facilities.
We and other carriers are required to make contributions to the federal Universal Service Fund, which provides support to promote access to telecommunications services at reasonable rates for those living in rural and high-cost areas, income-eligible consumers, rural health care facilities, schools and libraries. In 2012, the FCC established the Connect America Fund to support broadband access. The FCC is currently investigating a new assessment mechanism. We cannot yet determine the impact this proceeding will have on us.
The FCC released an order on November 18, 2011, which establishes a transition by July 2018 of all terminating intercarrier compensation rates to “Bill and Keep,” meaning that the exchange of traffic would generate no revenue or expense, with intermediate step-downs beginning in July 2012. Intercarrier compensation revenue, comprised of switched access revenue and reciprocal compensation revenue, represented 2% of our total revenue for the year ended December 31, 2012. We lowered our rates in July 2012 to comply with the order and the next mandated rate decrease is scheduled to occur in July of 2013. As a result of the order, we lost approximately $2.0 million in intercarrier compensation revenue in the year ended December 31, 2012 and expect intercarrier compensation to decline approximately $4.0 million in the year ended December 31, 2013 compared to the full year 2012.
Pole Attachments. In April 2011, the FCC adopted reforms to its pole attachment rules that generally require parity in pole attachment rental rates between cable television attachments and telecommunications attachments and streamlined the process for gaining access to utility company pole attachments. A number of utility companies have filed legal challenges to the rules in a federal appellate court. We and other telecommunications and cable television companies have filed petitions to intervene in the proceeding to support the FCC's position. We cannot predict the likely outcome of the challenge.
State and Local Regulation
We have obtained the required authorizations to provide intrastate telecommunication services in 40 states and the District of Columbia. These authorizations cover traditional voice services, private line services as well as switched access. We provide Internet Access and interstate private line-type services throughout our service area that do not require individual state certifications.
Additionally, where we have placed facilities in the public right-of-way, we have obtained the necessary permits, licenses and or franchises from local authorities.
Intercarrier Compensation. Most states continue to have jurisdiction over pricing of intrastate switched access. Increasingly, states have been reassessing this pricing for both ILECs and CLECs. Currently, 16 states in which we provide switched services have benchmarking rules that limit the switched access rates that we charge other carriers. The recent FCC Intercarrier Compensation Order (see "Federal Regulation--Intercarrier Compensation and Universal Service Fund”) requires all intercarrier compensation rates to transition to Bill and Keep ending July 1, 2018. States are responsible for ensuring that LECs reduce state switched access rates in accordance with the FCC Order.
Permits Licenses and Franchises. We may be required to obtain street opening and construction permits and other rights-of-way from municipal authorities in order to install and expand our network in certain municipalities. In some cities, our fiber licensors or subcontractors already possess the requisite authorizations to construct or expand our network. Any increase in the difficulty or cost of obtaining these authorizations and permits could adversely affect us, particularly in locations where we compete with companies that already have the necessary permits.
In some of the metropolitan areas where we provide network services, we pay right-of-way or franchise fees based on a percentage of gross revenue or other measures such as fees per linear foot of fiber that we install. Municipalities that do not currently impose fees may seek to do so, and renewals of existing franchises may result in increased fees. Under the Telecommunications Act of 1996 (the “1996 Act”), municipalities are required to impose such fees on a competitively neutral and nondiscriminatory basis. Municipalities that have fee structures that favor the ILECs may or may not conform their practices in a timely manner or without legal challenges by us or other CLECs. Moreover, ILECs with which we compete may be exempted from such local franchise fee requirements by previously enacted legislation that allows the ILECs to utilize rights-of-way throughout their states without having to pay franchise fees to local governments.
We are party to various regulatory and administrative proceedings in the ordinary course of business. Subject to the discussion above, we do not believe that these proceedings will have a material adverse effect on our business.
Employees
We had 3,147 and 3,051employees as of December 31, 2012 and 2011, respectively.
Item 1A.
Item 1A.
Risk Factors
We may be unable to sustain our revenue growth and increase our cash flow despite the implementation of several initiatives designed to do so.
Our objective is to increase our revenue growth, cash flow and margins in order to continue to build shareholder value. We have pursued and continue to pursue several growth initiatives, including:
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Expanding our sales reach through an increase in our sales and support resources with focus on acquiring new skills including technical IT knowledge;
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Investing in new technologies to deliver new and innovative capabilities to drive sales of data and Internet services;
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Further advancing our network and systems functionality to increase efficiencies, capabilities and to enable more dynamic customer connections;
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Targeting customer care initiatives to improve customer retention; and
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Continuing the expansion of our network reach in existing and adjacent markets to reach more customers.
Our ability to manage and achieve the intended benefits of this expansion depends on many factors, including our ability to:
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Attract new customers and existing customers to our new and innovative service offerings;
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Employ new technologies and remain competitive with technologies adopted by competitors;
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Remain competitive against much larger carriers;
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Attract the sales and technical personnel that we need to carry out our plans; and
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Acquire facilities from other carriers at a reasonable price with acceptable service quality to serve customers that are not directly connected to our network.
There is no assurance that our growth initiatives will result in their intended objective of improvements in our results of operations. Factors such as customer disconnections, price competition and declining prices could adversely affect our ability to sustain revenue growth unless we can sell and install growing volumes of services to outpace those impacts.
The market for our services is highly competitive, and many of our competitors have significant advantages that may adversely affect our ability to compete with them.
We operate in an increasingly competitive environment, and some companies may have competitive advantages over us. Most ILECs offer substantially the same services that we offer and may in varying degrees benefit from:
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Their name recognition;
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Greater financial and technical resources;
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Larger networks and broader network coverage;
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The ability to provide other services that complement the services that they offer in competition with ours;
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Their wireless service offerings;
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The ability to leverage a customers’ total expenditures with them by providing lower prices for bundled service offerings and subsidizing services that compete with ours; and
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Regulatory decisions that decrease regulatory oversight of ILECs.
Consolidations involving ILECs, CLECs and others may result in fewer, but much larger and more effective competitors. We also face competition from other CLECs and cable companies. The cable companies are primarily competing for smaller business customers currently and single-site Ethernet applications; however, if they expand their network coverage and product offerings there may be additional competition for the customers that we target. Price cutting or other aggressive attempts by other carriers to retain customers in the dampened economic environment may pressure our pricing or require us to reduce prices for existing services upon contract renewals, thereby reducing our revenue and margins. In some of the markets in which we operate, we may experience increased competition for the medium and large enterprise customers that we target, which could adversely affect our revenue and margins. In addition, new technologies could create additional competition in the future.
The economic environment in the U.S. and globally could affect our future operating results.
Beginning in late 2007, the unfavorable economic environment had varying degrees of impact on our business, reflected primarily in longer sales cycles, decreased sales and higher customer disconnections that dampened our revenue growth. Continued economic uncertainty or a lack of economic growth could increase our customer disconnections of service and bad debt, and prices and new sales may decline or sales may be delayed due to decreased demand for our services, customer cash flow constraints, customer credit deteriorations and other factors. Unfavorable economic conditions could also prevent us from achieving the benefits of capital investments in our business that we have made for future growth. Our operating results and financial condition could be materially and adversely affected if there were to be a material adverse change in any of these factors. Our revenue, margins and cash flow are subject to fluctuations in the ordinary course of business due to the timing of sales and installations, disputes and dispute resolutions, pricing declines upon contract renewals, expense and capital expenditures and seasonality in sales and usage-based services. A return to recession or a further slowing of the economy could amplify the effect of those normal fluctuations on our results. Our key vendors that supply critical equipment and software or other goods and services that we rely upon in the provision of our services could be adversely affected by negative macro-economic factors. There is no assurance that we could replace critical components with alternate providers on a timely and cost efficient basis if our key vendors experience a financial crisis.
Several customers account for a significant portion of our revenue, and some of our customers may disconnect their services due to price competition, customer consolidations, financial difficulties, or other factors.
We have substantial business relationships with a few large customers, especially other carriers. Our 10 largest customers accounted for approximately 18% of our total revenue in 2012. The highly competitive environment in the long haul carrier sector and technological changes have challenged the growth prospects of some of our carrier customers and the economic environment, competition and other factors have impacted some of our enterprise customers and could lead to reductions in our revenue in the future. Ongoing consolidation in the telecommunications industry could result in the consolidated companies disconnecting some of the services they purchase from us or buying fewer services from us than the pre-consolidation companies. In addition, our revenue from these customers could be impacted by competitive pricing pressure and by customers' heightened cost-cutting initiatives.
Our service agreements with customers that have already satisfied their initial terms are subject to termination by the customer on short notice and do not require the customer to maintain the services at current levels. After expiration of their current agreements, customers may not choose to continue to purchase the same services or level of services.
Our revenue churn, defined as the average lost recurring monthly billing from customers’ partial or complete service disconnections (excluding pricing declines upon contract renewals and lost usage revenue), was 0.9%, 0.9%, and 1.0% of total monthly revenue in 2012, 2011 and 2010, respectively. We experience customer and service disconnections in the normal course of business primarily associated with price competition from other providers, industry consolidation, customer network optimization, customers moving facilities to other locations, cost cutting, business contractions and customer financial difficulties. We believe that the economic downturn contributed to an increase in churn beginning in late 2007 and higher churn levels in 2008 and 2009. While we experienced improvements in churn starting in 2010, we do not know whether the favorable churn results are sustainable and cannot predict the total impact on revenue from future customer disconnections or the timing of such disconnections. Replacing this revenue with new revenue from other customers may be difficult and more costly. Further, we expect revenue will continue to be impacted by pricing declines to current market levels for existing customers that renew services with expired terms.
If we do not adapt to rapid changes in the telecommunications industry and continue to offer services that satisfy customers’ needs, we could lose customers or market share.
The telecommunications industry continues to experience rapid and significant changes in technologies and architectures to deliver new services to customers and to deliver existing services more cost-effectively. We expect that new technologies will continue to enable advances in our customers’ IT environments that create new demand drivers. We believe that our future success will depend in part on our ability to anticipate and respond to the rapidly changing needs and demands of our customers on a timely basis and to compete with our competitors' offerings. Our failure to obtain and integrate new technologies and applications, and develop new service offerings to meet those customer needs or to keep pace with or exceed the service capabilities of our competitors could impact the breadth of our service portfolio, resulting in less competitive and compelling offerings that could impair our ability to attract and retain customers. We may be unable to keep pace with competitive offerings without making significant additional capital investments or adversely affecting our margins.
Revenue from certain of our more traditional products such as dedicated network services and certain voice services is growing slowly or is declining. As a result, our overall revenue growth is driven primarily by our Ethernet, managed services and VPN services and we must continue to develop those and other next generation services in order to continue to grow our revenue. New product development may be capital intensive and may pressure margins until the new products begin to generate substantial revenue. New products that are largely software based are increasingly complex and may require more customer support and additional systems development. In addition to investing in new technologies, we must replace some of the equipment that supports our traditional services as that equipment ages, even though the revenue base from those services is not growing. If we do not properly manage this process, including the migration of customers to our newer technologies, we may lose customers and market share, and our margins and returns could be adversely affected.
We may be adversely affected by changes in the regulation of special access services or by the FCC's failure to regulate Ethernet services offered by the ILECs as special access.
We purchase special access circuits and other services from ILECs to expand the reach of our network. If the special access services we buy from the ILECs were to be further deregulated, ILECs would have a greater ability to continue to increase the prices and reduce the service quality of special access services they sell to us. Competitive pressures or fixed term contracts may preclude us from passing those costs on to customers. As the prices we must pay for special access services increase, our margins may be adversely affected. A change in the regulations governing special access services could also reduce the likelihood that ILECs will sell us special access on reasonable terms and conditions.
We use the facilities of other carriers to reach some of our customer locations, and our ability to compete for those customers could be adversely affected by the cost of those facilities or by such carriers’ service issues.
Although we provide a substantial portion of our services entirely on our own network facilities, we must use the facilities of other carriers to connect our local markets, serve customer locations within our markets not served by our network and serve customer locations in U.S. markets outside of our service areas or outside of the U.S. Many of these carriers are also our competitors and if they cause delays in provisioning services, provide poor service quality or the cost of those facilities is unreasonable, our revenue and margins could be adversely affected. We have experienced price increases and service issues with some of these carriers from time to time.
The FCC is reviewing its regulation of interstate special access pricing in a pending proceeding commenced in 2005 that has not yet resulted in proposed rules. We have advocated that the FCC modify its special access pricing flexibility rules to return certain services to price-cap regulation to protect against unreasonable price increases. We cannot predict when the FCC will act on interstate special access pricing regulation or the impact of any such action. The FCC has also granted petitions for forbearance from regulation of certain special access services, including Ethernet services offered by ILECs as special access with the result that prices for the Ethernet and OC-n high capacity data services of the petitioning carriers are no longer regulated and can increase. We continue to pursue commercial arrangements with the ILECs for these services on acceptable terms and conditions. However, without some regulation of ILEC special access services, there is no assurance that we will be able to obtain reasonable pricing, terms and conditions for these services that will allow us to competitively price our services that utilize unregulated ILEC services. We expect that the ILECs will continue to advocate deregulation of all forms of special access services, and we cannot predict the outcome of the FCC’s proceedings in this regard. As a result, we cannot assure that we will continue to be able to obtain special access services at reasonable rates or on a timely basis or that the service quality we receive will be acceptable. If we experience difficulties in obtaining high-quality, reliable, and reasonably priced service from the ILECs, and are unable to obtain the same services from other carriers, we may be at a competitive disadvantage or our margins may be adversely affected.
Our substantial existing debt and debt service requirements could impair our financial condition and our ability to fulfill our obligations under our debt agreements.
As of December 31, 2012, our total debt and capital lease obligations were approximately $1.8 billion. Our level of debt may affect our operations and our ability to make payments on our outstanding indebtedness. Subject to certain covenants in our credit agreement and the indentures for our outstanding senior notes, we may incur significant additional indebtedness in the future. Our substantial indebtedness could, for example:
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Limit our ability to obtain additional financing in the future for working capital, capital expenditures, acquisitions or other corporate purposes;
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Make us more vulnerable to the current and future economic downturns or other adverse developments than less leveraged competitors; and
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Decrease our ability to withstand competitive pressures.
Our revolving credit facility, Term Loan B and the indentures relating to our senior notes contain restrictive covenants that may limit our flexibility, and breach of those covenants may cause us to be in default under those agreements.
The credit agreement for our revolving credit facility (“Revolver”) and Term Loan B (“Term Loan”) and the indentures relating to our senior notes limit, and in some circumstances prohibit, our ability to, among other things:
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Incur additional debt;
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Pay dividends;
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Make capital expenditures, investments or other restricted payments;
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Guarantee debts;
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Create liens;
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Sell assets;
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Repurchase our common stock; and
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Engage in mergers and acquisitions.
These restrictions could limit our ability to obtain future financing, make acquisitions or needed capital expenditures, withstand future economic downturns, conduct operations or otherwise take advantage of business opportunities that may arise. In addition, if we do not comply with these restrictions and financial covenants in our credit agreement that require us to maintain certain minimum financial ratios if we draw on our Revolver, the indebtedness outstanding under our credit agreement, and by reason of cross-acceleration or cross-default provisions, our senior notes and any other outstanding indebtedness we may then have, could become immediately due and payable. If we are unable to repay those amounts, our lenders or bondholders could initiate a bankruptcy or liquidation proceeding or the secured lenders could foreclose on the collateral granted to them to secure that indebtedness. If our lenders or bondholders were to accelerate the repayment of outstanding indebtedness, we may not have sufficient liquid assets to repay that indebtedness.
We will require substantial capital to expand our operations, we have a significant debt maturity in 2013 and we may not be able to obtain additional financing.
The development and expansion of our network requires substantial capital investment. If this capital is not available when needed, our business could be adversely affected. Our 2012 capital expenditures were $343.4 million and our estimate of our 2013 capital expenditures is $360 million to $370 million. We also expect to have substantial capital expenditures thereafter. In addition, holders of our outstanding $374 million principal amount of 2 3/8% senior convertible debentures due 2026 (the "Convertible Debentures") have the option to require us to purchase all or part of the Convertible Debentures on April 1, 2013, April 1, 2016, or April 1, 2021, or at any time prior to April 1, 2026 to convert the Convertible Debentures into shares of our common stock. Upon conversion, we will have the right to deliver, in lieu of shares of common stock, cash or a combination of cash and shares of common stock. Depending on the market price of our stock at the time of conversion, our conversion obligation will likely substantially exceed the principal amount of the Convertible Debentures. As of December 31, 2012, the if-converted value of the Convertible Debentures exceeded the principal amount by $136.9 million. This amount could increase or decrease depending on the market price of our stock at the time of conversion. We also have the option to redeem the Convertible Debentures any time on or after April 6, 2013 at a redemption price equal to 100% of the principal amount plus accrued and unpaid interest. Based on current assumptions, we expect to generate sufficient cash from operations along with available cash, cash equivalents and investments of $974.3 million and borrowing capacity under our Revolver of $80 million to provide sufficient funds to meet our expected capital expenditure and liquidity needs to operate our business and service our debt for the foreseeable future. However, if we satisfy our obligations under the Convertible Debentures in whole or in part with cash, we may be required to seek additional financing to satisfy our cash needs if:
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Our business plans and cost estimates are inaccurate;
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We are not able to generate sufficient cash flow from operations to service our debt, fund our capital expenditures and finance our business operations;
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We experience a significant reduction in demand for our products or an acceleration of customer disconnections;
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We decide to significantly accelerate the expansion of our business and existing network; or
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We wish to consummate acquisitions, mergers, joint ventures or other strategic transactions that require incremental capital.
Although we completed a debt offering in 2012 on favorable terms, it is difficult to predict future debt market conditions and whether we will be able to obtain additional financing, if needed, on terms acceptable to us or at all. Depending upon market conditions, any additional financing we might seek could be with rates and terms significantly less favorable than those contained in our current Revolver, Term Loan or other outstanding debt instruments. Other factors, such as a rating downgrade could further impact our potential access to financing sources. The failure to raise sufficient funds on reasonable terms if needed may require us to modify or significantly curtail our business plan. This could have a material adverse impact on our growth, ability to compete and ability to service our debt.
In addition, the lenders under our Revolver could refuse to lend funds if we are not in compliance with our financial covenants, such as leverage and interest coverage ratios that are primarily derived from the financial measure that we define as M-EBITDA (see note 4 to Item 6. “Selected Financial Data”), debt levels and interest expense. A lack of revenue growth, revenue losses, pricing declines or rising costs could negatively impact our M-EBITDA margins and cause our failure to meet the minimum required ratios. Even if we meet the conditions for borrowing under the Revolver, we may be unable to draw upon the entire commitment if any of our lenders are unable to perform their obligations to advance funds due to their own financial difficulties.
We may complete a significant business combination or other transactions that could increase our shares outstanding, and may result in a change in control, and increase our debt.
We regularly evaluate potential acquisitions, mergers, joint ventures and other arrangements that would extend our geographic markets, expand our services, enlarge the capacity of our network or expand the types of services provided through our network. If we enter into a definitive agreement for any acquisition, merger, joint venture or other arrangement, we may require additional financing that could result in an increase in our debt, result in a change of control, increase the number of our outstanding shares or all of these effects. A substantial transaction may require the consent of our lenders and a change of control with a ratings decline could trigger prepayment obligations under our debt agreements. There can be no assurance that we will enter into any transaction or, if we do, on what terms. In addition, the success of any significant acquisition or business combination is dependent, in part, on our ability to successfully integrate the acquired business into ours, which also carries substantial risks.
Our ability to use net operating loss ("NOL") carryforwards to reduce future tax payments could be negatively impacted if there is an “ownership change” as defined under Section 382 of the Internal Revenue Code, and our Section 382 stockholder rights plan has expired.
We have substantial NOLs for U.S. federal income tax purposes and, under the Internal Revenue Code, we may “carry forward” these NOLs in certain circumstances to offset any current and future taxable income and thus reduce our federal income tax liability, subject to certain requirements and restrictions. If we experience an “ownership change,” as defined in Section 382 of the Internal Revenue Code and related Treasury regulations at a time when our market capitalization is below a certain level, our ability to use the NOLs could be substantially limited. This limit could impact the timing of the usage of the NOLs, thus accelerating cash tax payments or causing NOLs to expire prior to their use, which could affect the ultimate realization of that asset.
We have experienced reductions in switched access and reciprocal compensation revenue as a result of regulatory changes and will experience further reductions in the future.
Over time, FCC and state regulations have resulted in reducing our switched access and reciprocal compensation revenue. In November 2011, the FCC adopted an order providing for terminating intercarrier compensation rates to transition to Bill and Keep over a six year period beginning in July 2012 that will decrease both our intercarrier compensation revenue and our intercarrier compensation expense. We lowered our rates in July 2012 to comply with the Order, and the next mandated rate decrease is scheduled to occur in July 2013. As a result of the Order, we lost approximately $2.0 million in intercarrier compensation revenue in the year ended December 31, 2012 and expect to lose approximately $4.0 million in the year ended December 31, 2013 compared to the full year 2012. There is no assurance that we will be able to compensate for the reduction in intercarrier compensation revenue with other revenue sources.
We may be adversely impacted by deterioration in the financial condition of financial institutions or mutual funds that hold our investments.
As of December 31, 2012, our cash, cash equivalents and investments are held in financial institutions, prime money market mutual funds, U.S. Treasury money market mutual funds, certificates of deposit, commercial paper and debt securities issued by the U.S. Treasury and other government agencies. We are exposed to risks resulting from deterioration in the financial condition or failure of financial institutions holding our cash deposits, decisions of our investment advisers and the investment managers of the money market funds and defaults in securities underlying the funds and investments, which could adversely impact our ability to access these cash balances. We actively monitor the depository institutions and the performance and quality of our investments and the mutual funds that hold our cash and cash equivalents and adjust the cash balances in our accounts as appropriate. We prioritize safety over investment return in choosing the investment vehicles for cash and cash equivalents and investments and have diversified these investments to the extent practical to minimize our exposure to any one investment vehicle or financial institution. This strategy generally results in lower interest income from investments included in cash and cash equivalents and investments. We may change the nature of our cash, cash equivalent and short-term investments as market conditions change.
Balances in certain of our accounts with financial institutions in the U.S. exceed the FDIC insurance limit when it is impractical to spread these amounts over multiple institutions. We cannot assure that access to our cash, cash equivalents and investments will not be impacted by additional and yet unforeseeable adverse conditions in the financial markets.
We may lose customers if we experience network or system failures that significantly disrupt the availability and quality of the services that we provide. System failures or cyber-attacks may also cause interruptions to service delivery and the completion of other corporate functions.
Our operations depend on our ability to deliver reliable service for customers. Interruptions in service or performance problems could result from errors, network equipment failures, fiber cuts, natural disasters, accidents, terrorist acts, power losses, security breaches, vandalism or other illegal acts, computer viruses or other causes. Service interruptions or degradations in service performance could undermine confidence in our services and cause us to lose customers or make it more difficult to attract new ones. Because many of our services are critical to the businesses of many of our customers, any significant interruption or degradation in service could result in lost profits or other losses to customers. Although we generally limit our liability for service failures in our service agreements to limited service credits and generally exclude any liability for “consequential” damages such as lost profits, a court might not enforce these limitations on liability, which could expose us to financial loss. Further, if we fail to meet the service level commitments that we provide to customers with respect to certain services, we may be obligated to provide service credits or other compensation to our customers, which could negatively affect our operating results.
As we grow our business, we have increased our dependency on automation and systems in order to scale our business. If our key systems become impaired for any significant period of time, our ability to service our customers at current levels, obtain critical data, provision or bill for our services or perform other critical corporate functions could be adversely affected.
Like other companies with significant IT systems, our systems are subject to cyber-attacks and other intrusions. These intrusions could potentially disrupt our services or systems or compromise the privacy of data. While our security has thus far been able to prevent significant harm or security breaches from these intrusions, we cannot assure that our security measures will be able to prevent all possible risks to our systems. Breaches of network or IT security that compromise the privacy of customer or employee confidential data could result in damage to our reputation.
We depend on third party vendors for information systems, equipment and other operational functions.
We have agreements with vendors that provide for the development and operation of IT systems such as billing systems and operational functions such as centralized equipment and spares management. We also rely on vendors to supply equipment and software that is critical to the provision of our services. The failure of these vendors to perform their services in a timely and effective manner at acceptable costs or to provide reliable equipment and software could have a material adverse effect on our operations and our ability to provide high quality services to our customers, monitor costs, bill customers, provision services, deploy equipment and achieve operating efficiencies.
We depend on key personnel for our current and future performance.
Our senior management team has performed effectively as a team over a considerable period of time. Our current and future performance depends to a significant degree upon the continued contributions of our senior management team and other key personnel. We have not experienced significant turnover among these employees. The loss or unavailability of members of our senior management team or key employees could cause disruption to our business. We cannot assure that we would be able to successfully implement our succession plans or identify or employ qualified replacements for senior management or key employees on acceptable terms if their services are no longer available. Unanticipated turnover may also adversely affect the performance of our senior management team or other internal organizations. In addition, our development of new services and support systems is dependent in part upon hiring and retaining the specific technical skills that we require, which may be in short supply.
We must obtain access to rights-of-way and pole attachments on reasonable terms and conditions; IRUs of fiber and capacity that are important to our operations may not be renewed.
The development, expansion, and maintenance of our network depend, in part, on our ability to obtain rights-of-way and pole attachments as well as certain governmental authorizations and permits. In order to compete effectively, we must obtain such rights, authorizations and permits in a timely manner, at reasonable costs, and on satisfactory terms and conditions. Any increase in the difficulty or cost of obtaining these rights, authorizations or permits could adversely affect us, particularly in areas where we must compete with companies that already have the necessary permits and access.
In certain cities and municipalities where we provide network services over our own fiber optic facilities, we pay license or franchise fees for the use of public rights-of-way. The 1996 Act permits municipalities to charge these fees only if they are competitively neutral and nondiscriminatory, but certain municipalities may not conform their practices to the requirements of the 1996 Act in a timely manner or without legal challenge. We also face the risk that other cities may start imposing new fees, existing fees will be increased or franchises will not be renewed. Some of our franchise agreements also provide for increases or renegotiation of fees at certain intervals. Increases in fees may have a negative impact on our financial condition. If any of our existing franchise or license agreements for a particular metropolitan area are terminated prior to their expiration date and we are forced to remove our fiber optic cables from the streets or abandon our network in place, even with compensation, such termination could have a material adverse effect on us.
A portion of our services are provided on network fiber facilities licensed or leased from other companies through IRUs or similar arrangements. The facilities under these agreements have remaining terms generally ranging from 10 years to 20 years and can be terminated earlier by the grantors if we materially breach the agreements or other events of default occur as defined in the agreements. Prior to expiration of the terms of these IRUs, we likely will have to negotiate for their renewal. We cannot assure that the counterparties will agree on the terms of any renewal or that the terms of any renewal will be favorable to us. If these agreements are not renewed or are terminated for default, we will have no further interest in the fiber or capacity covered by those agreements and will likely need to build, lease or otherwise obtain alternative fiber network capacity.
Recently enacted health care reform legislation and state and local tax charges may increase our costs.
Congress in 2009 enacted sweeping health care reform legislation that will be implemented in stages over six years. Health care reform as mandated and implemented under the legislation and any future federal or state mandated health care reform is likely to increase the costs of our employer-sponsored medical plans either directly or as a result of providers passing through their increased costs. If the cost increase is material, our financial condition could be adversely affected or if those increased costs must be borne by employees, employee morale could be adversely affected.
Our tax burden has increased and could continue to increase, possibly to a significant degree, due to changes in state and local tax laws imposed by these jurisdictions in an attempt to reduce their budget deficits. These changes could include rate increases, removal of exemptions, suspension of the use of NOLs and other measures to raise their revenue. We cannot predict the degree to which these tax changes will affect our net income, M-EBITDA and cash flow.
Catastrophic events or other business disruptions could affect our future operating results.
Our operating results and financial condition could be materially and adversely affected if there is a catastrophic event such as a terrorist attack on the United States, or a major earthquake, fire, hurricane, flood or similar event that affects our central offices, corporate headquarters, network operations centers or other facilities. Although we have implemented measures that are designed to mitigate the effects of such events, we cannot predict all of the potential impacts of such events. We maintain insurance coverage for some of these events; however, the potential liabilities or damage associated with these events could exceed the insurance coverage we maintain. Our inability to operate our networks or operate key systems as a result of such events, even for a limited period of time, may result in significant expenses or loss of customers and associated revenue. Even if our facilities are not impacted directly by a catastrophic event, potential impacts on our suppliers may result in difficulties in obtaining equipment, fiber optics or other network components that may affect our ability to provision new services to customers, expand our networks or replace obsolete equipment.
Our ability to offer residential and content services is limited by our Capacity License Agreements.
Our Capacity License Agreements with the Cable Operations prohibit us from using facilities licensed under those agreements until 2028 to (i) engage in the business of providing, offering, packaging, marketing, promoting, or branding (alone or jointly with or as an agent for other parties) any residential services, or (ii) produce or otherwise provide entertainment, information, or other content services. Although we do not believe that these restrictions will materially affect our business and operations in the immediate future, we cannot predict the effect of such restrictions in the rapidly changing telecommunications industry. We do not currently have plans to offer residential or content services in any of our service areas.
We may be required to record impairment charges in the future.
Under U.S. generally accepted accounting principles, we are required to review the carrying amounts of our assets, including goodwill, to determine whether current events or circumstances warrant adjustments to those amounts. These determinations are based in part on our judgments regarding the cash flow potential of various assets, and involve projections that are inherently subject to change based on future events. If we determine in the future that the cash flow potential of any of our assets, including acquired assets, is significantly less than we believed at the time of purchase, and that conclusion is based on a long-term rather than short-term trend, we may need to record an impairment charge.
Item 1B.
Item 1B.
Unresolved Staff Comments
None.
Item 2.
Item 2.
Properties
We lease network hub sites, central office sites, other facility locations and sales and administrative offices in the cities in which we operate our network. During 2012, 2011 and 2010, rental expense for our facilities and offices totaled approximately $70.4 million, $64.6 million and $61.0 million, respectively. We believe that our properties, taken as a whole, are in good operating condition and are adequate for our business operations. We currently lease approximately 167,000 square feet of space in Littleton, Colorado, where our corporate headquarters is located, approximately 130,000 square feet of space in Greenwood Village, Colorado, where one national operations center and other administrative functions are located, and approximately 48,000 square feet of space in O’Fallon, Missouri, where another national operations center is located.
On January 8, 2013, we entered into a lease for a total of approximately 161,200 square feet of space in Lone Tree, Colorado. We intend to relocate our national operations center and other administrative functions to this new location prior to
the expiration of the lease at our current facility in Greenwood Village, Colorado. We plan to take possession of 33,000 square feet of the new location in January 2013 and plan to take possession of the remaining approximately 127,900 square feet of the building during the summer of 2015.
Item 3.
Item 3.
Legal Proceedings
We are party to various claims and legal and regulatory proceedings in the ordinary course of business. We do not believe that these claims or proceedings, individually or in the aggregate, are material or are likely to have a material adverse effect on our business, financial condition, or results of operations.
Item 4.
Item 4.
Mine Safety Disclosures
Not applicable.
PART II
Item 5.
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market Information
Our common stock is traded on the NASDAQ Global Select Market of the NASDAQ Stock Market under the symbol “TWTC”. The following table sets forth the intraday high and low sales prices for our common stock for each of the quarters of 2011 and 2012 as reported on the NASDAQ Stock Market:
Dividends
We have never paid or declared any dividends. We may consider paying dividends in the future to the extent permitted by our debt covenants. The decision whether to pay dividends will be made by our Board of Directors in light of conditions then existing, including our results of operations, financial condition and requirements, business conditions, covenants under debt agreements and other contractual arrangements, and other factors.
Number of Stockholders
As of January 31, 2013, there were 495 holders of record of our common stock.
Performance Graph
The following graph compares total stockholder return on our common stock since December 31, 2007, with the NASDAQ Composite Index (U.S. and foreign companies) and the NASDAQ Telecommunications Index. The graph assumes that $100 was invested in our stock at the closing price of $20.29 on December 31, 2007, and that the same amount was invested in the NASDAQ Composite Index and the NASDAQ Telecommunications Index. Our closing price on December 31, 2012 was $25.47.
Comparison of Cumulative Total Return on Investment
Purchases of Equity Securities by the Issuer and Affiliated Purchasers
The following table presents our purchases of equity securities reportable during the three months ended December 31, 2012:
___________________
(1)
On November 16, 2011, our Board of Directors authorized a multi-year repurchase program of up to $300 million of our common stock from time to time using a variety of methods, including open market purchases, block trades and privately negotiated transactions. Our open market purchases may be carried out pursuant to a pre-established trading plan under Rule 10b5-1 under the Securities Exchange Act of 1934. The authorization has no time limit, and may be suspended or discontinued at any time. As of December 31, 2012, approximately $278.0 million remained available under the authorization.
Item 6.
Item 6.
Selected Financial Data
Selected Consolidated and Combined Financial and Other Operating Data
The following table is derived in part from our audited consolidated financial statements. This information should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the audited consolidated financial statements and the notes thereto.
___________________
(1)
We classify certain taxes and fees billed to customers and remitted to government authorities on a gross versus net basis in revenue and expense. The total amounts classified as revenue, primarily included in voice services, associated with such taxes and fees were approximately $79.8 million, $63.5 million, $51.3 million, $40.0 million and $36.9 million for the years ended December 31, 2012, 2011, 2010, 2009 and 2008, respectively. This has no impact on Modified EBITDA or net income (loss) but is dilutive to Modified EBITDA margin.
(2)
Includes the following non-cash stock-based employee compensation expense:
(3)
Includes a non-cash income tax benefit of $299.0 million for the year ended December 31, 2010 to recognize the value of tax assets.
(4)
“Modified EBITDA” is a non-GAAP financial measure and is defined by us as net income (loss) before depreciation, amortization and accretion expense, interest expense, interest income, debt extinguishment costs, other income (loss), impairment charges, income tax expense (benefit), cumulative effect of change in accounting principle, and non-cash stock-based employee compensation expense. Modified EBITDA is not intended to replace operating income (loss), net income (loss), cash flow and other measures of financial performance and liquidity reported in accordance with accounting principles generally accepted in the United States. Rather, Modified EBITDA is a measure of operating performance and liquidity that investors may consider in addition to such measures. Other companies may define Modified EBITDA or similar terms differently. Our management believes that Modified EBITDA is a standard measure of operating performance and liquidity that is commonly reported and widely used by analysts, investors, and other interested parties in the telecommunications industry because it eliminates many differences in financial, capitalization, and tax structures, as well as non-cash and non-operating charges to earnings. We believe that Modified EBITDA trends are a valuable indicator of whether our operations are able to produce sufficient operating cash flow to fund working capital needs, service debt obligations, and fund capital expenditures. We currently use Modified EBITDA for these purposes. Modified EBITDA also is used internally by our management to assess ongoing operations and is a measure used to test compliance with certain covenants of our senior notes, our Revolver and our Term Loan. The definition of EBITDA under our Revolver, our Term Loan and our senior notes differs, but not materially, from the definition of Modified EBITDA used in this table. Modified EBITDA as used in this document may not be comparable to similarly titled measures reported by other companies due to differences in accounting and disclosure policies.
(5)
The reconciliation between net income (loss) and Modified EBITDA is as follows:
The reconciliation between net cash provided by operations and Modified EBITDA, as a measure of liquidity, is as follows:
(6)
Modified EBITDA margin represents Modified EBITDA as a percentage of revenue.
(7)
Our net interest coverage ratio is calculated by dividing net cash interest expense by Modified EBITDA. We believe that our net interest coverage ratio provides a measurement of our ability to cover our interest payments on our debt and capital lease obligations. For this purpose, the net cash interest expense excludes non-cash interest expense. The reconciliation between interest expense and net cash interest expense is as follows:
(8)
During 2012, building additions include an increase of 532 previously connected buildings identified during alignment of key operating systems. As of the first quarter of 2011, to better reflect our reach, we modified our on-network ("on-net") building count definition to include all locations served directly by our fiber network, including previously excluded locations without electronics and ILEC local serving offices ("LSOs"). Inclusion of these locations and LSOs resulted in the addition of approximately 1,400 and 1,200 locations to our on-net buildings from those we previously reported as of December 31, 2010 and 2009, respectively. This change has only been reflected back to the year ended December 31, 2009 because this information is not available for periods prior to December 31, 2009.
(9)
Our gross leverage ratio is calculated by dividing the principal amount of our total debt and capital lease obligations by Modified EBITDA. Our net leverage ratio is calculated by dividing the principal amount of our total debt and capital lease obligations less cash and cash equivalents and short-term investments by Modified EBITDA. We believe that our leverage ratios provide a measurement of our ability to cover our total debt and capital lease obligations.
Item 7.
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis should be read in conjunction with the "Selected Financial Data" and the accompanying consolidated financial statements and related notes thereto, included elsewhere in this report. This section and other parts of this report contain forward-looking statements that involve risks and uncertainties. See "Caution Regarding Forward-Looking Statements" at the beginning of this report. Forward-looking statements are not guarantees of future performance, and our actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in the subsection entitled "Risk Factors" above. We assume no obligation to revise or update any forward-looking statements for any reason, except as required by law.
Overview
We are a leading national provider of managed network services, specializing in business Ethernet, data networking, converged, IP VPN, Internet access, voice, including VoIP, and network security services to enterprise organizations, including public sector entities, and carriers throughout the U.S., including their global locations. Our revenue is derived from business communication services, including data, high-speed Internet access, network and voice services. Our customers include, among others, enterprise organizations in the financial services, technology and scientific, health care, distribution, manufacturing and professional services industries, public sector entities, system integrators and communications service providers, including ILECs, competitive local exchange carriers ("CLECs"), wireless communications companies and cable companies.
Through our subsidiaries, we serve 75 metropolitan markets with local fiber networks that are connected by our regional fiber facilities and national IP backbone. As of December 31, 2012, our fiber network spanned approximately 29,000 route miles (including approximately 22,000 metropolitan route miles) connecting to 17,948 buildings served directly by our local fiber facilities. In 2012 we added approximately 2,500 new buildings directly connected to our network, including 532 previously connected buildings that were identified during an alignment of key operating systems. Our fiber networks also connect to over 400 key third party data centers across the country where customers deploy their own equipment or connect to cloud service providers. We continue to extend our fiber footprint within our existing markets by connecting our network into additional locations and to expand our data, voice and IP networking capabilities between our markets, supporting secure end-to-end business Ethernet, IP VPN and converged solutions for customers.
Our objective is to be the leading national provider of high quality, business networking solutions leveraging our integrated network, operational capabilities, dedicated people, local presence, personalized customer experience and advanced support systems to meet the complex and evolving needs of our customers and increase stockholder value. The key elements of our business strategy include:
•
Focusing our service offerings on meeting our customers' complex evolving needs, emphasizing business Ethernet and IP VPN services (which we refer to as strategic services), Internet-based services and converged service offerings and developing our advanced service capabilities, which we refer to as the "Intelligent Network". We launched the initial phase of the Intelligent Network, Enhanced Management, in June 2012 for IP VPN, converged and Ethernet services, and the second phase, Dynamic Capacity, which allows customers to manage or schedule bandwidth, in August 2012;
•
Enabling enterprise cloud computing and other developing customer IT and business strategies by leveraging our fiber network, data services portfolio, Intelligent Network capabilities and the numerous third party and customer data centers connected to our network;
•
Delivering a differentiated customer care strategy by engaging all of our employees and continually incorporating customer feedback to provide the best possible customer service;
•
Leveraging our local fiber assets and national IP backbone and integrating and managing other carriers’ facilities to enable our customers to connect to any of their locations with our network solutions, and using our local presence and local sales, sales engineering, customer support and operational resources, backed by a national organization, to provide personalized service and customized solutions for our customers;
•
Enhancing our multi-channel sales strategy;
•
Employing a disciplined capital allocation strategy to invest for growth in the near and long term to broaden our reach and capabilities and increase operational efficiencies; and
•
Investing in our people to drive the execution of our strategies.
Our revenue is derived from business communications services, including data, high-speed Internet access, voice and network services. Although we analyze revenue by customer type, we present our financial results as one segment across the
U.S. because our business is centrally managed. The percentage of revenue by customer type for each of the past three years is as follows:
Revenue Trends
Total Revenue
Our revenue has grown for the past consecutive 33 quarters through December 31, 2012, including throughout the various economic cycles. We expect our future revenue growth to be driven in part by the increasingly web-based economy and developing IT strategies such as cloud computing, collaboration, data center connectivity and disaster recovery, all of which require the reliable connectivity and network capacity that we provide. We also expect that our enhanced service capabilities will drive more demand for our existing Ethernet and VPN product suite and enhance our future data services revenue growth. Our national footprint and new and enhanced service capabilities enable us to serve customers with multi-point, multi-city locations. Our year-over-year growth rate increased over each of the prior years ended December 31, 2010, 2011 and 2012 and was 5.1%, 7.4% and 7.6%, respectively. These higher year-over-year growth rates were primarily due to higher demand, low revenue churn and an increase in certain taxes and fees that are reported on a gross versus net basis in revenue and expense. We also believe that our newer and enhanced services, our customer experience initiatives to increase customer loyalty and retention and improved economic conditions contributed to our growing revenue. In 2012, our service installations increased year-over-year, although at a growth rate lower than our total overall revenue growth rate. As a result, beginning in the three months ended March 31, 2012, we experienced a trend of lower quarterly year-over-year revenue growth rates, including for the three months ended December 31, 2012 (excluding the impact of a large customer settlement) and expect this trend to continue into 2013. Increasing our rate of revenue growth will be dependent on higher service installations to keep pace with the growing total base of revenue as well as retaining revenue from existing customers. To capture growing market demand and share, we are implementing several initiatives in 2013 focused on increasing sales to contribute to an accelerating growth rate over time (see "Modified EBITDA Trends and Growth Initiatives" below).
Revenue for data and Internet, network and the majority of our voice services is generally billed in advance on a monthly fixed-rate basis and recognized over the period the services are provided. Revenue for the majority of intercarrier compensation and certain components of voice services, such as certain components of long distance, is generally billed on a transactional basis in arrears based on a customer's actual usage; therefore, we use estimates to recognize revenue in the period earned. Due to the time required to obtain or build necessary facilities, obtain rights to install equipment in multi-tenant buildings and other factors related to service installation, some of which are not within our control, there is often a time lag between the time a sale, or "booking" (i.e., signed contract) is made, and the time revenue commences. Our installation intervals are generally longer for the more complex solutions delivered to our customers. In some situations, the timing of service installations may be subject to factors that our customers control, such as their readiness for us to install equipment on their premises or the readiness of their equipment. Due to all of these factors, installation intervals may range between two weeks for single-site, less complex services to 6 to 12 months or longer for the more complex solutions.
Enterprise Customer Revenue
Revenue from enterprise customers has increased for the past 42 consecutive quarters through December 31, 2012 and increased 6.3%, 9.4% and 10.5% for the years ended December 31, 2010, 2011 and 2012 over the respective prior years primarily due to increased installations of our data and Internet services such as business Ethernet and VPN and other services and an increase in certain taxes and fees. Revenue from our enterprise customers represented 79% of our total revenue for the year ended December 31, 2012. We expect our future revenue growth to come primarily from our enterprise customer base.
Carrier Customer Revenue
Our carrier revenue represented 19% of total revenue for the year ended December 31, 2012. Carrier revenue has been gradually declining as a percentage of revenue due to the higher contribution from enterprise customer revenue coupled with continued disconnections and repricing of carrier contracts upon renewals somewhat offset by installed sales of Ethernet services to carriers to serve their end users' needs. Carrier revenue from wireless providers represented 30% of total carrier revenue for both the years ended December 31, 2012 and 2011. While we expect some contribution to carrier revenue as we expand our data and Internet service offerings to our wholesale customer base, our carrier revenue historically has been impacted by pricing declines in connection with carrier customer contract renewals, disconnections resulting from price competition from other carriers, customer cost cutting measures and carrier consolidation. We expect these impacts on our carrier revenue to continue.
Intercarrier Compensation Revenue
Intercarrier compensation revenue, which consists of switched access services and reciprocal compensation, represented 2% of our total revenue for the year ended December 31, 2012, and is expected to continue to decline in the future as a percentage of total revenue due to federal and state mandated rate reductions and changes in the regulatory regime for intercarrier compensation. We lowered our rates in July 2012 to comply with a 2011 FCC Order. Another mandated rate decrease will occur in July of 2013. As a result of the order, we lost approximately $2.0 million in intercarrier compensation revenue in the year ended December 31, 2012 and expect to lose approximately $4.0 million in the year ended December 31, 2013 compared to the full year 2012. The order mandates further rate declines through 2018 when carriers will be required to exchange local traffic on a "bill and keep" basis, meaning that the exchange of traffic will not be compensatory. Intercarrier compensation revenue also may fluctuate based on variations in minutes of use originating and terminating on our network and changes in customer settlements.
Revenue and Customer Churn
Revenue churn, defined as the average lost recurring monthly billing for the period from a customer’s partial or complete disconnection of services (excluding pricing declines upon contract renewals and lost usage revenue) compared to reported revenue, is a measure used by management to evaluate revenue retention. Customer and service disconnections occur as part of the normal course of business and are primarily associated with price competition from other providers, customers moving facilities to other locations and customers' cost cutting, business contractions, financial difficulties and consolidation, among other reasons. After higher churn beginning in late 2007 and continuing through 2009, revenue churn improved in the year ended December 31, 2010 to pre-recession levels of 1.0% of monthly revenue and further improved to 0.9% in each of the years ended December 31, 2011 and 2012. We believe that the improvement in revenue churn is a result of improved economic conditions as well as our service portfolio, measures we put in place to increase revenue retention and our customer experience initiatives. As a component of revenue churn, revenue lost from customers fully disconnecting services was 0.2% for each of the years ended December 31, 2010, 2011 and 2012, respectively. We continue our initiatives to maintain revenue churn that is low relative to our industry, but do not expect contribution to our revenue growth rate from a lower revenue churn rate. If our revenue churn were to increase, our revenue growth would likely be negatively impacted. We cannot predict the total impact on revenue from future customer disconnections or the timing of such disconnections or whether these favorable churn trends will continue.
Customer churn, defined as the average monthly customer turnover for the period compared to the average monthly customer count for the period, was 1.1%, 1.0% and 1.0% for the years ended December 31, 2010, 2011 and 2012, respectively. The majority of this churn came from our smaller customers, which we expect will continue.
Pricing
We experience significant price competition across our service categories that impacts our revenue. We also believe that technology advancements over the years in the telecommunications industry have resulted in lower unit costs for some electronics and equipment that drives customer demand for higher bandwidth at the same or lower prices.
In our industry, service agreements typically range from two to five years, with fixed pricing for the contract term. When contracts are renewed with no changes to the services, pricing is frequently reduced to current market levels as a renewal incentive. In addition, during the terms of agreements, customers often purchase additional services or increase or decrease the capacity of existing services, subject to applicable early termination charges, depending on their business needs. During periods of economic downturn, our customers' needs may contract, resulting in fewer service additions.
Expenses and Modified EBITDA Trends
Pricing of Special Access Services
We purchase a substantial amount of special access services primarily from ILECs to expand the reach of our network and also provide special access services to our customers over our fiber facilities in competition with the ILECs. The ILECs have argued before the FCC that the high capacity telecommunications services that they sell, including special access services we buy from them, should no longer be subject to regulations governing price and quality of service. We have advocated that the FCC modify certain of its special access pricing flexibility rules to return these services to price-cap regulation to protect against unreasonable price increases for carriers such as us. The FCC is reviewing its regulation of special access pricing in a pending proceeding commenced in 2005 that has not yet resulted in proposed rules. In 2012, the FCC suspended the operation of the pricing flexibility triggers, which means that ILECs cannot expand the geographic scope of their capability to raise prices, pending further FCC review. We cannot predict when the FCC will act on interstate special access pricing regulation or the impact of any such action.
If the special access services we buy from the ILECs were to be further deregulated, ILECs would have a greater ability to increase the price and reduce the service quality of special access services they sell to us. As the prices we must pay for special access services increase, our margins are pressured.
In addition, the FCC has granted ILEC requests for forbearance from regulation of certain Ethernet and OC-n high capacity services offered by the ILECs as special access, with the result that prices we would pay for those services are no longer regulated and can increase. We are advocating reversal of these forbearance requests. We also continue to pursue and implement commercial arrangements with the ILECs and cable companies for these services on acceptable terms and conditions. In an attempt to stabilize the prices we pay for these services, we entered into a wholesale service agreement with a large ILEC for tariffed special access and other services for end-user access. However, since mid-2010, costs for some special access services subject to this agreement and those we buy from other significant ILEC suppliers of special access service have trended up. Expiration of the current wholesale agreement, without a new agreement with similar terms to replace it, could result in additional increases to our special access costs, which could be material.
Bad Debt Expense Trends
Due to the quality of our customer base, successful collection efforts, internal controls, bad debt recoveries, and our revenue recognition policies, including recognition of contract termination charges upon cash receipt, our bad debt expense was less than 1% of our total revenue for the year ended December 31, 2012, comparable to the years ended December 31, 2011 and 2010. We cannot assure that we will be able to maintain bad debt expense at this low level.
Modified EBITDA Trends and Growth Initiatives
We have had initiatives to expand our revenue growth, margins and cash flow that required both capital and operating investments. During the past three years ended December 31, 2012, these operating investments included expansion of our sales and sales support staff as well as IT and technical personnel and contract labor to support our growing customer base and new product and technology investments to provide future capabilities which differentiate our products and services from the competition. Our capital spending investments during these periods consisted of incremental success-based expenditures to support growing sales, new service portfolio enhancements, including our expanded Ethernet service portfolio and our Intelligent Network capabilities, including sales to wireless providers, strategic market expansion through fiber purchases to extend our network reach and corporate and IT initiatives that support the evolution of our services, enable our customer experience and drive increased scale and efficiency. We believe that these initiatives resulted in expansion of our revenue growth, margins and cash flows.
Our Modified EBITDA (see Note 4 to the table under Item 6. Selected Financial Data for a definition of Modified EBITDA) has increased sequentially for 23 consecutive quarters due to the contribution from revenue growth and the initiatives described above, among other factors. Modified EBITDA grew 6.2%, 7.4%, and 8.6% in the years ended December 31, 2010, 2011 and 2012, respectively, each compared to the respective period in the prior year. Modified EBITDA margin was 36.4%, 36.4% and 36.8% for the years ended December 31, 2010, 2011 and 2012, respectively. These margins included the absorption of increased costs for special access due to higher prices and costs associated with additions to our sales and support staff and IT and technical personnel and were impacted by the dilutive effect of volume and rate increases in certain taxes and fees that are reported on a gross versus net basis in revenue and expense (see “Revenue” in Note 1 to the consolidated financial statements).
The initiatives that we are implementing in 2013 are designed to reverse the 2012 trend of lower quarterly year-over-year growth rates and consist of further increasing investments in our sales and support staff to expand our market penetration, in new technologies to deliver new innovative capabilities to further drive our strategic data and Internet services, in further automation of network functionality to enable more dynamic customer network capacity and connections and in continuing the expansion of our network in existing and adjacent markets to reach more customers. While these initiatives are designed to increase sales in the near term to enable us to accelerate our revenue growth rate over the long term, we cannot assure that these and other initiatives will be sufficient to achieve our objectives of increased revenue growth, margins and cash flows or the timing of such anticipated benefits.
We believe that increasing our sales and support staff to leverage our service offerings and support our increasingly complex solutions will enable us to attract new customers, sell more services to existing customers and retain customers. However, we expect that the higher investments in this and the other growth initiatives discussed above will dampen our Modified EBITDA margin and cash flow in the near term until we can achieve higher service installations and an expansion in our rate of revenue growth that we expect will absorb the cost of the expanded sales reach and allow margins to expand again. We believe that future margin expansion will come from higher service installations, further leveraging our on-network facilities and increasing the network density of our less mature markets, since over the long term we have generally experienced margin improvement and increased cash flow from our less dense markets as those markets are expanded through on-net building additions and other network expansions. Our continued cost efficiency efforts are also intended to contribute to our overall margins. Our revenue and margins may also be impacted by, among other risks, competitive pressures, higher special access, fuel and energy costs, fluctuations in certain taxes and fees and any future inflationary pressures.
Seasonality and Fluctuations
We continue to expect business fluctuations to impact sequential quarterly trends in revenue, margins and cash flow. This includes the timing, as well as any seasonality of sales and service installations, usage, rate changes, disputes, settlements, repricing for contract renewals and fluctuations in revenue churn, expenses, capital expenditures and certain taxes and fees. Historically our revenue and expense in the first quarter has been impacted by the slowing of our customers' purchasing activities during the holidays and the resetting of payroll taxes in the new year. Our historical experience with quarterly fluctuations may not necessarily be indicative of future results.
Because we generally do not recognize revenue subject to billing disputes until the dispute is resolved, the timing of dispute resolutions and settlements may positively or negatively affect our revenue in a particular quarter. The timing of disconnections may also impact our results in a particular quarter, with disconnections early in the quarter generally having a greater impact. The timing of capital and other expenditures may affect our margins or cash flow. The convergence of any of these or other factors such as fluctuations in usage, increases or decreases in certain taxes and fees or pricing declines upon contract renewals in a particular quarter may result in our revenue growing more or less than previous trends, may impact our margins and other financial results and may not be indicative of future financial performance.
Critical Accounting Policies and Estimates
We prepare our financial statements in accordance with accounting principles generally accepted in the United States, which require us to make estimates and assumptions that affect reported amounts and related disclosures. We consider an accounting estimate to be critical if:
•
it requires assumptions to be made that were uncertain at the time the estimate was made; and
•
changes in the estimate or different estimates that could have been selected could have a material impact on our consolidated results of operations or financial condition.
Goodwill
We perform impairment tests at least annually on all goodwill and indefinite-lived intangible assets as required by relevant accounting standards, which require goodwill to be assigned to a reporting unit and tested using a consistent measurement date. For purposes of testing goodwill for impairment, our goodwill has been assigned to our one consolidated reporting unit and our test is performed in the fourth quarter of each year or more frequently if impairment indicators arise.
In reviewing goodwill for impairment we have the option to (i) assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount or (ii) bypass the qualitative assessment and proceed directly to a quantitative assessment. For our assessment in the year ended December 31, 2012, we opted to bypass the qualitative assessment and proceed directly to the quantitative assessment, which utilizes a two-step process. The first step is to identify if a potential impairment exists by comparing the fair value of the reporting unit to its carrying amount. If the fair value of the reporting unit exceeds its carrying amount, goodwill is not considered to have a potential impairment and the second step of the impairment test is not necessary. However, if a potential impairment exists, the fair value of the reporting unit is compared to the fair value of its assets and liabilities, excluding goodwill, to estimate the implied value of the reporting unit’s goodwill. If an impairment charge is deemed necessary, a charge is recognized for any excess of the carrying amount of the reporting unit’s goodwill over the implied fair value.
Considerable management judgment is necessary to estimate the fair value of our reporting unit and goodwill. We determine the fair value of our reporting unit based on the income approach, using a discounted projection of future cash flows which includes a five-year annual discounted cash flow (“DCF”) analysis with a terminal value to value the long-term future cash flows. This DCF analysis was used solely for the purpose of evaluating our goodwill for impairment and should not be interpreted as our prediction of future performance. The assumptions used in our DCF analysis are consistent with the assumptions we believe hypothetical marketplace participants would use. With respect to our DCF analysis, the timing and amount of future cash flows requires critical management assumptions, including estimates of expected future revenue growth rates, Modified EBITDA contributions, expected capital expenditures and an appropriate discount rate and terminal value. Our growth rate assumptions for this purpose are based on product and technology investments, fiber network expansions, changes in our underlying cost structure, market trends and historical results, among other items. In determining the fair value of our reporting unit for purposes of our assessment for the year ended December 31, 2012, we considered our five-year historical cumulative annualized growth rates for unlevered free cash flow (Modified EBITDA less capital expenditures) of 11.1%, excluding integration and branding costs that are not expected to recur. We applied a terminal multiple to estimated year five Modified EBITDA based on our long term cash flow growth expectations, which considers our expected operating performance and industry performance, to determine terminal value. The terminal value represents a significant portion of the resulting fair value of our reporting unit and therefore we compared the results to a growth model that estimates the value of future cash flow to perpetuity to assess the reasonableness. Projected cash flows were discounted to their present value using a discount rate of 8%, which represents a market-based participant weighted average cost of capital and may reflect the rate of return an outside investor would expect to earn. To corroborate the reasonableness of the resulting fair value of our reporting unit, we also considered our market capitalization at the date the test was performed.
The determination of fair value requires significant estimates and assumptions, which are subject to inherent uncertainties. Although our cash flow projections over the most recent three-year period have been reasonable compared to our actual results, actual results may vary significantly from estimates. Our methodology for our 2012 assessment was consistent with the methodology used in the prior year period. Our 2012 assessment resulted in the determination that the carrying value of our reporting unit does not exceed its fair value.
To assess the sensitivity of the assumptions used in our DCF analysis, we applied reductions of 20% to our critical estimates to test for impairment which we believe represents a reasonable change to our assumptions. When we applied a hypothetical two percentage point increase in the weighted average cost of capital, the resultant reduction in our fair value calculation would not have resulted in an impairment under our 2012 assessment. To assess the sensitivity of our future cash flow estimates including the terminal value used to derive the reporting unit’s fair value, we applied a hypothetical reduction of 20% to the estimated fair value of our reporting unit. The resultant reduction in fair value would not have resulted in an impairment under our 2012 assessment. We are not aware of any reasonably likely changes in our assumptions that would result in an impairment.
Impairment of Long-lived Assets
We perform an assessment of our long-lived assets, including property, plant and equipment and finite-lived intangible assets, whenever events and circumstances indicate that the carrying amount of such assets may not be recoverable. An impairment loss may exist when the estimated undiscounted cash flows attributable to the assets are less than their carrying amount. If an asset is deemed to be impaired, the amount of the impairment loss recognized represents the excess of the long-lived asset's carrying value as compared to its estimated fair value, based on management's assumptions and projections. Estimates are used to determine whether sufficient cash flows will be generated to recover the carrying amount of our investments in long term assets. The estimates are made for each of our seven geographic regions. Expected future cash flows are based on historical experience and management’s expectations of future performance. The assumptions used represent our best estimates including market growth rates, future pricing, market acceptance of our products and services and the future capital investments necessary.
Although events and circumstances in 2012 did not indicate that the carrying amount of such assets may not be recoverable, we performed a recoverability test. Our 2012 assessment did not result in any impairment charges. A hypothetical 20% reduction in our projected Modified EBITDA for each region would not have resulted in an impairment as of December 31, 2012.
Regulatory and Other Contingencies
We are subject to significant government and jurisdictional regulation, some of which is uncertain due to legal challenges of existing rules. Such regulation is subject to differing interpretations and inconsistent application, and has historically resulted in disputes with other carriers, regulatory authorities, and municipalities regarding the classification of traffic, rates, minutes of use and right-of-way fees.
Management estimates and accrues for its estimate of probable losses associated with regulatory and other contingencies. These estimates are based on assumptions and other considerations including expectations regarding regulatory rulings, historic experience and ongoing negotiations. We evaluate these reserves on an ongoing basis and make adjustments as necessary. A 10% unfavorable or favorable change in the estimates used for such reserves would have resulted in approximately an $8.3 million decrease or $5.0 million increase, respectively, in net income for the year ended December 31, 2012.
Deferred Tax Accounting
We have had a history of NOLs for tax purposes. When it is more likely than not that all or some portion of deferred tax assets may not be realized, we establish a valuation allowance for the amount that may not be realized. Each quarter we evaluate the need to retain all or a portion of the valuation allowance on our net deferred tax assets. During 2010, we determined that it is more likely than not that the vast majority of our deferred tax assets, including NOLs, will be realized, and as a result reversed $299.0 million of the valuation allowance. In making this determination, we analyzed, among other things, our recent history of earnings, cumulative earnings for the last 12 quarters, and forecasts of future earnings. The reversal of the valuation allowance recorded during 2010 resulted in an income tax benefit of $299.0 million, or $1.98 per basic share and $1.72 per diluted share, for the year ended December 31, 2010.
We continue to maintain a valuation allowance against certain deferred tax assets totaling $33.2 million. We believe it is more likely than not that deferred tax assets resulting from NOLs subject to certain limitations and those that require future income of special character will not be realized. Additionally, we have certain deferred tax assets attributable to stock option deductions for which the related valuation allowance cannot be reversed due to relevant accounting guidance concerning tax benefits related to the exercise of non-qualified stock options prior to the adoption of such accounting guidance.
As of December 31, 2012, we had NOLs for federal income tax purposes of approximately $823.0 million. If not utilized to reduce taxable income in future periods, these NOLs generally expire in various amounts beginning in 2022 and ending in 2026. We utilized NOLs to offset income tax obligations in each of the tax returns filed for the years ended December 31, 2011, 2010, 2009 and 2008. 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. In general, this would occur if certain ownership changes related to our stock that is held by 5% or greater stockholders exceeds 50 percent measured over a rolling three year period. If we experience such an ownership change, our utilization of NOLs to reduce future federal income tax obligations could be limited. In order to reduce the likelihood of an ownership change as defined by Section 382, our Board may adopt a rights plan in the future as they have did previously, subject to subsequent ratification by our stockholders, if it determines that our substantial NOLs are at risk of limitation under Section 382 or that such action otherwise is in the best interests of our stockholders.
Revenue and Receivables
Our services are complex and our tariffs and contracts may be correspondingly complex and subject to interpretations that cause disputes regarding amounts billed. In addition, changes in and interpretations of regulatory rulings create uncertainty and may cause disputes over minutes of use, rates or other provisions of our service. As such, we defer recognition of revenue until cash is collected on certain components of revenue, such as contract termination charges. We also reserve for customer billing disputes until they are resolved even if the customer has already paid the disputed amount.
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. As a result of an improvement in our collection activities, our overall receivables management and an improving economy, our allowance for doubtful accounts as a percentage of gross receivables has improved from 9% at December 31, 2010 to 8% at December 31, 2011 and 7% at December 31, 2012. A 10% change in the estimates used for our allowance for doubtful accounts would not have resulted in a material change in net income for the year ended December 31, 2012.
Stock-Based Compensation
We recognize the cost of stock-based payments as compensation expense over the requisite service period, which is generally the vesting period of the award. The fair value of restricted stock awards and restricted stock units granted is determined based on the market price of our common stock at the date of grant. We use the Black-Scholes pricing model to estimate the fair value of options as of the grant date. The Black-Scholes model by its design is dependent upon key data inputs estimated by management such as expected volatility, expected term and expected dividend yield. See Note 1 and Note 10 to the consolidated financial statements for a further discussion of our stock-based compensation plans.
Other Estimates
There are other accounting estimates reflected in our consolidated financial statements, including contingent loss accruals, compensation accruals, unpaid claims for medical and other self-insured plans, property and other tax exposures and asset retirement obligations and asset lives that require judgment but are not deemed critical in nature.
We believe that the current assumptions and other considerations used to estimate amounts reflected in the consolidated financial statements are appropriate. However, if actual experience differs from the assumptions and other considerations used in estimating amounts reflected in the consolidated financial statements, the resulting changes could have a material adverse effect on our results of operations and, in certain situations, on our financial condition.
Results of Operations
The following discussion provides analysis of our results of operations and should be read together with our audited consolidated financial statements, including the notes thereto, appearing elsewhere in this report:
2012 Compared to 2011
Revenue
Revenue by line of business was as follows:
___________________
(1)
We classify certain taxes and fees billed to customers and remitted to government authorities on a gross versus net basis in revenue and expense. The total amounts classified as revenue, primarily included in voice services, associated with such taxes and fees were approximately $79.8 million and $63.5 million for the years ended December 31, 2012 and 2011, respectively. This has no impact on Modified EBITDA or net income but is dilutive to Modified EBITDA margin.
The primary driver of total revenue growth was increased data and Internet services revenue from installed services to enterprise customers. The increase in data and Internet services revenue primarily resulted from installed sales of strategic Ethernet and VPN-based services and other services to enterprise customers, somewhat offset by revenue churn and re-pricing of renewed customer contracts at lower rates. Strategic services represented 53% of data and Internet services revenue for the year ended December 31, 2012 compared to 50% for the year ended December 31, 2011, resulting in 22% year over year growth.
More than half of the increase in voice services revenue resulted from an increase in both the volume and rate of certain taxes and fees remitted to government authorities that we classify on a gross versus net basis in revenue and expense, with the balance from installed sales of converged and other voice services, partially offset by revenue churn. Revenue based on minutes of use, including long distance, within voice services was 3% of our total revenue for both of the years ended December 31, 2012 and 2011.
The decrease in network services revenue was primarily from revenue churn (particularly from carrier customers) and re-pricing of renewed customer contracts at lower rates largely in transport services and customers transitioning to Ethernet services, partially offset by growth in high capacity and collocation services revenue.
Costs and Expense
The major components of costs and expenses were as follows:
Operating Expenses. Our operating expenses consist of costs directly related to the operation and maintenance of our network and the provisioning of our services. These costs, which are net of capitalized labor and overhead costs on capital projects, include the salaries and related expenses of customer care, provisioning, network maintenance, technical field and network operations and engineering personnel, costs to repair and maintain our network, and costs paid to other carriers for access to their facilities, interconnection, and facilities leased and associated utilities. We carry a significant portion of our traffic on our own fiber infrastructure, which enhances our ability to minimize and control access costs, which are the costs to purchase network services from other carriers. The increase in operating expenses primarily related to revenue growth, largely due to higher network access costs. Additionally, approximately a third of the increase in operating expenses resulted from an increase in both the volume and rate of certain taxes and fees. Operating costs as a percentage of revenue increased primarily as a result of growth in certain taxes and fees which we classify on a gross versus net basis in revenue and expense.
Selling, General and Administrative Expenses. Selling, general and administrative expenses consist of salaries and related costs for employees and other expenses related to sales and marketing, bad debt, IT, billing, regulatory, administrative and legal functions. The increase was primarily due to higher employee costs, regulatory fees and property and other taxes. The higher employee costs resulted primarily from incentive-based compensation due to expansion of the indirect sales channel, expansion of our sales, sales support and IT personnel, annual merit-based salary increases and non-cash stock-based compensation. The improvement in selling, general and administrative costs as a percentage of total revenue is primarily attributed to scaling of employee costs which as a percentage of revenue declined in 2012 compared to 2011.
Depreciation, Amortization and Accretion Expense. Although we experienced only a modest increase in total depreciation, amortization and accretion expense, depreciation expense increased as a result of additions to property, plant and equipment in 2012 and 2011, which was substantially offset by fully depreciated assets that can fluctuate based on the timing of assets becoming fully depreciated.
Operating Income and Net Income
The following table provides the components from operating income to net income for purposes of the discussions that follow:
___________________
NM - Not meaningful
(1)
See Note 1 under "Revenue" above.
(2)
See Note 4 and 5 in “Item 6. Selected Financial Data” for a definition of “Modified EBITDA” and for reconciliations of Modified EBITDA to net income (loss), the most comparable GAAP measure for operating performance, and Modified EBITDA, as a measure of liquidity, to net cash provided by operating activities.
(3)
Modified EBITDA margin represents Modified EBITDA as a percentage of revenue.
Interest Expense. The increase in interest expense is primarily due to the issuance of the 2022 Notes in October 2012.
Income Before Income Taxes. The increase in income before income taxes primarily resulted from higher Modified EBITDA as discussed below, somewhat offset by the increase in interest expense as a result of the issuance of the 2022 Notes.
Income Tax Expense. The increase in income tax expense resulted from higher income before income taxes. Our effective tax rate in the year ended December 31, 2012 was 43%. We expect our effective tax rate for the year ended December 31, 2013 to be similar to that for 2012.
Net Income and Modified EBITDA. The increase in net income resulted from an increase in income before income taxes, partially offset by higher income tax expense, as discussed above. The increase in Modified EBITDA was primarily the result of the contribution from revenue growth somewhat offset by higher employee costs, as discussed above. The improvement in Modified EBITDA margin primarily resulted from lower employee costs as a percentage of revenue. For the years ended December 31, 2012 and 2011, Modified EBITDA has been sufficient to cover our capital expenditures and service our debt, and we expect to generate sufficient Modified EBITDA in the foreseeable future to cover our expected capital expenditures and debt service requirements together with cash on hand, common stock (if used to satisfy our Convertible Debentures obligation in whole or in part) and borrowing capacity under our existing Revolver. See “Item 6. Selected Financial Data” Note 4 for a definition of Modified EBITDA and Note 5 for reconciliations of Modified EBITDA to net income (loss), which is the most comparable GAAP measure for operating performance, and Modified EBITDA to net cash provided by operations, which is the most comparable GAAP measure for liquidity.
2011 Compared to 2010
Revenue
Revenue by line of business was as follows:
___________________
(1)
We classify certain taxes and fees billed to customers and remitted to government authorities on a gross versus net basis in revenue and expense. The total amounts classified as revenue, primarily included in voice services, associated with such taxes and fees were approximately $63.5 million and $51.3 million for the years ended December 31, 2011 and 2010, respectively. This has no impact on Modified EBITDA or net income but is dilutive to Modified EBITDA margin.
The primary driver of growth in total revenue was increased data and Internet services revenue from installed services to enterprise customers. The increase in data and Internet services revenue primarily resulted from installed Ethernet and IP-based product sales to enterprise customers.
The decrease in network services revenue was primarily from revenue churn and repricing of renewed customer contracts largely in transport services partially offset by growth primarily in high capacity and collocation services revenue.
The increase in voice services revenue resulted primarily from increases in both rates and volume of certain taxes and fees remitted to government authorities that we classify on a gross versus net basis in revenue and expense. Installed sales of converged and other voice solutions were more than offset by revenue churn and a reduction in usage-based services. Revenue based on the minutes of service used by customers included in voice services was 3% and 4% of our total revenue for the years ended December 31, 2011 and 2010, respectively.
The decrease in intercarrier compensation was primarily due to fluctuations in dispute settlements and rate reductions somewhat offset by an increase in minutes of use terminated on our network. As a result of a November 2011 FCC order, we expect that approximately half of this revenue will be eliminated over a six year period that began in July 2012 and ends in July 2018.
Costs and Expense
The major components of costs and expenses were as follows:
Operating Expenses. The increase in operating expenses is primarily due to increased network access costs, certain taxes and fees and employee costs to support higher revenue growth.
Selling, General and Administrative Expenses. The increase in selling, general and administrative expenses was primarily due to higher employee costs and property taxes. The higher employee costs resulted from incentive-based compensation for sales employees due to increased customer installations of service, expansion of our sales and sales support personnel, annual merit-based salary increases, and other employee-related costs.
Depreciation, Amortization and Accretion Expense. The decrease in depreciation, amortization and accretion was primarily attributable to fully depreciated and retired assets partially offset by additions to property, plant and equipment in 2011 and 2010.
Operating Income and Net Income
The following table provides the components from operating income to net income for purposes of the discussions that follow:
___________________
NM - Not meaningful
(1)
See Note 1 under "Revenue" above.
(2)
See Note 4 and 5 in “Item 6. Selected Financial Data” for a definition of “Modified EBITDA” and for reconciliations of Modified EBITDA to net income (loss), the most comparable GAAP measure for operating performance, and Modified EBITDA, as a measure of liquidity, to net cash provided by operating activities.
(3)
Modified EBITDA margin represents Modified EBITDA as a percentage of revenue.
Interest Expense. The increase in interest expense was primarily due to higher effective interest rates on the variable rate Term Loan and as a result of a debt refinancing in the fourth quarter of 2010 that extended the term of a portion of that loan and an increase in non-cash interest expense associated with our Convertible Debentures.
Debt Extinguishment Costs. Debt extinguishment costs for the year ended December 31, 2010 resulted from the early retirement of $400 million principal amount of our 9 1/4% Senior Notes due February 2014 (the “2014 Notes”) and primarily consisted of $13.7 million in cash paid for call premiums and $3.6 million in non-cash write offs of deferred debt issuance costs. There were no such costs for the year ended December 31, 2011.
Other Income. During the year ended December 31, 2010, we recognized a gain of $0.8 million related to proceeds received upon liquidation of previously impaired commercial paper. There was no such gain during the year ended December 31, 2011. See Note 3 to our consolidated financial statements.
Income Before Income Taxes. The increase in income before income taxes primarily resulted from debt extinguishment costs in 2010 that did not recur, an increase in Modified EBITDA and lower depreciation, amortization and accretion, partially offset by an increase in interest expense.
Income Tax Expense (Benefit). The change in income tax expense (benefit) primarily related to a $299.0 million non-cash income tax benefit recognized during the three months ended June 30, 2010 resulting from the recognition of the value of deferred tax assets that we believe are realizable (see Note 9 to the consolidated financial statements), as well as a higher effective tax rate in 2011 and an increase in income before income taxes for the year ended December 31, 2011.
Net Income and Modified EBITDA. The decrease in net income resulted from the income tax expense (benefit) described above, partially offset by the increase in income before income taxes. The increase in Modified EBITDA was primarily the result of the contribution from revenue growth partially offset by an increase in employee and field related costs. Modified EBITDA margins included the absorption of higher costs associated with the expansion of our employee base for sales, sales support, IT and technical personnel, increases in access costs due to higher prices and increased volume and increases in revenue and expenses for certain taxes and fees. For the years ended December 31, 2011 and 2010, Modified EBITDA was sufficient to cover our capital expenditures and service our debt.
Liquidity and Capital Resources
Historically, we have generated cash flow from operations consisting primarily of payments received from customers for the provision of business communications services offset by payments to other telecommunications carriers, payments to employees, and payments for interest and other operating, selling, general and administrative expenses. We have also generated cash from debt and equity financing activities and have used these funds and cash flows from operations to service or repay our debt obligations, make capital expenditures to expand our network and fund acquisitions. Additionally, we have also used cash to repurchase our common stock. In November 2011, our Board of Directors authorized a multi-year repurchase program of up to $300 million of our common stock, of which approximately $22.0 million was repurchased as of December 31, 2012. We may also use cash on hand in the future to repay current debt maturities or to satisfy debt repurchase obligations. Holders of our outstanding Convertible Debentures have the option to require us to purchase all or part of the Convertible Debentures on April 1, 2013, April 1, 2016, or April 1, 2021, or at any time prior to April 1, 2026 to convert the debentures into shares of our common stock. See "Capital Resources--Possible Future Uses of Cash" below.
At December 31, 2012, we had approximately $1.8 billion of total debt and capital lease obligations and $974.3 million of cash, cash equivalents and short-term investments compared to approximately $1.4 billion of total debt and capital lease obligations and $484.9 million of cash, cash equivalents and short-term investments at December 31, 2011. Net debt of $784.9 million (defined as total debt and capital lease obligations less cash, cash equivalents and short-term investments) decreased $90.7 million primarily due to cash provided by operating activities resulting from higher Modified EBITDA and net proceeds from stock option exercises partially offset by capital expenditures, repurchases of our common stock, payment of deferred financing costs in connection with the issuance of the 2022 Notes and an increase in our debt resulting from accretion of the discount on our Convertible Debentures.
In October 2012, we completed an offering of the 2022 Notes at an offering price of 100% of the principal amount of $480 million. For a description of the significant terms of the 2022 Notes, see Note 6 to the consolidated financial statements. Interest expense will increase $25.8 million annually as a result of issuance of the 2022 Notes. We may use the net proceeds of this offering to settle the conversion obligations for the Convertible Debentures to the extent holders elect to convert their Convertible Debentures and we elect to settle the conversion obligations in whole or in part in cash, or if we otherwise redeem the Convertible Debentures. See "Capital Resources--Possible Future Uses of Cash" below for the terms under which the Convertible Debentures may be settled or redeemed. Any net proceeds not used for these purposes would be used for general corporate purposes. Pending the application of the net proceeds to these uses, we have invested the proceeds in cash equivalents.
Working capital, defined as current assets less current liabilities, was $506.2 million as of December 31, 2012, an increase of $134.7 million from December 31, 2011. The increase in working capital is primarily a result of cash provided by operations and the proceeds from the issuance of the 2022 Notes somewhat offset by capital spending, an increase in the current portion of long-term debt for our Convertible Debentures and prepayment of a portion of our Term Loan. Our working capital ratio, defined as current assets divided by current liabilities, was 1.76 as of December 31, 2012 as compared to 2.27 as of December 31, 2011.
Cash Flow Activity
Cash and cash equivalents were $806.7 million and $353.4 million as of December 31, 2012 and 2011, respectively. In addition, we had investments of $167.6 million and $131.5 million as of December 31, 2012 and 2011, respectively, which were short-term in nature and generally available to fund our operations. The change in cash and cash equivalents during the periods presented were as follows:
Operations. The increase in cash provided by operating activities in 2012 compared to 2011 primarily related to higher Modified EBITDA and changes in working capital, which were largely due to the timing of payments to vendors and employees and the collection of receivables.
The increase in cash provided by operating activities in 2011 compared to 2010 primarily related to higher Modified EBITDA somewhat offset by changes in working capital and other noncurrent assets and liabilities, which were largely due to the timing of payments to vendors and employees and the collection of receivables.
Investing. The change in cash used in investing activities in 2012 compared to 2011 is primarily a result of the net increase in cash used for the purchase and sale of investments in 2012. Our balances of cash, cash equivalents and investments fluctuate over time based on our cash requirements and market interest yields. Cash used for capital expenditures for the year ended December 31, 2012 was $338.1 million, the majority of which was success-based spending initiatives (see "Capital Expenditures and Requirements" below), compared to $340.7 million for the year ended December 31, 2011.
The change in cash used in investing activities in 2011 compared to 2010 is primarily a result of the net decrease in cash used for the purchase and sale of investments in 2011 somewhat offset by an increase in capital expenditures. Our balances of cash, cash equivalents and investments fluctuate over time based on our cash requirements and market interest yields. Cash used for capital expenditures for the year ended December 31, 2011 was $340.7 million, the majority of which was success-based spending initiatives, compared to $321.8 million in capital expenditures for the year ended December 31, 2010.
Financing. Cash provided by financing activities for 2012 was primarily due to the $470.8 million in net proceeds from the issuance of the 2022 Notes and $23.4 million in proceeds from option exercises, somewhat offset by prepayment of the $101.5 million tranche of the Term Loan B due January 2013, repurchases of $13.4 million of our common stock and withholding taxes paid by us on behalf of employees in net share settlements of restricted stock of $10.0 million. Cash used in financing activities for 2011 primarily consisted of repurchases of $58.6 million of our common stock. Cash used in financing activities for 2010 primarily consisted of repurchases of $49.9 million of our common stock and payments of $7.2 million on the Term Loan and capital lease obligations.
Our financing activities from 2010 to 2012 were comprised of the following:
•In October 2012, we completed an offering of the 2022 Notes at an offering price of 100% of the principal amount of $480 million, as discussed above. For a description of the significant terms of the 2022 Notes, see Note 6 to the consolidated financial statements.
•In March 2010, we completed an offering of the 2018 Notes at an offering price of 99.284% of the principal amount. The purpose of the 2018 Notes offering was to extend our debt maturities and reduce interest rates. The net proceeds from the offering were used to fund extinguishment of the 2014 Notes, of which $366.5 million principal amount were purchased at a price of 103.45% of the principal amount in a concurrent tender offer. Notes representing the remaining $33.5 million principal amount of the 2014 Notes were either tendered or redeemed at a price of 103.083% of the principal amount. For a description of the significant terms of the 2018 Notes, see Note 6 to the consolidated financial statements.
•In December 2010, we amended and restated our 2006 Credit Agreement to extend $474.1 million of the total $577.5 million outstanding principal amount of our Term Loan at that date from January 2013 to December 2016 (the “extended tranche”). The January 2013 maturity of the remaining $103.4 million of outstanding principal was unchanged (the “January 2013 tranche”). The term of our undrawn Revolver was extended from October 2011 to December 2014. In August 2012, we extinguished in full the outstanding principal amount of $101.5 million of the January 2013 tranche by utilizing cash and cash equivalents.
As of December 31, 2012, we had the following indebtedness outstanding or available:
___________________
(1)
The Convertible Debentures are redeemable in whole or in part at our option at any time on or after April 6, 2013 at a redemption price equal to 100% of the principal amount of the debentures to be redeemed, plus accrued and unpaid interest. Holders of the Convertible Debentures have the option to require us to purchase all or part of the Convertible Debentures on April 1, 2013, April 1, 2016, or April 1, 2021, or at any time prior to April 1, 2026 to convert the debentures into shares of our common stock. Upon conversion, we will have the right to deliver, in lieu of shares of common stock, cash or a combination of cash and shares of common stock.
(2)
The aggregate annual estimated interest payments are based on the effective interest rate of 3.47% at December 31, 2012.
(3)
Interest on outstanding amounts, if any, will be computed on a specified Eurodollar rate plus 2.5% to 3.5% and will be reset periodically. We are required to pay a commitment fee on the undrawn commitment amounts on a quarterly basis of 0.5% per annum.
The following diagram summarizes our corporate structure in relation to our outstanding indebtedness and credit facility as of December 31, 2012. The diagram does not depict all aspects of the ownership structure among the operating and holding entities, but rather summarizes the significant elements relative to our debt in order to provide a basic overview.
a
TWTC and substantially all of these subsidiaries guarantee the 2018 and 2022 Notes on an unsecured basis and the Revolver and the Term Loan on a secured basis.
b
The assets and equity interests of these subsidiaries are pledged to secure the Revolver and the Term Loan.
c
The Term Loan matures in December 2016. The principal amount is reduced by quarterly principal payments.
d
The Convertible Debentures are redeemable in whole or in part at our option at any time on or after April 6, 2013 at a redemption price equal to 100% of the principal amount of the debentures to be redeemed, plus accrued and unpaid interest. Holders of the Convertible Debentures have the option to require us to purchase all or part of the Convertible Debentures on April 1, 2013, April 1, 2016, or April 1, 2021, or at any time prior to April 1, 2026 to convert the debentures into shares of our common stock.
Capital Expenditures and Requirements
Our total capital expenditures were $343.4 million for the year ended December 31, 2012 compared to $342.7 million for the year ended December 31, 2011, with the majority of capital expenditures in each period for success-based initiatives. The increase in capital expenditures over the prior year reflects higher strategic fiber purchases to extend our network reach as well as product and technology investments to enable future capabilities offset by certain cell site projects and infrastructure and technology upgrades in 2011 that did not recur and equipment-related capital efficiencies. In each of the full years ended 2005 through 2012, over 75% of our total annual capital expenditures, excluding capital expenditures for integration and branding, were for what we deem success-based opportunities that were linked to new installations and capacity requirements. Success-based spending consists of short-to-medium length capital projects, in terms of anticipated time between capital spending and return on investment, driven by customer opportunities. This includes costs to connect to new customer locations with our fiber network and increase capacity in our network, IP backbone enhancements, collocation facility expansion and central office infrastructure to serve growing customer demands. These types of expenditures can fluctuate as our volume of sales and service installations increases or decreases.
For 2013, we expect capital expenditures of approximately $360 million to $370 million (see “Capital Resources” below for discussion of anticipated funding sources), the majority of which we expect to be related to success-based opportunities. Included in our expected capital expenditures are amounts we must spend to replace older network components, especially electronics, that we expect will continue to grow over time. We expect quarterly fluctuations in our capital spending due to the timing of large projects and other external factors such as customer readiness, permitting and weather. We generally do not make long-term commitments for capital expenditures and have the ability to adjust our capital expenditures if our cash from operations is lower than anticipated or in response to a change in demand.
Capital Resources
Based on current assumptions, we expect to generate sufficient cash from operations along with available cash on hand (including cash equivalents and investments), common stock (if used to settle our Convertible Debentures in whole or in part) and borrowing capacity under our undrawn Revolver to provide sufficient funds to meet our expected capital expenditure and liquidity needs to operate our business and service our debt for the foreseeable future. However, if our assumptions prove incorrect or if there are other factors that negatively affect our cash position such as material unanticipated losses, a significant reduction in demand for our services, an acceleration of customer disconnections, or other adverse factors, or if we make acquisitions or enter into joint ventures, we may need to seek additional sources of funds through financing or other means. There is no assurance that other sources of financing on acceptable terms will be available in the future. Other risks, such as a rating downgrade on our debt or adverse debt market conditions, could further impact our potential access to or the cost of financing sources.
Our ability to draw upon the available commitments under our Revolver is subject to compliance with all of the covenants contained in the credit agreement and our continued ability to make certain representations and warranties. In the case of the Revolver, the covenants include financial covenants, such as leverage and interest coverage ratios and limitations on capital expenditures that are primarily derived from Modified EBITDA and debt levels. We are required to comply with these ratios as a condition to any borrowing under the Revolver and for as long as any loans are outstanding under the Revolver. The representations and warranties include the absence of liens on our properties other than certain permitted liens, the absence of litigation or other developments that have or could reasonably be expected to have a material adverse effect on us and our subsidiaries as a whole, and continued effectiveness of the documents granting security for the loans.
A lack of revenue growth or an inability to control costs could negatively impact Modified EBITDA and cause our failure to meet the required minimum ratios under the Revolver if we have loans outstanding under the Revolver or wish to draw on it. Although we currently believe that we will continue to be in compliance with the covenants, various factors, including deterioration of the economy, increased competition and pricing pressure and loss of revenue from significant customers, an acceleration of customer disconnections, a significant reduction in demand for our products without adequate reductions in capital expenditures and operating expenses or an uninsured catastrophic loss of physical assets or other risk factors could cause us to fail to meet our covenants. If our revenue growth is not sufficient to sustain the Modified EBITDA performance required to meet the debt covenants described above, and we have loans outstanding under the Revolver or wish to draw on it, we would have to consider cost cutting or other measures to maintain required Modified EBITDA levels or to enhance liquidity.
The Revolver, Term Loan, 2018 Notes and 2022 Notes limit our ability to declare cash dividends, incur indebtedness, incur liens on property and undertake acquisitions, among other things. The Revolver, Term Loan, 2018 Notes and 2022 Notes also include cross default provisions under which we are deemed to be in default if we default under any of the other material outstanding obligations. If we are in default under any of the covenants under the Term Loan and Revolver, we also could potentially be subject to an acceleration of the repayment date of the Term Loan and the Revolver if we have borrowed under that facility. Covenant defaults under the credit agreement for the Revolver and Term Loan also may constitute an event of default under the indenture for the 2018 Notes and 2022 Notes. In addition, the lenders under the Revolver may require prepayment of outstanding revolving loans if a change of control and ratings decline occurs as defined in the credit agreement. We are required to offer to prepay the 2018 Notes, 2022 Notes and the Term Loan on an individual basis if a change of control and a debt rating decline occur as defined in the indenture for the 2018 Notes, 2022 Notes and the Term Loan agreement. If we do not comply with the covenants under the Revolver, we would not be able to draw funds under the Revolver, outstanding revolving loans could be accelerated or the lenders could cancel the Revolver unless the respective lenders agree to further modify the covenants. As of December 31, 2012, we were in compliance with all of our debt covenants.
Possible Future Uses of Cash. Our consistent financial performance and cash, cash equivalent and short-term investments of $974.3 million allow us flexibility to make strategic choices in the use of our cash. In order to reduce future cash interest payments, as well as future amounts due at maturity or mandatory redemption and reduce our leverage, we or our affiliates may, from time to time, enter into interest rate swap agreements or purchase or redeem our outstanding 2018 Notes, 2022 Notes or Convertible Debentures for cash or equity securities in the open market or privately negotiated transactions or engage in other transactions to reduce the principal amount of outstanding 2018 Notes, 2022 Notes or Convertible Debentures. We also may seek to refinance or otherwise replace or prepay all or a portion of our Term Loan and Revolver.
Under the terms of our Revolver, which is more restrictive than our Term Loan and the indenture for the 2018 Notes, we currently may repurchase a portion of our 2018 Notes or Convertible Debentures if we have a minimum of $225 million in cash and equivalents after giving effect to the repurchase and meet certain other conditions, which we met as of December 31, 2012, and do not use the Revolver proceeds for this purpose. The Convertible Debentures are redeemable in whole or in part at our option at any time on or after April 6, 2013 at a redemption price equal to 100% of the principal amount plus accrued and unpaid interest. In addition, holders of our outstanding Convertible Debentures have the option to require us to purchase all or part of the Convertible Debentures on April 1, 2013, April 1, 2016, or April 1, 2021 at a redemption price equal to 100% of the principal amount plus accrued and unpaid interest. The holders of the Debentures also have the right at any time prior to April 1, 2026 to convert the Convertible Debentures into shares of our common stock at a conversion rate of 53.6466 shares per $1,000 principal amount of debentures, representing a conversion price of $18.64 per share. Upon conversion, we will have the right to deliver, in lieu of shares of common stock, cash or a combination of cash and shares of common stock. If we elect to settle the conversion obligations other than by delivering only shares of common stock, and the price of our common stock exceeds $18.64 per share when the Convertible Debentures are converted, then for every $1,000 in principal amount of the Convertible Debentures surrendered for conversion, the holder will receive (i) $1,000 for the principal value of the Convertible Debentures, and (ii) the amount by which the conversion value (calculated as the product of the initial conversion rate and the average closing price of our common stock as described in the indenture) exceeds $1,000 ("principal plus premium"). As of December 31, 2012, the if-converted value of the Convertible Debentures exceeded the principal amount by $136.9 million. This amount could increase or decrease depending on the market price of our common stock at the time of conversion. See Note 1 to "Commitments" below for more information on the calculation upon conversion. If we notify the holders of our outstanding Convertible Debentures of redemption at a price equal to 100% of the principal amount plus accrued and unpaid interest, the holders instead would likely convert the debentures into shares of our common stock at principal plus premium, as discussed above, which they may do until one day prior to the redemption date.
On November 16, 2011, our Board of Directors authorized a multi-year repurchase program of up to $300 million of our common stock, of which approximately $22.0 million was repurchased as of December 31, 2012. This authorization does not have an expiration date, but can be withdrawn by the Board at any time. Our Revolver permits repurchases of our common stock up to $150 million annually in the aggregate if after the transaction we have a minimum of $225 million in cash and cash equivalents, have not used that basket for other permissible purposes, including dividend payments, and meet certain other conditions, which conditions we met as of December 31, 2012. Up to $50 million of this permitted amount that remains unused in any fiscal year may be carried over and used in the immediately succeeding calendar year for permissible purposes. This test under the Revolver is also more restrictive than our other debt agreements. We may consider repurchasing additional shares of our common stock in public or private transactions or may consider paying dividends to the extent permitted by our debt covenants. Additionally, we may consider merger and acquisition opportunities that could impact our cash usage. We will evaluate any such transactions in light of market conditions, taking into account our liquidity and prospects for access to capital, benefits to us of any such transaction and contractual constraints.
Risk Management. As of December 31, 2012, our cash, cash equivalents and short-term investments were held in financial institutions, prime money market mutual funds, U.S. Treasury money market mutual funds, certificates of deposit, commercial paper and debt securities issued by the U.S. Treasury and other U.S. government agencies. Although we actively monitor the depository institutions and the performance and quality of our investments and the mutual funds that hold our cash and cash equivalents, we are exposed to risks resulting from deterioration in the financial condition or failure of financial institutions holding our cash deposits, decisions of our investment advisors and the investment managers of the money market funds and defaults in securities underlying the funds and investments. We prioritize safety over investment return in choosing the investment vehicles for cash, cash equivalents and investments and have diversified these investments to the extent practical in an effort to minimize our exposure to any one investment vehicle or financial institution. We may change the nature of our cash, cash equivalent and short-term investments as market conditions change.
Off-Balance Sheet Arrangements. As of December 31, 2012, we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.
Commitments. The following table summarizes our long-term commitments as of December 31, 2012, and after giving effect to a real estate lease that was executed in January 2013, including commitments pursuant to debt agreements, lease obligations, fixed maintenance contracts, and other purchase obligations.
___________________
(1)
Holders of the Convertible Debentures have the option to require us to purchase all or part of the Convertible Debentures on April 1, 2013, April 1, 2016, or April 1, 2021 at a purchase price equal to 100% of the principal amount plus accrued and unpaid interest, or at any time prior to April 1, 2026 to convert the debentures into shares of our common stock (see Note 6 to the consolidated financial statements); therefore, the repayment obligation is presented in full at the earliest maturity date. Upon conversion, we have the right to deliver, in lieu of common stock, cash or a combination of cash and shares of common stock. The amount presented in the table above assumes that the repayment obligation is repaid at par value. If the price of our common stock exceeds $18.64 per share when the Convertible Debentures are converted, then for every $1,000 in principal amount of the Convertible Debentures surrendered for conversion, the holder will receive (i) $1,000 for the principal value of the Convertible Debentures, and (ii) the amount by which the conversion value (calculated as the product of the initial conversion rate and the average closing price of our common stock as described in the indenture) exceeds $1,000. Accordingly, if the Convertible Debentures are settled entirely in shares of our common stock, 20.1 million shares would be issued regardless of the market price of our common stock.
If any Convertible Debentures are converted, we will consider all alternatives available to us to settle our obligations under the Convertible Debentures. The examples illustrated below are hypothetical only and should not be construed to mean that we will consider only the combinations of cash and shares of our common stock demonstrated in the examples. The table shown below illustrates two hypothetical examples of settlement scenarios upon conversion for stock prices ranging from $18.64-$43.64 whereby (i) the principal amount of the notes, $373.7 million, is paid in cash and the incremental value is delivered in shares of our common stock, or (ii) both the principal value of the notes and the incremental value is delivered in shares of our common stock:
(2)
Interest payments on the Term Loan are calculated using the rate in effect as of December 31, 2012.
(3)
Includes amounts representing interest of $10.2 million.
(4)
Includes outstanding purchase orders initiated in the ordinary course of business for operating and capital expenditures.
(5)
Includes services purchased from other carriers to transport a portion of our traffic to the end-user, to interconnect with the ILECs, to lease our IP backbone, or to provide other ancillary services under contracts that can vary from month-to-month up to 60 months. Some services are purchased under volume plans that require us to maintain certain commitment levels to obtain favorable pricing. Some services are purchased under contracts that are subject to contract termination costs or penalties if services are disconnected before the end of the term.
Effects of Inflation
Historically, inflation has not had a material effect on us.
Item 7A.
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
Our interest income is sensitive to changes in the general level of interest rates. In this regard, changes in interest rates can affect the interest earned on our cash, cash equivalents and short-term investments. Based on our cash, cash equivalents and short-term investments of approximately $974.3 million at December 31, 2012, a one percent increase in the interest rate would change our annual interest earned by $9.7 million. At December 31, 2012, investments included in cash, cash equivalents and short-term investments were primarily comprised of prime money market mutual funds, U.S. Treasury money market mutual funds, certificates of deposit, commercial paper and debt securities issued by the U.S. Treasury and government agencies. We prioritize safety over investment return in choosing the investment vehicles for cash, cash equivalents and short-term investments, and have diversified these investments to the extent practical in an effort to minimize our exposure to any one investment vehicle or financial institution. We may change the nature of our cash, cash equivalents and short-term investments as market conditions change.
We have fixed and variable rate debt. Our exposure to variable rate debt is from changes in the Eurodollar rate as interest on the Term Loan varies based on a specified Eurodollar rate. Variable rate debt instruments represented approximately 27% and 41% of our total debt at December 31, 2012 and 2011, respectively. As of December 31, 2012, based on the $463.0 million outstanding balance on the Term Loan, a one percent change in the applicable rate would change the annual amount of interest we pay by $4.6 million.
At December 31, 2012, the fair values of our Term Loan, 2018 Notes, 2022 Notes and Convertible Debentures were $465.3 million, $470.9 million, $505.2 million and $512.2 million, respectively, as compared to carrying values of $463.0 million, $428.0 million, $480.0 million and $368.1 million, respectively. These notes and debentures are not listed on any securities exchange or inter-dealer automated quotation systems, and we have estimated the market value based on indicative pricing published by certain investment banks or trading levels in our long-term debt.
Item 8.
Item 8.
Financial Statements and Supplementary Data
See “Index to Consolidated Financial Statements” on page.
Item 9.
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None
Item 9A.
Item 9A.
Controls and Procedures
Disclosure Controls and Procedures
Our management, with the participation of the Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 as of December 31, 2012. Management recognizes that any disclosure controls and procedures no matter how well designed and operated, can only provide reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that as of December 31, 2012 our disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.
Changes in Internal Control Over Financial Reporting
There were no changes in our internal control over financial reporting that occurred during the quarter ended December 31, 2012 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Management’s Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15(d)-15(f) under the Securities Exchange Act of 1934. Our internal control structure is designed to provide reasonable assurance to our management and the Board of Directors regarding the reliability of financial reporting and the preparation and fair presentation of our financial statements prepared for external purposes in accordance with U.S. generally accepted accounting principles.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Management, including our Chief Executive Officer and Chief Financial Officer, assessed the effectiveness of our internal control over financial reporting as of December 31, 2012 using the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control-Integrated Framework. Our management has concluded that our assessment provides reasonable assurance that, as of December 31, 2012, our internal control over financial reporting was effective.
Our independent registered public accounting firm, Ernst & Young LLP, has issued an attestation report on our internal control over financial reporting as of December 31, 2012.
Item 9B.
Item 9B.
Other Information
Effective February 14, 2013, our Board of Directors adopted amendments to our By-laws to provide for enhanced disclosure by any stockholder nominating a director or submitting a proposal and by director nominees submitted by stockholders, permit Board members to approve Board or committee resolutions by electronic transmission and clarify the process for stockholder nominations if the Board increases the number of its members. This summary is qualified by the text of the By-laws as amended, included with this report as Exhibit 3.2.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders of tw telecom inc.
We have audited tw telecom inc.’s internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). tw telecom inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, tw telecom inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on the COSO criteria.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of tw telecom inc. as of December 31, 2012 and 2011 and the related consolidated statements of operations, comprehensive income, cash flows and changes in stockholders' equity for each of the three years in the period ended December 31, 2012 of tw telecom inc. and our report dated February 15, 2013 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Denver, Colorado
February 15, 2013
PART III
Item 10.
Item 10.
Directors, Executive Officers and Corporate Governance
The information with respect to directors if required by this Item will appear under the heading “Proposal 1: Election of Directors” and “Board Information” and the information with respect to executive officers, Section 16(a) Beneficial Ownership Reporting Compliance, material changes to procedures by which security holders may recommend nominees to the board of directors, and audit committee and financial experts required by this item will appear in our definitive proxy statement for the 2013 Annual Meeting of Stockholders to be filed with the SEC no later than April 30, 2013 (the “Proxy Statement”) pursuant to Regulation 14A of the General Rules and Regulations under the Securities Exchange Act of 1934. These portions of the Proxy Statement are incorporated by reference.
Code of Ethics
We have adopted a Code of Ethics for directors and officers (including our principal executive officer, principal financial officer, chief accounting officer, controller and treasurer) which is available at our website at www.twtelecom.com under “Investors.” Stockholders also may request a free copy of the Code of Ethics from:
tw telecom inc.
Attn: Legal Department
10475 Park Meadows Drive
Littleton, CO 80124
Item 11.
Item 11.
Executive Compensation
The information required by this item will appear in our Proxy Statement under the heading “Executive Compensation”. This portion of our Proxy Statement is incorporated by reference.
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information required by this item will appear under the headings “tw telecom Share Ownership” and “Securities Authorized for Issuance under Equity Compensation Plans” in our Proxy Statement. These portions of the Proxy Statement are incorporated by reference.
Item 13.
Item 13.
Certain Relationships and Related Transactions, and Director Independence
The information required by this item will appear under the headings “Certain Relationships and Related Transactions” and “Corporate Governance” in our Proxy Statement. These portions of the Proxy Statement are incorporated by reference.
Item 14.
Item 14.
Principal Accountant Fees and Services
Information regarding our principal auditor fees and services will appear under “Ratification of Appointment of Independent Auditors” in our Proxy Statement. These portions of the Proxy Statement are incorporated by reference.
GLOSSARY
Access Charges. The fees paid by long distance carriers for the local connections between the long distance carriers’ networks and the long distance carriers’ customers.
Central Offices. A telecommunications center where switches and other telecommunications facilities are housed. CLECs may connect with ILEC networks either at this location or through a remote location.
Class of Service. A method of managing traffic on a network that allows customers to group types of traffic and assign each type a different priority level.
Collaboration. An application, platform or device which generally leverages verbal, video media (e.g., telepresence, multimedia web conferencing) and data or presentation files which are designed to help people with a common task achieve a business objective. Collaboration usually involves network services including voice conferencing, video conferencing, local, metro or wide area data networks and the Internet.
Collocation. The ability of a telecommunications carrier to interconnect its network to the ILEC’s network by extending its facilities to the ILEC’s central office. Collocation with an ILEC can be physical where the interconnecting carrier places its network equipment within the ILEC’s central offices or virtual where the ILEC permits a carrier to interconnect its network to the ILEC’s network in a manner which is technically, operationally, and economically comparable to physical collocation, but without physically locating equipment within the central offices. Telecommunication carriers also allow customers to interconnect with their networks by placing equipment in space adjacent to the carrier’s central office.
CLEC (Competitive Local Exchange Carrier). A company that provides local exchange services, including dedicated service, in competition with the ILEC.
Cloud Computing. A style of computing where scalable and elastic IT enabled capabilities are provided as a service to external customers using Internet Protocol technologies.
Converged Services. A service offering that fully integrates any combination of communications services including IP VPN, voice, Internet, data, security and managed router service into a single managed IP solution.
Dedicated. Telecommunications lines dedicated to, or reserved for use by, a particular customer along predetermined routes (in contrast to links which are temporarily established).
Dedicated Transmission. The sending of electronic signals carrying information over a Dedicated Transport facility.
Dedicated Transport. A non-switched point-to-point telecommunications facility leased from a telecommunications provider by an end-user and used exclusively by that end-user.
Digital. A means of storing, processing and transmitting information by using distinct electronic or optical pulses that represent the binary digits 0 and 1. Digital transmission and switching technologies use a sequence of these pulses to represent information as opposed to the continuously variable analog signal. The precise digital numbers preclude distortion (such as graininess or snow in the case of video transmission, or static or other background distortion in the case of audio transmission).
DS-0, DS-1, DS-3. Standard North American telecommunications industry digital signal formats, which are distinguishable by bit rate (the number of binary digits (0 and 1) transmitted per second). DS-0 service has a bit rate of 64 kilobits per second. DS-1 service has a bit rate of 1.544 megabits per second and DS-3 service has a bit rate of 44.736 megabits per second. A DS-0 can transmit a single uncompressed voice conversation.
Ethernet. A network configuration in which data is separated into “frames” for transmission. Ethernet equipment scans the network to find the least-congested route for frames to travel from Point A to Point B, thus resulting in greater speed and fewer errors in frame transmission.
Fiber Optics. Fiber optic technology involves sending laser light pulses across glass strands in order to transmit digital information. Fiber optic cable is the medium of choice for the telecommunications and cable industries. Fiber is immune to electrical interference and environmental factors that affect copper wiring and satellite transmission.
Gbps (Gigabits per second). One billion bits of information. The information-carrying capacity (i.e., bandwidth) of a circuit may be measured in “billions of bits per second.”
Hub. Collocation centers located centrally in an area where telecommunications traffic can be aggregated for transport and distribution.
ILECs (Incumbent Local Exchange Carriers). The local phone companies, including regional bell operating companies and independent operating companies (such as Cincinnati Bell), which provide local exchange services.
Intelligent Network. Developing network capabilities that provide our customers end-to-end visibility to the performance of certain services we provide and which we plan to enable customers to control flexible amounts of bandwidth and prioritization of their applications through our customer portal or application program interfaces.
Internet. The name used to describe the global open network of computers that permits a person with access to the Internet to exchange information with any other computer connected to the network.
Internet Protocol (IP). The method or protocol by which data is sent from one computer or network to another on the Internet. Each computer or network has at least one IP address that uniquely identifies it from all other computers and networks that are connected to the Internet.
IntraLATA. A call that originates and terminates within the same LATA.
IXC (Interexchange Carrier). A long distance carrier.
LATA (Local Access and Transport Area). The geographical areas within which a local telephone company may offer telecommunications services, as defined in the divestiture order known as the Modified Final Judgment unless and until refined by the FCC pursuant to the Telecommunications Act of 1996.
LEC (Local Exchange Carrier). A telecommunications company that provides local telephone service in a geographic area. LECs included both ILECs and CLECs.
Local Exchange. A geographic area defined by the appropriate state regulatory authority in which telephone calls generally are transmitted without toll charges to the calling or called party.
Local Exchange Service/Local Exchange Telephone Service. Basic local telephone service, including the provision of telephone numbers, dial tone and calling within the local exchange area.
Long Distance Carriers (Interexchange Carriers or IXC). Long distance carriers providing services between LATAs, on an interstate or intrastate basis. A long distance carrier may be facilities-based or offer service by reselling the services of a facilities-based carrier.
Managed Service. Those services delivered by us where the interface provided to the customer requires no further protocol conversion and we monitor and manage the equipment providing the service and control the network administration.
Mbps (Megabits per second). Megabit means one million bits of information. The information carrying capacity (i.e., bandwidth) of a circuit may be measured in “millions of bits per second.”
Multiplexing. An electronic or optical process that combines a number of lower speed transmission signals into one higher speed signal. There are various techniques for multiplexing, including frequency division (splitting the total available frequency bandwidth into smaller frequency slices), time division (slicing a channel into timeslots and placing each signal into its assigned timeslot), and statistical (wherein multiplexed signals share the same channel and each transmits only when it has data to send).
NLAN (Native Local Area Network). Interconnection of computers for the purpose of sharing files that does not require protocol conversion between the networks.
Node. A point of connection into a fiber optic network.
OC-n. Optical carrier levels ranging from OC-1 (51.84 Mbps) to OC-192 (9.9 Gbps).
POPs (Points of Presence). Locations where an IXC has installed transmission equipment in a service area that serves as, or relays telephone calls to, a network switching center of the same IXC.
Private Line. A private, dedicated telecommunications link between different customer locations (excluding IXC POPs).
PSTN (Public Switched Telephone Network). The switched network available to all users generally on a shared basis (i.e., not dedicated to a particular user). The local exchange telephone service networks operated by ILECs are the largest and often the only public switched networks in a given locality.
Reciprocal Compensation. An arrangement in which two local exchange carriers agree to terminate traffic originating on each other’s networks in exchange for a negotiated level of compensation.
Redundant Electronics. A telecommunications facility that uses two separate electronic devices to transmit a telecommunications signal so that if one device malfunctions, the signal may continue without interruption.
Route Mile. The number of miles along which fiber optic cables are installed.
SONET (Synchronous Optical Network). A set of standards for optical communications transmission systems that define the optical rates and formats, signal characteristics, performance, management and maintenance information to be embedded within the signals and the multiplexing techniques to be employed in optical communications transmission systems. SONET facilitates the interoperability of dissimilar vendor's equipment. SONET benefits business customers by minimizing the equipment necessary for various telecommunications applications and supports networking diagnostic and maintenance features.
Special Access Services. The lease of private, dedicated telecommunications lines or circuits on an ILEC’s or a CLECs’ network, which run to or from another carrier’s POPs. Special access services do not require the use of switches. Examples of special access services are telecommunications circuits running between POPs of a single carrier, from one carrier’s POP to another carrier’s POP or from an end-user to a carrier’s POP.
STS-1. This dedicated transmission service is carried over high-capacity channels for full duplex, synchronous optical transmission of digital data on SONET standards. This service eliminates the need to maintain and pay for multiple dedicated lines.
Switch. A mechanical or electronic device that opens or closes circuits or selects the paths or circuits to be used for the transmission of information. Switching is a process of linking different circuits to create a temporary transmission path between users. Within this document, switches generally refer to voice grade telecommunications switches unless specifically stated otherwise.
Switched Access Services. The connection between an IXC’s POP and an end-user’s premises through the switching facilities of a local exchange carrier.
Switched Services. Telecommunications services that support the connection of one calling party with another calling party via use of a telephone switch (i.e., an electronic device that opens or closes circuits, completes or breaks an electrical path or selects paths or circuits).
SSL (Secure Sockets Layer). Cryptographic protocols that provide communication security over the Internet.
TDM (Time Division Multiplexing). A type of multiplexing that combines data streams by assigning each stream a different time slot in a set. TDM repeatedly transmits a fixed sequence of time slots over a single transmission channel.
Value Added Resellers. Companies that add features or services to an existing product, then resell it (usually to end-users) as an integrated product or “turn-key” solution. For example, the value added can come from professional services such as integrating, customizing, consulting, training and implementation or by developing a specific application for the product designed for the customer’s needs which is then resold as a combined product or service.
VoIP (Voice over Internet Protocol). The technology used to transmit voice conversations over a data network using the Internet Protocol.
VPN (Virtual Private Network). A private network that operates securely within a public network (such as the Internet) by means of encrypting transmissions.
PART IV
Item 15.
Item 15.
Exhibits and Financial Statement Schedules
(a) (1), (2) The Financial Statements and Schedule II-Valuation and Qualifying Accounts listed on the index on page following are included herein by reference. All other schedules are omitted, either because they are not applicable or because the required information is shown in the financial statements or the notes thereto.
(3) Exhibits: The Exhibit Index at the end of this report lists the exhibits filed with this report or incorporated herein by reference.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on February 15, 2013.
tw telecom inc.
By:
/s/ MARK A. PETERS
Mark A. Peters
Executive Vice President and
Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities and on the dates indicated.
tw telecom inc.
Index to Consolidated Financial Statements
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders of tw telecom inc.
We have audited the accompanying consolidated balance sheets of tw telecom inc. (the “Company”) as of December 31, 2012 and 2011, and the related consolidated statements of operations, comprehensive income, cash flows and changes in stockholders’ equity for each of the three years in the period ended December 31, 2012. Our audits also included the financial statement schedule listed at page. These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company at December 31, 2012 and 2011, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2012, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), tw telecom inc.’s internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 15, 2013 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Denver, Colorado
February 15, 2013
tw telecom inc.
CONSOLIDATED BALANCE SHEETS
December 31, 2012 and 2011
See accompanying notes to the consolidated financial statements.
tw telecom inc.
CONSOLIDATED STATEMENTS OF OPERATIONS
Years Ended December 31, 2012, 2011 and 2010
(a) Includes non-cash stock-based employee compensation expense (Note 1):
See accompanying notes to the consolidated financial statements.
tw telecom inc.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Years Ended December 31, 2012, 2011 and 2010
See accompanying notes to the consolidated financial statements.
tw telecom inc.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2012, 2011 and 2010
See accompanying notes to the consolidated financial statements.
tw telecom inc.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDER’S EQUITY
Years Ended December 31, 2012, 2011 and 2010
See accompanying notes to the consolidated financial statements.
tw telecom inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Organization and Summary of Significant Accounting Policies
Description of Business and Capital Structure
tw telecom inc. (the “Company”), a Delaware corporation, is a leading national provider of managed network services, specializing in business Ethernet, data networking, converged, IP based virtual private network or "IP VPN", Internet access, voice, including voice over Internet Protocol or "VoIP", and network security services to enterprise organizations, including public sector entities, and carriers throughout the United States, including their global locations.
The Company has one class of common stock outstanding with one vote per share. The Company also is authorized to issue shares of preferred stock. The Company’s Board of Directors has the authority to establish voting powers, preferences, and special rights for the preferred stock. No shares of preferred stock have been issued.
Basis of Consolidation
The consolidated financial statements include the accounts of the Company and all entities in which the Company has a controlling voting interest (“subsidiaries”). Significant intercompany accounts and transactions have been eliminated.
Estimates
The preparation of financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. Areas that require significant management judgments include income and other taxes, revenue and receivables, stock-based compensation, long-lived assets, regulatory fees, asset retirement obligations, evaluation of impairment of goodwill and long-lived assets, and carrier liabilities.
Segment Reporting
Because its business is centrally managed, the Company operates in one segment across the United States.
Cash Equivalents and Investments
The Company considers all highly liquid debt instruments with an original maturity of three months or less, when purchased, to be cash equivalents. The appropriate classification of securities is determined at the time of purchase and is reevaluated as of the end of each period. Debt securities are classified as held-to-maturity when the Company has the positive intent and ability to hold the securities to maturity and are carried at amortized cost. Debt securities not classified as held-to-maturity are classified as available-for-sale. Available-for-sale securities are carried at fair value, with the unrealized gains and losses, net of tax, reported in other comprehensive income or loss. Gains and losses on investments are calculated using the specific identification method and are recognized during the period the investment is sold. See Note 3 for further information.
At December 31, 2012 and 2011, the Company had restricted funds held at financial institutions of $1.3 million and $1.9 million, respectively. These amounts were included in other current assets and are restricted because they primarily secure outstanding surety bonds.
Receivables
The Company generally bills in advance for the majority of the services it provides and does not require significant collateral from its customers. The Company evaluates whether receivables are reasonably assured of collection by evaluation of certain factors, including ongoing credit evaluations of significant customers’ financial condition, and provides an allowance for doubtful accounts based on the expected collectability of all receivables. The allowance for doubtful accounts was $7.1 million, or 7% of gross receivables, at December 31, 2012, and $8.2 million, or 8% of gross receivables, at December 31, 2011.
tw telecom inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Property, Plant and Equipment
Property, plant and equipment are recorded at cost except for assets acquired through acquisition of businesses, which are recorded at fair value. Construction costs, labor and applicable overhead related to the development, installation and expansion of the Company’s network, and interest costs related to construction are capitalized. Capitalized labor and applicable overhead was $75.3 million, $71.6 million and $64.0 million for the years ended December 31, 2012, 2011 and 2010, respectively. Capitalized interest was $1.3 million, $2.1 million and $2.8 million for the years ended December 31, 2012, 2011 and 2010, respectively. Repairs and maintenance costs are charged to expense when incurred. The Company disposes of assets that are no longer in use. Losses on such disposals are included as a component of depreciation expense and were $1.1 million, $1.4 million and $1.2 million for the years ended December 31, 2012, 2011 and 2010, respectively.
The Company licenses the right to use fiber optic capacity from Time Warner Cable, Inc. in 16 markets, Comcast Corporation (as successor to Time Warner Cable) in three markets and an affiliate of Bright House Networks, LLC in four markets. The Company pays and records as a component of property, plant and equipment its allocable share of the cost of fiber and construction incurred by Time Warner Cable, Inc., Comcast Corporation and the Bright House Networks, LLC affiliate on routes where the parties are in joint construction.
Depreciation is calculated on the straight-line method over estimated useful lives as follows:
Income Taxes
Deferred income taxes are provided for temporary differences between the carrying amounts of assets and liabilities and the amounts used for tax purposes. The impact of a tax position is recognized in the financial statements if that position is more likely than not to be sustained on audit, based on technical merits of the position. The Company does not record a valuation allowance against net deferred tax assets when it is more likely than not that the net deferred tax asset will be realized.
Goodwill
The Company performs impairment tests at least annually on all goodwill and indefinite-lived intangible assets pursuant to relevant accounting standards which require goodwill to be assigned to a reporting unit and tested using a consistent measurement date. For purposes of testing goodwill for impairment, the Company’s goodwill has been assigned to the Company’s one consolidated reporting unit and is tested in the fourth quarter of each year or more frequently if impairment indicators arise. Potential impairment is indicated when the book value of a reporting unit, including goodwill, exceeds its fair value. If a potential impairment exists, the fair value of the reporting unit is compared to the fair value of its assets and liabilities, excluding goodwill, to estimate the implied value of the reporting unit’s goodwill. If an impairment charge is deemed necessary, a charge is recognized for any excess of the carrying amount of the reporting unit’s goodwill over the implied fair value. Considerable management judgment is necessary to estimate the fair value of assets; accordingly, actual results could vary significantly from estimates. There were no goodwill impairment charges during the years ended December 31, 2012, 2011 or 2010.
Other Assets
Other assets primarily include deferred debt issuance costs, which are amortized to interest expense over the life of the respective debt agreements, and long-term prepaid service contracts that are amortized over the service period.
tw telecom inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Impairment of Long-Lived Assets
The Company periodically reviews the carrying amounts of property, plant, and equipment and its identifiable intangible assets whenever current events or circumstances indicate the carrying amounts may not be recoverable. An impairment is required when the net book value of an asset exceeds the expected future undiscounted cash flows to be generated by that asset or group of assets and the loss is measured by the amount that the carrying value of the assets exceeds their fair value. Considerable management judgment is necessary to estimate the fair value of assets; accordingly, actual results could vary from estimates. Assets to be disposed of are carried at the lower of their carrying amount or fair value less costs to sell. The Company’s asset impairment tests did not result in any impairment charges during the years ended December 31, 2012, 2011 or 2010.
Asset Retirement Obligations
The Company records the estimated fair value of an asset retirement obligation when incurred. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset and depreciated over the asset’s estimated useful life. The Company has asset retirement obligations related to decommissioning of electronics in leased facilities and the removal of certain fiber and conduit systems. Considerable management judgment is required in estimating these obligations. Important assumptions include estimates of retirement costs, the timing of the future retirement activities and the likelihood of retirement provisions being enforced. Changes in these assumptions based on future information could result in adjustments to estimated liabilities.
Derivative Financial Instruments
The Company historically has utilized derivative financial instruments, specifically interest rate swap agreements, to mitigate interest rate risk. These instruments have been executed with financial institutions deemed creditworthy, and the Company monitors its exposure to these counterparties. All derivatives are recognized in the Company’s consolidated balance sheets at fair value.
Historically, the Company’s interest rate swaps have been designated as cash flow hedges. In an interest rate swap, a borrower of variable interest debt agrees with another party to make fixed payments equivalent to paying fixed rate interest on debt in exchange for receiving payments from the other party equivalent to receiving variable rate interest on debt, the effect of which is to eliminate some portion of the variability in the borrower’s overall cash flows.
If certain correlation and risk reduction criteria are met, the derivative is deemed to be highly effective in offsetting the changes in cash flows of the hedged item on a retrospective and prospective basis, and may be specifically designated as a hedge of exposure to changes in cash flow. For derivative instruments that are designated and qualify as a cash flow hedge, the effective portion of the gain or loss on the derivative instrument is reported as a component of other comprehensive income or loss. Amounts excluded from the assessment of hedge effectiveness, if any, as well as the ineffective portion of the gain or loss, are reported in results of operations immediately. The Company performs a quarterly assessment to determine whether each derivative instrument is highly effective in offsetting changes in cash flows of the hedged item. If the derivative instrument is determined to be not highly effective as a hedge, or if a derivative instrument ceases to be a highly effective hedge, hedge accounting is discontinued prospectively with respect to that derivative instrument. As of December 31, 2012, the Company has no outstanding interest rate swap agreements.
Regulation and Other Contingencies
The Company is subject to significant government and jurisdictional regulation, some of which is uncertain due to legal challenges of existing rules. Such regulation is subject to differing interpretations, inconsistent application and has resulted in disputes with carriers and municipalities regarding the classification of traffic, rights-of-way, rates and minutes of use.
Management estimates and accrues for its estimate of probable losses associated with government and jurisdictional regulation and other carrier contingencies. These estimates are based on assumptions and other considerations including studies of traffic patterns, expectations regarding regulatory rulings, historic experience and ongoing negotiations. The Company evaluates these reserves on an ongoing basis and makes adjustments as necessary.
tw telecom inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Revenue
The Company’s revenue is derived primarily from business communications services comprised of the following:
•Data and Internet services include services that enable customers to connect their internal computer networks and to access external networks, including Internet access at high speeds using Ethernet protocol, local and wide-area business Ethernet, and IP VPN solutions. Data and Internet services also include a portfolio of managed services including the data and Internet components of converged services, which fully integrates a combination of certain communication applications including IP VPN, Internet, security and managed router service into a single managed IP solution; and integrated services, which enable customers to purchase a full array of access options that include Internet services.
•Voice services include traditional and next generation voice capabilities, including voice services provided as stand alone and bundled products, long distance, toll free services and VoIP. Voice services also include the voice components of converged and integrated services.
•Network services are point-to-point services that transmit voice, data and images using state-of-the-art fiber optics, and collocation services that provide secure space with controlled climate and power where customers can locate their equipment to connect to the Company's network in facilities equipped for enterprise information technology environmental requirements.
The Company also generates revenue from intercarrier compensation. Intercarrier compensation is comprised of switched access services and reciprocal compensation. Switched access represents the compensation from another carrier for the delivery of traffic from a long distance carrier’s point of presence to an end-user’s premises provided through the Company’s switching facilities. The Federal Communications Commission ("FCC") and state public utility commissions regulate switched access rates in their respective jurisdictions. Reciprocal compensation represents compensation from local exchange carriers (“LECs”) for local exchange traffic originated on another LEC’s facilities and terminated on the Company’s facilities.
The Company’s customers include, among others, enterprise organizations in the financial services, technology and scientific, health care, distribution, manufacturing and professional services industries, public sector entities, system integrators and communications service providers, including incumbent local exchange carriers ("ILECs"), competitive local exchange carriers ("CLECs"), wireless communications companies and cable companies.
Revenue for network, data and Internet, and the majority of voice services is generally billed in advance on a monthly fixed rate basis and recognized over the period the services are provided. Revenue for the majority of intercarrier compensation and certain components of voice services, such as long distance, is generally billed on a transactional basis in arrears based on a customer’s actual usage; therefore, estimates are used to recognize revenue in the period earned.
The Company evaluates whether receivables are reasonably assured of collection based on certain factors, including the likelihood of billing being disputed by customers. If there is a billing dispute with a customer, revenue generally is not recognized until the dispute is resolved. The Company does not recognize revenue associated with contract termination charges until cash is received.
The Company classifies certain taxes and fees billed to customers and remitted to government authorities on a gross versus net basis in revenue and expense. In making this determination, the Company assesses, among other things, whether the Company is the primary obligor or principal taxpayer for the taxes and fees assessed in each jurisdiction where the Company does business. In jurisdictions where the Company determines that it is the principal taxpayer, the Company records the taxes and fees on a gross basis, including the taxes and fees in revenue and expense. In jurisdictions where the Company determines that it is merely a collection agent for the government authority, the Company records the taxes on a net basis. The total amounts classified as revenue, primarily included in voice services, associated with such taxes and fees were approximately $79.8 million, $63.5 million and $51.3 million for the years ended December 31, 2012, 2011 and 2010, respectively.
tw telecom inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Operating Expenses
Operating expenses consist of costs directly related to the operation and maintenance of the Company’s network and the provisioning of services, but exclude depreciation, amortization and accretion, which is reported separately. These costs, which are net of capitalized labor and overhead costs on capital projects (see “Property, Plant, and Equipment” above), include the salaries and related expenses of customer care, provisioning, network maintenance, technical field and network operations and engineering personnel, costs to repair and maintain the Company’s network, and costs paid to other carriers for access to their facilities, interconnection, and facilities leased and associated utilities.
Significant Customers
The Company has substantial business relationships with a few large customers, including major telecommunications carriers. The Company’s 10 largest customers accounted for an aggregate of 18%, 20% and 20% of the Company’s total revenue for the years ended December 31, 2012, 2011 and 2010, respectively. No customer accounted for 5% or more of total revenue in 2012, 2011 and 2010.
Stock-Based Compensation
The Company recognizes the cost of share-based employee compensation payments as expense over the requisite service period, which is generally the vesting period of the award. The fair value of restricted stock awards and restricted stock units granted is determined based on the market price of the Company’s common stock at the date of grant. The fair value of options is estimated at the date of grant using a Black-Scholes option pricing model. For purposes of the actual expense recognized in the years ended December 31, 2012, 2011 and 2010, the estimated fair value of the share-based payments is generally amortized to expense on a straight-line basis (net of estimated forfeitures) over the award’s vesting period.
Expected volatilities are based on the historical volatility of the Company’s common stock over a period generally commensurate with the expected term of the option. The risk-free rate for stock options granted during the period is determined by using the U.S. Treasury rate for the nearest period that coincides with the expected term. The expected term of stock options represents the weighted-average period the stock options are expected to remain outstanding and is based on historical data.
Recently Adopted Accounting Pronouncements
In June 2011, the Financial Accounting Standards Board ("FASB") issued an accounting standard update that eliminates the option to report other comprehensive income and its components in the statement of stockholders' equity. Instead, an entity is required to present items of net income and other comprehensive income in one continuous statement or in two separate but consecutive statements. The standard is effective for fiscal years beginning after December 15, 2011. The Company adopted this accounting standard update in the three months ended March 31, 2012. This update affected presentation and disclosure, but did not affect the Company's consolidated financial position, results of operations or cash flows.
In September 2011, the FASB issued an accounting standard update intended to simplify goodwill impairment testing. Entities have the option to perform a qualitative assessment on goodwill impairment to determine if a quantitative assessment is necessary. The accounting standard update is effective for fiscal years beginning after December 15, 2011. The Company adopted the new guidance effective January 1, 2012. This update affects testing steps only, and therefore adoption did not affect the Company's consolidated financial position, results of operations or cash flows. The Company opted not to perform a qualitative assessment in performing its annual impairment test for the year end December 31, 2012 and instead performed a quantitative assessment (see "Goodwill" above).
2. Earnings Per Common Share and Potential Common Share
Basic earnings per common share ("EPS") is measured as the income allocated to common stockholders divided by the weighted average outstanding common shares for the period. Diluted EPS is similar to basic EPS but presents the dilutive effect on a per share basis of potential common shares (such as convertible securities and stock options) as if they had been converted to shares at the beginning of the period presented. Potential common shares that have an anti-dilutive effect (e.g., those that increase income per share) are excluded from diluted EPS.
tw telecom inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The following is a reconciliation of the numerators and denominators used in the basic and diluted EPS computations:
Options to purchase shares of the Company’s common stock, restricted stock awards and restricted stock units to be settled in common stock upon vesting and shares of common stock subject to issuance upon conversion of the Company’s convertible debentures, which were excluded from the computation of diluted weighted average shares outstanding because their inclusion would be anti-dilutive, totaled 23.2 million shares, 26.1 million shares and 8.4 million shares at December 31, 2012, 2011 and 2010, respectively.
tw telecom inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
3. Investments
The Company’s investments at December 31, 2012 and 2011 are summarized as follows:
At December 31, 2012 and December 31, 2011, the carrying values of investments included in cash and cash equivalents approximated fair value. The aggregate fair value of available-for-sale securities by major security type is included in Note 8. The amortized cost basis of the available-for-sale securities was not materially different from the aggregate fair value. The contractual maturities of the Company’s available-for-sale securities are all within one year.
Proceeds from the sale and maturity of available-for-sale securities during the year ended December 31, 2012, 2011 and 2010 were $204.6 million, $208.3 million and $154.8 million, respectively. The Company recognized no material unrealized or realized net gains or losses from available-for-sale securities during the years ended December 31, 2012, 2011 and 2010.
During the year ended December 31, 2010, the Company’s investments were transferred from the held-to-maturity classification to the available-for-sale classification as a result of management’s decision to make the investments available to be sold prior to their maturity dates to purchase investments with a higher yield. At the date of transfer, the net carrying amount was $71.5 million and the Company recognized an immaterial amount of unrealized gain.
During the year ended December 31, 2010, the Company received $3.8 million in proceeds from liquidation of previously impaired commercial paper, resulting in an $0.8 million realized gain recorded in other income.
tw telecom inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
4. Property, Plant and Equipment
Property, plant and equipment consists of:
Depreciation expense was $275.8 million, $274.5 million and $279.9 million for the years ended December 31, 2012, 2011 and 2010, respectively.
The Company’s asset retirement obligations are included as a component of other long-term liabilities in the consolidated balance sheets. The following table provides asset retirement obligation liability activity for the years ended December 31, 2012, 2011 and 2010:
tw telecom inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
5. Intangible Assets
Goodwill
The Company had goodwill of $412.7 million at both December 31, 2012 and 2011.
Definite Life Intangibles
Definite life intangibles consist primarily of acquired customer relationships. Definite life intangible assets are amortized using methods that correlate to the pattern in which the economic benefits are expected to be realized. Customer relationships are amortized using the sum of the years digits method over an estimated life of 10 years. Other intangible assets, primarily acquired intangible assets, are amortized on a straight-line basis using expected lives of four or 10 years. During the year ended December 31, 2012, the Company purchased certain rights (included in the table below in "Other") and are amortized on a straight-line basis using an expected life of four years. Definite life intangible assets subject to amortization were as follows:
Intangible asset amortization expense was $6.2 million, $6.7 million and $7.8 million for the years ended December 31, 2012, 2011 and 2010, respectively.
The amortization expense related to intangible assets recorded as of December 31, 2012 for each of the five succeeding years is estimated to be the following: 2013-$6.0 million; 2014-$4.9 million; 2015-$3.9 million; 2016-$2.2 million and 2017-$0.
6. Long-Term Debt
tw telecom inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The schedule of principal payments on long-term debt as of December 31, 2012 is as follows (amounts in thousands):
___________________
(1)
Holders of the Convertible Debentures have the option to require the Company to purchase all or part of the Convertible Debentures on April 1, 2013, April 1, 2016, or April 1, 2021 at a purchase price equal to 100% of the principal amount plus accrued and unpaid interest, or at any time prior to April 1, 2026 to convert the debentures into shares of the Company's common stock; therefore, the repayment obligation is presented in full at the earliest maturity date. Upon conversion, the Company has the right to deliver, in lieu of common stock, cash or a combination of cash and shares of common stock. See further discussion below.
5 3/8% Senior Notes due 2022
In October 2012, the Company's wholly owned subsidiary, tw telecom holdings inc. ("Holdings") completed a private offering of $480 million principal amount 5 3/8% Senior Notes due 2022 (the "2022 Notes"), at an offering price of 100% of the principal amount. The Company may use the net proceeds of this offering to settle the conversion obligations for the 2 3/8% Convertible Senior Debentures due 2026 (the "Convertible Debentures") to the extent holders elect to convert their Convertible Debentures and the Company elects to settle the conversion obligations in whole or in part in cash, or if the Company otherwise redeems the Convertible Debentures. See the discussion below under 2 3/8% Convertible Senior Debentures due 2026 for the terms under which the Convertible Debentures may be settled or redeemed. Any net proceeds not used for these purposes would be used for general corporate purposes.
The 2022 Notes are unsecured obligations of Holdings and are guaranteed by the Company and substantially all of Holdings' subsidiaries. Interest is payable semi-annually on April 1 and October 1, commencing on April 1, 2013. The 2022 Notes are redeemable in whole or in part, at the Company's option at any time prior to October 1, 2017 at a price equal to 100% of the principal amount, plus accrued and unpaid interest, if any, liquidated damages, if any, plus a make-whole premium. The 2022 Notes are also redeemable in whole or in part, at the Company's option at any time on or after October 1, 2017, 2018, 2019 and 2020 at redemption prices of 102.688%, 101.792%, 100.896% and 100%, respectively, of the principal amount, plus accrued and unpaid interest, if any, and liquidated damages, if any. In addition, any time prior to October 1, 2015, at the Company's option, the Company may redeem up to 35% of the aggregate principal amount of the 2022 Notes with net proceeds from one or more equity offerings by the Company at a redemption price of 105.375% of their principal amount, plus accrued and unpaid interest, if any, and liquidated damages, if any. Offering costs of $9.2 million related to the 2022 Notes were deferred and will be amortized to interest expense over the term of the 2022 Notes. Interest expense, including amortization of deferred debt issuance costs relating to the 2022 Notes, was $6.7 million for the year ended year ended December 31, 2012.
As required by a registration rights agreement with the initial purchasers of the 2022 Notes, Holdings conducted an exchange offer to enable the holders of the 2022 Notes to exchange the unregistered 2022 Notes for notes registered under the Securities Act of 1933 with essentially identical terms. Pursuant to the exchange offer, which closed in January 2013, $479.8 million in principal amount of unregistered 2022 Notes were exchanged for $479.8 million in principal amount of registered 2022 Notes. The exchange offer for the 2022 Notes did not have a material impact on the Company's financial position or results of operations.
tw telecom inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
8% Senior Notes due 2018
In March 2010, Holdings completed an offering of $430 million aggregate principal amount of 8% Senior Notes due 2018 (the “2018 Notes”) at an offering price of 99.284% of the principal amount. The net proceeds from the offering were used to fund Holdings’ extinguishment of its 9¼% Senior Notes due February 2014. The 2018 Notes are unsecured obligations of Holdings and are guaranteed by the Company and substantially all of Holdings’ subsidiaries. Interest is payable semi-annually on September 1 and March 1. The 2018 Notes are redeemable in whole or in part, at Holdings’ option, at any time on or after March 1, 2014, 2015 and 2016 at redemption prices of 104%, 102% and 100%, respectively. In addition, prior to March 1, 2013, at Holdings’ option, Holdings may redeem up to 35% of the aggregate principal amount of the 2018 Notes with the net proceeds from one or more equity offerings by the Company at a redemption price of 108% of their principal amount, plus accrued and unpaid interest, if any. Offering costs of $9.5 million related to the 2018 Notes were deferred and are being amortized to interest expense over the term of the 2018 Notes. Interest expense, including amortization of deferred debt issuance costs and discount relating to the 2018 Notes, was $36.0 million, $36.0 million and $28.4 million for the years ended December 31, 2012, 2011 and 2010, respectively.
2 3/8% Convertible Senior Debentures due 2026
As of December 31, 2012, the Company had outstanding $373.7 million principal amount 2 3/8% Convertible Senior Debentures due April 1, 2026 (the “Convertible Debentures”). The Convertible Debentures are general, unsecured obligations of the Company. Interest is payable semi-annually on April 1 and October 1. The Convertible Debentures are redeemable in whole or in part at the Company’s option at any time on or after April 6, 2013 at a redemption price equal to 100% of the principal amount of the debentures to be redeemed, plus accrued and unpaid interest. Holders of the debentures have the option to require the Company to purchase all or part of the Convertible Debentures on April 1, 2013, April 1, 2016 or April 1, 2021 at 100% of the principal and unpaid interest, or at any time prior to April 1, 2026, to convert the debentures into shares of the Company’s common stock at a conversion rate of 53.6466 per $1,000 principal amount of debentures, representing a conversion price of $18.64 per share. Upon conversion, the Company will have the right to deliver, in lieu of shares of common stock, cash or a combination of cash and shares of common stock. As of December 31, 2012, an immaterial amount of Convertible Debentures had been converted and the Company delivered cash in lieu of common stock in connection with that conversion. As of December 31, 2012, the if-converted value of the Convertible Debentures exceeded the principal amount by $136.9 million. This amount could increase or decrease depending on the market price of the Company's common stock at the time of conversion.
In accordance with authoritative guidance issued by the FASB for convertible debt instruments, the Company separated the Convertible Debentures into debt and equity components at issuance and has assigned a value to each. The value assigned to the equity component was $120.5 million, net of an allocable portion of deferred debt issuance costs, as of December 31, 2012 and 2011, and is included as a component of additional paid in capital. The value assigned to the debt component was $253.3 million and represents the estimated fair value, as of the issuance date (March 29, 2006), of a similar instrument without the conversion feature. The unamortized discount is amortized to interest expense using the interest rate method through March 31, 2013. The following table reflects the principal and discount included in the consolidated balance sheets as of December 31, 2012 and 2011:
tw telecom inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The Company recognized the following amounts to interest expense related to the Convertible Debentures for the years ended December 31, 2012, 2011 and 2010:
Term Loan B
As of December 31, 2012, Holdings had a $680 million senior secured credit facility (the “Credit Facility”) consisting of a $600 million Term Loan B (“Term Loan”) and an undrawn $80 million revolving credit facility (the “Revolver”). On December 2, 2010, Holdings amended and restated the Credit Facility agreement to extend from January 2013 to December 2016 the maturity of approximately $474.1 million (the “extended tranche”) of the $577.5 million in principal amount of the Term Loan then outstanding. The January 2013 maturity date of the remaining $103.4 million in principal amount (the “January 2013 tranche”) was unchanged. The term of Holdings’ undrawn Revolver was extended from October 2011 to December 2014. In August 2012, Holdings extinguished in full the outstanding principal amount of $101.5 million of the January 2013 tranche by utilizing cash and cash equivalents. A $0.1 million write off of deferred debt issuance costs related to the extinguishment has been classified as debt extinguishment costs in the accompanying consolidated statements of operations for the year ended December 31, 2012. As of December 31, 2012, Holdings had outstanding $463.0 million principal amount of the extended tranche. Components of the Credit Facility, as amended, and related financing are detailed below:
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The Term Loan is a secured obligation, on a first lien basis, of Holdings. The Term Loan is guaranteed by the Company and Holdings’ subsidiaries. Repayments of the Term Loan are due quarterly in an amount equal to ¼ of 1% of the aggregate principal amount on the last day of each quarter. Interest on the extended tranche is computed based on a specified Eurodollar rate plus 3.25%. Interest is reset periodically and payable at least quarterly. Based on the Eurodollar rate in effect at December 31, 2012, the effective interest rate was 3.5%. In accordance with applicable accounting guidance, the amended and restated Term Loan agreement was accounted for as a modification of the existing debt. The fees paid to the holders of the extended tranche of $3.8 million were added to the allocable share of existing debt issuance costs and will be amortized over the term of the extended tranche. Interest expense, including amortization of deferred debt issuance costs and the effect of interest rate swap agreements, was $18.8 million, $22.3 million and $17.0 million for the years ended December 31, 2012, 2011 and 2010, respectively.
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The Revolver is secured and guaranteed in the same manner as the Term Loan. Interest on outstanding amounts, if any, will be computed based on a specified Eurodollar rate plus 2.5% to 3.5% and will be reset periodically and payable at least quarterly. The Company is required to pay a commitment fee on the undrawn commitment amounts on a quarterly basis of 0.5% per annum. If the Revolver were drawn, certain restrictive financial covenants would apply. The fees paid to the lenders of $0.5 million were added to the existing debt issuance costs and will be amortized through the expiration date. Commitment fee expense and amortization of deferred debt issuance costs relating to the Revolver was $0.6 million, $0.5 million and $0.5 million for the years ended December 31, 2012, 2011 and 2010, respectively.
The Term Loan negative covenants were amended in December 2010 so that the amended Term Loan agreement contains similar restrictions to those contained in the indenture for the 2018 Notes. These covenants are also similar to the restrictions contained in the indentures for the 2022 Notes issued in October 2012. The Revolver covenants, which also were amended in December 2010, contain additional restrictions, as well as certain financial covenants that the Company, Holdings and its subsidiaries must comply with if Holdings draws on the Revolver.
As of December 31, 2012, the Company and Holdings were in compliance with all of their covenants under the 2022 Notes, 2018 Notes, the Term Loan and the Revolver.
tw telecom inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
7. Derivative Financial Instruments
The variable rate Term Loan exposes the Company to variability in interest payments due to changes in interest rates. In order to mitigate interest rate fluctuations on the Term Loan, Holdings has in the past entered into derivative instruments, specifically interest rate swap agreements. The interest rate swap agreements effectively converted a portion of Holdings’ floating-rate debt to a fixed-rate for the term of the agreement, which reduces the impact of interest rate changes on future interest expense. Historically, the Company has designated its interest rate swap agreements as cash flow hedges. During the year ended December 31, 2011, the Company's remaining interest rate swap agreement expired.
The unrecognized losses for the interest rate swap agreement included in accumulated other comprehensive loss at December 31, 2010 were $2.4 million. There were no unrecognized losses for the interest rate swap agreement included in accumulated other comprehensive income at December 31, 2012 or 2011. The effect of the interest rate swaps on the consolidated statements of operations was as follows for the years ended December 31, 2012, 2011 and 2010:
8. Fair Value Measurements
Fair value, as defined by relevant accounting standards, is the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining the fair value measurements for assets and liabilities required to be recorded at fair value, the Company considers the principal or most advantageous market in which it would complete a transaction and considers assumptions that market participants would use when pricing the asset or liability, such as inherent risk, transfer restrictions and risk of nonperformance.
Fair Value Hierarchy
Relevant accounting standards set forth a fair value hierarchy that requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. A financial instrument’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the fair value measurement. Relevant accounting standards establish three levels of inputs that may be used to measure fair value:
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Level 1-Quoted prices in active markets for identical assets or liabilities. Level 1 assets that are measured at fair value on a recurring basis consist of the Company’s investments in prime money market mutual funds and U.S. Treasury money market mutual funds that are traded in an active market with sufficient volume and frequency of transactions, and are included as a component of cash and cash equivalents in the consolidated balance sheets.
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Level 2-Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets with insufficient volume or infrequent transactions (less active markets); or model-derived valuations in which all significant inputs are observable or can be derived principally from or corroborated by observable market data for substantially the full term of the assets or liabilities. Level 2 assets that are measured at fair value on a recurring basis consist of the Company’s investments in certificates of deposit, commercial paper, corporate debt securities, international government securities, and debt securities issued by the U.S. Treasury and government agencies using observable inputs in less active markets and are included as components of cash and cash equivalents and investments in the consolidated balance sheets. Level 2 liabilities that are measured, but not carried, at fair value on a recurring basis include the Company’s long-term debt. The Company's long-term debt has not been listed on any securities exchange or quoted on an inter-dealer automated quotation system. The Company has estimated the fair value of its long-term debt based on indicative pricing published by certain investment banks or trading levels in our long-term debt.
tw telecom inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
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Level 3-Unobservable inputs to the valuation methodology that are significant to the measurement of fair value of assets or liabilities. The Company did not have any Level 3 assets or liabilities that were measured at fair value at December 31, 2012 and 2011.
The following tables reflect assets and liabilities that are measured and carried at fair value on a recurring basis as of December 31, 2012 and 2011:
tw telecom inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The following table summarizes the carrying amounts and estimated fair values of the Company’s long-term debt, including the current portion:
9. Income Taxes
Income tax expense (benefit) for the years ended December 31, 2012, 2011 and 2010 was as follows:
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(1)
For the year ended December 31, 2011, the deferred income tax benefit related to the decrease in the valuation allowance primarily resulted from a change in tax legislation. For the year ended December 31, 2010, the deferred income tax benefit related to the decrease in the valuation allowance is comprised of (i) the portion related to future year’s earnings, which resulted in a reversal of $299.0 million in the valuation allowance in 2010 (see below), and (ii) the portion related to current year earnings.
Total income tax expense (benefit) differed from the amounts computed by applying the federal statutory income tax rate of 35% to income before income taxes as a result of the following items for the years ended December 31, 2012, 2011 and 2010:
tw telecom inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The tax effects of temporary differences that give rise to significant components of the Company’s deferred tax assets and liabilities at December 31, 2012 and 2011 are as follows:
Prior to 2009, the Company had a history of losses and, as a result, recognized a valuation allowance for net deferred tax assets, excluding consideration of the deferred tax liability for the amortization of indefinite lived intangibles. Each quarter, the Company evaluates the need to retain all or a portion of the valuation allowance on its net deferred tax assets. During 2010, the Company determined that it was more likely than not that the vast majority of its deferred tax assets, including net operating loss carryforwards (“NOLs”), will be realized, and as a result reversed $299.0 million of the valuation allowance. In making this determination, the Company analyzed, among other things, its recent history of earnings, its cumulative earnings for the last 12 quarters, and forecasts of future earnings. The reversal of the valuation allowance resulted in an income tax benefit of $299.0 million, or $1.98 per basic share and $1.72 per diluted share for the year ended December 31, 2010.
The Company continues to maintain a valuation allowance against certain deferred tax assets totaling $33.2 million. The Company believes it is more likely than not that certain deferred tax assets, including those resulting from NOLs subject to certain limitations and those that require future income of special character, will not be realized. Additionally, the Company has certain deferred tax assets attributable to stock option deductions for which the related valuation allowance cannot be reversed due to relevant accounting guidance concerning tax benefits related to the exercise of non-qualified stock options prior to the adoption of such accounting guidance. At December 31, 2012, $20.7 million of the valuation allowance related to stock compensation for which subsequently recognized tax benefits will be allocated directly to additional paid in capital.
As a result of certain realization requirements of applicable accounting guidance, the table of deferred tax assets and liabilities shown above does not include certain deferred tax assets that arose directly from (or the use of which was postponed by) tax deductions related to equity compensation in excess of compensation recognized for financial reporting. Stockholders' equity will be increased by $54.9 million if and when such deferred tax assets are ultimately realized. The Company uses the ordering rules prescribed by relevant accounting guidance for purposes of determining when the excess tax benefits have been realized. At December 31, 2012, the Company had $18.8 million in deferred tax assets related to stock-based compensation. If the actual future tax deductions are less than the deferred tax asset recorded, this may result in an increase to income tax expense.
tw telecom inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
At December 31, 2012, the Company had NOLs for federal income tax purposes of approximately $823 million. The Company’s NOLs, if not utilized to reduce taxable income in future periods, generally expire in various amounts beginning in 2022 and ending in 2026. The Company utilized NOLs to offset income tax obligations in each of the tax returns filed for the years ended December 31, 2011, 2010 and 2009. 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. In general, this would occur if certain ownership changes related to the Company’s common stock that are held by 5 percent or greater stockholders exceeds 50 percent measured over a rolling three year period. If the Company experienced such an ownership change at a time when its market capitalization is below a certain level, the utilization of its NOLs to reduce future federal income tax obligations could be limited.
As of December 31, 2012, the Company had no material uncertain tax positions.
10. Stock-Based Compensation
tw telecom 1998 Employee Stock Option Plan
The Company maintains the tw telecom 1998 Employee Stock Option Plan that reserved 9.0 million shares of common stock to be issued to officers and eligible employees under terms and conditions to be set by the Company’s Board of Directors. As of December 31, 2012, approximately 1.5 million shares of common stock were reserved for issuance upon exercise of outstanding options under that plan. Generally, the options vest over periods of up to four years and expire seven or ten years from the date of issuance. These options have been granted to employees of the Company with an exercise price equal to market value at the date of grant. The tw telecom 1998 Employee Stock Option Plan expired in August 2008 and no additional awards may be granted under this plan.
tw telecom 2000 Employee Stock Plan
The Company maintains the tw telecom 2000 Employee Stock Plan (as amended in June 2009) that permits up to 39.0 million shares of common stock to be issued pursuant to stock options and stock awards granted to officers, directors, and eligible employees under terms and conditions to be set by the Company’s Board of Directors. As of December 31, 2012, approximately 4.8 million shares of common stock were reserved for issuance upon exercise of outstanding options and vesting of stock awards and approximately 13.1 million shares of common stock were available for grant under the plan. Generally, the options and awards vest over periods of up to four years and options expire either seven or ten years from the date of issuance.
The options have been granted to employees of the Company with an exercise price equal to market value of the underlying stock at the date of grant. The fair value of the restricted stock awards and restricted stock units granted was measured based on the market value of the shares on the date of grant and the resulting expense related to these awards is recorded over their vesting periods, generally up to four years. The Company did not grant any stock options in the year ended December 31, 2012. The weighted-average fair value of options granted was $8.44 and $7.61 for the years ended December 31, 2011 and 2010, respectively, with the following weighted-average assumptions:
tw telecom inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The table below summarizes the Company’s stock option activity and related information for the year ended December 31, 2012:
The total intrinsic value of stock options exercised during the years ended December 31, 2012, 2011 and 2010 was $17.8 million, $13.4 million and $7.1 million, respectively. As of December 31, 2012, there was $1.7 million of total unrecognized compensation expense related to unvested stock options, which is expected to be recognized over a weighted-average period of 0.5 years.
The table below summarizes the Company’s restricted stock and restricted stock units and related information for the year ended December 31, 2012:
The total fair value of restricted stock and restricted stock units vested during the years ended December 31, 2012, 2011 and 2010 was $29.1 million, $17.7 million and $12.8 million, respectively. As of December 31, 2012, there was $54.0 million of total unrecognized compensation expense related to non-vested restricted stock awards and restricted stock units, which is expected to be recognized over a weighted-average period of 2.1 years.
Effective October 1, 2004, the Company adopted the tw telecom 2004 Qualified Stock Purchase Plan (the “2004 Stock Purchase Plan”). Employees who met certain eligibility requirements could elect to designate up to 15% of their eligible compensation, up to an annual limit of $25,000, to purchase shares of the Company’s common stock at a 15% discount to fair market value. Stock purchases occurred semi-annually, with the price per share equaling the lower of 85% of the market price at the beginning or end of the offering period. The Company is authorized to issue a total of 600,000 shares of the Company’s common stock to participants in the 2004 Stock Purchase Plan. In September 2007, the 2004 Stock Purchase Plan was amended to authorize an additional 600,000 shares for issuance under the 2004 Stock Purchase Plan. During the years ended December 31, 2012, 2011 and 2010, no shares were issued under the amended 2004 Stock Purchase Plan because the Company has not made any offerings under the amended plan.
tw telecom inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
11. Commitments and Contingencies
Leases and Fixed Obligations
The Company leases office space and furniture, facilities housing telecommunications equipment, and fiber optic use rights. Certain of the leases contain renewal clauses. The Company also enters into fixed price maintenance agreements for maintenance of its network.
At December 31, 2012, and after giving effect to a real estate lease that was executed in January 2013, commitments under capital and non-cancelable operating leases and maintenance agreements with terms in excess of one year were as follows:
As of December 31, 2012 and 2011, assets under capital lease obligations, which primarily consist of fiber optic network components, were $24.6 million and $19.3 million, respectively, with related accumulated depreciation of $7.8 million and $6.1 million, respectively. Depreciation expense related to assets under capital lease obligations was $1.7 million, $1.2 million and $1.4 million for years ended December 31, 2012, 2011 and 2010, respectively. The obligations under capital leases have been discounted at an average imputed interest rate of 7.4%. Rental expense under operating leases aggregated $77.1 million, $76.8 million and $73.9 million for the years ended December 31, 2012, 2011 and 2010, respectively.
Other Contingencies
Management routinely reviews the Company’s exposure to liabilities incurred in the normal course of its business operations. The Company is subject to significant government and jurisdictional regulation, some of which is uncertain due to legal challenges of existing rules. Such regulation is subject to differing interpretations and inconsistent application, and has historically resulted in disputes with other carriers, regulatory authorities and municipalities regarding the classification of traffic, rates, minutes of use and right-of-way fees. Where a probable contingency exists and the amount of the loss can be reasonably estimated, the Company records the estimated liability. Considerable judgment is required in analyzing and recording such liabilities and actual results may vary from the estimates.
The Company’s pending legal proceedings are limited to litigation incidental to its business. In the opinion of management, the ultimate resolution of these matters will not have a material adverse effect on the Company’s financial statements.
12. Employee Benefit Plans
Effective January 1, 1999, the Company adopted the tw telecom 401(k) Plan (the “401(k) Plan”). Employees who meet certain eligibility requirements may contribute up to 60% of their eligible compensation, subject to statutory limitations, to a trust for investment in several diversified investment choices, as directed by the employee. The Company makes a matching contribution of 100% of each employee’s contribution up to a maximum of 5% of the employee’s eligible compensation. The Company’s contributions to the 401(k) Plan aggregated $11.9 million, $11.6 million and $10.7 million for the years ended December 31, 2012, 2011 and 2010, respectively.
13. Quarterly Results of Operations (Unaudited)
The following summarizes the Company’s unaudited quarterly results of operations for 2012 and 2011:
The total net income per share for the 2012 and 2011 quarters do not equal net income per share for the respective years because the per share amounts for each quarter and for each year are computed based on their respective discrete periods.
14. Supplemental Guarantor Information
The 2018 Notes and 2022 Notes are unsecured obligations of Holdings ("Issuer") and are guaranteed by the Company (“Parent Guarantor”) and substantially all of the Issuer’s subsidiaries (“Combined Subsidiary Guarantors”). The guarantees are joint and several. A significant amount of the Issuer’s cash flow is generated by the Combined Subsidiary Guarantors. As a result, funds necessary to meet the Issuer’s debt service obligations are provided in large part by distributions or advances from the Combined Subsidiary Guarantors. The 2018 Notes and 2022 Notes are governed by an indenture that contains certain restrictive covenants. These restrictions affect, and in many respects significantly limit or prohibit, among other things, the ability of the Parent Guarantor, the Issuer and its subsidiaries to incur indebtedness, make prepayments of certain indebtedness, pay dividends, make investments, engage in transactions with stockholders and affiliates, issue capital stock of subsidiaries, create liens, sell assets, and engage in mergers and consolidations.
The following information sets forth the Company’s Condensed Consolidating Balance Sheets as of December 31, 2012 and 2011, Condensed Consolidating Statements of Operations for the years ended December 31, 2012, 2011 and 2010, Condensed Consolidating Statements of Comprehensive Income for the years ended December 31, 2012, 2011 and 2010 and Condensed Consolidating Statements of Cash Flows for the years ended December 31, 2012, 2011 and 2010.
tw telecom inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
tw telecom inc.
CONDENSED CONSOLIDATING BALANCE SHEET
December 31, 2012
tw telecom inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
tw telecom inc.
CONDENSED CONSOLIDATING BALANCE SHEET
December 31, 2011
tw telecom inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
tw telecom inc.
CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS
Year Ended December 31, 2012
tw telecom inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
tw telecom inc.
CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS
Year Ended December 31, 2011
tw telecom inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
tw telecom inc.
CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS
Year Ended December 31, 2010
tw telecom inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
tw telecom inc.
CONDENSED CONSOLIDATING STATEMENT OF COMPREHENSIVE INCOME
Year Ended December 31, 2012
tw telecom inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
tw telecom inc.
CONDENSED CONSOLIDATING STATEMENT OF COMPREHENSIVE INCOME
Year Ended December 31, 2011
tw telecom inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
tw telecom inc.
CONDENSED CONSOLIDATING STATEMENT OF COMPREHENSIVE INCOME
Year Ended December 31, 2010
tw telecom inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
tw telecom inc.
CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
Year Ended December 31, 2012
tw telecom inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
tw telecom inc.
CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
Year Ended December 31, 2011
tw telecom inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
tw telecom inc.
CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
Year Ended December 31, 2010
tw telecom inc.
SCHEDULE II-VALUATION AND QUALIFYING ACCOUNTS
Years Ended December 31, 2012, 2011 and 2010
EXHIBIT INDEX
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*
Incorporated by reference.
**
Management contract or compensation plan or arrangement.
†
Portions of this exhibit have been redacted and filed separately with the Securities and Exchange Commission pursuant to a request for confidential treatment.