Item 1. Business
OVERVIEW
In this document, Cbeyond, Inc. and its subsidiaries are referred to as “we”, the “Company” or “Cbeyond”.
We provide managed Internet Protocol-based, or IP-based, communications services to our target market of small businesses in select large metropolitan areas across the United States. Our services include local and long distance voice services, broadband Internet access, mobile voice and data, email, voicemail, web hosting, secure backup and file sharing, fax-to-email, virtual private network, and other communications and IT services. In January 2006, we began offering mobile voice and data services in conjunction with our landline-based services via our mobile virtual network operator, or MVNO, relationship with a nationwide wireless network provider.
Our voice services (other than our mobile voice and data services) are delivered using Voice over IP, or VoIP, technology and all of such services are delivered over our secure all-IP network, rather than over the best-efforts public Internet. Our network allows us to manage quality of service and achieve network and call reliability comparable to that of traditional phone networks.
We believe our all-IP network platform enables us to deliver an integrated bundle of communications services that may otherwise be unaffordable or impractical for our customers to obtain. We manage all aspects of our service offerings for our customers, including installation, provisioning, monitoring, proactive fault management and billing. We first launched our service in Atlanta in April 2001 and now also operate in Dallas, Denver, Houston, Chicago, Los Angeles, San Diego, Detroit and the San Francisco Bay Area, and, beginning in the first quarter of 2008, Miami.
We reported approximately $280.0 million in revenue in 2007, as compared to $213.9 million in 2006 and $159.1 million in 2005. We reported $52.1 million and $39.5 million of adjusted EBITDA, a non-GAAP measure-see “Non-GAAP Financial Measures” - and net income of $21.5 million and $7.8 million, on a consolidated basis, in 2007 and 2006, respectively. As of December 31, 2007, we were providing communications services to 35,041 customer locations.
Our IP/VoIP network architecture. We deliver our services (other than our mobile voice and data services) over a single all-IP network using T-1 connections. This allows us to provide a wide array of voice and data services, attractive service features (such as online additions and changes), quality of service and network and call reliability comparable to that of traditional telephone networks. Unlike traditional voice-centric circuit switched communications networks, which require separate networks in order to provide voice and data services, we employ a single integrated network, which uses technologies that digitize voice communications into IP packets and converges them with other data services for transport on an IP network. We transmit our customers’ voice and data traffic over our secure private network and do not use the public Internet, which is employed by other VoIP companies such as Vonage and Skype Technologies. Our network design exploits the convergence of voice and data services and we believe requires significantly lower capital expenditures and operating costs compared to traditional service providers using legacy technologies. The integration of our network with our automated front and back office systems allows us to monitor network performance, quickly provision customers and offer our customers the ability to add or change services online, thus reducing our customer care expenses. We believe that our all-IP network and automated support systems enable us to continue to offer new services to our customers in an efficient manner. Beginning in the first quarter of 2006, leveraging the flexibility of our IP network and back-office systems, we integrated mobile services with our wireline services. We currently have an arrangement with an established national mobile carrier, which provides our nationwide, privately-branded mobile service offering.
Our target market and value proposition. Our target market is businesses with 5 to 249 employees in large metropolitan cities, using four to forty-eight lines. According to 2007 Dun & Bradstreet data, there are approximately 1.4 million businesses with 5 to 249 employees in the 25 largest markets in the United States. As of December 31, 2007, we served nine of these markets and generally expect to continue opening three new markets per year and intend to establish operations in the top 25 markets in the U.S.
We provide each of our integrated packages of managed services at a competitively priced, fixed monthly fee. Certain enhanced services are available as optional add-ons, and we charge per-minute fees for long distance telephone and mobile phone usage in excess of included plan minutes. We believe that we provide a differentiated value proposition to our customers, most of which do not have dedicated in-house resources to fully address their communications requirements and who therefore value the ease of use and comprehensive management that we offer. Our primary competitors, the local telephone companies, do not generally offer packages of similar managed services to our target market. We believe that this value proposition, along with our fixed-length contracts, has been crucial to achieving our historical quarterly customer churn rate, which averaged approximately 1.1% for the year ended December 31, 2007.
Our Strategy
We intend both to grow our business in our current markets and to replicate our approach in additional markets. To achieve our goal of profitably delivering sophisticated communications tools to small businesses in our current and future markets, we have adopted a strategy with the following principal components:
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Focus solely on the small-business market in large metropolitan areas. We target small businesses, most of which do not have dedicated in-house resources to address their communications requirements fully and place a high value on customer support. By focusing exclusively on small business customers, we believe we are able to differentiate ourselves from larger service providers and deliver superior service that small business customers value.
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Offer comprehensive packages of managed IP and mobile communications services. We seek to be the single-source provider of our customers’ wireline local and long distance voice, data and mobile communications needs. All of our customers subscribe to one of our integrated BeyondVoice packages of applications. Each of our BeyondVoice packages includes local and long distance voice services and broadband Internet access, plus additional value-added applications. All of our services (other than our mobile voice and data services) are delivered over high-capacity T-1 connections. We do not offer our local and long distance voice services, mobile or broadband Internet access applications on an unbundled basis. We offer our services, including our mobile voice and data services, only under fixed-length, flat-rate contracts. We believe that this approach results in high average revenue per customer location and a low customer churn rate. Beginning in the first quarter of 2006, we added mobile voice and data services, including wireless email, calendar, contacts and web browsing to our service offerings. We also now offer integrated mobile/wireline applications such as unified messaging, one number service and simultaneous ring. These mobile services are, and will only be, offered in conjunction with our core BeyondVoice package, and we do not plan to offer mobile services on a stand-alone basis. Rather, we offer our customers a bundled mobile and wireline offering with one bill and shared minutes across their business.
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Increase penetration of enhanced services to our customer base. We seek to achieve higher revenue and margin per customer, increase customer productivity and satisfaction and reduce customer churn by providing enhanced services in addition to our local and long distance voice services and broadband Internet access applications. As of December 31, 2007, our average customer used a total of 6.3 applications, whether as part of a package or purchased as an additional service, compared with 5.6 applications as of December 31, 2006.
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Focus sales and marketing resources on achieving significant market penetration. We have chosen to focus our sales and marketing efforts on achieving deep market penetration and growing market share in a limited set of markets and gradually expanding the number of markets served, rather than taking an approach that emphasized having a sales presence in significantly more markets at an earlier stage in our company's history. We believe that our targeted approach has resulted in our obtaining market share, and therefore profitability, at a faster rate and with better financial results than would have resulted from an approach that emphasized having a sales presence in significantly more markets at an earlier date. In the future, we believe that our base of existing markets will enable us to expand into new markets at a faster pace than we have in the past. In addition, because we prefer to develop and promote sales management from within, rather than hire from outside our company, our constantly growing base of successful markets provides a training ground for more management personnel that we can use to open new markets.
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Replicate our business model in new markets. As of December 31, 2007, we operated in nine markets and generally expect to continue opening three new markets per year. Each time we expand into a new market, we adhere to the same process for choosing, preparing, launching and operating in those markets. In launching our business in each new market, we use the same disciplined financial and operational reporting system to enable us to closely monitor our costs, market penetration and provisioning of customers and maintain consistent standards across all of our markets.
Our Strengths
Our business is focused on rapidly growing a loyal customer base, while maintaining capital and operating efficiency. We believe we benefit from the following strengths:
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Our all-IP network. We are able to provide a wide range of enhanced communications services in a cost-efficient manner over a single network, in contrast to traditional communications providers, which may require separate, incremental networks or substantial network upgrades in order to support similar services. Our all-IP network architecture allows us to provide a comprehensive package of managed communications services including VoIP, with high network reliability and high quality of service.
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Capital efficiency. We believe that our business approach requires lower capital and operating expenditures to bring our markets to positive cash flow compared to communications carriers using legacy technologies and operating processes. In addition, our deployment of capital in each of our markets is largely success based, meaning, over time, a large portion of our capital outlay is incurred incrementally as our customer base grows.
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Our automated and integrated business processes. We believe that the combination of our disciplined approach to sales, installation and service together with our automated business processes allow us to streamline our operations and maintain low operating costs. Our front and back office systems are highly automated and are integrated to synchronize multiple tasks, including installation, billing and customer care. We believe this allows us to lower our customer service costs, efficiently monitor the performance of our network and provide automated and responsive customer support.
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Our highly regimented but personalized sales model. We believe we have a distinctive approach to recruiting, training and deploying our direct sales representatives, which ensures a uniform sales culture and an effective means of acquiring new customers. Our direct sales representatives follow a disciplined daily schedule and meet face-to-face with customers each day as part of a transaction-oriented, but personalized and consultative, selling process.
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Our experienced management team with focus on operating excellence. Our senior management team has substantial industry experience. Our top three executive officers have an average of over 20 years of experience in the communications industry and have worked at a broad range of communications companies, both at startups and mature businesses, including local telephone companies, long distance carriers, competitive carriers, web hosting companies, Internet and data providers and mobile communications providers.
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Our strong balance sheet and liquidity position. As of December 31, 2007, we had a strong balance sheet with $56.2 million in cash, cash equivalents and marketable securities and no debt. We believe that cash flows from operations and cash on hand will be sufficient to fund our capital expenditures and operating expenses, including those related to our current plans to continue opening three new markets per year. In addition, we have an open, undrawn $25.0 million revolving line of credit with Bank of America, secured by substantially all of our assets.
We believe our strategies and strengths have contributed to our financial and operating performance, including high revenue growth, attractive average revenue per customer location and low customer churn.
Our Customers
We are targeting entrepreneurial-class businesses, or those with 5 to 249 employees, in certain of the 25 largest metropolitan markets in the United States. According to 2007 Dun & Bradstreet data, there are approximately 1.4 million businesses with 5 to 249 employees in the 25 largest markets in the United States. We are focusing on these markets because of their high concentration of small businesses. We believe that focusing on these markets will allow us to maximize the resources we can apply by operating in the densest areas of small business in the United States. As of December 31, 2007, we were providing communications services to 35,041 customer locations.
Prior to joining Cbeyond, the majority of our customers received communications services from the incumbent local telephone companies, and many of these businesses had more than one provider for the basic services of local and long distance voice services and Internet access. These businesses, in most cases, did not receive the focus and personalized attention that larger enterprises enjoy and often lagged behind larger businesses in the adoption of productivity-enhancing and cost-effective service offerings.
The small businesses we target typically lack affordable access to a T-1 broadband connection and typically do not have dedicated in-house resources to manage their communications needs. A majority of our customer base uses 5 to 8 local voice lines, although the larger size customers in our range represent an increasing percentage of the total. Because we focus solely on small businesses, no single customer or group of customers represents a significant percentage of our customer base or revenues. Similarly, no single vertical customer segment represents a significant percentage of our base. Our largest customer sectors are professional services, which includes physicians, legal offices, banking institutions, consulting firms, accounting firms and real estate services. Each of these individually represents less than 5% of our customer base.
Our Managed Service Offerings
Integrated Service Offerings
We offer integrated managed communications services through our BeyondVoice packages, which are provided over one to three dedicated T-1 connections. The BeyondVoice packages are essentially a single basic product offered in three sizes, depending on the customer’s size and need for bandwidth:
Each of our BeyondVoice packages includes local and long distance voice services and broadband Internet access, plus a full line of managed services our customers can choose from to customize their package. Beginning in the first quarter of 2006, we incorporated mobile services into our BeyondVoice I package offering. The local and long distance voice services in our BeyondVoice packages include enhanced 911 services, which are comparable to the 911 services offered over traditional telephone networks, and business class features, which include call forwarding, call hunting, call transfer, call waiting, caller ID and three-way calling.
Enhanced Services
In addition to the applications offered in our BeyondVoice packages, we currently offer other services, which include voicemail, email, unified messaging, web hosting, virtual private network, BeyondMobile, BeyondOffice, secure backup and file sharing, fax-to-email, and other applications and features. In the future, we plan to offer other applications, such as network security, secure desktop, integrated mobile/wireline applications, one number service and simultaneous ring. Our enhanced services are sold on an a la carte basis to subscribers of our BeyondVoice bundled packages.
Sales and Marketing
Overview
Our sales force targets small businesses that have 5 to 249 employees. We believe that the traditional local telephone companies have not concentrated their sales and marketing efforts on this business segment. Our direct sales representatives meet face-to-face with customers each day as part of a transaction-oriented, but personalized and consultative, selling process. We adhere to the same sales and operating procedures in every market we enter. We track the performance of our sales team by maintaining detailed activity measurements in each of our markets.
We offer our customers a comprehensive communications solution that is simplified into three BeyondVoice packages sold at fixed, predetermined prices. We permit our sales people to sell only our offered packages and do not allow them to make discounted sales or alter the BeyondVoice packages (other than to add enhanced services or in connection with company-wide promotions). We believe that value is the primary motivating factor for our customers. We believe that our commitment to offering integrated packages of services helps to simplify the entry of orders into our automated provisioning and installation process. Through our strategy of offering bundled services, we seek to become the single-source provider of our customers’ wireline and mobile communications services. We believe these factors contribute to our low customer churn rate.
Sales Channels
Direct Sales. The cornerstone of our sales efforts is our direct sales force. At full staffing, we generally target 50 to 60 sales representatives per market. Our direct sales force accounted for approximately 78.9% of our year to date sales through December 31, 2007.
We believe we have a distinctive approach to recruiting and training our direct sales representatives which ensures a uniform sales approach and a consistent measure of revenue targets. We typically recruit individuals without prior telecommunications sales experience so that we can exclusively provide all of their formal training. The ongoing nature of our training is an essential part of our business strategy. We require our sales personnel to maintain a regimented daily schedule of training, appointment setting and face-to-face meetings with customers.
A substantial part of the compensation for our sales force is based on commission. We reinforce our clear expectations of success through a system of increasing quotas and advancement for those who succeed. We promote from within, where possible, and develop our own sales management talent from promising sales representatives, who have the opportunity to advance as we grow.
Indirect Sales. We supplement our direct sales force with our channel partners, who leverage their pre-existing business relationships with the customer and act as sales agents for us. The channel partners include value-added resellers, local area network consultants and other IT and telecommunications consultants to small businesses. As compensation for their services, our channel partners receive ongoing residual payments on their sales. Our channel partners contributed approximately 21.1% of our year to date sales through December 31, 2007.
Referrals Program
We believe we are building a culture of referrals that benefits both our direct and indirect selling efforts. We obtain approximately one-third of our new customers from our referral program through our current base of customers and through our referral partners. Our customers and referral partners are eligible to receive a one-time referral credit for each new customer they refer.
Marketing and Advertising
We focus our marketing resources on our direct and indirect sales efforts and programs that support those efforts. We market ourselves as “the last communications company a small business will ever need.” We have launched a focused marketing campaign of targeted print and online media. Our marketing local print media, industry specific print media and online advertising expenses for the year ended December 31, 2007 were $2.7 million.
Operations
Once a customer is signed, we believe we provide a highly differentiated customer experience in each aspect of the service relationship. Our highly-automated and optimized business processes are designed to provide rapid and reliable installation, accurate billing and responsive, 24x7 care and support using both web-enabled and human resources.
We continue to put emphasis on customer service as a key differentiator to drive customer satisfaction and customer referrals for new business. Our “VP Customer Experience” executive management position focuses on defining the overall customer experience across all customer touch points and the implementation of a cohesive program to ensure customer satisfaction and higher customer retention rates. This customer experience focus has also contributed to continued improvements in our automated care and support capabilities used to service our customers and increase our operational efficiency.
Installation
We employ a team of service coordinators in each of our markets to handle the order entry and customer installation process. A centralized circuit provisioning and customer activation group takes responsibility for ensuring that T-1 circuits from the local telephone company to the customer’s location are provisioned correctly and on time, together with local number portability and the appropriate features and applications ordered by the customer. We seek to provision our BeyondVoice I customers within 30 calendar days, our BeyondVoice II within 40 calendar days and our BeyondVoice III customers within 60 calendar days. Our automated processes allow us to reduce the time and human intervention necessary to fill our circuit orders with the local telephone company. Currently, a majority of all circuit orders receive a firm order commitment from the local telephone company with no human intervention in less than 24 hours from submission. Once an order is submitted, an outsourced technician is dispatched to the customer’s location to install the integrated access device, to connect the customer’s equipment to our network, and to activate and test the services. After installation of the integrated access device, new services added by the customer will work with the customer’s existing equipment and require no further equipment changes or capital expenditures.
Billing
We bill all of our customers electronically. Our customers receive their billing information via email. Full billing detail and analytical capabilities are available to our customers on the web through our Cbeyond Online website. We do not send any paper bills. In addition, over 39.5% of our customers pay us online, either via credit card, electronic funds transfer, or automatic account debit. Because we employ flat-rate billing in advance, customers are able to budget their costs, billing is simplified and errors are kept to a minimum. Because billing-related calls are often the largest percentage of calls to customer care among communications service providers, our approach to billing greatly reduces the amount of resources needed in our customer care organization.
Customer Care and Cbeyond Online
We offer our customers 24x7 support through live access to dedicated care representatives and through online resources. Although customers can choose to speak with one of our Cbeyond representatives on a real-time basis, Cbeyond Online has become our primary channel for customer care.
We offer a broad range of capabilities online, including functions allowing customers to:
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review their requested services and accept their installation order (for new customers);
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view, pay and analyze their bills;
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view and modify their services and account features;
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view and modify account information;
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research products and troubleshoot issues using the section of our web site devoted to frequently asked questions, which we call our Find-It-Fast knowledge base; and
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submit requests for account changes.
Underpinning our care and support operations is a network that provides our customers with reliable and high quality service. Our network operations group manages and tracks network performance. We have deployed state-of-the-art network monitoring and diagnostic tools to provide our care representatives and network operations center personnel with real-time insight into problem areas and the information needed to address them.
Our All-IP Network Architecture
We deliver our services (other than our mobile voice and data services) over our single all-IP network using T-1 connections to connect customers to our network. This allows us to provide a wide array of voice and data services, attractive service features (such as real-time online adds and changes), and network reliability and call quality comparable to that of traditional telephone networks. Unlike traditional voice-centric circuit-switched communications networks, we employ a single integrated network using technologies that digitize voice communications into IP packets and converge them with other data services for transport on an IP network. We transmit our customers’ voice traffic over our secure private network and do not rely on the best efforts public Internet. Our network design exploits the convergence of voice and data services and requires significantly lower capital expenditures and operating costs compared to traditional service providers using legacy technologies. The integration of our network with our automated front and back office systems allows us to monitor network performance, quickly provision customers and offer our customers the ability to add or change services online, thus reducing our customer care expenses. We believe that our all-IP network and automated support systems enable us to continue to offer new services to our customers in an efficient manner.
There are two distinct strategies that carriers adopt in deploying VoIP services:
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Voice as an application over the public Internet. Because calls are carried over the public Internet and not over a private network such as ours, service is often provided on a best-efforts basis. These service
providers focus mainly on the consumer market. We believe that these offerings may lack the call quality, network reliability, security and service features that business customers require.
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Our managed IP network. We have deployed an all-IP network over which voice calls primarily travel over a managed IP connection as opposed to the public Internet. This approach allows us to deliver quality of service similar to the quality of a public switched telephone network. In our model, voice is an application over a private data network.
Initially, all of our customers connected to our BeyondVoice service via their existing analog premise equipment. For those original customers, as well as any new customers using their existing analog premise equipment, we install and manage an integrated access device on the customer’s premise that converts VoIP traffic to analog time-division multiplexing, or TDM, and interconnects with the customer’s phone system via digital or analog connections. By interconnecting with the customer’s existing TDM-based phone system, we significantly minimize the investment required to switch to our VoIP service, simplify the installation of our service and greatly reduce the sales lead-time.
While the majority of our new customers still connect to our service via their existing analog premise equipment, over the past several years, we have observed a steady increase in the deployment of IP-based phone systems in the small business market. According to several industry analysts, the sales of IP-based phone systems have surpassed that of the traditional TDM phone systems. Many of these IP-based phone systems, or IP-PBXs, use a standards-based and highly flexible protocol called session initiation protocol, or SIP, and provide significant cost savings and increased functionality. One of the key benefits for many small businesses is that they now have access to direct inward dial, or DID, capability. DIDs allow each employee to have their own direct phone number and not just an extension. The availability of DIDs allows the end user to take advantage of many productivity enhancing applications such as unified messaging, auto attendant, integrated voicemail, selective call routing and much more.
In early 2005, we began offering our BeyondVoice with SIPconnect service that allows customers to connect their IP-PBX to our integrated access device directly via SIP rather than traditional analog or digital. Direct SIP peering between a customer’s IP-PBX and our VoIP network eliminates the need for the customer to purchase a TDM gateway; significantly reducing their hardware investment. SIP peering also eliminates the VoIP to TDM conversions which reduces the voice traffic latency, thereby increasing the voice quality. End-to-end SIP signaling and a pure IP bearer path lay the foundation for richer communication services than offered by the public switched telephone network today, which are essential to the future of packet-based communications and the delivery of productivity enhancing applications.
The main advantage of our IP network architecture is its low cost structure relative to traditional circuit-switched networks. Our more efficient single-network approach enables us, relative to the historical experiences of legacy carriers, to:
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buy fewer network components (and at lower cost);
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lease fewer telecommunications circuits;
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employ fewer staff;
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rent less collocation space;
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incur lower maintenance costs; and
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integrate fewer support systems.
Legacy competitive carriers often manage numerous overlapping and interconnected network technologies to provide the package of services that we provide on our single all-IP network. Legacy network architectures can include: a circuit-switched local or long distance voice network, digital subscriber line, IP and frame relay data transmission networks, and asynchronous transfer mode and synchronous optical network intracity transport
networks. These different legacy networks generally require the expense and complexity of dedicated circuits and network transmission and monitoring equipment. We believe that we benefit from the efficiency of being able to provide all our services over a single network.
One of the benefits of our IP network is the ability to integrate voice and data packets seamlessly. Bandwidth for voice is dynamically allocated, which allows the customer to enjoy full access to the 1.5 Mbps of bandwidth a T-1 connection affords when no voice traffic is present on the access circuit. When a customer activates a voice line, the allocated bandwidth automatically adjusts to allow the caller the amount of the T-1 connection needed to process the call. This feature allows us to provide increased speed and performance to our customers in their Internet usage while assuring high quality voice service. Because legacy time-division multiplexing service providers must dedicate fixed portions of their customer circuits to voice and data, they are unable to employ dynamic bandwidth allocation.
We organize our network into three groupings of equipment and circuits for purposes of network management and quality measurement:
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the core network, which is located in our data centers and primarily comprises softswitches, backbone routers and media and feature servers;
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the distribution network, which includes collocation equipment such as T-1 aggregation routers and trunking gateways, as well as DS-3 transport circuits; and
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the access network, which comprises the T-1 local loops and integrated access devices that connect customers’ equipment to our extended network.
Our software monitors network quality and tracks potential problems by monitoring each of these network groupings.
The largest single monthly expense associated with our network is the cost of leasing T-1 circuits to connect to our customers. We lease T-1s primarily from the local telephone companies on a wholesale basis using unbundled network element, or UNE, loops or enhanced extended links. An UNE enhanced extended link consists of a T-1 loop connected to the interoffice transport unbundled network element. This design allows us to obtain the functionality of a T-1 loop without the need for collocation in the local telephone company’s serving office. We are able to take advantage of T-1 UNE loop and UNE enhanced extended links and the associated cost-based pricing of each because we meet certain qualifying criteria established by the Federal Communications Commission, or the FCC, for use of these services and because we have built the processes and systems to take advantage of these wholesale circuits, in contrast to many competitive carriers, which lease T-1 circuits under special access, or retail, pricing. As a result of regulatory changes adopted via the FCC’s Triennial Review Remand Order, or TRRO, we are required to lease T-1 circuits under special access pricing when serving customers in certain geographical areas within the cities we serve. See “Government Regulation.”
We employ these wholesale T-1 circuits as follows:
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UNE loops. A UNE loop is the facility that extends from the customer’s premises to our equipment collocated in the local exchange company end-office that serves that customer location. We employ UNE loops when we have a collocation in the central office that serves a customer. We use high-capacity T-1 unbundled loops to serve our customers.
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Enhanced extended links. An enhanced extended link is a combination of an unbundled T-1 loop and an associated T-1 transport element that are joined together by the local telephone company at the end-office serving the customer location. This allows us to obtain access to customer premises without having a collocation at the serving central office. The current FCC rules require local telephone companies to provide T-1 enhanced extended links to carriers subject to certain local use criteria, which we meet. Once we achieve sufficient density from a remote office, we deploy a dedicated DS-3 transport and regroom the T-1 transport elements onto the DS-3 and remove the T-1 transport elements.
Historically, approximately half of our circuits were provisioned using UNE loops and half using enhanced extended links. Our monthly expenses are significantly less when using UNE loops rather than enhanced extended links, but UNE loops require us to incur the capital expenditures of central office collocation equipment. Both UNE loops and enhanced extended links are substantially less expensive for us than special access circuits. We lease DS-3 circuits from local telephone companies or competitive carriers to carry traffic from the end-office collocation to our equipment in a tandem wire center collocation. We install central office collocation equipment in those central offices having the densest concentration of small businesses. We usually launch a market with several collocations and add collocations as the business grows. For example, in Atlanta, our most mature market, we had 15 collocations at the time of our initial public offering in November 2005 and 25 collocations as of December 31, 2007.
Our VoIP technology allows us to concentrate approximately five times as many T-1 circuits onto our DS-3 transport circuits as legacy time-division multiplexing providers. Specifically, we can dynamically allocate available transport bandwidth and can converge and mix voice and data traffic on the network, which offers us significant cost savings.
Our software-based VoIP architecture also provides the flexibility to add services and change features quickly, in contrast to legacy providers whose systems have historically required them to make time consuming physical moves, adds and changes. We believe that our all-IP, private network is optimized to deliver services in an efficient, flexible and cost-effective manner.
Relationship with Cisco Systems
Cisco Systems, Inc., or Cisco Systems, supplies the majority of our VoIP network technology. When we began our business in 2000, we evaluated a number of softswitch technologies and VoIP platforms. As a result, we determined that Cisco Systems’ softswitch represented the most advanced softswitch for our needs, incorporating business-class features that business users require with a higher degree of reliability and sophistication than other competing technologies. In addition, we chose a single-vendor solution in an effort to mitigate the risk of integrating equipment from multiple vendors in a relatively new technology. We believe that the risk of integrating competing products has greatly diminished, and we will deploy those products with the best combination of price and performance going forward, whether from Cisco Systems or competing manufacturers.
Competition
As a managed services provider in the communications industry, we broadly compete with companies that could provide both voice and enhanced services to small businesses in our markets.
As a provider of voice services, our primary competitors are the incumbent local phone companies: Qwest in Denver and AT&T in Atlanta, Dallas, Detroit, Houston, Chicago, Los Angeles, San Diego, and the San Francisco Bay Area. Based on information provided by our customers at the time of activation, approximately 67.4% of our customers used an incumbent local telephone company for local telephone service prior to signing with us, and the remainder used competitive local telephone companies. Many of our customers, prior to joining with us, used multiple vendors for local and long distance voice services and broadband Internet access and have enjoyed the convenience of a sole-sourced service since signing with us. In addition to the local telephone companies, we compete with other competitive carriers in each of our markets. These competitive carriers include Covad Communications Group, Inc., XO Communications, LLC, NuVox Communications, PAETEC, Integra Telecom, Inc., and ITC^Deltacom, Inc., among many others. Certain of these competitive carriers have adopted VoIP technology similar to that employed by us, and in the future we expect others to do so.
In addition, there are other providers using VoIP technology, such as Vonage Holdings Corp., Skype Technologies SA, a subsidiary of eBay, Inc., deltathree, Inc. and 8x8, Inc., which offer service using the public Internet to access their customers. We do not currently view these companies as our direct competitors because
they primarily serve the consumer market and businesses with fewer than four lines. Certain cable television companies, such as Cox Communications, Inc., Comcast Cable Communications, Inc., TimeWarner Cable, Inc. and Cablevision Systems Corp., have deployed VoIP primarily to address consumers and to compete better against local telephone companies for residential customers, although each of these companies also offers packaged services to small business customers. We expect that, in the future, other companies may be formed to take advantage of our VoIP-based business model. Existing companies may also expand their focus in the future to target small business customers. In addition, certain utility companies have begun experimenting with delivering voice and high speed data services over power lines.
In connection with our BeyondMobile offering, we compete with national wireless phone companies, such as AT&T, Sprint Nextel Corporation, T-Mobile USA, Inc. and Verizon Wireless, as well as regional wireless providers.
Government Regulation
Our communications services business is subject to the statutory framework established by Congress, state legislatures and varying degrees of federal, state and local regulation. In contrast to certain other IP-based carriers, we have elected to operate as a common carrier and thus our business does not rely on the regulatory classification of, or regulatory treatment for, IP-based carriers in particular. As a common carrier, we are subject to the jurisdiction of both federal and state regulatory agencies, which have the authority to review our prices, terms and conditions of service. The regulatory agencies exercise minimal control over our prices and services, but do impose various obligations such as reporting, payment of fees and compliance with consumer protection and public safety requirements. In addition, it is possible that, in limited circumstances, we will be subject to requirements placed on “interconnected VoIP providers” in addition to the requirements we are subject to as a common carrier.
We operate as a facilities-based carrier and have received all necessary state and FCC authorizations to do so. Unlike resale carriers, we do not rely upon access to incumbent local exchange carrier switching facilities or capabilities. As a facilities-based carrier, we have undertaken a variety of regulatory obligations, including (for example) providing access to emergency 911 systems, permitting law enforcement officials access to our network upon proper authorization, contributing to the cost of the FCC’s (and, where applicable, the state) universal service programs and making our services accessible to persons with disabilities.
By operating as a common carrier, we also benefit from certain legal rights established by federal legislation, especially the federal Telecommunications Act of 1996, or the Telecom Act, which gives us and other common carrier competitive entrants the right to interconnect to the networks of incumbent telephone companies and access to elements of their networks on an unbundled basis. These rights are not available to providers who do not operate as common carriers. We have used these rights to gain interconnection with the incumbent telephone companies and to purchase selected unbundled network elements, or UNEs, at prices based on incremental cost, especially T-1 loop UNEs that provide us access to our customers’ premises.
Congress, the FCC and state regulators are considering a variety of issues that may result in changes in the statutory and regulatory environment in which we operate our business. Several bills have been introduced regarding telecommunications issues such as the FCC’s power to forbear from enforcing its regulations, but none would have any impact on our right to purchase UNEs. While negative federal legislation is always a possibility, we believe it unlikely that any such negative legislation will be passed by Congress in 2008. The FCC’s current rules, as established in the August 2003 “Triennial Review Order” and subsequent orders discussed below, establish the general framework of regulation that allows us to purchase the UNEs that we buy. In addition, some of the changes under consideration by Congress, the FCC and state regulators may affect our competitors differently than they affect us. For example, the FCC’s elimination of the UNE-P rules several years ago affected resale carriers that seek to compete against us, but elimination of those rules did not affect us, because we never relied on UNE-P as a part of our business model. Changes in the universal service fund may affect the fees we
are required to pay to contribute to funding this program, but since we and our competitors generally pass these fees through to customers, we expect any changes to have minimal competitive effect. Similarly, we do not expect changes in inter-carrier compensation rules to have a material effect on us because we derive the vast majority of our revenues directly from our customers, rather than from other carriers. Reciprocal compensation for termination of local calls is not a significant source of revenue, and we derive relatively little revenue from access charges for origination and termination of long distance calls over our network. The Colorado commission is examining certain UNE rates which may include a review of T-1 and DS-3 UNEs. If these UNEs are included in the docket, it is possible that we would be subject to future rate increases.
Although the nature and effects of governmental regulation are not predictable with certainty, we believe that the FCC is unlikely to adopt rules that extinguish our basic right or ability to compete in the telecommunications markets and that any rule changes that affect us will likely be accompanied by transition periods sufficient to allow us to adjust our business practices accordingly. The following sections describe in more detail the regulatory developments described above and other regulatory matters that may affect our business.
Regulatory Framework
Our business relies heavily on the use of T-1 UNE loops and UNE enhanced extended links, or EELs, that include T-1 loop components, for access to customer premises. Our existing strategy is based on FCC rules that require incumbent local exchange carriers to provide us these UNEs at wholesale prices based on incremental costs. As a result of a court decision, the FCC issued rules, which became effective on March 11, 2005, limiting the obligation of incumbent local exchange carriers to provide UNEs in certain circumstances. The new rules require, among other things, that incumbent local exchange carriers continue providing T-1 UNE loops in most situations, but not in high-density central offices. This exception affects the price we pay to obtain access to T-1 loops in some of the central business districts we serve, as discussed in more detail below. On June 16, 2006, the DC Court of Appeals upheld the FCC’s new rules in their entirety. These rules may nevertheless change at any time due to future FCC decisions, and we are unable to predict how such future developments may affect our business.
The Telecom Act
The Telecom Act, which substantially revised the Communications Act of 1934, established the regulatory preconditions to allow companies like us to compete for the provision of local communications services. Before the passage of the Telecom Act, states typically granted an exclusive franchise in each local service area to a single dominant carrier, often a former subsidiary of AT&T, known as a regional Bell operating company, which owned the entire local exchange network and operated a virtual monopoly in the provision of most local exchange services. The regional Bell operating companies, following some recent consolidation including AT&T finalizing its purchase of BellSouth at the end of 2006, now consist of Verizon, Qwest Communications and AT&T Communications.
Among other things, the Telecom Act preempts state and local governments from prohibiting any entity from providing communications service on a common carrier basis, which has the effect of eliminating prohibitions on entry that existed in almost half of the states at the time the Telecom Act was enacted. At the same time, the Telecom Act preserved state and local jurisdiction over many aspects of local telephone service and, as a result, we are subject to varying degrees of federal, state and local regulation.
The Telecom Act provided the opportunity to accelerate the development of competition at the local level by, among other things, requiring the incumbent carriers to cooperate with competitors’ entry into the local exchange market. To that end, incumbent local exchange carriers are required to allow interconnection of their networks with competitive networks. Incumbent local exchange carriers are further required by the Telecom Act to provide access to certain elements of their network to competitive local exchange carriers.
We have developed our business, including being designated as a common carrier, and designed and constructed our networks to take advantage of the features of the Telecom Act that require cooperation from the incumbent carriers. We believe that the continued viability of the provisions relating to these matters is critical to the success of the competitive regime contemplated by the Telecom Act. There have been numerous attempts to revise or eliminate the basic framework for competition in the local exchange services market through a combination of federal legislation, new FCC rules, and challenges to existing and proposed regulations by the incumbent carriers. We anticipate that Congress will consider a range of proposals to modify the Telecom Act over the next few years, including some proposals that could restrict or eliminate our access to elements of the incumbent local exchange carriers’ networks. We consider it unlikely, however, that Congress would reverse the fundamental policy of encouraging competition in communications markets.
Congress may also consider legislation that would address the impact of the Internet on the Telecom Act. Such legislation could seek to clarify the regulations applicable to VoIP and Internet providers. We believe that such legislation is unlikely to result in the imposition of new regulatory obligations on us, although it is possible that it will eliminate certain regulatory obligations that apply to us as a result of our status as a common carrier.
Federal Regulation
The FCC regulates interstate and international communications services, including access to local communications networks for the origination and termination of these services. We provide interstate and international services on a common carrier basis. The FCC requires all common carriers to obtain an authorization to construct and operate communications facilities and to provide or resell communications services, between the United States and international points. We have secured authority from the FCC for the installation, acquisition and operation of our wireline network facilities to provide facilities-based domestic and international services.
The FCC imposes extensive economic regulations on incumbent local exchange carriers due to their ability to exercise market power. The FCC imposes less regulation on common carriers without market power including, to date, competitive local exchange carriers. Unlike incumbent carriers, our retail services are not currently subject to price cap or rate of return regulation. We are therefore free to set our own prices for end-user services subject only to the general federal guidelines that our charges for interstate and international services be just, reasonable and non-discriminatory. We have filed tariffs with the FCC containing interstate rates we charge to long distance carriers for access to our network, also called interstate access charges. The rates we can charge for interstate access, unlike our end user services, are limited by FCC rules. We are also required to file periodic reports, to pay regulatory fees based on our interstate revenues and to comply with FCC regulations concerning the content and format of our bills, the process for changing a customer’s subscribed carrier and other consumer protection matters. The FCC has the authority to impose monetary forfeitures and to condition or revoke a carrier’s operating authority for violations of these requirements. Our operating costs are increased by the need to assure compliance with these regulatory obligations.
The Telecom Act is intended to increase competition. Specifically, the Telecom Act opens the local services market by requiring incumbent local exchange carriers to permit interconnection to their networks and establishing incumbent local exchange carrier obligations with respect to interconnection with the networks of other carriers, provision of services for resale, unbundled access to elements of the local network, arrangements for local traffic exchange between both incumbent and competitive carriers, number portability, access to phone numbers, access to rights-of-way, dialing parity and collocation of communications equipment in incumbent central offices. Incumbent local exchange carriers are required to negotiate in good faith with carriers requesting any or all of these arrangements. If the negotiating carriers cannot reach agreement within a prescribed time, either carrier may request binding arbitration of the disputed issues by the state regulatory commission. Where an agreement has not been reached, incumbent local exchange carriers remain subject to interconnection obligations established by the FCC and state communications regulatory commissions.
The Telecom Act also permitted a regional Bell operating company to enter the long distance market within its local telephone service area upon showing that certain statutory conditions set forth in Section 271 of the Telecom Act have been met and upon obtaining FCC approval. The FCC has approved regional Bell operating company petitions for in-region long distance for every state in the nation, and each regional Bell operating company is now permitted to offer long distance service to its local telephone customers. The FCC subsequently relieved the Regional Bell Operating Companies, or RBOC, of some of the conditions imposed for Section 271 long distance approval, including in particular conditions that impose obligations to provide access to broadband (although not T-1) UNEs beyond what the FCC has required in its Triennial Review Order, or TRO, and Triennial Review Remand Order, or TRRO, which are discussed below in more detail. As a result of the state commission reviews to implement the FCC’s TRO/TRRO decisions, some states (e.g., Georgia and Illinois) adopted rules to implement the requirement that RBOCs provide competitors with access to network elements pursuant to section 271 or-in the case of Illinois-pursuant to state law. Some states, like Georgia and Illinois, have also adopted rules setting the rates that an RBOC must charge for such network elements. The FCC is currently considering whether to preempt such state regulation of UNEs offered exclusively under Section 271, but the rules are not faring well in various federal court appeals: federal district courts in Atlanta and Chicago recently declared that the Georgia and Illinois Public Service Commissions lacked the authority to set rates for 271 or similar state-based network elements.
Triennial Review Order and Appeals. As discussed above, we rely on provisions of the Telecom Act that require the incumbent local exchange carriers to provide competitors access to elements of their local network on an unbundled basis, known as UNEs. The Telecom Act requires that the FCC consider whether competing carriers would be impaired in their ability to offer telecommunications services without access to particular UNEs.
In the TRO of August 2003, the FCC substantially revised its rules interpreting and enforcing the UNE requirements, while maintaining the general regulatory framework under which we purchase our UNEs. The FCC also adopted new eligibility requirements for the use of UNE EELs. Under these rules, a carrier seeking to purchase an EEL must certify that each circuit so purchased meets specific criteria designed to ensure that the circuit will be used to provide local exchange voice service. We believe, and are prepared to so certify, that all of our EEL circuits satisfy these criteria. These aspects of the Order were not affected by the subsequent court decision reviewing the TRO or by the TRRO.
In the TRO, the FCC also eliminated unbundling for certain incumbent local exchange carrier fiber that utilize packet technology and severely restricted unbundling for fiber loops to homes and, in a subsequent order, other “predominantly residential” locations such as apartment buildings. We currently do not use any fiber-to-home UNEs. We were, therefore, not materially affected by this ruling, although the elimination of UNE loops serving “predominantly residential” buildings could restrict our access to some small business customers.
In March 2004, a court decision required the FCC to reconsider portions of its TRO, and as a result the FCC further revised the rules in the “TRRO” adopted in late 2004, effective March 11, 2005. The TRRO for the most part required that incumbent local exchange carriers continue to make access available to competitors for the high capacity loop and transport UNEs we use. However, the new rules placed new conditions and limitations on the incumbent local exchange carriers’ obligation to unbundle these elements.
Incumbent local exchange carriers are required to continue providing T-1 UNE loops at cost-based rates, except in central offices serving 60,000 or more business lines and in which four or more fiber-based competitors have colocated. Because many of our customers are located in high-density central business districts, some of our existing T-1 loops are affected by this new limitation. An incumbent local exchange carrier is also not required to provide more than 10 T-1 UNE loops to any single building, even in an area in which T-1 loops are unbundled.
Incumbent local exchange carriers are also required to continue providing both T-1 and DS-3 transport circuits, except on routes connecting certain high-density central offices. An incumbent local exchange carrier is
not required to offer UNE T-1 transport (including transport as a component of a T-1 EEL) between central offices that both serve at least 38,000 business lines or have four or more fiber-based collocators. For DS-3 transport, the exemption from bundling applies if both central offices serve at least 24,000 business access lines or have three or more collocators. Again, because of the nature of the markets we serve, many of the T-1 EELs and DS-3 transport circuits we use are affected by this exemption. The FCC also imposed a cap of 12 on DS-3 transport UNEs and a cap of 10 T-1 transport UNEs that must be made available by an incumbent local exchange carrier on any given route, even where the high-density exception does not apply. Due to certain inconsistencies between the rules and the text of the TRRO with regard to the application of the T-1 transport cap, the states have applied that cap inconsistently. Various parties, including us, have petitioned the FCC to reconsider its decision on the transport cap, and these petitions are currently pending with the FCC. On June 16, 2006, the D.C. Circuit Court of Appeals upheld the FCC’s TRRO in its entirety.
We expect that access to T-1 loops serving current and new customer locations will continue to be available to us regardless of future changes in the FCC rules, although not necessarily at current prices. All incumbent local exchange carriers are required, independent of the UNE rules, to offer us some form of T-1 loop and transport services. It is possible that the FCC may establish rates for some of these services at levels that are comparable to current UNE rates, or that we may be able to negotiate reasonable prices for these services through commercial negotiations with incumbent local exchange carriers. However, we cannot be assured that either of these possibilities will occur. If all other options were unavailable, we would be required to pay special access rates for these services. These rates are substantially higher than the rates we pay for UNEs.
SBC/AT&T and Verizon/MCI merger proceedings. In late 2005, the FCC and DOJ approved the mergers of SBC with AT&T and Verizon with MCI. The FCC, however, placed certain conditions on its approval of the mergers. Significantly, the FCC froze UNE pricing for two years and special access pricing for thirty months at current rates. The FCC, however, further ruled that UNE rates under appeal at the time of the conditions are exempt from this provision if higher rates are ultimately required. The Texas rates are still under appeal. If higher rates are ultimately ordered, the rate freeze would not apply.
AT&T/BellSouth merger proceeding. In early 2006, AT&T (formerly SBC/AT&T) and BellSouth announced their agreement to merge, and the merger was closed on December 31, 2006. The DOJ allowed the merger to proceed without conditions, but the FCC, in granting its approval of the merger, imposed significant conditions including an agreement by AT&T not to use FCC forbearance procedures for a period of 42 months, not to seek any UNE rate increases for the same period and to allow competitive carriers to use Interconnection Agreements effective in any AT&T state in any other AT&T state.
TELRIC proceeding. In late 2003, the FCC initiated a proceeding to address the methodology used to price UNEs and to determine whether the current methodology-total element long-run incremental cost, or TELRIC-should be modified. Specifically, the FCC is evaluating whether adjustments should be made to permit incumbent local exchange carriers to recover their actual embedded costs and whether to change the time horizon used to project the forward looking costs. This proceeding is still pending, and we cannot be certain as to either the timing or the result of the agency’s action.
Special Access proceeding. In January 2005, the FCC released a Notice of Proposed Rulemaking to initiate a comprehensive review of rules governing the pricing of special access service offered by incumbent local exchange carriers subject to price cap regulation (including BellSouth, AT&T, Qwest, Verizon and some other incumbent local exchange carriers). To the extent we are no longer able to obtain certain T-1 loops and DS-3 transport circuits as UNEs, we may choose to obtain equivalent circuits as special access, in which case our costs will be determined by the incumbent local exchange carriers’ special access pricing. Special access pricing by the major incumbent local exchange carriers currently is subject to price cap rules as well as pricing flexibility rules which permit these carriers to offer volume and term discounts and contract tariffs (Phase I pricing flexibility) and remove special access service in a defined geographic area from price caps regulation (Phase II pricing flexibility) based on showings of competition. The Notice of Proposed Rulemaking tentatively concludes that the
FCC should continue to permit pricing flexibility where competitive market forces are sufficient to constrain special access prices, but the FCC will undertake an examination of whether the current triggers for pricing flexibility (based on certain levels of collocation by competitors within the defined geographic area) accurately assess competition and have worked as intended. The Notice of Proposed Rulemaking also asks for comment on whether certain aspects of incumbent local exchange carrier special access tariff offerings (e.g. basing discounts on previous volumes of service; tying nonrecurring charges and termination penalties to term commitments; and imposing use restrictions in connection with discounts), are unreasonable. We cannot predict the impact, if any, that this proceeding will have on our cost structure.
Intercarrier compensation. In 2001, the FCC initiated a proceeding to address rules that require one carrier to make payment to another carrier for the exchange of traffic (intercarrier compensation). In its notice of proposed rulemaking, the FCC sought comment on some possible advantages of moving from the current rules to a bill-and-keep structure for all traffic types in which carriers would recover costs from their own customers, not from other carriers. In February 2005, the FCC requested further comments on these issues and on several specific proposed plans for restructuring intercarrier compensation. More recently, AT&T, BellSouth, numerous rural carriers and others offered a new proposal for reforming intercarrier compensation. We currently have little to no revenue exposure to the exchange of local traffic since our traffic is balanced and in most cases subject to bill-and-keep arrangements with other local carriers. We do, however, collect revenue for access charges for the origination and termination of other carriers’ long distance traffic. If the FCC were to move to a mandatory bill-and-keep arrangement for this traffic or to a single cost based rate structure, at significantly lower rates than we currently charge, our revenues would be reduced. We believe, however, that we have much less reliance on this type of revenue than many other competitive providers, because the vast majority of our revenue derives from our end user customers. We also consider it likely that, if the FCC does adopt a bill-and-keep regime, it will provide some opportunity for carriers to adjust other rates to offset lost access revenues. Nevertheless, we cannot predict either the timing or the result of this FCC rulemaking.
Regulatory treatment of VoIP. In February 2004, the FCC initiated a proceeding to address the appropriate regulatory framework for VoIP providers. Currently, the regulatory classification of most VoIP providers is not clear. In the proceeding initiated in 2004, the FCC is considering what regulation is appropriate for VoIP providers and whether the traffic carried by these providers will be subject to access charges. The principal focus of this rulemaking is on whether VoIP providers should be subject to some or all of the regulatory obligations of common carriers. We currently treat our services as subject to common carrier rules and regulations and, as a result, we do not anticipate that future rulings on the regulatory treatment of VoIP will have a material impact on us. Nevertheless, it is possible that the FCC’s classification of VoIP services could affect our rights to obtain T-1 loops and other UNEs.
As part of that proceeding, the FCC adopted new rules requiring all “interconnected VoIP providers” within 120 days to enable all of their customers to reach designated emergency services by dialing 911. Interconnected VoIP providers were also required to deliver notices to their customers advising them of limitations in their 911 emergency services and to make certain compliance filings with the FCC. As a regulated common carrier, however, we provide “traditional” 911 service over our dedicated network. Because the FCC’s definition of the term “interconnected VoIP provider” is not entirely clear, the rules could be interpreted to apply to our services. As such, we took steps to meet the notification and acknowledgement requirements to comply with FCC’s order based on our interpretation of the order. We cannot guarantee that the FCC will agree with our interpretation of its order, should it ever be addressed.
Forbearance proceedings. On March 19, 2006, a Verizon Petition for Forbearance from Title II regulation and other requirements for broadband transmission facilities used to serve large business customers was granted by default as a matter of law due to inaction by the FCC. Thus Verizon has now been relieved of common carrier obligations for these broadband transmission facilities. While the instant relief granted does not have a direct impact on the UNE facilities used by us and appears not to apply to T-1 or DS-3 circuits, it will impact access
rights to higher capacity transmission facilities in the future. All appeals associated with the default grant have been denied, and the grant is now final.
Following the default grant of the Verizon petition, AT&T, Qwest, and BellSouth requested the same relief as that extended to Verizon. AT&T and BellSouth were granted the requested relief. The Qwest petition remains pending. The relief granted to AT&T and BellSouth does not have a direct impact on the UNE T-1, UNE DS-3 or special access facilities we use but will impact access rights to higher capacity transmission facilities in the future. The relief requested in the pending Qwest petition should not have a direct impact on the UNE T-1, UNE DS-3 or special access facilities we use but would impact access rights to higher capacity transmission facilities in the future.
On September 6, 2006, Verizon filed six petitions with the FCC requesting forbearance from the FCC’s unbundling rules. Specifically, Verizon seeks the elimination of all loop and transport unbundling requirements and of dominant carrier regulation for switched access service in Pittsburgh, New York, Boston, Providence, Virginia Beach and Philadelphia. As the basis for its request, Verizon relies upon a decision made in 2005 by the FCC that relieved Qwest of its unbundling obligations in the Omaha MSA and of its dominant carrier status and obligations based on the level of cable penetration in that market. In that proceeding, the FCC eliminated Qwest’s obligation to offer loop and transport UNEs under §251 of the Telecommunications Act of 1996 (the “Act”) in nine wire centers in the Omaha metropolitan statistical area, or MSA, in which the local cable operator has a specified level of facilities build-out. In the same proceeding, the FCC also reaffirmed Qwest’s obligation to continue providing those UNEs under §271 of the Act. The net impact of this FCC action did not eliminate the availability of UNEs in Omaha, but it did make them more expensive. On December 5, 2007, the FCC denied each of the six Verizon petitions in their entirety.
On April 30, 2007, Qwest filed similar forbearance petitions covering Denver, Minneapolis, Phoenix and Seattle. The FCC must act on these petitions by mid-2008.
Despite the recent denials of LEC forbearance petitions (and subject to significant merger-related limitations operating to constrain AT&T forbearance activity until mid-2011), we think there remains a possibility that the regional Bell operating companies and other Incumbent Local Exchange Carriers (ILEC’s) may file additional forbearance petitions in the future seeking elimination of unbundling requirements in other MSAs. We are not aware of wire centers in any MSA in which we currently offer or plan to offer service that would meet the apparent standard for UNE elimination applied in previous forbearance proceedings. Depending on the future levels of facilities-based deployment in the markets at issue, however, such forbearance petitions could eventually raise the prices that we pay for T-1 loops, EELs, and other UNE facilities currently made available under §251 of the Act. Further, additional grants of forbearance in markets where we do not currently have facilities could cause us to adjust or modify plans for expansion into those markets.
Customer proprietary network information (CPNI). In early 2006, the FCC required all carriers to certify compliance with FCC’s CPNI rules and requirements. On February 14, 2006, the FCC initiated a proceeding seeking industry comment on what additional steps the FCC should take, if any, to further protect the privacy of CPNI collected and held by telecommunications carriers. We are unable to predict what new requirements, if any, may be placed on carriers.
We are also subject to federal and state rules and regulations pertaining to CPNI. In connection with these rules and regulations, the FCC has initiated a series of investigations regarding the CPNI practices of individual companies, including ours. The FCC’s investigation of our CPNI compliance began on February 1, 2006. On April 21, 2006, the FCC issued a Notice of Apparent Liability which became part of ongoing discussions between us and the FCC regarding our potential noncompliance with several administrative record-keeping rules. On October 9, 2007, this matter came to a close when we entered into a consent decree with the FCC, whereby we made a payment of $0.2 million to the United States Treasury. We had accurately estimated and recorded this liability in prior periods.
State Regulation
State agencies exercise jurisdiction over intrastate telecommunications services, including local telephone service and in-state toll calls. To date, we are authorized to provide intrastate local telephone, long distance telephone and operator services in California, Colorado, Georgia, Illinois, Texas, Michigan and Florida, as well as in eight other states where we are not yet operational. As a condition to providing intrastate telecommunications services, we are required, among other things, to:
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file and maintain intrastate tariffs or price lists describing the rates, terms and conditions of our services;
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comply with state regulatory reporting, tax and fee obligations, including contributions to intrastate universal service funds; and
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comply with, and to submit to, state regulatory jurisdiction over consumer protection policies (including regulations governing customer privacy, changing of service providers and content of customer bills), complaints, transfers of control and certain financing transactions.
Generally, state regulatory authorities can condition, modify, cancel, terminate or revoke certificates of authority to operate in a state for failure to comply with state laws or the rules, regulations and policies of the state regulatory authority. Fines and other penalties may also be imposed for such violations. As we expand our operations, the requirements specific to any individual state will be evaluated to ensure compliance with the rules and regulations of that state.
In addition, the states have authority under the federal Telecom Act to determine whether we are eligible to receive funds from the federal universal service fund. They also have authority to approve or (in limited circumstances) reject agreements for the interconnection of telecommunications carriers’ facilities with those of the incumbent local exchange carrier, to arbitrate disputes arising in negotiations for interconnection and to interpret and enforce interconnection agreements. In exercising this authority, the states determine the rates, terms and conditions under which we can obtain access to the loop and transport UNEs that are required to be available under the FCC rules. The states may re-examine these rates, terms and conditions from time to time.
State commissions are in the process of implementing the TRO and TRRO by conducting proceedings to interpret the TRO/TRRO requirements for purposes of amending the interconnection agreements as required by the TRRO. Many of these proceedings have concluded for the most part; however, various sub-issues remain under review and decisions are still subject to petitions for reconsideration and appeals in many cases. As such, the orders are not final and changes could occur that would impact the rulings of the state commissions. As a part of the TRRO implementation proceedings, many states are also requiring incumbent local exchange carriers to provide access to the network elements required under Section 271 and in some cases are conducting investigations to provide pricing of 271 network elements. State rulings on our rights to access 271 network elements and the pricing of 271 elements will also be subject to appeals and possibly FCC intervention. California, Georgia, Illinois and Texas have addressed 271 access rights in the context of the TRRO proceedings, but only Georgia set rates for 271 network elements, a decision that was subsequently overturned by a United States District Court. This decision will result in higher access rates for us for a small percentage of circuits that we purchase from BellSouth, but the court explicitly stated that BellSouth may not issue backbills for the period of time during which we were paying lower rates.
State governments and their regulatory authorities may also assert jurisdiction over the provision of intrastate IP communications services where they believe that their authority is broad enough to cover regulation of IP-based services. Various state regulatory authorities have initiated proceedings to examine the regulatory status of IP telephony services. We operate as a regulated carrier subject to state regulation, rules and fees and, therefore, do not expect to be affected by these proceedings. The FCC proceeding on VoIP is expected to address, among other issues, the appropriate role of state governments in the regulation of these services.
Local Regulation
In certain locations, we are required to obtain local franchises, licenses or other operating rights and street opening and construction permits to install, expand and operate our telecommunications facilities in the public rights-of-way. In some of the areas where we provide services, we pay license or franchise fees based on a percentage of gross revenues. Cities that do not currently impose fees might seek to impose them in the future, and after the expiration of existing franchises, fees could increase. Under the federal Telecom Act, state and local governments retain the right to manage the public rights-of-way and to require fair and reasonable compensation from telecommunications providers, on a competitively neutral and non-discriminatory basis, to recover the costs associated with government’s management of the public rights-of-way. As noted above, these activities must be consistent with the federal Telecom Act and may not have the effect of prohibiting us from providing telecommunications services in any particular local jurisdiction. In certain circumstances, we may be subject to local fees associated with construction and operation of telecommunications facilities in the public rights-of-way. To the extent these fees are required, we comply with requirements to collect and remit the fees.
History
We incorporated in March 2000 as Egility Communications, Inc. and changed our name in April 2000 to Cbeyond Communications, Inc. In November 2002, we recapitalized by merging the limited liability company that served as our holding company into Cbeyond Communications, Inc., the surviving entity in the merger. On July 13, 2006, we changed our name from Cbeyond Communications, Inc. to Cbeyond, Inc. Cbeyond, Inc. now serves as a holding company for our subsidiaries and directly owns all of the equity interests of our operating company, Cbeyond Communications, LLC.
Intellectual Property
We do not own any patent registrations, applications, or licenses. We maintain and protect trade secrets, know-how and other proprietary information regarding many of our business processes and related systems. We also hold several federal trademark registrations, including:
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Cbeyond®;
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BeyondVoice®;
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BeyondOffice®;
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BeyondMobile®;
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The last communications company a small business will ever need® ; and
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Cbeyond Logo.
Employees
At December 31, 2007, we had 1,187 employees. None of our employees are represented by labor unions. We believe that relations with our employees are good.
Where You Can Find More Information
Our website address is www.cbeyond.net. The information contained on, or that may be accessed through, our website is not part of this annual report. You may obtain free electronic copies of our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports at our investor relations website, ir.cbeyond.net/index.cfm, under the heading “SEC Filings” or on the Securities and Exchange Commission’s, or the SEC’s, Internet website at www.sec.gov. These reports are available on our investor relations website as soon as reasonably practicable after we electronically file them with the SEC. You can also find our Code of Ethics on our website under the heading “Corporate Governance” or by requesting a copy from us.
Item 1A.
Item 1A. Risk Factors
Risk Related to our Business
The success of our expansion plans depends on a number of factors that are beyond our control.
We have grown our business by entering new geographical markets, and we plan to continue opening three new markets per year. Although we expanded into 3 markets in 2007, there is no guarantee we will be able to maintain our past growth. Our success in expanding to new markets depends on the following factors:
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the availability and retention of qualified and effective local management;
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the overall economic health of the new markets;
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the number and effectiveness of competitors;
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the pricing structure under which we will be able to obtain circuits and purchase other services required to serve our customers;
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our ability to establish a relationship and work effectively with the local telephone company for the provision of access lines to customers; and
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the maintenance of state regulation that protects us from unfair business practices by local telephone companies or others with greater market power who have relationships with us as both competitors and suppliers.
We may not be able to continue to grow our customer base at historic rates, which would result in a decrease in the rate of revenue growth.
We experienced an annual growth rate in customer locations of 28.2% as of December 31, 2007 from December 31, 2006. We may not experience this same growth rate in the future, or we may not grow at all, in our current markets. Future growth in our existing markets may be more difficult than our growth has been to date due to increased or more effective competition in the future, difficulties in scaling our business systems and processes or difficulty in maintaining sufficient numbers of qualified market management personnel, sales personnel and qualified integrated access device installation service providers to obtain and support additional customers. Failure to continue to grow our customer base at historic rates would result in a corresponding decrease in the rate of our revenue growth.
The fixed pricing structure for our integrated packages makes us vulnerable to price increases by our suppliers for network equipment and access fees for circuits that we lease to gain access to our customers.
We offer our integrated packages to customers at a fixed price for one, two or three years. If we experience an increase in our costs due to price increases from our suppliers, vendors or third-party carriers or increases in access, installation, interconnection fees payable to local telephone companies or other fees, we may not be able to pass these increases on to our customers immediately, and this could materially harm our results of operations.
We face intense competition from other providers of communications services that have significantly greater resources than we do. Several of these competitors are better positioned to engage in competitive pricing, which may impede our ability to implement our business model of attracting customers away from such providers.
The market for communications services is highly competitive. We compete, and expect to continue to compete, with many types of communications providers, including traditional local telephone companies. In the future, we may also face increased competition from cable companies, new VoIP-based service providers or other managed service providers with similar business models to our own. We integrated mobile services with our existing services in the first quarter of 2006 and now face competition from mobile service providers as well.
Our current or future competitors may provide services comparable or superior to those provided by us, or at lower prices, or adapt more quickly to evolving industry trends or changing market requirements.
A substantial majority of our target customers are existing small businesses that are already purchasing communications services from one or more of these providers. The success of our operations is dependent on our ability to persuade these small businesses to leave their current providers. Many of these providers have competitive advantages over us, including substantially greater financial, personnel and other resources, better access to capital, brand name recognition and long-standing relationships with customers. These resources may place us at a competitive disadvantage in our current markets and limit our ability to expand into new markets. Because of their greater financial resources, some of our competitors can also better afford to reduce prices for their services and engage in aggressive promotional activities. Such tactics could have a negative impact on our business. For example, some of our competitors have adopted pricing plans such that the rates that they charge are not always substantially higher, and in some cases are lower, than the rates that we charge for similar services. In addition, other providers are offering unlimited or nearly unlimited use of some of their services for an attractive monthly rate. Any of the foregoing factors could require us to reduce our prices to remain competitive or cause us to lose customers, resulting in a decrease in our ARPU and revenue.
Continued industry consolidation could further strengthen our competitors, and we could lose customers or face adverse changes in regulation.
In 2005, Verizon announced its merger with MCI, and SBC announced its merger with AT&T, with the combined company being renamed AT&T. In late 2006, AT&T and BellSouth completed the merger of their two companies. While we believe that, at least in the short term, this increasing consolidation in the communications industry will result in a greater focus on the part of our competitors on the large enterprise and consumer markets, the increased size and market power of these companies may have adverse consequences for us. These competitors could focus their large resources, in the future, on regaining share in the small business sector, and we could lose customers or not grow as rapidly. Furthermore, these companies could use their greater resources to lobby effectively for changes in federal or state regulation that could have an adverse effect on our cost structure or our right to use access circuits that they are currently required to make available to us. These changes would have a harmful effect on our future financial results.
Increasing use of VoIP technology by our competitors, entry into the market by new providers employing VoIP technology and improvements in quality of service of VoIP technology provided over the public Internet could increase competition.
Our success is based partly on our ability to provide voice and broadband services at a price that customers typically pay for voice services alone by taking advantage of cost savings achieved by employing VoIP technology, as compared to using traditional networks. The adoption of VoIP technology by other communications carriers, including existing competitors such as local telephone companies that currently use legacy technologies, could increase price competition.
Moreover, other VoIP providers could also enter the market. Because networks using VoIP technology can be deployed with less capital investment than traditional networks, there are lower barriers to entry in this market, and it may be easier for new entrants to emerge. Increased competition may require us to lower our prices or may make it more difficult for us to retain our existing customers or add new customers.
We believe we generally do not compete with VoIP providers who use the public Internet to transmit communications traffic, as these providers generally do not provide the level and quality of service typically demanded by the business customers we serve. However, future advances in VoIP technology may enable these providers to offer an improved level and quality of service to business customers over the public Internet and with lower costs than using a private network. This development could result in increased price competition.
Our operational support systems and business processes may not be adequate to effectively manage our growth.
Our continued success depends on the scalability of our systems and processes. As of December 31, 2007, none of our individual market operations have supported levels of customers substantially in excess of 8,500, and our centralized systems and processes have not supported more than approximately 35,000 customer locations. We cannot be certain that our systems and processes are adequate to support ongoing growth in customers. In addition, our growing managed services profile, including our new mobile services and associated new applications, may create operating inefficiencies and result in service problems if we are unsuccessful in fully integrating such new services into our existing operations. Failure to manage our future growth effectively could harm our quality of service and customer relationships, which could increase our customer churn, result in higher operating costs, write-offs or other accounting charges and otherwise materially harm our financial condition and results of operations.
We depend on local telephone companies for the installation and maintenance of our customers’ T-1 access lines and other network elements and facilities.
Our customers’ T-1 access lines are installed and maintained by local telephone companies in each of our markets. If the local telephone company does not perform the installation properly or in a timely manner, our customers could experience disruption in service and delays in obtaining our services. Since inception, we have experienced routine delays in the installation of T-1 lines by the local telephone companies to our customers in each of our markets, although these delays have not yet resulted in any material impact to our ability to compete and add customers in our markets. Any work stoppage action by employees of a local telephone company that provides us services in one of our markets could result in substantial delays in activating new customers’ lines and could materially harm our operations. Although local telephone companies may be required to pay fines and penalties to us for failures to provide us with these installation and maintenance services according to prescribed time intervals, the negative impact on our business of such failures could substantially exceed the amount of any such cash payments. Furthermore, we are also dependent on traditional local telephone companies for access to their collocation facilities, and we utilize certain of their network elements. Failure of these elements or damage to a local telephone company’s collocation facility would cause disruptions in our service.
We depend on third-party providers who install our integrated access devices at customer locations. We must maintain relationships with efficient installation service providers in our current cities and identify similar providers as we enter new markets in order to maintain quality in our operations.
The installation of integrated access devices at customer locations is an essential step that enables our customers to obtain our service. We outsource the installation of integrated access devices to a number of different installation vendors in each market. We must ensure that these vendors adhere to the timelines and quality that we require to provide our customers with a positive installation experience. In addition, we must obtain these installation services at reasonable prices. If we are unable to continue maintaining a sufficient number of installation vendors in our markets who provide high quality service at reasonable prices to us, we may have to use our own employees to perform installations of integrated access devices. We may not be able to manage such installations effectively using our own employees with the quality we desire and at reasonable costs.
Some of our services are dependent on facilities and systems maintained by or equipment manufactured by third parties over which we have no control, the failure of which could cause interruptions or discontinuation of some of our services, damage our reputation, cause us to lose customers and limit our growth.
We provide some of our existing services, such as email and web hosting, by reselling to our customers services provided by third parties, and beginning in the first quarter of 2006, we started offering mobile options integrated with our existing services by reselling mobile services provided by an established national third-party mobile carrier and reselling mobile equipment manufactured by third parties. We do not have control over the
networks and other systems maintained by these third parties or their equipment manufacturing processes, facilities or supply chains. If our third-party providers fail to maintain their facilities properly or fail to respond quickly to network or other problems, our customers may experience interruptions in the service they obtain from us or we may not be able to supply the needed mobile equipment. Any service interruptions experienced by our customers could negatively impact our reputation, cause us to lose customers and limit our ability to attract new customers.
We are regulated by the Federal Communications Commission, state public service commissions and local regulating governmental bodies. Changes in regulation could result in price increases on the circuits that we lease from the local telephone companies or losing our right to lease these circuits from them.
We operate in a highly regulated industry and are subject to regulation by telecommunications authorities at the federal, state and local levels. Changes in regulatory policy could increase the fees we must pay to third parties, make certain required inputs for our network less readily available to us or subject us to more stringent requirements that could cause us to incur additional operating expenditures.
The T-1 connections we provide to our customers are leased primarily from our competitors, the local telephone companies. The rules of the FCC, adopted under the Telecommunications Act of 1996, generally entitle us to lease these connections at wholesale prices based on incremental costs. It is possible, though we believe unlikely, that Congress will pass legislation in the future that will diminish or eliminate our right to lease such connections at regulated rates. In addition, a court decision in late 2004 led the FCC to eliminate our right to purchase connections at wholesale prices based on incremental costs in some situations. Therefore, the costs we incur to obtain some of these T-1 connections increased.
Our rights of access to the facilities of local telephone companies may also change as a result of future regulatory decisions, including forbearance petitions as well as court decisions. Although AT&T is prevented by merger conditions placed on it by the FCC from filing forbearance petitions related to UNE availability until at least mid-2010, Qwest is under no such restriction and in fact filed a forbearance petition with the FCC on April 27, 2007 seeking to escape unbundling requirements in Denver, Colorado, where we do business. In December 2007, the FCC denied a similar request from Verizon regarding New York, Philadelphia, Virginia Beach, Pittsburg, Providence and Boston. Should the Denver petition be granted in whole or in part, our access to UNE availability in Denver would be diminished, which may lower our margins in Denver.
Although we expect that we will continue to be able to obtain T-1 connections for our customers, we may not be able to do so at current prices. The pricing for the majority of the T-1 connections we use is established by state regulatory commissions and, from time to time, this pricing is reviewed and the state commission decisions are subject to appeal. If our right to obtain these connections at regulated prices based on incremental costs is further impaired, we will need either to negotiate new commercial arrangements with the local telephone companies to obtain the connections, perhaps at unfavorable rates and conditions, or to obtain other means of providing connections to our customers, which may be expensive and require a long timeframe to implement, either of which may cause us to exit such affected markets and decrease our customer base and revenues.
The FCC is also considering changing its rules for calculating incremental cost-based rates, which could result in either increases or decreases in our cost to lease these facilities. Significant increases in wholesale prices, especially for the loop element we use most extensively, could materially harm our business
The FCC is reexamining its policies towards VoIP and telecommunications in general. New or existing regulation could subject us to additional fees or increase the competition we face.
We currently operate as a regulated common carrier, which subjects us to some regulatory obligations. The FCC adopted rules applicable to “interconnected VoIP providers,” but it has not determined whether to classify interconnected VoIP providers as common carriers. The rules applicable to interconnected VoIP providers
require them to provide access to emergency 911 services for all customers that are comparable to the 911 services provided by traditional telephone networks, to implement certain capabilities for the monitoring of communications by law enforcement agencies pursuant to a subpoena or court order and to contribute to the federal universal service fund. As a common carrier, we currently comply with the 911 requirements, comply with the law enforcement assistance requirements applicable to traditional telecommunications carriers and contribute to the federal universal service fund. The FCC continues to examine its policies towards services provided over IP networks, such as our VoIP technology, and the results of these proceedings could impose additional obligations, fees or limitations on us.
We are also subject to federal and state rules and regulations pertaining to CPNI. In connection with these rules and regulations, the FCC initiated a series of investigations regarding the CPNI practices of individual companies, including ours. The FCC’s investigation of our CPNI compliance has been resolved; however, it is possible there may be additional investigations in the future that may result in fines or assessments.
Regulatory decisions may also affect the level of competition we face. Reduced regulation of retail services offered by local telephone companies could increase the competitive advantages those companies enjoy, cause us to lower our prices in order to remain competitive or otherwise make it more difficult for us to attract and retain customers.
Our customer churn rate may increase.
Customer churn occurs when a customer discontinues their service with us, whether due to going out of business or switching to a competitor. Changes in the economy, as well as increased competition from other providers, can both impact our customer churn rate. We cannot predict general economic conditions. Nor can we predict future pricing by our competitors, but we anticipate that aggressive price competition will continue. Lower prices offered by our competitors could contribute to an increase in customer churn. Although our customer churn rate was approximately 1.0% per month for the years ended December 31, 2005 and 2006 and also for the first half of 2007, our churn has recently increased to 1.1% in the third quarter of 2007 and to 1.4% in the fourth quarter of 2007. We believe this elevated churn is due to general economic factors. We also believe churn will continue to be elevated through at least the first quarter of 2008. While we believe churn may be reduced in future periods, there is no assurance that this will occur, as we cannot predict the effects or duration of the current economic downturn. Higher customer churn rates could adversely impact our revenue growth. A sustained and significant growth in the churn rate could have a material adverse effect on our business.
We obtain the majority of our network equipment and software from Cisco Systems, Inc. Our success depends upon the quality, availability and price of Cisco’s network equipment and software.
We obtain the majority of our network equipment and software from Cisco Systems. In addition, we rely on Cisco Systems for technical support and assistance. Although we believe that we maintain a good relationship with Cisco Systems and our other suppliers, if Cisco Systems or any of our other suppliers were to terminate our relationship or were to cease making the equipment and software we use, our ability to maintain, upgrade or expand our network could be impaired. Although we believe that we would be able to address our future equipment needs with equipment obtained from other suppliers, we cannot assure you that such equipment would be compatible with our network without significant modifications or cost, if at all. If we were unable to obtain the equipment necessary to maintain our network, our ability to attract and retain customers and provide our services would be impaired. In addition, our success depends on our obtaining network equipment and software at affordable prices. Significant increases in the price of these products would harm our financial results and may increase our capital requirements.
We depend on third-party vendors for information systems. If these vendors discontinue support for the systems we use or fail to maintain quality in future software releases, we could sustain a negative impact on the quality of our services to customers, the development of new services and features and the quality of information needed to manage our business.
We have entered into agreements with vendors that provide for the development and operation of back office systems, such as ordering, provisioning and billing systems. We also rely on vendors to provide the systems for monitoring the performance and condition of our network. The failure of those vendors to perform their services in a timely and effective manner at acceptable costs could materially harm our growth and our ability to monitor costs, bill customers, provision customer orders, maintain the network and achieve operating efficiencies. Such a failure could also negatively impact our ability to retain existing customers or to attract new customers.
We use software technology developed internally and by third-party vendors, and hardware technology developed by third-party vendors. We or any of these vendors could be subject of a lawsuit alleging a violation of the intellectual property of third parties.
We have created software systems, purchased software from third-party vendors and purchased hardware from third-party vendors. Our contracts with these vendors provide indemnification for Cbeyond should any entity allege that Cbeyond is violating its intellectual property. Should an entity bring suit or otherwise pursue intellectual property claims against us based on its own technology or the technology of third-party vendors, the result of those claims could be to raise our costs or deny us access to technology currently necessary to our network or software systems.
If we are unable to generate the cash that we need to pursue our business plan, we may have to raise additional capital on terms unfavorable to our stockholders.
The actual amount of capital required to fund our operations and development may vary materially from our estimates. If our operations fail to generate the cash that we expect, we may have to seek additional capital to fund our business. If we are required to obtain additional funding in the future, we may have to sell assets, seek debt financing or obtain additional equity capital. In addition, the terms of our secured revolving line of credit with Bank of America subjects us to restrictive covenants limiting our flexibility in planning for, or reacting to changes in, our business, and any other indebtedness we incur in the future is likely to include similar covenants. If we do not comply with such covenants, our lenders could accelerate repayment of our debt or restrict our access to further borrowings. If we raise funds by selling more stock, our stockholders’ ownership in us will be diluted, and we may grant future investors rights superior to those of the common stockholders. If we are unable to obtain additional capital when needed, we may have to delay, modify or abandon some of our expansion plans. This could slow our growth, negatively affect our ability to compete in our industry and adversely affect our financial condition.
If we cannot negotiate new (or extensions of existing) interconnection agreements with local telephone companies on acceptable terms, it will be more difficult and costly for us to provide service to our existing customers and to expand our business.
We have agreements for the interconnection of our network with the networks of the local telephone companies covering each market in which we operate. These agreements also provide the framework for service to our customers when other local carriers are involved. We will be required to negotiate new interconnection agreements to enter new markets in the future. In addition, we will need to negotiate extension or replacement agreements as our existing interconnection agreements expire. Most of our interconnection agreements have terms of three years, although the parties may mutually decide to amend the terms of such agreements. If we cannot negotiate new interconnection agreements or renew our existing interconnection agreements on favorable terms or at all, we may invoke binding arbitration by state regulatory agencies. The arbitration process is expensive and time-consuming, and the results of an arbitration may be unfavorable to us. If we are unable to
obtain favorable interconnection terms, it would harm our existing operations and opportunities to grow our business in our current and new markets.
Our competitors may be better positioned than we are to adapt to rapid changes in technology, and we could lose customers.
The communications industry has experienced, and will probably continue to experience, rapid and significant changes in technology. Technological changes, such as the use of wireless network access to customers in place of the T-1 access lines we lease from the local telephone companies, could render aspects of the technology we employ suboptimal or obsolete and provide a competitive advantage to new or larger competitors who might more easily be able to take advantage of these opportunities. Some of our competitors, including the local telephone companies, have a much longer operating history, more experience in making upgrades to their networks and greater financial resources than we do. We cannot assure you that we will obtain access to new technologies as quickly or on the same terms as our competitors, or that we will be able to apply new technologies to our existing networks without incurring significant costs or at all. In addition, responding to demand for new technologies would require us to increase our capital expenditures, which may require additional financing in order to fund. As a result of those factors, we would lose customers and our financial results could be harmed.
System disruptions could cause delays or interruptions of our service, which could cause us to lose customers or incur additional expenses.
Our success depends on our ability to provide reliable service. Although we have designed our network service to minimize the possibility of service disruptions or other outages, our service may be disrupted by problems on our system, such as malfunctions in our software or other facilities, overloading of our network and problems with the systems of competitors with which we interconnect, such as physical damage to telephone lines and power surges and outages. Although we have experienced isolated power disruptions and other outages for short time periods, we have not had any system disruptions of a sufficient duration or magnitude that would have a significant impact to our customers or our business. Any significant disruption in our network could cause us to lose customers and incur additional expenses.
Business disruptions, including disruptions caused by security breaches, terrorism or other disasters, could harm our future operating results.
The day-to-day operation of our business is highly dependent on the integrity of our communications and information technology systems, and on our ability to protect those systems from damage or interruptions by events beyond our control. Sabotage, computer viruses or other infiltration by third parties could damage our systems. Such events could disrupt our service, damage our facilities, damage our reputation, and cause us to lose customers, among other things, and could harm our results of operations. In addition, a catastrophic event could materially harm our operating results and financial condition. Catastrophic events could include a terrorist attack on the United States, or a major earthquake, fire, or similar event that affects our central offices, corporate headquarters, network operations center or network equipment. We believe that communications infrastructures, such as the one on which we rely, may be vulnerable in the case of such an event, and our markets, which are metropolitan markets, or Tier 1 markets, may be more likely to be the targets of terrorist activity.
We have had material weaknesses in internal control over financial reporting in the past and cannot assure you that additional material weaknesses will not be identified in the future. Our failure to implement and maintain effective internal control over financial reporting could result in material misstatements in our financial statements which could require us to restate financial statements, cause investors to lose confidence in our reported financial information and have a negative effect on our stock price.
During 2003 and 2004, management and our independent registered public accounting firm identified material weaknesses in our internal control over financial reporting, as defined in the standards established by the
American Institute of Certified Public Accountants, that affected our financial statements for each of the years in the four-year period ended December 31, 2004.
We cannot assure you that additional material weaknesses in our internal control over financial reporting will not be identified in the future. Any failure to maintain or implement required new or improved controls, or any difficulties we encounter in their implementation, could result in additional material weaknesses, cause us to fail to meet our periodic reporting obligations or result in material misstatements in our financial statements. Any such failure could also adversely affect the results of periodic management evaluations and annual auditor attestation reports regarding the effectiveness of our internal control over financial reporting required under Section 404 of the Sarbanes-Oxley Act of 2002. The existence of a material weakness could result in errors in our financial statements that could result in a restatement of financial statements, cause us to fail to meet our reporting obligations and cause investors to lose confidence in our reported financial information, leading to a decline in our stock price.
We have not been profitable in the past and we may not continue to be profitable in the future.
We have experienced losses in the past. For the year ended December 31, 2005, we recorded a net loss of approximately $0.3 million (excluding the gain of $4.1 million from the payoff of our debt). Although we recorded net income of $21.5 million and $7.8 million for the years ended December 31, 2007 and 2006, respectively, this does not guarantee positive income in the future.
Risks Related To Our Common Stock
Future sales of shares by existing stockholders or issuances of our common stock by us could reduce our stock price.
If our existing stockholders sell substantial amounts of our common stock in the public market or we issue additional shares of common stock, par value $0.01 per share, the market price of our common stock could decline.
We may also issue shares of our common stock from time to time as consideration for future acquisitions and investments. If any such acquisition or investment is significant, the number of shares that we issue may in turn be significant. In addition, we may grant registration rights covering those shares in connection with any such acquisitions and investments.
In the future, we may sell additional shares of our common stock to raise capital. We cannot predict the size of future issuances or the effect, if any, that they may have on the market price of our common stock. The issuance and sales of substantial amounts of common stock, or the perception that such issuances and sales may occur, could adversely affect the market price of our common stock.
Anti-takeover provisions in our charter documents and Delaware corporate law might deter acquisition bids for us that our stockholders might consider favorable.
Our amended and restated certificate of incorporation provides for a classified board of directors; the inability of our stockholders to call special meetings of stockholders, to act by written consent, to remove any director or the entire board of directors without cause, or to fill any vacancy on the board of directors; and advance notice requirements for stockholder proposals. Our board of directors is also permitted to authorize the issuance of preferred stock with rights superior to the rights of the holders of common stock without any vote or further action by our stockholders. These provisions and other provisions under Delaware law could make it difficult for a third party to acquire us, even if doing so would benefit our stockholders.
Because we do not currently intend to pay dividends on our common stock, stockholders will benefit from an investment in our common stock only if it appreciates in value.
The continued expansion of our business will require substantial funding. Accordingly, we do not currently anticipate paying any dividends on shares of our common stock. Any determination to pay dividends in the future will be at the discretion of our board of directors and will depend upon results of operations, financial condition, contractual restrictions, restrictions imposed by applicable law and other factors our board of directors deems relevant. Accordingly, realization of a gain on stockholders’ investments will depend on the appreciation of the price of our common stock. There is no guarantee that our common stock will appreciate in value or even maintain the price at which stockholders purchased their shares.
Item 1B.
Item 1B. Unresolved SEC Staff Comments
None.
Item 2.
Item 2. Properties
We lease a 124,227 square-foot facility for our corporate headquarters in Atlanta. We also lease data center facilities in Atlanta and in Dallas as well as sales office facilities in each of our markets outside of Atlanta. Our total rental expenses for the year ended December 31, 2007 were approximately $0.6 million for our collocation and data center facilities and approximately $4.4 million for our offices. We do not own any real estate. Our management believes that our properties, taken as a whole, are in good operating condition and are suitable for our business operations. As we expand our business into new markets, we expect to lease additional data center facilities and sales office facilities.
(1) Represents the term date of the most significant lease for each respective market.
From time to time, as we have entered into new leases or extend existing lease terms, we have received leasehold improvement concession allowances and free rent abatement. In accordance with the guidance under FASB Statement No. 13, Accounting for Leases, FASB Staff Position No. FAS 13-1, Accounting for Rental Costs Incurred During a Construction Period, and FASB Technical Bulletin No. 88-1 (as amended), Issues Relating to Accounting for Leases, we have included these tenant incentives in our straight-line rent expense over the life of the lease and are amortizing the leasehold improvements to depreciation expense over the shorter of the useful life of the asset(s) added or the lease term. Our lease agreements also generally have lease renewal options that are at our discretion and range in terms.
Item 3.
Item 3. Legal Proceedings
From time to time, we are involved in legal proceedings arising in the ordinary course of our business. We believe that we have adequately reserved for these liabilities and that, as of December 31, 2007, there is no litigation pending that could have a material adverse effect on our results of operations and financial condition.
Item 4.
Item 4. Submission of Matters to a Vote of Stockholders
No matters were submitted to a vote of security holders during the fourth quarter of 2007.
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market Price Information and Dividend Policy for Our Common Stock
Our common stock is currently traded on the Nasdaq Global Market under the symbol “CBEY.” Prior to November 2, 2005, no established public trading market for our common stock existed.
As of February 27, 2008, there were approximately 86 holders of record of shares of our common stock.
The table below shows, for the quarters indicated, the reported high and low trading prices of our common stock on The Nasdaq Global Market:
As of February 27, 2008, the closing price of our common stock was $17.42.
We have never paid or declared any dividends on our common stock and do not anticipate paying any dividends in the foreseeable future. The terms of our line of credit with Bank of America restrict our ability to pay dividends on our common stock. We currently anticipate that we will use any future earnings for use in the operation of our business and to fund future growth. The decision whether to pay dividends will be made by our board of directors in light of conditions then existing, including factors such as our results of operations, financial condition and requirements, business conditions and covenants under any applicable contractual arrangements.
Securities Authorized for Issuance Under Equity Compensation Plans
We issue our employees share-based awards under our 2005 Equity Incentive Award Plan (the “2005 Plan”), which has been approved by our stockholders. The following table provides information as of December 31, 2007 regarding outstanding options and shares reserved for future issuance under the 2005 Plan:
(1) Shares remaining for issuance under the 2002 Equity Incentive Award Plan and the 2000 Equity Incentive Award Plan were rolled into the 2005 Plan, pursuant to our registration statement on Form S-8 (File No. 333-129556) filed with the SEC on November 8, 2005.
Transfer Agent and Registrar
American Stock Transfer and Trust Company is the transfer agent and registrar for our common stock.
Item 6.
Item 6. Selected Financial Data
You should read the following selected consolidated financial data in conjunction with our consolidated financial statements and related notes thereto and with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this report. The statement of operations data for the years ended December 31, 2007, 2006 and 2005, and the balance sheet data as of December 31, 2007 and 2006, are derived from, and are qualified by reference to, the audited financial statements and notes thereto included elsewhere in this Form 10-K. The statement of operations data for the years ended December 31, 2004 and 2003, and the balance sheet data as of December 31, 2005, 2004 and 2003, are derived from the audited financial statements not included herein. Historical results are not necessarily indicative of results to be expected in the future.
(1) Represents cash and non-cash purchases of property and equipment on a combined basis.
(2) Adjusted EBITDA is not a substitute for operating income, net income, or cash flow from operating activities as determined in accordance with generally accepted accounting principles, or GAAP, as a measure of performance or liquidity. See “Non-GAAP Financial Measures” for our reasons for including adjusted EBITDA data in this report and for material limitations with respect to the usefulness of this measurement. The following table sets forth a reconciliation of total adjusted EBITDA to net income (loss):
NON-GAAP FINANCIAL MEASURES
We use the total adjusted EBITDA of our reportable segments as a principal indicator of the operating performance of our business on a consolidated basis. Our chief executive officer, who is our chief operating decision maker, also uses our segment adjusted EBITDA to evaluate the performance of our reportable segments in accordance with SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information. EBITDA represents net income (loss) before interest, income taxes, depreciation and amortization. We define adjusted EBITDA as net income (loss) before interest, income taxes, depreciation and amortization expenses, excluding, when applicable, non-cash share-based compensation, public offering expenses, gain recognized on troubled debt restructuring, gain from write-off of carrying value in excess of principal, loss on disposal of property and equipment and other non-operating income or expense. Our total adjusted EBITDA represents the sum of adjusted EBITDA for each of our segments.
Our total adjusted EBITDA is a non-GAAP financial measure. Our management uses total adjusted EBITDA in its decision-making processes relating to the operation of our business together with GAAP measures such as revenue and income from operations.
Our calculation of total adjusted EBITDA excludes, when applicable:
•
the gains related to our troubled debt restructuring in 2002, public offering expenses incurred and the gain from the early payoff of our restructured debt in 2005; and
•
non-cash share-based compensation, loss on disposal of property and equipment and other non-operating income or expense, none of which are used by management to assess the operating results and performance of our segments or our consolidated operations.
Our management believes that total adjusted EBITDA permits a comparative assessment of our operating performance, relative to our performance based on our GAAP results, while isolating the effects of depreciation and amortization, which may vary from period to period without any correlation to underlying operating performance, and of non-cash share-based compensation, which is a non-cash expense that varies widely among similar companies. We provide information relating to our total adjusted EBITDA so that investors have the same data that we employ in assessing our overall operations. We believe that trends in our total adjusted EBITDA are a valuable indicator of the operating performance of our company on a consolidated basis and of our operating segments’ ability to produce operating cash flow to fund working capital needs, to service debt obligations and to fund capital expenditures.
In addition, total adjusted EBITDA is a useful comparative measure within the communications industry because the industry has experienced recent trends of increased merger and acquisition activity and financial restructurings, which have led to significant variations among companies with respect to capital structures and cost of capital (which affect interest expense) and differences in taxation and book depreciation of facilities and equipment (which affect relative depreciation expense), including significant differences in the depreciable lives of similar assets among various companies, as well as non-operating or infrequent charges to earnings, such as the effect of debt restructurings.
Accordingly, total adjusted EBITDA allows analysts, investors and other interested parties in the communications industry to facilitate company to company comparisons by eliminating some of the foregoing variations. Total adjusted EBITDA as used in this report may not, however, be directly comparable to similarly titled measures reported by other companies due to differences in accounting policies and items excluded or included in the adjustments, which limits its usefulness as a comparative measure.
Our calculation of total adjusted EBITDA is not directly comparable to EBIT (earnings before interest and taxes) or EBITDA. In addition, total adjusted EBITDA does not reflect:
•
our cash expenditures, or future requirements, for capital expenditures or contractual commitments;
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changes in, or cash requirements for, our working capital needs;
•
our interest expense, or the cash requirements necessary to service interest or principal payments on our debts; and
•
any cash requirements for the replacement of assets being depreciated and amortized, which will often have to be replaced in the future, even though depreciation and amortization are non-cash charges.
Total adjusted EBITDA is not intended to replace operating income, net income (loss) and other measures of financial performance reported in accordance with GAAP. Rather, total adjusted EBITDA is a measure of operating performance that you may consider in addition to those measures. Because of these limitations, total adjusted EBITDA should not be considered as a measure of discretionary cash available to us to invest in the growth of our business. We compensate for these limitations by relying primarily on our GAAP results and using total adjusted EBITDA as a supplemental financial measure.
Item 7.
Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
You should read the following discussion together with our consolidated financial statements and the related notes and other financial information included elsewhere in this report. The discussion in this report contains forward-looking statements that involve risks and uncertainties, such as statements of our plans, objectives, expectations and intentions. The cautionary statements made in this report should be read as applying to all related forward-looking statements wherever they appear in this report. Our actual results could differ materially from those discussed here.
In this report, Cbeyond, Inc. and its subsidiaries are referred to as “we”, the “Company” or “Cbeyond”.
Overview
We provide managed IP-based communications services to our target customers of small businesses with 5 to 249 employees in selected large metropolitan areas. We provide these services through bundled packages of local and long distance voice services, broadband Internet services and mobile services, together with additional applications and services, for an affordable fixed monthly fee under contracts with terms of one, two or three years. We currently operate in Atlanta, Dallas, Denver, Houston, Chicago, Los Angeles, San Diego, Detroit and the San Francisco Bay Area, and, beginning in the first quarter of 2008, Miami.
We sell three integrated packages of services, primarily delineated by the number of local voice lines, long distance minutes and T-1 connections provided to the customer. Each of our BeyondVoice packages includes local and long distance voice services and broadband Internet access, plus additional value-added applications. Customers may also choose to add extra features or lines for an additional fee. Beginning in the first quarter of 2006, we started offering mobile services, which are integrated with our existing landline services.
Our voice services (other than our mobile voice services) are delivered using VoIP technology, and all of such services are delivered over our secure all-IP network, which we believe affords greater service flexibility and significantly lower network costs than traditional service providers using circuit-switch technologies. We offer our mobile voice and data services via our mobile virtual network operator relationship with a nationwide wireless network provider. We believe our high degree of systems automation contributes to operational efficiencies and lower costs in our support functions.
We sell our services primarily through a direct sales force in each market, supplemented by sales agents. These agents often have other business relationships with the customer and, in many cases, perform equipment installations for us at our customers’ sites. A significant portion of our new customers are generated by referrals from existing customers and partners. We offer financial incentives to our customers and other sources for referrals.
We compete primarily against incumbent local exchange carriers and, to a lesser extent, against competitive local exchange carriers, both of which are local telephone companies. Local telephone companies do not generally have the same focus on our target market and principally concentrate on medium or large enterprises or residential customers. In addition, cable television providers have begun serving the small business market with telephone service, in addition to high speed Internet access and video. To date, we have not experienced significant competition from cable television providers and do not believe that they intend to offer the breadth of services and applications that our customers purchase from us. We compete primarily based on our high-value bundled services that bring many of the same managed services to our customers that have historically been available only to large businesses, as well as based on our customer care, network reliability and operational efficiencies.
We formed Cbeyond and began the development of our network and business processes following our first significant funding in early 2000. We launched our first market early in 2001 and have since expanded operations into nine additional markets. The following comprises the service launch date for our current markets and the anticipated launch date of our future announced markets:
In future years, we generally expect to continue opening three new markets per year and intend to establish operations in the largest 25 markets.
We focus on adjusted EBITDA as a principal indicator of the operating performance of our business. EBITDA represents net income (loss) before interest, income taxes, depreciation and amortization. We define adjusted EBITDA as net income (loss) before interest, income taxes, depreciation and amortization expenses, excluding, when applicable, non-cash share-based compensation, public offering expenses, gains related to our troubled debt restructuring and our early payoff of the restructured debt, gain or loss on disposal of property and equipment and other non-operating income or expense. In our presentation of segment financial results, adjusted EBITDA for a geographic segment does not include corporate overhead expense and other centralized operating costs. We believe that adjusted EBITDA trends are a valuable indicator of our operating segments’ relative performance and of whether our operating segments are able to produce operating cash flow to fund working capital needs, to service debt obligations and to fund capital expenditures.
We believe our business approach requires significantly less capital to launch operations compared to traditional communications companies using legacy technologies. Based on our historical experience, over time, a substantial majority of our market-specific capital expenditures are success-based, incurred primarily as our customer base grows. We believe the success-based nature of our capital expenditures mitigates the risk of unprofitable expansion. We have a relatively low fixed-cost component in our budgeted capital expenditures associated with each new market we enter, particularly in comparison to service providers employing time-division multiplexing, which is a technique for transmitting multiple channels of separate data, voice and/or video signals simultaneously over a single communication medium, or circuit-switch technology, which is a switch that establishes a dedicated circuit for the entire duration of a call.
The nature of the primary components of our operating results-revenues, cost of revenue and selling, general and administrative expenses-are described below:
Revenue
The majority of our customers subscribe to our BeyondVoice I package, which serves customers with 4-15 local voice lines, or generally 30 or fewer employees. We also sell subscriptions of BeyondVoice II to customers with 16-24 local voice lines, or generally 31-100 employees. Our BeyondVoice III package is typically offered to
customers with 101-249 employees. Each BeyondVoice I customer receives all our services over a dedicated broadband T-1 connection providing a maximum symmetric bandwidth of 1.5 Mbps (megabits per second). BeyondVoice II customers receive their services over two dedicated T-1 connections offering a maximum symmetric bandwidth of 3.0 Mbps. BeyondVoice III customers receive their services over three dedicated T-1 connections offering a maximum symmetric bandwidth of 4.5 Mbps. We believe that our customers highly value the level of symmetric bandwidth offered with our services. As of December 31, 2007, approximately 84.1% of our customer base had BeyondVoice I, 14.8% had BeyondVoice II, and 1.1% had BeyondVoice III.
Average monthly revenue per customer location was $748 for the year ended December 31, 2007, compared to $747 for the same period in 2006.
Average monthly revenue per customer location is impacted by a variety of factors, including the distribution of customer installations during a period, the adoption by customers of applications for which incremental fees are paid, the trend toward customers signing three-year contracts at lower package prices as compared to shorter term contracts, the amount of long distance call volumes that may generate overage charges above the basic amount of minutes included in customers’ packages as well as additional terminating access charges and customer usage and purchase patterns. We expect average monthly revenue per customer location to be relatively stable in future periods. Customer revenues represented approximately 97.8%, 97.5% and 97.4% of total revenues in 2007, 2006 and 2005, respectively. Access charges paid to us by other communications companies to terminate calls to our customers represented the majority of the remainder of total revenues.
Customer revenues are generated under contracts that typically run for three-year terms. Therefore, customer churn rates have an impact on projected future revenue streams. Throughout our history, we have maintained monthly churn rates of approximately 1.0%, but have recently experienced elevated rates attributable, primarily, to deteriorating economic conditions. Specifically, we experienced an average monthly churn rate of 1.1% in the third quarter of 2007 and 1.4% in the fourth quarter of 2007. We expect an elevated level to continue through at least the first quarter of 2008. In response to deteriorating economic conditions, we have taken steps which we believe will mitigate the risk of heightened churn and bad debt levels on a longer term basis. These steps include a tightening of credit and collection policies and practices for customers with a higher risk profile.
Cost of Revenue
Our cost of revenue represents costs directly related to the operation of our network, including payments to the local telephone companies and other communications carriers such as long distance providers and our mobile provider, for access, interconnection and transport fees for voice and Internet traffic, customer circuit installation expenses paid to the local telephone companies, fees paid to third-party providers of certain applications such as web hosting services, collocation rents and other facility costs, telecommunications-related taxes and fees, and the cost of mobile handsets. The primary component of cost of revenue is the access fees paid to local telephone companies for the T-1 circuits we lease on a monthly basis to provide connectivity to our customers. These access circuits link our customers to our network equipment located in a collocation facility, which we lease from local telephone companies. The access fees for these circuits vary by state and are the primary reason for differences in cost of revenue across our markets.
As a result of the TRRO, we are required to lease circuits under special access, or retail, rates in locations that are deemed to offer competitive facilities as outlined in the FCC’s regulations and interpreted by the state regulatory agencies. For additional discussion, see “Results of Operations-Revenue and Cost of Revenue.”
Where permitted by regulation, we lease our access circuits on a wholesale basis as UNE loops or extended enhanced loops as provided for under the FCC’s Telecommunications Elemental Long Run Incremental Cost rate
structure. We employ UNE loops when the customer’s T-1 circuit is located where it can be connected to a local telephone company’s central office where we have a collocation, and we use extended enhanced links when we do not have a central office collocation available to serve a customer’s T-1 circuit. Historically, approximately half of our circuits are provisioned using a combination of UNE and Special Access loops and half using extended enhanced links, although the impact of the TRRO has reduced our usage of the T-1 transport portion of extended enhanced links and resulted in the conversion of a majority of the previously installed T-1 transports to DS-3 transports. Our monthly expenses are significantly less when using UNE loops rather than extended enhanced links, but UNE loops require us to incur the capital expenditures of central office collocation equipment. Both UNE loops and extended enhanced loops offer significant cost advantages over special access-based circuits. We install central office collocation equipment in those central offices having the densest concentration of small businesses. We usually launch operations in a new market with several collocations and add additional collocation facilities over time as we confirm the most advantageous locations in which to deploy the equipment. We believe our discipline of leasing these T-1 access circuits on a wholesale basis rather than on the basis of special access rates from the local telephone companies is an important component of our operating cost structure.
We receive service credits from various local telephone companies to adjust for prior errors in billing, including the effect of price decreases retroactively applied upon the adoption of new rates as mandated by regulatory bodies. These service credits are often the result of negotiated resolutions of bill disputes that we conduct with our vendors. We also receive payments from the local telephone companies in the form of performance penalties that are assessed by state regulatory commissions based on the local telephone companies’ performance in the delivery of circuits and other services that we use in our network. Because of the many factors, as noted, that impact the amount and timing of service credits and performance penalties, estimating the ultimate outcome of these situations is uncertain. Accordingly, we recognize service credits and performance penalties as offsets to cost of revenue when the ultimate resolution and amount are known. These items do not follow any predictable trends and often result in variances when comparing the amounts received over multiple periods.
Selling, General and Administrative Expenses
Our selling, general and administrative expenses consist of salaries and related costs for employees and other expenses related to sales and marketing, engineering, information technology, billing, regulatory, administrative, collections and legal and accounting functions. In addition, share-based compensation expense is included in selling, general and administrative expense. Our selling, general and administrative expenses include both fixed and variable costs. Fixed selling expenses include salaries and office rents. Variable selling costs include commissions and marketing collateral. Fixed general and administrative costs include the cost of staffing certain corporate overhead functions such as IT, marketing, administrative, billing and engineering, and associated costs, such as office rent, legal and accounting fees, property taxes and recruiting costs. Variable general and administrative costs include the cost of provisioning and customer activation staff, which grows with the level of installation of new customers, and the cost of customer care and technical support staff, which grows with the level of total customers on our network. As we expand into new markets, certain fixed costs are likely to increase; however, these increases are intermittent and not proportional with the growth of customers.
Results of Operations
Year Ended December 31, 2007 Compared to Year Ended December 31, 2006
Revenue and Cost of Revenue (Dollar amounts in thousands, except average revenue per customer location)
Revenue. Total revenue increased for the twelve months ended December 31, 2007 compared to the twelve months ended December 31, 2006 in proportion to the increase in the average number of customers year over year and a slight increase in average monthly revenue per customer location from the twelve months ended December 31, 2007 to the twelve months ended December 31, 2006. We expect average monthly revenue per customer location to be relatively stable in future periods.
Revenues from access charges paid to us by other communications companies to terminate calls to our customers increased for the twelve month comparison period. These terminating access charges grew substantially less than our customer base during the current year due to reductions in access rates on interstate calls as mandated by the FCC. These rate reductions were anticipated and are expected to continue in the future.
The following comprises the segment contributions to the increase in revenue in the twelve month period ended December 31, 2007 as compared to the twelve month period ended December 31, 2006 (Dollar amounts in thousands):
Cost of Revenue. Cost of revenue increased for the twelve month period of 2007 compared to the twelve month period of 2006 in proportion to the increase in the average number of customers year over year. As a percentage of total revenue, cost of revenue slightly increased to 30.2% in the twelve months ended December 31, 2007 from 30.1% in the twelve months ended December 31, 2006.
Circuit access fees, or line charges, which primarily relate to our lease of T-1 circuits connecting our equipment at network points of collocation to our equipment located at our customers’ premises, represented the largest component of cost of revenue. The increase in circuit access fees is correlated to the increase in the number of customers as well as a rise in circuit access fees due to the impact of the TRRO (described below); however, these costs are offset by savings related to our ongoing network optimization efforts.
The other principal components of cost of revenue include long distance charges, installation costs to connect new circuits, the cost of transport circuits between network points of presence, the cost of local interconnection with the local telephone companies’ networks, Internet access costs, the cost of third-party applications we provide to our customers, access costs paid by us to other carriers to terminate calls from our customers and certain taxes and fees, and the costs of mobile handsets. As a percent of revenue, other costs of service increased for the twelve months ended December 31, 2007 primarily due to the impact of the growth in our mobile service offering.
The rates charged by ILECs for our high-capacity circuits in place on March 11, 2005 that were affected by the FCC’s new rules were increased 15% effective for one year until March 2006. In addition, by March 10, 2006, we were required by the FCC’s new rules to transition these existing facilities to alternative arrangements, such as other competitive facilities or to other wholesale arrangements offered by the ILECs (e.g., special access services) or other negotiated rates with ILECs. Subject to any contractual protections under our existing interconnection agreements with ILECs or amendments to such agreements, beginning March 11, 2005, new circuits that were added were subject to the ILECs’ higher “special access” pricing. New circuits include any new installations of DS-1 loops and/or DS-1 and DS-3 transport facilities in the affected ILEC wire centers, on the affected transport routes or that exceeded the caps.
Beginning on March 11, 2005, we began estimating and accruing the difference between the new pricing resulting from the TRRO and the pricing being invoiced by ILECs. We continue to accrue certain amounts relating to the implementation of the TRRO due to billing rates that continue to reflect pre-TRRO pricing. A substantial amount of these accrued expenses have never been invoiced by the ILECs and are subject to a two-year statutory back billing limit. During twelve months ended December 31, 2007 approximately $0.4 million of TRRO expenses accrued from March 11, 2005 through December 31, 2005 passed the statutory back
billing limit and were reversed as a benefit to cost of revenue. For the portion of the accrued TRRO expenses that have been invoiced as of December 31, 2007, we have been billed $2.4 million in excess of the amount that has been cumulatively recognized in our results of operations. Management believes these excess billings are erroneous and that the amounts accrued represent the best estimate of the final settlement of these liabilities.
We estimated the probable liability for implementation of certain provisions of the TRRO and accrued approximately $6.2 million through December 31, 2007 and $4.4 million through December 31, 2006 for these liabilities. Due to the TRRO provisions, $1.8 million and $2.5 million was charged to cost of revenue in the twelve months ended December 31, 2007 and December 31, 2006, respectively. These estimates are for all markets and, where alternate pricing agreements have not been reached, are based on special access rates available under volume and/or term pricing plans. We believe volume and/or term pricing plans are the most probable pricing regime to which we are subject to based on our experience and our intent to enter into volume and/or term commitments where more attractively priced alternatives do not exist.
Certain aspects of the new FCC rules are subject to ongoing court challenges and estimates relating to the implementation of the new FCC rules are subject to multiple interpretations. We cannot predict the results of future court rulings, how the FCC may respond to any such rulings or any changes in the availability of unbundled network elements as the result of future legislative or regulatory decisions.
Transport charges have increased as a percentage of revenue to 4.1% from 3.9% for the twelve months ended December 31, 2007 as compared to the twelve months ended December 31, 2006 as a result of network optimization efforts aimed to reduce future transport costs. We recorded $1.1 million in installation expenses from network architecture changes associated with the TRRO and an additional $1.0 million for additional network optimization efforts inspired by the TRRO-related project in the twelve months ended December 31, 2006. The network optimization project undertaken in response to the TRRO was completed in the quarter ended June 30, 2006. However, additional network optimization efforts continue, including the planned migration of portions of our network traffic in 2008 to Company-owned transport facilities acquired under indefeasible rights of use contracts. We recorded $1.1 million in installation expenses resulting from network optimization efforts in the twelve months ended December 31, 2007 and believe that these network optimization efforts will be an ongoing part of our business in future periods, although they are not expected to result in significant installation expenses in each period.
Selling, General and Administrative (Dollar amounts in thousands)
Selling, General and Administrative Expenses and Other Operating Expenses. Annual selling, general and administrative expenses increased for 2007 compared to 2006 primarily due to increased employee costs. Higher employee costs, which includes commissions paid to our direct sales representatives, principally relate to the additional employees necessary to staff new markets and to serve the growth in customers. As a percentage of consolidated revenues, the 1.3% increase in 2007 is fully attributable to new markets, as is illustrated above. New markets for 2007 include San Diego, Detroit, San Francisco Bay Area and Miami. Corporate selling, general and administrative costs includes an increase of $5.6 million in share-based compensation for the twelve months ended December 31, 2007, including $1.5 million of employer contributions to the 401(k) Plan that began in 2007. As the newer markets mature, we expect selling, general and administrative costs in these markets to decrease as a percentage of revenue as our customer base and revenues grow without proportional increases in these expenses.
Marketing costs, including advertising, increased in absolute dollars but are relatively consistent as a percent of revenues. In general our marketing costs will continue to increase as we add customers and expand to new markets.
Other selling, general and administrative expenses include professional fees, outsourced services, rent and other facilities costs, maintenance, recruiting fees, travel and entertainment costs, property taxes and bad debt expense. This increase in absolute dollars in this category of costs is primarily due to the addition of new as well as expanded operations needed to keep pace with the growth in customers. As a percentage of revenue, other selling, general and administrative costs slightly decreased for the twelve month period ended December 31, 2007 when compared to the comparable period of 2006 due to realizing efficiencies from achieving economies of scale. We expect this positive trend to continue.
The continuing deterioration of general economic conditions resulted in an increase in the number of customers disconnected for non-payment, causing an increase in the customer churn rate and an increase in bad debt expense to $4.8 million in 2007, from $3.6 million in 2006, or 1.7% of revenues in each year, of which $2.0
million was recognized in the fourth quarter of 2007. In response to the changing economic environment, we tightened our credit and collections policies and practices for customers with a higher risk profile. Management reviews the collections policies and practices on an ongoing basis and adjusts them when deemed appropriate.
The twelve months ended December 31, 2006 includes $0.9 million of public offering costs related to our secondary offering completed in October of 2006.
Depreciation and Amortization (Dollar amounts in thousands)
Depreciation and Amortization Expense. Depreciation and amortization expense increased in 2007 over 2006 due to the continued significant capital investments associated with our growth and expansion.
Other Income (Expense) (Dollar amounts in thousands)
Interest Income. Interest income increased for the twelve month period ended December 31, 2007 as a result of significantly higher cash and investment balances as well as higher interest rates over the comparable twelve month period ended December 31, 2006.
Interest Expense. Interest expense for the twelve month period ended December 31, 2007 and 2006 relates primarily to commitment fees under our revolving credit facility. Interest expense increased for the twelve months ended December 31, 2007 compared to 2006 as the credit facility was not outstanding for the full period in 2006.
Loss on Disposal of Property and Equipment. Loss on disposal of equipment for the twelve month period ended December 31, 2007 and 2006 principally consists of unrecoverable integrated access devices from disconnected customers and write-offs of certain network and software assets that we replaced due to obsolescence or upgrade. The loss on unrecoverable integrated access devices will continue to increase as our customer base grows and will vary with customer churn rates as well. The write-off of certain network and software assets will fluctuate dependent upon management decisions to replace and upgrade components of our network.
Income tax expense. In 2006 and until the fourth quarter of 2007, the majority of our taxable income was offset by the utilization of net operating loss carryforwards from prior years and a full valuation allowance, or reserve, on the remaining net deferred tax assets. Income tax expenses recognized relate primarily to amounts due under the alternative minimum tax rules or to states where we either do not have net operating loss carryforwards or the taxing regime does not consider net operating losses. Income tax expense for the twelve month period ended December 31, 2007 also reflects a $9.6 million benefit arising from the release of a portion of our valuation allowance related to our net deferred tax asset, which was entirely recognized in the fourth quarter.
Our net deferred tax asset totals approximately $44.7 million at December 31, 2007 and primarily relates to net operating loss carryforwards. Due to our history of losses, we had fully reserved for this net deferred tax asset in past periods. During the fourth quarter of 2007, we concluded that there was sufficient positive evidence present, such that we will be able to utilize a portion of these loss carryforwards to offset future taxable income, resulting in a partial reduction of the reserves against the asset to reflect the amount of net deferred tax assets that are more likely than not to be realized. In order to realize the benefits of the deferred tax asset recognized, we will need to generate approximately $25.1 million in taxable income prior to 2010, which, based on current projected performance, management expects to be able to meet.
Year Ended December 31, 2006 Compared to Year Ended December 31, 2005
Revenue and Cost of Revenue (Dollar amounts in thousands, except average revenue per customer location)
Revenue. Revenue increased for the twelve months ended December 31, 2006 compared to the twelve months ended December 31, 2005 in proportion to the increase in customers year over year and, additionally, the recognition of promotional breakage of $0.8 million in the twelve months ended December 31, 2006, and $0.3 million in the twelve months ended December 31, 2005 related to certain customer promotional liabilities recorded in prior periods; offset by a slight decline in average monthly revenue per customer location to the twelve months ended December 31, 2006 from the twelve months ended December 31, 2005. Revenues from access charges paid to us by other communications companies to terminate calls to our customers increased for the twelve month comparison period primarily due to our growth in customers.
The following comprises the segment contributions to the increase in revenue in the twelve month period ended December 31, 2006 as compared to the twelve month period ended December 31, 2005 (Dollar amounts in thousands):
Cost of Revenue. Cost of revenue increased for the twelve month period of 2006 compared to the twelve month period of 2005, mostly attributable to the 36.1% increase in the average number of customers year over year. The remaining increase in cost of revenue, as well as the increase as a percentage of revenue, relates primarily to the impact of regulatory changes and increased level of installation charges to affect circuit changes in connection with our network optimization plan in response to the TRRO.
Circuit access fees, or line charges, which primarily relate to our lease of T-1 circuits connecting our equipment at network points of collocation to our equipment located at our customers’ premises, represented the largest component of cost of revenue. The increase in circuit access fees is a direct result of the increase in the number of customers, as well as a rise in circuit access fees due to the impact of the TRRO and regulatory rulings in Georgia.
The other principal components of cost of revenue include long distance charges, installation costs to connect new circuits, the cost of transport circuits between network points of presence, the cost of local interconnection with the local telephone companies’ networks, Internet access costs, the cost of third-party applications we provide to our customers, access costs paid by us to other carriers to terminate calls from our customers and certain taxes and fees, and, beginning in 2006, the costs of mobile handsets. As a percent of revenue, other costs of service increased for the twelve months ended December 31, 2006 primarily due to the impact of our network grooming activities, which involve changes in network architecture to improve efficiency or reduce costs related to the TRRO (described below), and the impact of our new mobile offering, which involves subsidies on the sale of mobile handsets and a lower gross margin for mobile service than our overall gross margin.
In February 2006, the Georgia Public Service Commission (the “PSC”) ordered a rate increase for the lease of unbundled network elements provided by BellSouth. The increased rates were applicable both prospectively and retroactively to June 2003. We estimated and accrued approximately $1.5 million through December 31, 2005 for the cumulative impact of this action, which was charged to cost of revenue in the fourth quarter of 2005. Prior to the PSC staff recommendation, there was insufficient information as to whether the outcome of this matter would result in a change in pricing and whether such change in pricing, if any, would be applied retroactively or prospectively.
In February 2005, the FCC issued its TRRO and adopted new rules, effective March 11, 2005, governing the obligations of ILECs, to afford access to certain of their network elements, if at all, and the cost of such facilities. The TRRO reduces the ILECs’ obligations to provide high-capacity loops within, and dedicated transport facilities between, certain of the ILECs’ wire centers that are deemed to be sufficiently competitive, based upon various factors such as the number of fiber-based collocators and/or the number of business access lines within these wire centers. In addition, certain caps are imposed regarding the number of unbundled network element, or
UNE, facilities that companies like us may have on a single route or into a single building. Where the wire center conditions or the caps are exceeded, the TRRO eliminates the ILECs’ obligations to provide these high-capacity circuits to competitors at the discounted rates historically received under the 1996 Telecommunications Act.
The rates charged by ILECs for our high-capacity circuits in place on March 11, 2005 that were affected by the FCC’s new rules were increased 15% effective for one year until March 2006. In addition, by March 10, 2006, we were required by the FCC’s new rules to transition these existing facilities to alternative arrangements, such as other competitive facilities or to other wholesale arrangements offered by the ILECs (e.g., special access services) or other negotiated rates with the ILECs. Subject to any contractual protections under our existing interconnection agreements with ILECs or amendments to such agreements, beginning March 11, 2005, new circuits that were added were subject to the ILECs’ higher “special access” pricing. New circuits include any new installations of DS-1 loops and/or DS-1 and DS-3 transport facilities in the affected ILECs’ wire centers, on the affected transport routes or that exceeded the caps.
We are able to estimate the probable liability for implementation of certain provisions of the TRRO and have accrued approximately $4.4 million through December 31, 2006 for these increased costs, $2.5 million of which was charged to cost of revenue in the year ended December 31, 2006. This cumulative estimate includes $3.7 million for the total cost impact related to wire centers and transport routes determined to be sufficiently competitive to be subject to the FCC’s new rules, of which $2.1 million is reflected in cost of revenue through December 31, 2006. This cumulative estimate also includes $0.7 million for costs associated with the caps imposed on the number of circuits that we may have on a single route or into a single building, of which approximately $0.4 million is reflected in cost of revenue through December 31, 2006. This estimate is for all markets and, where alternate pricing agreements have not been reached, is based on special access rates available under volume and/or term pricing plans. We believe volume and/or term pricing plans are the most probable pricing regime to which we are subject to based on our experience and our intent to enter into volume and/or term commitments where more attractively priced alternatives do not exist.
Certain aspects of the new FCC rules are subject to ongoing court challenges and the implementation of the new FCC rules is subject to multiple interpretations. We cannot predict the results of future court rulings, or how the FCC may respond to any such rulings, or any changes in the availability of unbundled network elements as the result of future legislative or regulatory decisions.
We made changes in our network architecture via a network optimization project to mitigate the increases in transport circuit costs resulting from the FCC rule changes. This network optimization project, undertaken in response to the TRRO, was completed in the quarter ended June 30, 2006 and resulted in $1.3 million in installation expenses during the six months ended June 30, 2006, which included $0.2 million for additional network optimization efforts inspired by the TRRO-related project. These additional network optimization efforts continued during the remainder of 2006, in which we incurred an additional $0.8 million in installation expenses. We believe that these network optimization efforts will be an ongoing part of our business in future periods, although they may not result in significant installation expenses in each period.
Selling, General and Administrative (Dollar amounts in thousands)
Selling, General and Administrative Expenses and Other Operating Expenses. Selling, general and administrative expenses, excluding share-based compensation expense, increased at a slower rate than our revenue or customers for the twelve month period ended December 31, 2006. This change is evidenced by its decline as a percentage of revenue to 53.5% in the twelve month period ended December 31, 2006 from 54.3% in the twelve month period ended December 31, 2005. As shown in the table below, this decrease was greater after considering the effects of new markets, including Los Angeles and San Diego for 2006. Also affecting the trends in selling, general and administrative expenses are our introduction of mobile services in all markets during the first quarter of 2006 and increased cost associated with being a public company.
Salaries, wages and benefits, which include commissions paid to our direct sales representatives, comprised the largest portion of our selling, general and administrative expenses for all comparison periods. The primary factor increasing this category of costs was the increase in employees as the company grows. However, the growth in the cost of benefits, such as medical insurance payments made by us, per employee, caused this expense line item to grow at a faster rate than the number of employees.
Marketing costs, including advertising, increased in absolute dollars, as we have increased our marketing efforts into new mediums to address the increasingly competitive environment, but decreased as a percent of revenues. Our marketing costs will continue to increase as we add customers and expand to new markets.
Other selling, general and administrative expenses include professional fees, outsourced services, rent and other facilities costs, maintenance, recruiting fees, travel and entertainment costs, property taxes and bad debt expense. The increase in this category of costs was primarily due to the addition of new operations needed to keep pace with the growth in customers and the cost of being a public company, including preparing for Sarbanes-Oxley Act compliance, and professional fees associated with a heightened level of regulatory activity. As a percentage of revenue, other selling, general and administrative costs decreased for the twelve month period ended December 31, 2006 when compared to the comparable period of 2005 due to realizing efficiencies from achieving economies of scale. We expect this positive trend to continue.
Share-based compensation for 2006 reflects the January 1, 2006 adoption of SFAS 123(R), Share-Based Payment, which requires us to reflect in our operating results expense based on the fair value of share-based payments to our employees. In 2005, we recognized share-based compensation under APB No. 25, which based expense on the intrinsic value of the share-based payments on the date of grant. The fair value approach results in a higher value, which causes greater expenses to be recorded in the financial results.
Depreciation and Amortization (Dollar amounts in thousands)
Depreciation and Amortization Expense. Depreciation and amortization expense increased in 2006 over 2005 due to the continued significant capital investments associated with our growth and expansion.
Other Income (Expense) (Dollar amounts in thousands)
Interest Income. Interest income increased for the twelve month period as a result of significantly higher cash balance throughout the year as well as higher interest rates during 2006.
Interest Expense. Interest expense decreased $2.3 million for the twelve month period ended December 31, 2006 compared to December 31, 2005. The decrease in interest expense between the periods resulted from the payoff of our debt with Cisco Capital in November 2005. The interest expense in the twelve months of 2006 relates primarily to commitment fees under our revolving credit facility with Bank of America.
Loss on Disposal of Property and Equipment. Our loss on disposal of equipment increased by less than $0.1 million for the twelve month period ended December 31, 2006 compared to December 31, 2005. Our loss principally consists of unrecoverable integrated access devices from disconnected customers and write-offs of certain network and software assets that we replaced due to obsolescence or upgrade. The loss on unrecoverable integrated access devices will continue to increase as our customer base grows, and the write-off of certain network and software assets will fluctuate dependent upon management decisions to replace and upgrade components of our network.
Gain from write-off of carrying value in excess of principal. The gain from write-off of carrying value in excess of principal resulted from the payoff or our debt with Cisco Capital using the proceeds from our initial
public offering in November 2005 and represents the carrying value in excess of principal remaining from the trouble debt restructuring that occurred in 2002.
Income tax expense. Income tax expense increased $0.4 million for the twelve month period ended December 31, 2006 compared to the twelve month period ended December 31, 2005, due to alternative minimum tax (AMT) requirements.
Segment Data
We monitor and analyze our financial results on a segment basis for reporting and management purposes, as is presented in Note 12 to our Consolidated Financial Statements hereto. At December 31, 2007, our operating segments were geographic and included Atlanta, Dallas, Denver, Houston, Chicago, Los Angeles, San Diego, Detroit and the San Francisco Bay Area. In addition, in 2007, we incurred capital expenditures for the Miami and Minneapolis markets, which are scheduled to become operating segments in 2008. The balance of our operations is in our Corporate group, for which the operations consist of corporate executive, administrative and support functions and centralized operations, which includes network operations, customer care and provisioning. Our corporate group is treated as a separate segment consistent with the manner in which we monitor and analyze our financial results. We do not allocate these Corporate costs to the other segments because these costs are managed and controlled on a centralized, functional basis that spans all markets, with centralized, functional management held accountable for corporate results. We also believe that the decision not to allocate these centralized costs provides a better evaluation of our revenue-producing geographic segments. We do not report assets by segment since we manage our assets and make decisions on technology deployment and other investments on a company-wide rather than a local market basis. Our chief operating decision maker does not use segment assets in evaluating the performance of our operating segments. As a result, we do not believe that segment asset disclosure is meaningful information to investors.
In addition to segment results, we use total adjusted EBITDA to assess the operating performance of the overall business. Because our chief operating decision maker primarily evaluates the performance of our segments on the basis of adjusted EBITDA, we believe that segment adjusted EBITDA data should be available to investors so that investors have the same data that we employ in assessing our overall operations. Our chief operating decision maker also uses revenue to measure our operating results and assess performance, and both revenue and adjusted EBITDA are presented herein in accordance with SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information.
Other public companies may define adjusted EBITDA in a different manner or present varying financial measures. Accordingly, adjusted EBITDA as presented herein may not be comparable to other similarly titled measures of other companies. Adjusted EBITDA is also not directly comparable to EBIT (earnings before interest and taxes) or EBITDA. Adjusted EBITDA, while management believes provides useful information, should not be considered in isolation or as an alternative to other financial measures determined under GAAP, such as operating income or loss.
The operating results from our operating segments reflect the costs of a pre-launch phase in each market in which the local network is installed and initial staffing is hired, followed by a startup phase, beginning with the launch of service operations, when customer installations begin. Our sales efforts, our service offerings and the prices we charge customers for our services are generally consistent across our operating segments. Operating expenses include costs of service and selling, general and administrative costs incurred directly in the markets where we serve customers. Although our network design and market operations are generally consistent across all our operating segments, certain costs differ among the various geographical markets. These cost differences result from different numbers of network central office collocations, prices charged by the local telephone companies for customer T-1 access circuits, prices charged by local telephone companies and other telecommunications providers for transport circuits, office rents and other costs that vary by region.
We record costs in our markets prior to launching service to customers. The following comprises the service launch date for our current markets and the anticipated launch date of our future announced markets:
Current Markets
Service Launch Date
Atlanta
2nd Quarter 2001
Dallas
3rd Quarter 2001
Denver
1st Quarter 2002
Houston
1st Quarter 2004
Chicago
1st Quarter 2005
Los Angeles
1st Quarter 2006
San Diego
1st Quarter 2007
Detroit
3rd Quarter 2007
San Francisco Bay Area
4th Quarter 2007
Miami
1st Quarter 2008
Announced Markets
Planned Service Launch Date
Minneapolis
3rd Quarter 2008
Liquidity and Capital Resources (Dollar amounts in thousands)
Overview. We commenced operations in 2001. Until 2004, we funded our operations primarily through issuance of an aggregate of $120.8 million in equity securities and borrowings under a line of credit facility established with Cisco Capital, used principally to purchase property and equipment from Cisco Systems. In 2004, we recorded positive cash flow from operating activities for the first time. We raised $17.0 million from issuance of equity securities in December 2004 and another approximately $65.0 million of net proceeds from our initial public offering in November 2005. Total outstanding borrowings, of $64.3 million, which were all with Cisco Capital, were repaid in November 2005 with proceeds from our initial public offering, and the credit facility was terminated.
Cash Flows From Operations. The increase in cash provided by operating activities of $18.1 million to $61.8 million for the year ended December 31, 2007 from $43.7 million for the year ended December 31, 2006 is primarily comprised of an increase in net income of $13.7 million, an increase in non-cash share-based compensation of $5.6 million, an increase in depreciation and amortization of $3.6 million, an increase in the provision for doubtful accounts of $1.2 million, an increase of $7.3 million from accounts payable and an increase of $2.1 million from accounts receivable; partially offset by a decrease of $9.6 million from the deferred tax benefit, a decrease of $4.1 million from other liabilities, and a decrease of $1.2 million from our change in inventory.
Cash provided by operating activities was $43.7 million in the year ended December 31, 2006 and $29.6 million in the year ended December 31, 2005. The increase in cash provided by operating activities of $14.0 million in 2006 from 2005 is primarily comprised of an increase in net income of $4.0 million, an elimination of $1.6 million in interest expense associated with the reduction in carrying value in excess of principal from the restructuring of a portion of our Cisco Capital debt in 2002, an increase of $4.1 million in non-cash share-based compensation expense associated with the adoption of SFAS 123(R), an increase in depreciation and amortization expense of $3.0 million resulting from the growth in assets arising from the growth in customers and the addition of assets needed to support our newer markets, which included Houston, Chicago and Los Angeles, an increase of $4.1 million related to the non-cash gain recognized upon the payoff of our credit facility with Cisco Capital in 2005, an increase of $3.7 million from other assets, an increase of $1.3 million from prepaid expenses and other current assets and an increase of $1.7 million in other accrued expenses. These increases in cash flow from operations were primarily offset by a decrease of $5.9 million in accounts payable, a decrease of $2.7 million from accounts receivable and a decrease of $0.8 million from our change in inventory.
Cash Flows From Investing Activities. Our principal cash investments are historically for purchases of property and equipment and for purchases of marketable securities. Cash purchases of property and equipment primarily include network capital expenditures such as integrated access devices, T-1 aggregation routers, trunking gateway routers, softswitches, other network routers, associated growth expenditures related to these items, diagnostic and test equipment, certain collocation and data center buildout expenditures and equipment installation costs and non-network capital expenditures, such as the cost of software licenses and implementation costs associated with our operational support systems as well as our financial and administrative systems, servers and other equipment needed to support our software packages, personal computers, internal communications equipment, furniture and fixtures and leasehold improvements to our office space. Our cash purchases of property and equipment were $55.0 million, $42.1 million and $21.3 million for 2007, 2006 and 2005, respectively.
In 2005 and prior periods, network-related capital expenditures were primarily financed through our credit facility with Cisco Capital and, accordingly, were non-cash transactions. After giving consideration to non-cash purchases of property and equipment, capital expenditures increased $13.7 million for the twelve months ended December 31, 2007 compared to the twelve months ended December 31, 2006 and increased $14.1 million for the twelve months ended December 31, 2006 compared to the twelve months ended December 31, 2005. Our capital expenditures resulted from growth in customers in our existing markets, network additions needed to support our entry into new markets, and enhancements and development costs related to our operational support systems in order to offer additional applications and services to our customers. We expect that future capital expenditures will continue to be concentrated in these areas. We believe that capital efficiency is a key advantage of the IP-based network technology that we employ. In addition to the above, we experienced an increase of $9.8 million in net cash flows from investment redemptions and purchases for the year ended December 31, 2007 compared to the year ended December 31, 2006 and a decrease of $4.6 million in net cash flows from investment redemptions and purchases for the year ended December 31, 2006 compared to the year ended December 31, 2005.
We periodically invest excess cash balances in the marketable securities of highly-rated commercial paper and money market funds. Purchases of marketable securities were $45.0 million, $65.9 million and $10.6 million in 2007, 2006 and 2005, respectively. We periodically redeem our marketable securities in order to transfer the funds into other operating and investing activities. We redeemed $55.0 million, $66.1 million and $15.3 million in 2007, 2006 and 2005, respectively.
Non-cash Purchases of Property and Equipment. Purchases of property and equipment through our credit facility with Cisco Capital, which terminated in November 2005, were recorded as non-cash purchases because they were directly financed by Cisco Capital without the exchange of cash for the assets that we purchased. Network capital expenditures include the purchase of integrated access devices, T-1 aggregation routers, trunking gateway routers, softswitches, other network routers, associated growth expenditures related to these items,
diagnostic and test equipment, certain collocation and data center buildout expenditures and equipment installation costs. Our non-cash additions to property and equipment were $2.6 million, $1.8 million and $8.4 million in 2007, 2006 and 2005, respectively. As noted above, the balance of our debt under the Cisco Capital credit facility was repaid in November 2005 using a portion of the proceeds from our initial public offering and the facility was terminated. Therefore, there were no non-cash purchases of property and equipment after November 2005 relating to our credit facility with Cisco Capital.
Cash Flows From Financing Activities. Cash flows provided from financing activities was $5.3 million in the year ended December 31, 2007 compared to $4.0 million in the year ended December 31, 2006. The principal component of the change in cash flow provided by financing activities in the twelve months ended December 31, 2007 is the increase of proceeds from the exercise of stock options of $0.7 million and the increase in the excess tax benefit relating to share-based compensation of $0.4 million.
Cash flows used in financing activities were $4.0 million in the year ended December 31, 2006 compared to cash flows provided by financing activities of $7.3 million in the year ended December 31, 2005. The principal component of cash flows provided by financing activities in the year ended December 31, 2006 was proceeds from the exercise of stock options of $4.1 million. The primary use of cash in the year ended December 31, 2005 was the repayment of long-term debt and capital leases of $73.0 million offset by proceeds from our initial public offering of approximately $65.0 million. We had no payments on long-term debt in 2007 or 2006 due to the payoff of our debt after our initial public offering in November 2005.
We believe that cash on hand plus cash generated from operating activities will be sufficient to fund capital expenditures, operating expenses and other cash requirements associated with our present market expansion plan, which is to continue opening three new markets per year. Our business plan assumes that cash flow from operating activities of our mature markets will offset the negative cash flow from operating activities and cash flow from financing activities with respect to the additional markets we plan to launch. We intend to adhere to our policy of fully funding all future market expansions in advance and do not anticipate entering markets without having more than sufficient cash on hand or borrowing capacity to cover projected cash needs.
Commitments. The following table summarizes our commitments as of December 31, 2007, including commitments pursuant to debt agreements and operating lease obligations:
Operating Leases: We lease office space in several U.S. locations. Operating lease amounts include future minimum lease payments under all our noncancelable operating leases with an initial term in excess of one year.
Purchase Commitments: Purchase commitments represent an estimate of all open purchase orders and contractual obligations in the ordinary course of business for which we have not received the goods or services.
Interest Payments: Anticipated interest payments represent payments related to our open, but unused, line of credit.
We are required under certain of the listed contractual obligations to maintain letters of credit. As of December 31, 2007, we had outstanding letters of credit totaling $1.1 million, which expire at various dates through May 2016.
Revolving Line of Credit
In addition to the sources of cash noted above, on February 8, 2006, our wholly-owned subsidiary Cbeyond Communications, LLC entered into a credit agreement with Bank of America that provides for a secured revolving line of credit for up to $25.0 million. The credit agreement terms were subsequently amended on
July 2, 2007. The following description of the line of credit briefly summarizes the facility’s terms and conditions that are material to us. As of December 31, 2007, there were no amounts drawn down on the line of credit.
General. The secured revolving line of credit will terminate by its terms on February 8, 2011. The revolving line of credit will be available to finance working capital, capital expenditures, and other general corporate purposes. All borrowings will be subject to the satisfaction of customary conditions, including absence of a default and accuracy of representations and warranties.
Interest and Fees. The interest rates applicable to loans under the revolving line of credit are floating interest rates that, at our option, will equal a LIBO rate or an alternate base rate plus, in each case, an applicable margin. The base rate is a fluctuating interest rate equal to the higher of (a) the prime rate of interest per annum publicly announced from time to time by Bank of America, as administrative agent, as its prime rate in effect at its principal office in New York City and (b) the overnight federal funds rate plus 0.50%. The interest periods of the Eurodollar loans are one, two, three or six months, at our option. The applicable margins for LIBO rate loans are 1.75%, 2.00%, and 2.25% for loans drawn in aggregate up to $8.3 million, between $8.3 million and $16.7 million, and between $16.7 million and $25.0 million, respectively. The applicable margins for alternate base rate loans are 0.25%, 0.50%, and 0.75% for loans drawn in aggregate up to $8.3 million, between $8.3 million and $16.7 million, and between $16.7 million and $25.0 million, respectively. In addition, we are required to pay to Bank of America under the revolving line of credit a commitment fee for unused commitments at a per annum rate of 0.25%.
Prepayments. Voluntary prepayments of loans and voluntary reductions in the unused commitments under the revolving line of credit are permitted in whole or in part, in minimum amounts and subject to certain other limitations. Mandatory prepayments are required in an amount equal to 100% of the net cash proceeds of all asset sales or dispositions received by us or any of our subsidiaries greater than $0.5 million in any calendar year and 100% of the net proceeds from the issuance of any debt, other than permitted debt. Mandatory prepayments will permanently reduce the revolving credit commitment.
Security. All of our direct and indirect subsidiaries are guarantors of our obligations under the revolving line of credit. All amounts owing under the line of credit (and all obligations under the guaranties) will be secured by a first lien on all tangible and intangible assets, whether now owned or hereafter acquired, subject (in each case) to exceptions satisfactory to Bank of America.
Covenants and Other Matters. The revolving line of credit requires us to comply with certain financial covenants, including minimum consolidated adjusted EBITDA, minimum leverage ratio, as determined by our debt divided by adjusted EBITDA, and maximum capital expenditures.
The revolving line of credit also includes certain negative covenants restricting or limiting our ability to, among other things:
•
declare dividends or redeem or repurchase capital stock or make other stockholder distributions;
•
prepay, redeem or purchase certain debt;
•
guarantee or incur additional debt, other than certain permitted indebtedness, including permitted purchase money indebtedness and capital leases;
•
engage in sale leaseback transactions;
•
make loans or investments;
•
grant liens or other security interests to third parties, other than in connection with permitted indebtedness and capital leases;
•
engage in mergers, acquisitions, investments in other businesses, or other business combinations;
•
transfer assets;
•
change our fiscal reporting periods or method of accounting; and
•
enter into transactions with affiliates.
The revolving line of credit also contains certain customary representations and warranties, affirmative covenants, notice provisions, indemnification and events of default, including change of control, cross-defaults to other debt and judgment defaults.
Off-Balance Sheet Arrangements
We have no off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on our financial condition, results of operations, liquidity, capital expenditures or capital resources.
Critical Accounting Policies
We prepare consolidated financial statements in accordance with accounting principles generally accepted in the United States, which require us to make estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures in our consolidated financial statements and accompanying notes. We believe that of our significant accounting policies, which are described in Note 2 to the consolidated financial statements included herein, the following involved a higher degree of judgment and complexity and are therefore considered critical. While we have used our best estimates based on the facts and circumstances available to us at the time, different estimates reasonably could have been used in the current period, or changes in the accounting estimates that we used are reasonably likely to occur from period to period which may have a material impact on the presentation of our financial condition and results of operations. Although we believe that our estimates, assumptions and judgments are reasonable, they are based upon information presently available. Actual results may differ significantly from these estimates under different assumptions, judgments or conditions.
Revenue Recognition. We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectibility is reasonably assured. Revenue derived from local voice and data services is billed monthly in advance and deferred until earned at the end of the month. Revenues derived from other telecommunications services, including long distance, excess charges over monthly rate plans and terminating access fees from other carriers, are recognized monthly as services are provided and billed in arrears.
Mobile headset revenue is recognized at the time of shipment utilizing the residual method to allocate the arrangement consideration. Under the residual method, the amount of consideration allocated to mobile handsets equals the total arrangement consideration less the aggregate fair value of the undelivered items.
Our marketing promotions include various rebates and customer reimbursements that fall under the scope of EITF Issue No. 00-22, Accounting for “Points” and Certain Other Time-Based or Volume-Based Sales Incentive Offers, and Offers for Free Products or Services to be Delivered in the Future, and EITF Issue No. 01-09, Accounting for Consideration Given by a Vendor to a Customer. In accordance with these pronouncements, we record these promotions as a reduction in revenue when earned by the customer. When these promotions are earned over time, we ratably allocate the cost of honoring the promotions over the period required for eligibility as a reduction in revenue. EITF 01-09 also requires that measurement of the obligation should be based on the
estimated number of customers that will ultimately earn and claim the promotion. Accordingly, we recognize the benefit of estimated breakage on customer promotions when such amounts are reasonably estimable.
Allowance for Doubtful Accounts. We have established an allowance for doubtful accounts through charges to selling, general and administrative expense. The allowance is established based upon the amount we ultimately expect to collect from customers and is estimated based on a number of factors, including a specific customer’s ability to meet its financial obligations to us, as well as general factors, such as the length of time the receivables are past due, historical collection experience and the general economic environment. Customer accounts are typically written off against the allowance approximately sixty days after disconnection of the customers’ service, when our direct collection efforts cease. Generally, customer accounts are considered delinquent and the service disconnection process begins when they are sixty days in arrears. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, or if economic conditions worsened, additional allowances may be required in the future, which could have a material effect on our consolidated financial statements. If we made different judgments or utilized different estimates for any period, material differences in the amount and timing of our expenses could result.
Impairment of Long-Lived Assets. In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, we review long-lived assets for impairment when events or changes in circumstances indicate the carrying value of such assets may not be recoverable. If an indication of impairment is present, we compare the asset’s estimated fair value to its carrying amount. If the estimated fair value of the asset is less than the carrying amount of the asset, we record an impairment loss equal to the excess of the asset’s carrying amount over its fair value. The fair value is determined based on valuation techniques such as a comparison to fair values of similar assets or using a discounted cash flow analysis.
Share-Based Compensation. Prior to January 1, 2006, we accounted for share-based compensation under the recognition and measurement provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees (APB 25), and related interpretations, as permitted by Financial Accounting Standards No. 123, (SFAS 123) Accounting for Stock-Based Compensation. Under this guidance, we recognized non-cash compensation expense for share-based awards by measuring the excess, if any, of the estimated fair value of the common stock at the date of grant over the amount an employee must pay to acquire the stock and amortizing that excess on a straight-line basis over the vesting period of the applicable share-based awards. Additional paid-in capital and deferred compensation were recorded at the date of the grants to reflect the intrinsic value of the awards. Under APB 25, the deferred compensation was amortized to expense over the vesting periods on a straight line basis, with adjustments for forfeitures as they occurred.
Effective January 1, 2006, we adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (SFAS 123(R)) using the modified prospective transition method. Under that transition method, compensation cost recognized on or after January 1, 2006 includes: (a) compensation cost for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, Accounting for Stock-Based Compensation, and (b) compensation cost for all share-based payments granted on or after January 1, 2006, based on the grant date fair value estimated in accordance with SFAS 123(R). Results for prior periods have not been restated. Under SFAS 123(R), compensation is recorded over the vesting period directly to paid-in capital. Thus, upon adoption, we eliminated the deferred compensation balance relating to employee share-based awards with an offsetting reduction to additional paid-in capital.
As of December 31, 2007 and December 31, 2006, total unrecognized compensation cost related to non-vested awards totaled approximately $23.4 million and $11.6 million, respectively, and is expected to be recognized over a weighted-average period of 1.88 years and 1.87 years.
We evaluate the appropriateness of the underlying assumptions each time we estimate the fair value of equity instruments requiring measurement under SFAS 123(R). To assist us in validating our assumptions, we periodically engage consultants with relevant experience to assess and evaluate our assumptions.
The risk-free interest rate used in estimating the fair value of share-based awards is based on the U.S. Treasury zero-coupon securities using the contractual term of the share-based awards. We also use historical data to estimate the suboptimal exercise barrier and the forfeiture rate of share-based awards granted. Through the third quarter of 2007, we had not been a public company long enough to rely on our own volatility history. Therefore our expected volatility was based on historical volatilities experienced by companies considered representative of us based on four primary categories: size, stage of lifecycle, capital structure and industry. This approach to estimating volatility remained consistent over time, although the mix and weighting of representative volatilities were refined periodically to ensure that the four primary categories were appropriately considered. Beginning in the fourth quarter of 2007, we began using our own market-based historical volatility. In reviewing the modifications to the development of our underlying valuation assumptions, we consider whether applying the refined assumptions would have had a material impact on recent valuations performed using the previous assumptions, noting that the effect on compensation expenses would not have resulted in a materially different amount.
Through 2006, we granted only stock options to our employees. Beginning in 2007, we expanded our share-based compensation to include grants of restricted shares as well as a 401(k) match and contribution to be paid in Company stock.
Valuation Allowances for Deferred Tax Assets. We provide for the effect of income taxes on our financial position and results of operations in accordance with SFAS No. 109, Accounting for Income Taxes. Under this accounting pronouncement, income tax expense is recognized for the amount of income taxes payable or refundable for the current year and for the change in net deferred tax assets or liabilities resulting from events that are recorded for financial reporting purposes in a different reporting period than recorded in the tax return. We made assumptions, judgments and estimates to determine our current provision for income taxes and also our deferred tax assets and liabilities and any valuation allowance to be recorded against our net deferred tax asset.
Our judgments, assumptions and estimates relative to the current provision for income tax take into account current tax laws, our interpretation of current tax laws and, allowable deductions. Changes in tax law or our interpretation of tax laws could materially impact the amounts provided for income taxes in our financial position and results of operations. Our assumptions, judgments and estimates relative to the value of our net deferred tax asset take into account predictions of the amount and category of future taxable income. Actual operating results and the underlying amount and category of income in future years could render our current assumptions, judgments and estimates of recoverable net deferred taxes inaccurate, thus materially impacting our financial position and results of operations.
Our valuation allowance for our net deferred tax asset is designed to take into account the uncertainty surrounding the realization of our net operating losses and our other deferred tax assets.
Recent Accounting Pronouncements
In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes-An Interpretation of FASB Statement No. 109 (FIN 48). FIN 48 prescribes a recognition threshold and measurement attribute for financial statement recognition and measurement of a tax positions taken or expected to be taken in a tax return. In addition, it provides guidance on the measurement, derecognition, classification and disclosure of tax positions, as well as the accounting for related interest and penalties. FIN 48 is effective for fiscal years beginning after December 15, 2006. We have adopted FIN 48 effective January 1, 2007, and the adoption of this statement did not have an impact on our consolidated financial statements.
In June 2006, the Emerging Issues Task Force issued EITF Issue No. 06-03, How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation) (EITF 06-03). EITF 06-03 provides guidance regarding accounting for certain taxes assessed by a governmental authority that are imposed on and concurrent with specific revenue-producing
transactions between a seller and a customer. These taxes and surcharges include, among others, universal service fund charges, sales, use, value added, and some excise taxes. We have historically presented and will continue to present universal service fund charges on a gross basis. Such amounts totaled $6.0 million, $4.3 million and $3.2 million, respectively, for the years ended December 31, 2007, 2006 and 2005.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurement (SFAS 157). This standard defines fair value, establishes a framework for measuring fair value and expands disclosure about fair value measurements. This statement is effective for us beginning in 2008 and is not expected to have a material impact on our financial statements.
In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (SFAS 159). This standard allows entities to voluntarily choose to measure certain financial assets and liabilities at fair value (the fair value option). The fair value option may be elected on an instrument-by-instrument basis and is irrevocable, unless a new election date occurs. If the fair value option is elected for an instrument, SFAS 159 specifies that unrealized gains and losses for that instrument shall be reported in earnings at each subsequent reporting date. SFAS 159 is effective for us in 2008. We do not expect that we will elect the fair value option under SFAS 159, and we do not expect SFAS 159 to have a material impact on our financial statements.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
All of our financial instruments that are sensitive to market risk are entered into for purposes other than trading. Our primary market risk exposure is related to investments we may make in marketable securities. We place our marketable securities investments in instruments that meet high credit quality standards as specified in our investment policy guidelines. At December 31, 2007, all investments were in money market funds and, accordingly, had no financial instruments sensitive to market risk for fluctuations in interest rates.
Item 8.
Item 8. Financial Statements and Supplementary Data
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The Board of Directors and Stockholders
Cbeyond, Inc. and Subsidiaries
We have audited Cbeyond, Inc. and Subsidiaries’ internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Cbeyond, 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 Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on Cbeyond, Inc. and Subsidiaries’ 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, Cbeyond, Inc. and Subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Cbeyond, Inc. and Subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of operations, stockholders’ equity (deficit) and cash flows for each of the three years in the period ended December 31, 2007 of Cbeyond, Inc. and Subsidiaries, and our report dated February 29, 2008 expressed an unqualified opinion thereon.
/s/ ERNST & YOUNG LLP
Atlanta, Georgia
February 29, 2008
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
ON THE CONSOLIDATED FINANCIAL STATEMENTS
The Board of Directors and Stockholders
Cbeyond, Inc. and Subsidiaries
We have audited the accompanying consolidated balance sheets of Cbeyond, Inc. and Subsidiaries (the “Company”) as of December 31, 2007 and 2006, and the related consolidated statements of operations, stockholders’ equity (deficit) and cash flows for each of the three years in the period ended December 31, 2007. Our audits also included the financial statement schedule listed in the Index at Item 15(a). 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 consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company at December 31, 2007 and 2006, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2007, 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.
As discussed in Notes 2, 7 and 9 to the consolidated financial statements, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123(R), Share-Based Payment, effective January 1, 2006, and Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes-an Interpretation of FASB Statement No. 109, effective January 1, 2007.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2007, 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 29, 2008 expressed an unqualified opinion thereon.
/s/ ERNST & YOUNG LLP
Atlanta, Georgia
February 29, 2008
CBEYOND, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Amounts in thousands, except per share amounts)
See accompanying notes.
CBEYOND, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Amounts in thousands, except per share data)
See accompanying notes.
CBEYOND, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)
(Amounts in thousands)
See accompanying notes.
CBEYOND, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Amounts in thousands)
See accompanying notes.
CBEYOND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2007
(Amounts in thousands, except per share amounts)
1. Description of Business
Cbeyond, Inc., a managed service provider, was incorporated on March 28, 2000 in Delaware, for the purpose of providing integrated packages of voice, mobile and broadband data services to small businesses in major metropolitan areas across the United States. As of December 31, 2007, these services were provided in metropolitan Atlanta, Dallas, Denver, Houston, Chicago, Los Angeles, San Diego, Detroit and San Francisco.
2. Summary of Significant Accounting Policies
Principles of Consolidation
The consolidated financial statements include the accounts of Cbeyond, Inc. and its wholly-owned subsidiaries (collectively, the “Company”). All intercompany balances and transactions have been eliminated in the consolidation process.
Use of 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 amounts reported in the financial statements and accompanying notes. Actual results may differ from those estimates.
Revenue Recognition
The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable and collectibility is reasonably assured. Revenue derived from local voice and data services is billed in advance and deferred until earned. Revenues derived from other telecommunications services, including long distance, excess charges over monthly rate plans and terminating access fees from other carriers, are recognized monthly as services are provided and billed in arrears.
Mobile handset revenue is recognized at the time of shipment utilizing the residual method to allocate the arrangement consideration and totaled $2,328 and $771, or 0.8% and 0.4% of total revenues, in 2007 and 2006, respectively, and was not part of our offering in 2005. Under the residual method, the amount of consideration allocated to mobile handsets equals the total arrangement consideration less the aggregate fair value of the undelivered items consisting of monthly service charges for the contractual term of the service agreement.
The Company’s marketing promotions include various rebates and customer reimbursements that fall under the scope of Emerging Issues Task Force (EITF) Issue No. 00-22, Accounting for “Points” and Certain Other Time-Based or Volume-Based Sales Incentive Offers, and Offers for Free Products or Services to be Delivered in the Future, and EITF Issue No. 01-09, Accounting for Consideration Given by a Vendor to a Customer (EITF 01-09). In accordance with these pronouncements, the Company records these promotions as a reduction in revenue when earned by the customer. When these promotions are earned over time, the Company ratably allocates the cost of honoring the promotion over the underlying promotion period as a reduction in revenue. EITF 01-09 additionally requires that measurement of the obligation should be based on the estimated number of customers that will ultimately earn and claim the promotion. Prior to 2005, sufficient historical information did not exist to reasonably estimate the amount of the obligation that would ultimately be earned and claimed. Accordingly, the Company recorded the full liability without an estimate of breakage. During 2005, the Company accumulated sufficient historical experience to reasonably estimate breakage for certain of its promotions and recognized approximately $336 as the initial change in estimate for these promotions. During
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
2006, the Company gained sufficient historical experience to begin estimating breakage for the remaining promotions for which enough history did not exist in 2005 and recognized approximately $776 as the initial change in estimate for these promotions. During 2007, there were no material amounts recognized relating to these promotions where breakage had not previously been recognized. In addition, there have been no material changes in estimated breakage rates after the initial estimates were made.
Accounts Receivable and the Allowance for Doubtful Accounts
Accounts receivable are comprised of gross amounts invoiced to customers plus accrued revenue, which represents earned but unbilled revenue at the balance sheet date. The gross amount invoiced includes pass-through taxes and fees, which are recorded as liabilities at the time they are billed. Deferred customer revenue represents the amounts billed to customers in advance but not yet earned.
The allowance for doubtful accounts is established based upon the amount the Company ultimately expects to collect from customers and is estimated based on a number of factors, including a specific customer’s ability to meet its financial obligations to the Company, as well as general factors, such as length of time the receivables are past due, historical collection experience and the general economic environment. Customer accounts are typically written off against the allowance approximately sixty days after disconnection of the customers’ service, when the Company’s direct collection efforts cease. Customer accounts are generally considered delinquent and the service disconnection process begins when a customer is sixty days in arrears.
Bad debt expense totaled $4,821, or 1.7% of revenue, in 2007, $3,629, or 1.7% of revenue, in 2006, and $3,468, or 2.2% of revenue, in 2005. Of the total bad debt expense in 2007, $2,046 was recognized in the fourth quarter when the Company experienced the greatest impact of general economic conditions.
Cash and Cash Equivalents
Cash and cash equivalents include all U.S. government backed highly liquid investments with original maturities of three months or less at the date of purchase. The carrying amount of cash and cash equivalents approximates fair value.
Restricted Cash Equivalents and Marketable Securities
Restricted cash equivalents and marketable securities consist of money market funds held as collateral for letters of credit issued on behalf of the Company. Some vendors providing services to the Company require letters of credit to be redeemed in the event the Company cannot meet its obligations to the vendor. These letters of credit are issued to the Company’s vendors, and in return, the Company is required to maintain cash or cash equivalents on hand with the bank at a dollar amount equal to the letters of credits outstanding, in a restricted cash account that holds money market funds. In the event market conditions change and the letters of credit outstanding increase beyond the level of cash on hand at a commercial bank, the Company will be required to provide additional capital. The Company’s collateral requirements (restricted cash) were $1,135 and $1,020 as of December 31, 2007 and 2006, respectively.
Marketable Securities
Marketable securities consist of commercial paper and are classified as investments available for sale. The Company’s investments available for sale are carried at fair value or at cost, which approximates fair value. As of December 31, 2006, the Company held debt securities consisting of commercial paper maturing in January 2007 with an adjusted cost basis of $9,995, which approximated its fair value. As of December 31, 2007, all investments were in money market funds and, accordingly, the Company had no financial instruments sensitive to market risk for fluctuations in interest rates.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Inventories
The Company states its inventories at the lower of cost or market. Inventories consist primarily of mobile devices and are stated using the first-in, first-out (FIFO) method. Shipping and handling costs incurred in conjunction with the sale of inventory are included as an element of cost of revenue. The cost of mobile handsets is included in cost of revenue upon shipment to a customer.
Property and Equipment
Property and equipment are stated at cost and depreciated over estimated useful lives using the straight-line method. Leasehold improvements are amortized over the shorter of the life of the lease or the duration of their economic value to the Company. Repair and maintenance costs are expensed as incurred. The Company pays certain equipment maintenance costs in advance under multi-year maintenance contracts, which are included in current and non-current assets.
Network engineering costs incurred during the construction phase of the Company’s networks are capitalized as part of property and equipment and recorded as construction-in progress until the projects are completed and placed into service.
The Company capitalizes internal-use software in accordance with Statement of Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use (SOP 98-1). For the years ended December 31, 2007 and 2006, the Company capitalized $7,778 and $4,107, respectively, associated with these development efforts. These costs are amortized to expense generally over a period of three years depending on the useful life of the related asset.
Income Taxes
The Company accounts for income taxes in accordance with Statement of Financial Accounting Standard No. 109, Accounting for Income Taxes (SFAS 109), which requires companies to recognize deferred income tax assets and liabilities for temporary differences between the financial reporting and tax basis of recorded assets and liabilities and the expected benefits of net operating loss and credit carryforwards. SFAS 109 requires that deferred income tax assets be reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred income tax assets will not be realized. The Company evaluates the realizability of its deferred income tax assets, primarily resulting from net operating loss carryforwards, and adjusts its valuation allowance, if necessary, as occurred during the fourth quarter of 2007 (see Note 7).
Effective January 1, 2007, the Company adopted Financial Accounting Standards Board (FASB) Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109 (FIN 48). FIN 48 requires that a position taken or expected to be taken in a tax return be recognized in the financial statements when it is more likely than not (i.e., a likelihood of more than fifty percent) that the position would be sustained upon examination by tax authorities. A recognized tax position is then measured at the largest amount of benefit that is greater than fifty percent likely of being realized upon ultimate settlement. Upon adoption, the Company did not have any material unrecognized tax benefits. As of December 31, 2007, the Company does not have any material unrecognized tax benefits.
The Company is currently using Regular and Alternative Minimum Tax (AMT) net operating losses to offset taxable income expected to be generated for the year. The Company commissioned a study and determined that there was no limitation on the Company’s ability to utilize net operating loss carryforwards under Internal Revenue Code Section 382 due to changes in ownership occurring through September 13, 2006. Subsequent to
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
this study, the Company facilitated a secondary offering of its common stock in October 2006. Although the September 2006 study has not been formally updated, management has evaluated whether the effects of the secondary offering and any other transactions subsequent to September 13, 2006 have impacted the Company’s ability to utilize net operating loss carryforwards. Based on this evaluation, management concluded that no limitations have occurred which would meaningfully limit the Company’s ability to utilize its net operating loss carryforwards.
Beginning in 2007, the Company’s operations in Dallas and Houston became subject to a new state income tax, referred to as the Texas Margin Tax. The 2007 impact of the Texas Margin Tax is $148, which includes a one-time exclusion of the Company’s Texas business activity through June 30, 2007 and certain other benefits available during 2007. The estimated 2008 impact of the Texas Margin Tax is approximately $890.
The Company recognizes interest and penalties accrued related to unrecognized tax benefits as components of its income tax provision. The Company did not have any interest and penalties accrued upon the adoption of FIN 48, and, as of December 31, 2007, the Company does not have any interest and penalties accrued related to unrecognized tax benefits.
The tax years 2004 to 2006, according to statute, remain open to examination by the major taxing jurisdictions to which the Company is subject. Due to the use of net operating losses generated in tax years prior to the statutory three-year limit, earlier tax years of 2000 to 2003 may also be subject to examination.
Impairment and Other Losses on Long-Lived Assets
The Company evaluates impairment losses on long-lived assets used in operations when events and circumstances indicate that the assets might be impaired. If the Company’s review indicates that the carrying value of an asset will not be recoverable, based on a comparison of the carrying value of the asset to the undiscounted cash flows, the impairment will be measured by comparing the carrying value of the asset to the fair value. Fair value will be determined based on quoted market values, discounted cash flows or appraisals. The Company’s review will be at the lowest levels for which there are identifiable cash flows that are largely independent of the cash flows of other assets.
The Company occasionally replaces equipment and software due to obsolescence and upgrade. During the normal course of operations, the Company also writes equipment off that it is not able to recover from former customers. This equipment resides at customer locations to enable connection to the Company’s telecommunications network.
Marketing Costs
The Company expenses marketing costs, including advertising, in support of its sales efforts as these costs are incurred. Such costs amounted to approximately $2,747, $2,185 and $1,819 during 2007, 2006 and 2005, respectively.
Deferred Financing Costs
The Company has incurred a total of $260 of loan costs in connection with obtaining a five year line of credit facility commitment from Bank of America that was finalized in 2006 (the “line of credit”). In accordance with the Company’s policy, deferred loan costs are amortized from the effective date of the agreement or amendment over the then remaining life of the facility, which resulted in approximately $97 and $45 of amortization to interest expense in 2007 and 2006, respectively.
CBEYOND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Concentrations of Risk
Financial instruments that potentially subject the Company to significant concentrations of credit risk consist of trade accounts receivable, which are generally unsecured. The Company’s risk is mitigated by its accounts receivable being diversified among a high number of customers with relatively low average balances segregated by both geography and industry type. Because the Company’s operations were conducted in Atlanta, Georgia; Dallas, Texas; Houston, Texas; Denver, Colorado; Chicago, Illinois; Los Angeles, California, San Diego, California; Detroit, Michigan; and San Francisco, California through 2007, its revenues and receivables were geographically concentrated in these cities.
Fair Value
The Company has used the following methods and assumptions in estimating its fair value disclosures for financial instruments:
•
The carrying amounts reflected in the consolidated balance sheets for cash and cash equivalents, restricted cash and cash equivalents, marketable securities and accounts receivable equals or approximates their respective fair values.
•
The carrying amounts reported in the consolidated balance sheets for capital leases approximate fair value due to the use of imputed interest rates based on the variable interest rates of the Company’s prior debt.
Share-Based Compensation
Prior to January 1, 2006, the Company accounted for share-based compensation under the recognition and measurement provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees (APB 25), and related interpretations, as permitted by Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (SFAS 123). Under this guidance, the Company recognized non-cash compensation expense for share-based awards by measuring the excess, if any, of the estimated fair value of the common stock at the date of grant over the amount an employee must pay to acquire the stock and amortizing that excess on a straight-line basis over the vesting period of the applicable share-based awards. Additional paid-in capital and deferred compensation were recorded at the date of the grants to reflect the intrinsic value of the awards. Under APB 25, the deferred compensation was amortized to expense over the vesting periods on a straight line basis, with adjustments for forfeitures as they occurred.
Effective January 1, 2006, the Company adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (SFAS 123(R)) using the modified prospective transition method. Under that transition method, compensation cost recognized on or after January 1, 2006 includes: (a) compensation cost for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, and (b) compensation cost for all share-based payments granted on or after January 1, 2006, based on the grant date fair value estimated in accordance with SFAS 123(R). Results for prior periods have not been restated. Under SFAS 123(R), compensation is recorded over the vesting period directly to paid-in capital. Thus, upon adoption, the Company eliminated the deferred compensation balance relating to employee share-based awards with an offsetting reduction to additional paid-in capital.
The following pro forma information shows the effect on the Company’s statement of operations as if the Company had accounted for its employee share-based awards under the fair value method of SFAS 123 for the year ended December 31, 2005. The Company’s pro forma expense calculations under FAS 123 considered
CBEYOND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
estimated forfeitures as of the date of grant and, accordingly, are considered to reasonably approximate the expense that would have been recorded had the expense been calculated under FAS 123(R).
Basic and Diluted Net Income (Loss) Attributable to Common Stockholders per Common Share
Basic net income (loss) attributable to common stockholders per common share excludes dilution for potential common stock issuances and is computed by dividing net income (loss) attributable to common stockholders by the weighted-average common shares outstanding for the period. For the year ended December 31, 2007 and 2006, the Company reported net income, and accordingly considered the dilutive effect of share-based awards outstanding during the period. For purposes of the calculation of diluted earnings per share for the years ended December 31, 2007 and 2006, an additional 2,152 and 2,020 shares, respectively were added to the denominator because they were dilutive for the period. Weighted average shares issuable upon the exercise of stock options that were not included in the calculation of diluted earnings per share were 584 and 203 for the years ended December 31, 2007 and 2006, respectively. Such shares were not included because they were anti-dilutive. As the Company reported a net loss attributable to common stockholders for the year ended 2005, the conversion of Preferred Stock and the exercise of stock options and warrants were not considered in the computation of diluted net loss attributable to common stockholders per common share because their effect is anti-dilutive.
Reclassifications
Reclassifications have been made to the December 31, 2006 statement of cash flows and statement of stockholders’ equity to aggregate certain share based compensation amounts that were previously presented separately.
Recent Accounting Pronouncements
In June 2006, the Emerging Issues Task Force issued EITF Issue No. 06-03, How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation) (EITF 06-03). EITF 06-03 provides guidance regarding accounting for certain taxes assessed by a governmental authority that are imposed on and concurrent with specific revenue-producing
CBEYOND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
transactions between a seller and a customer. These taxes and surcharges include, among others, universal service fund charges, sales, use, value added, and some excise taxes. The Company has historically presented and will continue to present universal service fund charges on a gross basis. Such amounts totaled $5,988, $4,338 and $3,158, respectively, for the years ended December 31, 2007, 2006 and 2005.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurement (SFAS 157). This standard defines fair value, establishes a framework for measuring fair value in accounting principles generally accepted in the United States and expands disclosure about fair value measurements. This pronouncement applies to other accounting standards that require or permit fair value measurements. Accordingly, this statement does not require any new fair value measurement, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify the source of the information. This statement is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years, and is not expected to have a material impact on the Company’s financial statements.
In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (SFAS 159). This standard allows entities to voluntarily choose to measure certain financial assets and liabilities at fair value (the fair value option). The fair value option may be elected on an instrument-by-instrument basis and is irrevocable, unless a new election date occurs. If the fair value option is elected for an instrument, SFAS 159 specifies that unrealized gains and losses for that instrument shall be reported in earnings at each subsequent reporting date. SFAS 159 is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company does not expect to elect the fair value option under SFAS 159, and does not expect this statement to have a material impact on the Company’s financial statements.
3. Property and Equipment
Property and equipment consist of:
At December 31, 2007, $1,000 was included in property and equipment relating to a 20 year indefeasible right of use for certain fiber network infrastructure. This asset was not placed in service during 2007. Once placed in service in early 2008, it will be depreciated over the contract term. Any future debt outstanding under the Company’s line of credit with Bank of America will be collateralized by a pledge of substantially all of the assets of the Company.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
4. Accrued Liabilities
5. Capitalization
Common Stock
Cbeyond’s certificate of incorporation authorizes the issuance of 50,000 shares of common stock. In November 2005, Cbeyond issued 6,132 shares of common stock in an initial public offering for $12.00 a share, and as more fully described below, issued 19,546 shares of common stock as a result of the conversion of preferred shares, including accumulated dividends. The proceeds from the offering were $65,030, net of underwriter commissions of $4,941 and expenses of $3,641. Subsequent to the initial public offering and prior to December 31, 2005, all outstanding warrants were exercised in a cashless transaction resulting in the issuance of 716 common shares (see Note 6). Also in conjunction with the initial public offering, the Company effected a 1 for 3.88 reverse stock split. All share and per share amounts included in these financial statements and notes have been adjusted to reflect this split as if it were in effect for all periods presented. As of December 31, 2007, no shares were reserved for issuance under the Company’s 2002 Stock Incentive Plan (see Note 9), and 1,267 shares were reserved for issuance under the Company’s 2005 Stock Incentive Plan (see Note 9).
Preferred Stock
In November 2002, in connection with a corporate reorganization and pursuant to a stock purchase agreement, Cbeyond issued 12,398 shares of Series B preferred stock (Series B) for $3.88 per share; including 753 shares issued in conjunction with the cancellation of debt (see Note 6). In December 2004, Cbeyond amended its certificate of incorporation to authorize 15,206 shares of Series B and 1,546 shares of Series C preferred stock (Series C) and, pursuant to a stock purchase agreement with substantially all of the existing Series B preferred stockholders and certain other investors, Cbeyond issued 1,437 shares of Series C for $11.83 per share. Additionally, the Company issued 9 shares of Series B to an existing Series B preferred stockholder at $3.88 per share under the stockholders’ prior stock purchase agreement.
Each share of the Series B and Series C (collectively, the “Preferred Stock”) was convertible initially into one share of the Company’s common stock. The conversion price per share of common stock was equal to the original price paid per share of Preferred Stock. All of the shares of Preferred Stock would automatically convert to common stock in the event of a public offering of the Company’s common stock meeting certain conditions, subject to adjustment for dilutive events. In November 2005, The Company completed such a public offering. Accordingly, 12,407 and 1,570 issued and outstanding shares of Series B and Series C, respectively, were converted into common stock at the time of the transaction. The cumulative unpaid dividends of Series B and Series C were converted into 5,413 and 156 shares of common stock, respectively.
CBEYOND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The Preferred Stock accumulated dividends at an annual rate of 12% compounded daily on the Preferred Stock’s liquidation value. The liquidation value of the Preferred Stock was equal to the original price paid per share of Preferred Stock plus cumulative unpaid dividends. As provided for in the Company’s amended and restated certificate of incorporation, accumulated dividends of $22,845 accrued through the date of the public offering were paid in common stock in lieu of cash upon conversion of the Preferred Stock.
The holders of the Company’s common stock and Preferred Stock voted as one class, with each share of Preferred Stock entitled to one vote for each share of common stock issuable upon conversion.
As of December 31, 2007, Cbeyond was authorized to issue up to 15,000 shares of Preferred Stock, of which there were no shares issued or outstanding.
The following table summarizes the Preferred Stock transactions during the period covered by these financial statements:
6. Debt
Bank of America Credit Agreement
On February 8, 2006, the Company entered into a credit agreement with Bank of America that provides for a secured revolving line of credit for up to $25,000. The credit agreement terms were subsequently amended on July 2, 2007. The interest rates applicable to loans under the revolving line of credit are floating interest rates that, at the Company’s option, will equal a LIBO rate or an alternate base rate plus, in each case, and applicable margin. The current base rate is a fluctuating interest rate equal to the higher of (a) the prime rate of interest per annum publicly announced from time to time by Bank of America, as administrative agent, as its prime rate in effect at its principal office in New York City and (b) the overnight federal funds rate plus 0.50%. The interest periods of the Eurodollar loans shall be 1, 2, 3 or 6 months, at the Company’s option. The current applicable margins for LIBO rate loans are 1.75%, 2.00% and 2.25% for loans drawn in aggregate up to $8,333, between $8,333 and $16,667, and between $16,667 and $25,000, respectively. The current applicable margins for alternate base rate loans are 0.25%, 0.50%, and 0.75% for loans drawn in aggregate up to $8,300, between $8,300 and $16,700, and between $16,700 and $25,000, respectively. In addition, the Company is required to pay to Bank of America under the revolving line of credit a commitment fee for unused commitments at a per annum rate of 0.25%. The term of the facility is five years. In addition, the facility contains certain restrictive covenants, including restrictions on the payment of dividends.
At December 31, 2007 and 2006, there were no borrowings outstanding under the Bank of America Credit Agreement.
Cisco Credit Facility
The Company entered into the Credit Facility in 2001 to support the Company’s entry into its first five markets. The Credit Facility was amended five times through March 2005 to accommodate new market
CBEYOND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
expansions and changing economic conditions. After all amendments, the Credit Facility provided for borrowings of up to $105,400 through December 31, 2005, payable in quarterly installments through March 31, 2010. The majority of borrowings available under the Credit Facility were restricted to purchases of network equipment and services.
In connection with amendments to the Credit Facility in November 2002, the Company issued warrants to Cisco Capital to acquire up to 720 shares of the Company’s common stock at an exercise price of approximately $0.04 per share. The Company calculated a fair value for the warrants of $2,215. These warrants, which were subject to vesting upon the occurrence of certain triggering events, became fully vested during 2005 and were exercised in 2005 subsequent to the initial public offering.
In addition, the Company amended the Credit Facility as part of a corporate reorganization in November 2002. In conjunction with this amendment, Cisco Capital cancelled $25,000 of the amount outstanding in exchange for 753 shares of Series B (Debt Exchange). As a result of the significant discount on the value of the Company’s debt cancelled in the Debt Exchange, the Company accounted for the exchange as a troubled debt restructuring in accordance with SFAS No. 15 and EITF Issue No. 02-4, Determining whether Debtor’s Modification or Exchange of Debt Instruments is within the Scope of FASB Statement No. 15. Under SFAS No. 15, a gain is recognized to the extent that the carrying amount of the debt before the restructuring, net of unamortized discounts and loan costs and other consideration exchanged as partial settlement, exceeds future contractual payments (principal and interest combined) of the restructured debt. Based on this calculation, the Company recorded a gain of $4,338 at the date of the restructuring. Projected future interest payments estimated based on the interest rate in effect at the date of the restructuring, approximately 7.3%, were considered carrying value in excess of principal. As interest was paid in subsequent periods, payments were applied against the carrying value, resulting in no interest expense after the date of restructuring, except to the extent actual interest rates exceeded the interest rate in effect at the date of restructuring. The effects of such fluctuations were recognized in the period the applicable interest rate changed, except that no gain was recorded until it could no longer be offset by future payments.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The table below illustrates the activity recognized from the date of the troubled debt restructuring through the final pay-off of the debt after the initial public offering.
7. Income Taxes
In 2007 and 2006, the Company utilized net operating loss carryforwards to offset the majority of its taxable income. Income taxes recognized relate primarily to AMT or to states that either do not have net operating loss carryforwards or that have taxing regimes that do not consider net operating losses. In addition, the Company recorded an income tax benefit of $9,623 during the year ended December 31, 2007 for the release of a portion of the valuation allowance, resulting in an increase to basic and diluted earnings per share of $0.35 and $0.32, respectively.
CBEYOND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Due to the Company’s history of losses, the net deferred tax asset had a full valuation allowance until the fourth quarter of 2007 when the Company partially reduced its valuation allowance. This change in estimate resulted from management determining that there was sufficient positive evidence that the Company will be able to utilize a portion of its loss carryforwards to offset future taxable income. The current and deferred income tax provisions were as follows for the years ended December 31, 2007, 2006 and 2005:
The change in valuation allowance of $14,035 for the year ended December 31, 2007 consists of the benefit of $9,623 for the release of a portion of the valuation allowance against the net deferred tax asset and a change in the net deferred tax asset resulting from normal activity during the year. The Company has also revised previous deferred tax balances to reflect cumulative adjustments to certain temporary differences and net operating losses.
The following table summarizes the significant differences between the U.S. federal statutory tax rate and the Company’s effective tax rate for financial statement purposes for the years ended December 31, 2007, 2006 and 2005:
CBEYOND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The income tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective income tax bases, which give rise to deferred tax assets and liabilities, as of December 31, 2007 and 2006 are as follows:
At December 31, 2007, the Company has federal net operating loss carryforwards of approximately $131,739 and state net operating loss carryforwards of $111,783, which begin expiring in 2021. The federal net operating loss carryforward consists of both regular net operating losses of $96,453 (with a corresponding deferred tax asset of $33,759) and net operating losses related to share-based compensation of $35,286. Pursuant to FAS 123(R), any income tax benefit derived from net operating losses related to share-based compensation is reflected as additional paid-in-capital at the time such benefit is recognized. Utilization of existing net operating loss carryforwards may be limited in future years if significant ownership changes were to occur. The Company has recorded a partial valuation allowance for its net deferred tax assets at December 31, 2007 and a full valuation allowance for its net deferred tax assets at December 31, 2006 due to the uncertainty of future taxable income.
The Company continues to follow the “with and without approach”, including indirect effects under FAS 123(R) which considers the impact of the excess stock option deduction last when computing its income tax provision. Under this approach, the provision for income taxes during the year ended December 31, 2007 and December 31, 2006 consisted of $362 and $430 of estimated alternative minimum tax (AMT) expected to be due at year-end. The AMT tax results from the ability to offset only 90% of AMT net operating losses against AMT taxable income. The AMT results in a credit that will be used to offset income taxes due in future periods, when and if the Company pays regular income tax. The Company also recorded state tax expense in 2007 of $358. This expense is primarily a result of the new Taxes Margin Tax and from those states in which the Company does not have net operating loss carryforwards.
CBEYOND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
8. Employee Benefit Plan
The Company has a 401(k) Profit Sharing Plan (the Plan) for the benefit of eligible employees and their beneficiaries. All employees are eligible to participate in the Plan on the first day of the following quarter of the Plan year following the date of hire provided they have reached the age of 18. The Plan provides for an employee deferral up to the dollar limit that is set by law.
As of the year ended December 31, 2006, the Plan did not provide for a matching contribution by the employer. Effective January 1, 2007, the Company began to match 50% of contributions up to 3% of eligible compensation to all 401(k) plan participants as well as provide a Company contribution of 1.5% of eligible compensation to all active employees as of the end of the 401(k) plan year, June 30. The Company match and contribution are both funded in Company stock subsequent to the 401(k) plan year-end. The Company contribution vests over time; however, the employees may elect to sell the shares in order to diversify their investments. Although the match and contribution are provided in Company shares, Company shares are not an investment option otherwise, and the employees may not use their 401(k) to purchase additional Company shares.
9. Share-Based Compensation Plans
In November 2005, in connection with the Company’s initial public offering, the Company adopted the Cbeyond Communications, Inc. 2005 Equity Incentive Plan (Incentive Plan). The Incentive Plan permits the grant of nonqualified stock options, incentive stock options, restricted stock and stock purchase rights, collectively referred to as share-based awards. The number of shares of common stock that may be issued can increase on January 1st of each year according to terms specified under the Incentive Plan. On January 1, 2007, the number of shares covered by the Incentive Plan increased by 851 shares. At December 31, 2007, the number of shares of common stock that may be issued pursuant to the Incentive Plan was 6,657, including 3,615 shares rolled over into the Incentive Plan from the Company’s previous stock incentive plans. Substantially all of the share-based awards granted under the Incentive Plan following the 2005 initial public offering vest at a rate of 25% per year over four years, although the Board of Directors may occasionally approve a different vesting period. Options are granted at exercise prices not less than the fair market value of the Company’s common stock on the date of grant. The fair market value of the Company’s common stock is determined by the closing price of the Company’s common stock on the NASDAQ Global Market on the grant date. Beginning in 2007, the Company’s policy defines the grant date as the second day following a quarterly earnings release for previously approved standard option grants. Share-based awards expire 10 years after the grant date.
In November 2002, in connection with the Company’s recapitalization, the Company adopted the Cbeyond Communications, Inc. 2002 Equity Incentive Plan (2002 Plan) and issued 1,621 and 295 options thereunder with respective vesting periods of two and three years. The 2002 Plan permits the grant of nonqualified stock options, incentive stock options and stock purchase rights. The number of shares of common stock that may be issued pursuant to the 2002 Plan is 3,608. Substantially all of the options granted under the 2002 Plan following the 2002 recapitalization vest at a rate of 25% per year over four years, although the Board of Directors may occasionally approve a different vesting period. Options issued under the 2002 Plan were generally granted at exercise prices equal to the estimated fair value of the Company’s common stock on the date of grant. For each fiscal year since the 2002 recapitalization and prior to the Company’s initial public offering in November 2005, the Company had determined the fair value of its common stock by using independent external valuation events
CBEYOND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
such as arms-length transactions in the Company’s shares, significant business milestones that may have affected the value of our business, and internal valuation estimates based on discounted cash flow analysis of the Company’s financial results or other metrics, such as multiples of revenue and adjusted EBITDA. Options expire 10 years after the grant date.
In addition to the 2002 Plan, the Company also maintains a 2000 Stock Incentive Plan (2000 Plan), of which the number of shares of common stock that may be issued pursuant to the 2000 Plan is 7. All of the shares that remained available for issuance under the 2002 Plan and the 2000 Plan were rolled into the Incentive Plan and no additional awards will be granted under either the 2002 Plan or the 2000 Plan. All awards granted under the 2002 Plan or 2000 Plan that expire without having been exercised or are cancelled, forfeited or repurchased also will become available for grant under the Incentive Plan.
A summary of the status of the Incentive Plan, the 2002 Plan and the 2000 Plan is presented in the table below:
During 2007, the weighted average fair value of the 620 options and 1 restricted stock unit that vested during the period was $7.64 and $29.62 per share, respectively, representing a total fair value vested during the period of $4,737 and $39, respectively. During 2006, the total fair value of the 5 shares of restricted stock granted and vested during the period was $106. The fair value of share based awards measured at the applicable grant date is amortized over the vesting period and recognized as non-cash share-based compensation in the consolidated statement of operations. The Company has 1,267 share-based awards available for future grant as of December 31, 2007.
CBEYOND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Prior to January 1, 2006, the Company followed APB No. 25 and related Interpretations in accounting for its stock options. Under APB No. 25, if the exercise price of the Company’s employee stock options equaled or exceeded the market value of the underlying stock on the date of the grant, no compensation expense was recognized. Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS 123(R), under which the Company recognizes, as expense over the applicable service period, the fair value of the options granted. Total share-based compensation expense recognized in 2007 totaled $9,989 under the new method, a reduction of $0.36 and $0.34, respectively, in basic and diluted earnings per share. In 2006, total share-based compensation expense totaled $4,355 under the new method, a reduction of $0.16 and $0.15, respectively, in basic and diluted earnings per share. Additionally, the adoption increased cash flows from financing activities and decreased cash flows from operating activities by $657 and $290 in 2007 and 2006, respectively, relating to excess tax benefits from the exercise of stock options.
The fair value of options was estimated at the date of grant using a binomial option-pricing model with the following weighted-average assumptions:
The Company accounts for equity instruments issued to non-employees in accordance with the provisions of SFAS No. 123(R) (or SFAS No. 123 for periods prior to January 1, 2006) and EITF Issue No. 96-18, Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with, Selling Goods or Services. All transactions in which goods or services are the consideration received for the issuance of equity instruments are accounted for based on the fair value of the equity instrument issued, which the Company deems more reliably measurable than the fair value of the consideration received. The measurement date of the fair value of the equity instrument issued is the earlier of the date on which the counterparty’s performance, or obligation to perform, is complete or the date on which it is probable that performance will occur.
Management evaluates the appropriateness of its underlying assumptions each time it estimates the fair value of equity instruments requiring measurement under SFAS 123(R). To assist management in validating its assumptions, the Company periodically engages consultants with relevant experience to assess and evaluate its assumptions.
The risk-free interest rate used in estimating the fair value of options is based on the U.S. Treasury zero-coupon securities using the contractual term of the option. The Company also uses historical data to estimate the suboptimal exercise barrier and the forfeiture rate of options granted. Through the third quarter of 2007, the Company had not been a public company long enough to rely on its own volatility history. Therefore, expected volatility was based on historical volatilities experienced by companies considered comparable to Cbeyond based on four primary categories: size, stage of lifecycle, capital structure and industry. This approach to estimating volatility remained consistent over time, although the mix and weighting of representative volatilities were refined periodically to ensure that the four primary categories were appropriately considered. Beginning in the fourth quarter of 2007, the Company began using its own market-based historical volatility. In reviewing the modifications to the development of its underlying valuation assumptions, the Company considered whether applying the refined assumptions would have had a material impact on recent valuations performed using the previous assumptions, noting that the effect on compensation expenses would not have resulted in a materially different amount.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Options with graded vesting are expensed on a straight line basis over the vesting period. The amount of compensation cost recognized at any date is at least equal to the portion of the grant date value of the award that is vested at that date. During the years ended December 31, 2007, 2006 and 2005, the Company issued 769, 854, and 34 shares resulting from the exercise of common stock and vesting of restricted stock, respectively, resulting from the exercise of stock options. The total intrinsic value of options exercised during the years ended December 31, 2007, 2006 and 2005, based on market value at the exercise dates is set forth in the table above. As of December 31, 2007, unrecognized compensation cost related to unvested stock option awards totals approximately $23,403 and is expected to be recognized over a weighted-average period of 1.88 years.
As described in Note 8, the Company has a commitment to contribute shares to the Plan at the end of each plan year (June 30). The number of shares is variable based on the share price on the last day of the plan year when the obligation becomes fixed and payable. Based on the December 31, 2007 share price, 21 shares are required to satisfy the $721 obligation accrued from July 1, 2007 to December 31, 2007. The ultimate number of shares relating to the obligation at December 31, 2007 will be higher or lower depending on whether the share price on June 30, 2008 has decreased or increased from the December 31, 2007 share price. In addition, the shares that will be issued in 2008 will increase relating to further obligations accruing from January 1, 2008 through June 30, 2008.
During the year ended December 31, 2007, the Company recognized $1,480 of share-based compensation expense relating to the match and contribution under the Plan. As of the last day of the 401(k) plan year, the Company’s contribution relating to the six months ended June 30, 2007 became fixed based on the active 401(k) plan participants as of the end of the plan year. Accordingly, the Company contributed 21 shares of Company stock to the respective employees’ 401(k) accounts in July 2007.
10. Commitments
The Company has entered into various operating leases, with expirations through June 2016, for network facilities, office space, equipment, and software used in its operations. Future minimum lease obligations under non-cancelable operating leases as of December 31, 2007 are as follows:
Total rent expense for the years ended December 31, 2007, 2006 and 2005 was $4,957, $3,360 and $2,766, respectively. Certain real estate leases have fixed escalation clauses, holidays, and leasehold improvement allowances. Such leasehold improvement allowances were $2,565, $1,775 and $887 in 2007, 2006 and 2005, respectively. These allowances are capitalized as leasehold improvements, which are depreciated over the shorter of their useful lives or the lease term. Expense under such operating leases is recorded on a straight-line basis over the life of the lease. The Company’s lease agreements also generally have lease renewal options that are at its discretion and range in terms.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
At December 31, 2007, the Company had outstanding letters of credit of $1,135. These letters of credit expire at various times through May 2016 and collateralize the Company’s obligations to third parties.
11. Selected Quarterly Financial Data (unaudited)
Unaudited Interim Results
12. Segment Information
The Company’s management monitors and analyzes financial results on a segment basis for reporting and management purposes. Specifically, the Company’s chief operating decision maker allocates resources to and evaluates the performance of its segments based, depending on which segment, on revenue, direct operating expenses, and certain non-GAAP financial measures. The accounting policies of the Company’s reportable segments are the same as those described in the summary of significant accounting policies.
At December 31, 2007, the operating segments were geographic and included Atlanta, Dallas, Denver, Houston, Chicago, Los Angeles, San Diego, Detroit and the San Francisco Bay Area. Although Miami and Minneapolis have not yet entered their operating phase as of December 31, 2007, the pre-launch expenses and/or capital expenditures associated with preparing for operations and building out the network infrastructure are disclosed for purposes of this segment disclosure. The balance of the Company’s operations is in its Corporate group, for which the operations consist of corporate executive, administrative and support functions and centralized operations, which includes network operations, customer care and provisioning. The Corporate group is treated as a separate segment consistent with the manner in which management monitors and analyzes financial results.
Corporate costs are not allocated to the other segments because such costs are managed and controlled on a functional basis that spans all markets, with centralized, functional management held accountable for corporate
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
results. Management also believes that the decision not to allocate these centralized costs provides a better evaluation of each revenue-producing geographic segment. Management does not report assets by segment since it manages assets and makes decisions on technology deployment and other investments on a company-wide rather than on a local market basis. The chief operating decision maker does not use segment assets in evaluating the performance of operating segments. As a result, management does not believe that segment asset disclosure is meaningful information to investors. In addition to segment results, the Company uses total adjusted EBITDA to assess the operating performance of the overall business. Because the chief operating decision maker primarily evaluates the performance of each segment on the basis of adjusted EBITDA, management believes that segment adjusted EBITDA data should be available to investors so that investors have the same data that management employs in assessing the Company’s overall operations. Our chief operating decision maker also uses revenue to measure our operating results and assess performance, and both revenue and adjusted EBITDA are presented herein in accordance with SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information.
EBITDA is a non-GAAP financial measure commonly used by investors, financial analysts and ratings agencies. EBITDA is generally defined as net income (loss) before interest, income taxes, depreciation and amortization. However, the Company uses adjusted EBITDA, also a non-GAAP financial measure, to further exclude, when applicable, non-cash share-based compensation, public offering expenses, gains relating to troubled debt restructuring and the early payoff of restructured debt, gain or loss on asset dispositions and other non-operating income or expense. Adjusted EBITDA is presented because this financial measure, in combination with revenue and operating expenses, is an integral part of the internal reporting system used by the Company’s chief operating decision maker to assess and evaluate the performance of its business and its operating segments, both on a consolidated and on an individual basis.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The table below presents information about the Company’s reportable segments:
CBEYOND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
CBEYOND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
13. Public Offering Costs
In early 2005, the Company began incurring costs associated with its initial public offering which was completed in November 2005. The costs associated with the November 2005 public offering, excluding the underwriting discount, totaled $3,641 and were offset against the proceeds of the offering.
In October 2006, the Company completed a secondary public offering of 4,907 shares of common stock, including 201 shares that were issued by the Company in connection with option exercises executed at the time of the offering. All offered shares were from existing stockholders with no proceeds to the Company. All direct costs of this offering, which were primarily legal and accounting fees with outside service firms related to the preparation of the registration statement, were expensed as incurred and totaled $945.
14. Contingencies
Triennial Review Remand Order
In February 2005, the Federal Communications Commission (FCC) issued its Triennial Review Remand Order (TRRO) and adopted new rules, effective March 11, 2005, governing the obligations of incumbent local exchange carriers (ILECs) to afford access to certain of their network elements, if at all, and the cost of such facilities. The TRRO reduces the ILECs’ obligations to provide high-capacity loops within, and dedicated transport facilities between, certain ILEC wire centers that are deemed to be sufficiently competitive, based upon various factors such as the number of fiber-based collocators and/or the number of business access lines within such wire centers. In addition, certain caps are imposed regarding the number of unbundled network element (UNE) facilities that the ILECs are required to make available on a single route or into a single building. Where the wire center conditions or the caps are exceeded, the TRRO eliminated the ILECs’ obligations to provide these high-capacity circuits to competitors at the discounted rates historically received under the 1996 Telecommunications Act.
The rates charged by ILECs for the Company’s high-capacity circuits in place on March 11, 2005 that were affected by the FCC’s new rules were increased 15% effective for one year until March 2006. In addition, by March 10, 2006, the Company was required to transition those existing facilities to alternative arrangements, such as other competitive facilities or the higher-priced “special access services” offered by the ILECs, unless another rate had been negotiated. Subject to any contractual protections under the Company’s existing interconnection agreements with ILECs, beginning March 11, 2005, the Company was also potentially subject to the ILECs’ higher “special access” pricing for any new installations of DS-1 loops and/or DS-1 (the capacity equivalent of a T-1) and DS-3 (the capacity equivalent of 28 T-1s) transport facilities in the affected ILEC wire centers, on the affected transport routes or that exceeded the caps.
Beginning on March 11, 2005, the Company began estimating and accruing the difference between the new pricing resulting from the TRRO and the pricing being invoiced by ILECs. The Company continues to accrue certain amounts relating to the implementation of the TRRO due to billing rates that continue to reflect pre-TRRO pricing. A substantial amount of these accrued expenses have never been invoiced by the ILECs and are subject to a two-year statutory back billing limit. During the year ended December 31, 2007 approximately $425 of TRRO expenses accrued from March 11, 2005 to December 31, 2005 passed the statutory back billing limit and were reversed as a benefit to cost of revenue. For the portion of the accrued TRRO expenses that have been invoiced as of December 31, 2007, the Company has been billed $2,434 in excess of the amount it has cumulatively recognized in its results of operations. Management believes these excess billings are erroneous and that the amounts accrued represent the best estimate of the final settlement of these liabilities.
CBEYOND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The Company estimated the probable liability for implementation of certain provisions of the TRRO and has accrued approximately $6,211, $4,400 and $1,893 for the years ended December 31, 2007, 2006 and 2005, respectively for these liabilities. Due to the TRRO provisions, $1,803, $2,507 and $1,893 was charged to cost of revenue in the year ended December 31, 2007, 2006 and 2005, respectively. These estimates are for all markets and, where alternate pricing agreements have not been reached, are based on special access rates available under volume and/or term pricing plans. The Company believes volume and/or term pricing plans are the most probable pricing regime to which we are subject to based on the Company experience and its intent to enter into volume and/or term commitments where more attractively priced alternatives do not exist.
During October 2006, the Company amended its interconnection agreement for the Atlanta market. This agreement established the pricing in effect from March 11, 2005 through March 10, 2006 for certain circuits added subsequent to March 11, 2005. The agreed upon pricing was lower than the special access rates previously accrued, resulting in a reduction of the accrual and expense of $304, $216 of which relates to 2005. This change in estimate is reflected in the results of operations for year ended December 31, 2006.
General Regulatory Contingencies
The Company operates in a highly regulated industry and is subject to regulation and oversight by telecommunications authorities at the federal, state and local levels. Decisions made by these agencies, including the various rulings made to date regarding interpretation and implementation of the TRRO, compliance with various federal and state rules and regulations and other administrative decisions are frequently challenged through both the regulatory process and through the court system. Challenges of this nature often are not resolved for long periods of time and occasionally include retroactive impacts. At any point in time, there are a number of similar matters before the various regulatory agencies that could be either beneficial or adverse to the Company’s results of operations. In addition, the Company is always at risk of non-compliance, which can result in fines and assessments. The Company regularly evaluates the potential impact of matters undergoing challenges and matters involving compliance with regulations to determine whether sufficient information exists to require either disclosure and/or accrual in accordance with Statement of Financial Accounting Standard No. 5, Accounting for Contingencies. However, due to the nature of the regulatory environment, reasonably estimating the range of possible outcomes and the probabilities of the possible outcomes is difficult since many matters could range from a gain contingency to a loss contingency.
Dissolution of Captive Leasing Entities
Effective December 31, 2006, the Company dissolved and collapsed its captive leasing companies. These entities, historically, purchased assets tax-free and leased the assets to the operating companies as a means of preserving cash flow in the Company’s start-up phase of operations. During 2006, management determined that the nature of the Company’s operations and experience with asset duration did not justify the administrative cost and effort of maintaining these entities. In connection with the collapse, a final accounting of all activity under the leasing entities was performed and reconciled back to historical sales tax filings. Certain underpayments were identified that resulted in the recognition of approximately $128 in penalties and interest in selling, general and administrative costs during the fourth quarter of 2006. This amount represents management’s best estimate of what it believes it will have to pay in connection with finalizing all sales tax returns for the leasing entities. During 2007, an additional $74 in penalties and interest were accrued related to these underpayments. There are certain scenarios that are reasonably possible where a taxing authority could calculate penalties and interest in excess of the amounts accrued by the Company. In accordance with FAS 5, the additional interest and penalties could range from zero to $516.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
15. Related Party Transactions
Cbeyond has had a close relationship with Cisco Systems, Inc. and its financing subsidiary, Cisco Systems Capital (collectively, Cisco). Cisco has been and continues to be one of the Company’s major equipment suppliers. In addition, one of its executives is on the Company’s Board of Directors and Audit Committee.
Cisco was also the Company’s principal lender until shortly after the Company’s initial public offering when Cbeyond repaid all outstanding borrowings and cancelled its credit facility. In connection with transactions under the credit arrangement, Cisco became a significant shareholder of the Company.
During the year ended December 31, 2007, 2006, and 2005, the Company purchased approximately $21,148, $18,700, and $7,550, respectively, of equipment and services from Cisco. As of December 31, 2007 and 2006, the Company’s outstanding accounts payable to Cisco totaled approximately $1,012 and $1,300, respectively.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures
None.
Item 9A.
Item 9A. Controls and Procedures
Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(b) as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective.
Management's Annual Report On Internal Control Over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. With the participation of our Chief Executive Officer and Chief Financial Officer, management conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2007 based on the Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management concluded that our internal control over financial reporting was effective as of December 31, 2007. There were no changes in our internal control over financial reporting during the quarter ended December 31, 2007 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Our independent registered public accounting firm, Ernst & Young LLP, has audited and reported on our consolidated financial statements and the effectiveness of our internal control over financial reporting, which appear in Item 8 of this Annual Report.
Item 9B.
Item 9B. Other Information
None.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
The information required by this item will be contained in our definitive proxy statement issued in connection with the 2008 annual meeting of stockholders filed with the SEC within 120 days after December 31, 2007 and is incorporated herein by reference.
The Board of Directors for Cbeyond, Inc. (the “Company”) has adopted a Code of Ethics. This Code of Ethics applies to all of the Company’s directors, officers and employees and all such individuals are required to strictly adhere to the principles as described in the Code of Ethics. The Code of Ethics is available on our website at www.cbeyond.net.
Item 11.
Item 11. Executive Compensation
The information required by this item 11 will be contained in our definitive proxy statement under the captions “The Board of Directors and Committees,” “Executive Compensation,” “Compensation Discussion and Analysis,” and “Compensation Committee Interlocks and Participation” issued in connection with the 2008 annual meeting of stockholders filed with the SEC within 120 days after December 31, 2007 and is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters
The information required by this item 12 will be contained in our definitive proxy statement under the caption “Security Ownership of Certain Beneficial Owners” issued in connection with the 2008 annual meeting of stockholders filed with the SEC within 120 days after December 31, 2007 and is incorporated herein by reference.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
The information required by this Item 13 will be contained in our definitive proxy statement under the caption “Certain Relationships and Related Transactions” issued in connection with the 2008 annual meeting of stockholders filed with the SEC within 120 days after December 31, 2007 and is incorporated herein by reference.
Item 14.
Item 14. Principal Accounting Fees and Services
The information required by this item 14 will be contained in our definitive proxy statement under the caption “Ratification of Independent Registered Public Accounting Firm” issued in connection with the 2008 annual meeting of stockholders filed with the SEC within 120 days after December 31, 2007 and is incorporated herein by reference.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
(A) 1. Financial Statements.
The response to this item is included in Item 8.
2. Financial Statement Schedule.
The following financial statement schedule is filed as a part of this report.
Schedule II-Valuation and Qualifying Accounts
Years Ended December 31, 2007, 2006, and 2005
(Dollars in thousands)
(1) Represents accounts written off during the period less recoveries of accounts previously written off.
3. Exhibits
See the response to Item 15(b) below.
(B) Exhibits.
The following exhibits are filed as part of, or are incorporated by reference into, this report on Form 10-K:
INDEX TO EXHIBITS
(a) Incorporated by reference to Registration Statement on Firm S-1 filed on September 19, 2006 (File No. 333-137445), as amended by Amendment No. 1 filed on September 25, 2006.
(b) Incorporated by reference to Registration Statement on Form S-1 filed on May 16, 2005 (File No. 333-124971), as amended by Amendment No. 1 filed on June 30, 2005, by Amendment No. 2 filed on July 27, 2005, by Amendment No. 3 filed on August 24, 2005, by Amendment No. 4 filed on September 20, 2005, by Amendment No. 5 filed on October 3, 2005, by Amendment No. 6 filed on October 5, 2005, by Amendment No. 7 filed on October 7, 2005 and by Amendment No. 8 filed on October 27, 2005.
(c) Incorporated by reference to Form 8-K dated February 14, 2006 filed on February 14, 2006 (File No. 000-51588).
(d) Incorporated by reference to Form 10-Q for second quarter 2007, filed on August 7, 2007 (File No. 000-51588).
(e) Incorporated by reference to Form 10-Q for third quarter 2007 filed on November 6, 2007 (File No. 000-51588).
(f) Cbeyond, Inc. plans to enter into these At-Will Employment Agreements with such individuals shortly after the filing of this report.
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.
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 and in the capacities and on the dates indicated.