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CBEY > SEC Filings for CBEY > Form 10-Q on 8-May-2014All Recent SEC Filings

Show all filings for CBEYOND, INC.

Form 10-Q for CBEYOND, INC.


Quarterly Report

Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Please read the following discussion together with our Condensed Consolidated Financial Statements and the related notes and other financial information included elsewhere in this periodic report and our Annual Report on Form 10-K. The discussion in this periodic report contains forward-looking statements that involve risks and uncertainties, such as statements of our plans, objectives, expectations, and intentions. The cautionary statements made in this report should be read as applying to all related forward-looking statements wherever they appear in this report. Our actual results could differ materially from those discussed here. See "Cautionary Notice Regarding Forward-Looking Statements" elsewhere in this report.
Cbeyond is the technology ally for small and mid-sized businesses. We enable our customers to focus on their core business activities by shifting the burden of IT infrastructure management to us. We deliver cloud-based services, communications services, and network connectivity through award-winning enterprise data centers and a private, all-IP enterprise network. Our strategy is based on the belief that small and mid-sized businesses highly value the capabilities and productivity such technologies and services enable, but do not generally have the resources, expertise, or time to purchase and manage them, particularly for the smaller scale of operations typical of our target customers.
Founded in 1999, Cbeyond is a technology service provider with a long history of delivering innovative technologies and services to small and mid-sized businesses. We first launched our service offerings in Atlanta in April 2001 and have since expanded our on-net network and service offerings into 13 additional metropolitan markets. Our off-net network, which is managed by third-party network providers, extends the reach of our services across the majority of the United States.
Recognizing that our greatest value proposition for customers is when we are able to bring them those technologies and services that are more resource intensive or difficult to obtain and manage, we focus more of our selling and service delivery efforts toward small and mid-sized businesses that are dependent on technology and have complex IT needs. Our research enables us to define and quantify a segment of the small-business customer market called the "technology-dependent" customer. Technology-dependent customers have the following characteristics:
• The bulk of their employees use personal computers on the job;

• They have knowledge workers who need to share data from a centralized source;

• They have remote workers who need to access data on the go;

• They need symmetric Metro Ethernet to run their business;

• They are often multi-location businesses; and

• They have a willingness to consider outsourcing their infrastructure as a way to preserve capital and increase both focus and productivity.

In connection with our focus on technology-dependent customers, we defined certain of our technology-dependent customers as "Cbeyond 2.0" customers. Cbeyond 2.0 customers are those customers that we provide network access at speeds of 10 Mbps and higher, or certain cloud-based services, such as virtual servers, physical servers, or cloud PBX services. In addition, we designate customers using our MPLS service as Cbeyond 2.0 customers. We refer to all other customers as Cbeyond 1.0 customers. Although Cbeyond 1.0 customers also frequently purchase cloud-based services from us, we delineate between Cbeyond 1.0 and Cbeyond 2.0 based on how pervasive or significant we believe such services are to a customer's operation. Specifically, we consider the cloud-based services that qualify a customer as Cbeyond 2.0 as infrastructure-as-a-service in nature. We believe the distinction is important because infrastructure services are generally longer-term in nature, generate higher revenues, and provide a gateway for software-as-a-service products. We estimate that almost one-half of our customers are technology-dependent, but are not currently considered Cbeyond 2.0 customers because either they do not currently utilize cloud-based solutions or advanced network services, or they obtain these services from other providers. We believe this makes them strong prospects to become Cbeyond 2.0 customers. During the three months ended March 31, 2014, we generated $24.5 million, or 22.5% of revenue from Cbeyond 2.0 customers, which represents a 78.1% increase over the amount recognized from Cbeyond 2.0 customers during the three months ended March 31, 2013. In early 2012, we announced our plan to realign our distribution channels by building a new direct sales group dedicated to managing both existing and new technology-dependent customers, reducing our traditional direct sales force, and consolidating certain offices. Since our initial realignment actions, we have made and continue to make adjustments to our distribution channels and service organizations based on the experience gained in targeting technology-dependent customers.

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In January 2014, we implemented a workforce reduction plan to rebalance our resources to support the continued implementation of this strategy and to address the current financial impacts of our transformation, including reducing expenses to offset a portion of expected revenue declines and the compression of margins. This workforce reduction plan affected approximately 100 employees and resulted in $2.3 million of realignment charges recognized in the first quarter of 2014. During the first quarter of 2014, we also closed or downsized certain branch offices, incurring approximately $0.3 million in losses under non-cancelable office leases. We have incurred cumulative realignment costs of $6.9 million as of March 31, 2014.
On April 19, 2014, the Company entered into a definitive agreement to be acquired by Birch Communications, Inc. Under the terms of the agreement, which was unanimously approved by the Company's Board of Directors on April 19, 2014, the Company's stockholders will receive between $9.97 and $10.00 per share in cash, in a transaction valued at approximately $323.4 million. The exact amount that the Company's stockholders will receive will be based on the actual number of shares of the Company's common stock (including restricted stock) and stock options outstanding at the effective time of the transaction, which will be determined, in part, by stock transactions relating to previously granted stock awards to employees that occur after April 19, 2014. In connection with the transaction, Birch has obtained debt financing commitments from PNC Bank, National Association, PNC Capital Markets LLC and Jefferies Finance LLC. The transaction is subject to approval by the Company's stockholders, receipt of regulatory approvals and other customary closing conditions, and is expected to close in the third quarter of 2014.

Revenue (in thousands)
                                   Three months ended March 31,          Change from Previous Period
                                       2014              2013             Dollars             Percent
1.0 customer revenue             $        84,074     $   106,214     $       (22,140 )          (20.8 )%
2.0 customer revenue                      24,463          13,732     $        10,731             78.1  %
Total revenue                    $       108,537     $   119,946     $       (11,409 )           (9.5 )%

Our focus on realigning our sales force to acquire higher-value customers has resulted in a lower number of new customers than we have achieved historically. Because of this, in recent periods, customer churn has exceeded new customer growth, resulting in a decline in customers and total revenue. We expect similar trends in the near-term until our realignment results in Cbeyond 2.0 customer revenue growth exceeding the revenue from churned Cbeyond 1.0 customers. Our revenue growth strategy includes offering service bundles that are increasingly oriented toward higher-value, technologically sophisticated solutions; however, a significant portion of our revenue base is derived from providing traditional telecommunications services. For the one-half of our existing customer base that we do not consider technology-dependent, traditional telecommunications services will continue to be our primary source of revenue. To support the higher bandwidth needs of technology-dependent customers, we are acquiring fiber network assets in multiple markets primarily under 20-year capital leases, including agreements for the indefeasible rights of use (or "IRU") of certain fiber network assets. During the three months ended March 31, 2014 and 2013, we took delivery of fiber assets with future minimum capital lease obligations of $1.2 million and $3.0 million, respectively. The cash outlays for these obligations are financed through fiber providers and will be payable by us as capital lease obligations.
In addition to our fiber capital lease obligations, we have outstanding construction orders for fiber assets with future minimum lease payments of $10.7 million, for which we have obtained BAAs. As of March 31, 2014, we have placed additional construction orders that total $20.5 million for which we have not yet obtained BAAs. We do not expect to be able to obtain BAAs for every order placed. Therefore, we expect a portion of these orders may never be constructed. Additional construction orders may be placed under these contracts in the future.
We currently include all revenue from customers who purchase network access from us within our average monthly revenue per customer location (or "ARPU") calculation. Thus, revenue from customers who purchase cloud-based services independent of network access is excluded from ARPU. After considering all cloud-based services, we believe that Cbeyond 2.0 customers currently provide a significantly higher ARPU than that of our Cbeyond 1.0 customers. We have not determined the revenue metrics that best represent the results of the consolidated business or the results from customers that purchase cloud-based services independent of network access.
We have focused our sales efforts on customers that purchase both network and cloud-based services based on the belief that these services, when combined, offer the greatest value proposition to customers and allow us significantly greater control over the quality of services. Therefore, revenue from non-network customers has not grown as quickly as revenue from customers who purchase both network and cloud-based services from us. Given the significant revenue opportunities that we believe exist from non-network customers, we will begin actively selling certain cloud-based services, such as cloud PBX with mobile services, independent of network access. We expect that in the next few quarters these efforts will begin to result in higher revenue growth from non-network customers than in prior periods.

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Calculation of ARPU (Dollar amounts in thousands, except ARPU)

                                              Three months ended March 31,
                                                2014                 2013
Total revenue                             $      108,537       $      119,946
Revenue from non-network customers        $       (3,746 )     $       (3,650 )
(A) Network access customer revenue       $      104,791       $      116,296
(B) Average network access customers              52,841               59,063
ARPU (A / B / number of months in period) $          661       $          656

As we accelerate sales of cloud-based services to both new and existing technology-dependent customers, we expect our revenue to include an increasing proportion of higher ARPU Cbeyond 2.0 customers. Our concentrated focus on technology-dependent customers has resulted in a net decline in customers in recent periods. Longer-term, we expect that ARPU will increase as our customer mix becomes more oriented to those who are technology-dependent and are using our services to satisfy their technology needs. In addition, we expect that our future capital expenditures and operating expenses will continue to be more focused on selling to these types of customers. Operating expenses will include the cost of revenue to support a higher bandwidth Metro Ethernet network and the selling expenses of a more focused and consultative sales force. Capital expenditures will include the costs of building out a higher bandwidth network, additional hosting infrastructure, and product development.
Our chief operating decision maker uses Adjusted EBITDA and Free Cash Flow on a consolidated basis, accompanied by disaggregated revenue information by service offering, to assess the financial performance of the business. We believe Adjusted EBITDA and Free Cash Flow are important performance metrics for evaluating our ability to generate cash that can potentially be used by the business for capital investments, acquisitions, reduction of debt, or potential payment of dividends or share repurchases. We have also designed our corporate bonus plan to include Adjusted EBITDA as a component.
Management believes that Adjusted EBITDA data should be available to investors so that investors have the same data that management employs in assessing operations. EBITDA is a non-GAAP financial measure commonly used by investors, financial analysts, and ratings agencies. EBITDA is generally defined as net income (loss) before interest, income taxes, depreciation, and amortization. However, we use Adjusted EBITDA, also a non-GAAP financial measure, to further exclude, when applicable, non-cash share-based compensation; public offering or acquisition-related transaction costs; purchase accounting adjustments; gains, losses, and other costs associated with asset dispositions; and non-operating income or expense. Adjusted EBITDA may exclude charges for employee severances, asset or facility impairments, other exit activity costs associated with a management directed plan (including realignment costs), and costs associated with our strategic review.
We define Free Cash Flow as Adjusted EBITDA less cash capital expenditures. For purposes of calculating Free Cash Flow, we distinguish capital expenditures that require the up-front outlay of cash from those where payment is deferred on a longer-term basis. This distinction is driven primarily by the significant investments we are making to lease fiber network assets that generally have an expected useful life of 20 years, which is substantially longer than our typical asset lives. We believe this distinction is warranted and appropriate since these investments are expected to yield meaningful positive cash flows in future periods when the debt and lease payments occur. These favorable future cash flows will result from fiber infrastructure replacing a portion of the access and transport circuits previously leased from ILECs. Reconciliation of Capital Expenditures (in thousands)

                                     Three months ended March 31,
                                           2014                  2013
Cash capital expenditures (1)  $        12,929                 $ 12,434
Non-cash capital expenditures:
Fiber capital lease assets               1,242                    3,017
Total capital expenditures     $        14,171                 $ 15,451

(1) Represents cash purchases of property and equipment per the Condensed Consolidated Statements of Cash Flows.

Adjusted EBITDA decreased $3.9 million, or 18.8% during the three months ended March 31, 2014 over the comparable period in 2013. The decline in Adjusted EBITDA reflects the decline in our customer base to whom we provide traditional telecommunications services, partially offset by an increase in revenue from Cbeyond 2.0 customers, a reduction in cost of revenue caused by recent changes in the way we assess telecommunication-related fees, and a lower average number of employees.

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Reconciliation of Free Cash Flow and Adjusted EBITDA to Net loss (in thousands)

                                               Three months ended March 31,
                                                  2014               2013
Free Cash Flow                              $       3,986       $       8,399
Cash capital expenditures                          12,929              12,434
Adjusted EBITDA                             $      16,915       $      20,833
Depreciation and amortization                     (16,191 )           (17,605 )
Non-cash share-based compensation                  (2,713 )            (2,979 )
Realignment costs (1)                              (2,631 )              (467 )
Strategic review costs (2)                           (710 )                 -
Costs associated with asset disposition (3)          (100 )                 -
Interest expense, net                                (232 )              (153 )
Loss before income taxes                           (5,662 )              (371 )
Income tax expense                                   (263 )              (185 )
Net loss                                    $      (5,925 )     $        (556 )

(1) During the three months ended March 31, 2014, $2.6 million of realignment costs are included in Selling, general and administrative expense as compared to $0.5 million for the comparable period in 2013. See Note 5 to the Condensed Consolidated Financial Statements .

(2) Amounts related to our strategic review primarily include fees incurred with bankers and advisors.

(3) During the three months ended March 31, 2014, we incurred $0.1 million of costs related to our fiber dispute discussed in Note 10 to the Condensed Consolidated Financial Statements .

Our revenue is disaggregated into Network, Voice and Data or Managed Hosting and Cloud. Managed Hosting and Cloud includes virtual servers, physical servers, and cloud PBX services to customers and distribution channels that are not limited by geographical location. Our focus is to provide these services to Network access customers; however, certain customers purchase these cloud-based services independent of network access. Managed Hosting and Cloud also includes other services, such as virtual receptionist, Microsoft® Exchange hosting, Web hosting, and fax-to-email, that are purchased by Network access customers in quantities that exceed those included in their bundled service package. We seek to sell our bundled service offerings through three-year contracts, but also offer one-year and two-year contracts at generally higher prices. As a result, customer churn rates impact our projected future revenue streams. We define customer churn rate for a given month as the number of Network access customers disconnected in that month divided by the total number of Network access customers at the beginning of that month. Due to differences in ARPU between Cbeyond 1.0 customers and Cbeyond 2.0 customers, we believe a unit-based churn metric may become less meaningful than it has been historically. In the future, we may transition to a revenue-based churn metric that will be applicable to all revenue, including revenue from customers that purchase cloud-based services independent of network access.
Although not a significant source of our Network, Voice and Data revenue, we charge other communications companies for terminating calls to our customers on our network. Terminating access charges have historically grown at a slower rate than our customer base due to reductions in access rates on interstate calls as mandated by the Federal Communications Commission. These rate reductions are expected to continue in the future.
We also charge our customers fees to recover a portion of the costs we incur to comply with regulations.
Cost of Revenue
Our cost of revenue represents costs directly related to the operation of our network and includes payments for access circuits, interconnection and transport fees, customer circuit installation costs, fees paid for Web hosting services, collocation rents and other facility costs, telecommunications-related taxes and fees, and the cost associated with our mobile offering. Cost of revenue associated with our cloud-based services includes licensing fees for the required operating systems, broadband service and access fees, and power for our data center facilities.
The primary component of cost of revenue consists of the access fees paid to local telephone companies for circuits we lease on a monthly basis to provide connectivity to our customers. These access circuits link our customers to our network equipment located in a collocation facility, which we also generally lease from local telephone companies.

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Historically, most of the circuits we leased have been T1s, which are the largest component of our circuit access fees. However, we have converted many of our existing customer T1 circuits and have begun serving new customers using higher-capacity Metro Ethernet in place of T1 circuits in a number of locations. Although not available to us on a ubiquitous basis in all areas, Ethernet technology provides us with the opportunity to offer a large percentage of our customers' bandwidth at speeds well in excess of T1 circuits while reducing our ongoing operating expenses. Costs related to our fiber network include maintenance and depreciation costs for dark fiber (or fiber provided by third parties and operated by us) and access fees for lit fiber (or fiber both provided and operated by third parties). We have experienced increases in access costs due to serving customers with higher-capacity Metro Ethernet and expect these increases to continue as we expand the number of such customers, particularly where we obtain these high bandwidth circuits through third parties.
Cost of revenue also includes transport costs, which are primarily the costs we incur with ILECs for traffic between central offices where we have collocation equipment, traffic between our collocations and other wire centers, and intercity traffic between our markets.
Another significant component of our cost of revenue is the cost associated with our mobile offering. These costs include usage-based charges, monthly recurring base charges, or some combination thereof, depending on the type of mobile product in service, and the cost of mobile equipment sold to our customers. The cost of mobile devices typically exceeds our selling price due to the highly competitive marketplace and traditional pricing practices for mobile services. We believe these costs are offset over time by the long-term profitability of our service contracts.
We routinely negotiate and receive telecommunication billing recoveries from various local telephone companies to resolve prior errors in billing, including the effect of price decreases retroactively applied upon the adoption of new rates as mandated by regulatory bodies. We also receive payments from local telephone companies in the form of performance penalties that are assessed by state regulatory commissions based on the local telephone companies' performance in the delivery of circuits and other services. Because of the many factors that impact the amount and timing of telecommunication billing recoveries, we are often unable to estimate the outcome of these situations. Accordingly, we generally recognize telecommunication billing recoveries as offsets to cost of revenue when the ultimate resolution and amount are known and verifiable. These items do not follow any predictable trends and often result in variances when comparing the amounts received over multiple periods. In the future, through systematic improvements in process applications, and after gaining further historical experience, we may be able to more reliably estimate the outcome of telecommunication billing recoveries prior to being known and verifiable, which could result in earlier recognition of these recoveries. Selling, General and Administrative Expense Our selling, general and administrative expense consist of salaries and related costs for employees and other costs related to sales and marketing, engineering, IT, billing, regulatory, administrative, collections, legal, and accounting functions. In addition, bad debt expense and share-based compensation expense are included in selling, general and administrative expenses.
Our selling, general and administrative expense includes both fixed and variable costs. Fixed costs include the cost of staffing certain corporate functions such as IT, marketing, administrative, billing and engineering, and other associated costs, such as office rent, legal and accounting fees, property taxes, and recruiting. Variable costs include commissions; bonuses; marketing materials; the cost of provisioning and customer activation staff, which varies with the level of new customer installations; and the cost of customer care and technical support staff, which varies with the level of total customers on our network and the complexity of our product offering.
Also included in selling, general and administrative expense are realignment costs. These costs are related to our strategic shift to directly focus our selling and service delivery efforts toward the customers within our target market of technology-dependent small and mid-sized businesses that have complex IT needs. Realignment costs primarily relate to employee severances and facility exit costs.

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Results of Operations
Revenue (Dollar amounts in thousands, except ARPU)
                                 For the three months ended March 31,
                                    2014                        2013                Change from previous period
                                             % of                      % of
                            Dollars         Revenue      Dollars      Revenue         Dollars            Percent
Network, Voice and Data  $    99,903          92.0 %   $ 113,352        94.5 %   $       (13,449 )        (11.9 )%
Managed Hosting and
Cloud                          8,634           8.0 %       6,594         5.5 %             2,040           30.9  %
Total revenue                108,537                     119,946                         (11,409 )         (9.5 )%
Cost of revenue               36,556          33.7 %      38,788        32.3 %            (2,232 )         (5.8 )%
Gross profit (exclusive
of depreciation and
amortization):           $    71,981          66.3 %   $  81,158        67.7 %   $        (9,177 )        (11.3 )%
Network access customer
Customer locations at
period end                    51,923                      58,434                          (6,511 )        (11.1 )%
ARPU                     $       661                   $     656                 $             5            0.8  %
Average monthly churn
rate                             1.7 %                       1.6 %                           0.1 %

Total revenue decreased in the three months ended March 31, 2014 compared to the three months ended March 31, 2013 due to a decline in the number of customers. Our realignment of distribution channels to focus on higher-value customers resulted in fewer new customers than churned customers. The increase in Managed Hosting and Cloud revenue is largely due to our focus on technology-dependent customers and sales of our cloud-based service offerings. Our focus on realigning our sales force to acquire higher-value customers has resulted in a lower number of new customers than we have achieved historically. Because of this, in recent periods, customer churn has exceeded new customer growth, . . .

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