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BWNG > SEC Filings for BWNG > Form 10-Q on 9-Aug-2004All Recent SEC Filings

Show all filings for CORVIS CORP

Form 10-Q for CORVIS CORP


Quarterly Report

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Forward-looking Statements

Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") contains forward-looking statements that are based on current expectations, estimates, forecasts and projections about us, our future performance, the industries in which we operate, our beliefs and our management's assumptions. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to assess. Actual results could differ materially from those currently anticipated as a result of a number of factors, including, but not limited to, the risks and uncertainties discussed under "Risk Factors" and "MD&A" in the Company's filings with the Securities and Exchange Commission.

You should read the following discussion and analysis along with our unaudited condensed consolidated financial statements and the notes to those statements included elsewhere in this report and in conjunction with our audited consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K/A for the year ended December 31, 2003, filed on March 23, 2004 with the Securities and Exchange Commission.


Corvis Corporation operates two divisions within the communications industry. Our communications services division, acquired on June 13, 2003 and managed within our Broadwing Communications, LLC subsidiary ("Broadwing"), delivers data and Internet, broadband transport and voice communications services nationwide. Our communications equipment division designs, manufactures and sells high performance all-optical and electrical/optical communications systems that we believe accelerate carrier revenue opportunities and lower the overall cost of network ownership for carriers.

Until the Broadwing acquisition, the Corvis communications equipment division was the primary focus of our capital investment and the sole source of our revenue. Due to significant declines in the opportunities within the communications equipment market, the communications services division is now the major focus of capital investment for the Company. Revenue from the communications services division will account for most of Corvis' revenue for the foreseeable future. Reflecting our realigned business focus, the communications services division comprised 99% and 98% of total revenue for the three and six months ended June 30, 2004, respectively, while the remaining 1% and 2%, respectively, is attributable to communications equipment sales. Our communications equipment division has been restructured through staff reductions and other consolidation efforts that were substantially completed in late 2003. Our communications equipment division continues to service the networks of our existing customers, maintains certain centralized business operations and supports our Broadwing network. Because our consolidated results of operations only include the results of Broadwing since the acquisition date, the consolidated results of operations for 2003 and 2004 are not comparable to prior years.

Communications Services

Broadwing provides communications services to large enterprises, mid-market businesses and other communications service providers over a nationwide facilities based network connecting 137 cities nationwide. We believe that Broadwing's network and growth-oriented strategy will enable Broadwing to compete effectively in the markets in which it operates. Broadwing's all-optical network, capable of transmitting up to 800 Gbs per fiber, gives customers the benefit of high quality, technologically advanced solutions allowing for rapid provisioning, and highly flexible customized networking.

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In February 2004, Corvis agreed to acquire Focal Communications Corporation ("Focal"), a Chicago-based competitive local exchange carrier that provides voice and data solutions to enterprises, carriers and resellers for total consideration of $210.0 million, which will be comprised of approximately $101.0 million in Corvis common stock to be issued to Focal's equity holders and the assumption or payment of approximately $109.0 million of Focal's existing debt and other long-term capital lease obligations, of which approximately $86.6 million will be due upon demand at closing. Focal operates in 23 Tier 1 markets from Boston to Miami and New York to Los Angeles, owns metro fiber footprint in nine Tier 1 national markets and maintains a 4,000 enterprise and wholesale/carrier customer base. The Company expects the Focal acquisition to close on or about September 1, 2004.

The Company anticipates that the merger will result in overall benefits to the Company. We believe that the addition of Focal's network to our communications services division will enable us to reduce our network access and termination costs, expand our current customer base and product offering to grow revenue, expand the reach of the Company's nationwide all-optical network into targeted local markets throughout the United States, and improve the ability to negotiate better arrangements with vendors, all of which we believe will allow us to better compete in the highly competitive market for telecommunications services. Achieving the benefits of the merger will depend in part on the successful integration of Corvis' and Focal's operations and personnel in a timely and efficient manner. Integrating Corvis and Focal will be a complex and time-consuming process that is expected to carry into 2005. We cannot predict with certainty that the operations of the combined companies can be successfully integrated or that any of the anticipated benefits of the merger will be realized, and the failure to do so could have a material adverse effect on our financial position and results of operations.

Communications Equipment

Starting in 2001 and continuing through 2004, conditions within the general economy and the communications sector, in particular, have resulted in reduced capital expenditures by carriers and a reduced demand for communications networking systems. These declines have had a severe adverse impact on our communications equipment division revenue and results of operations. We cannot predict when or if market conditions will improve.

In response to these conditions, we have implemented a series of restructuring initiatives within our communications equipment division designed to decrease our business expenses and to conserve our financial resources. These actions included staff reductions, facility consolidations and the curtailment of discretionary spending. Our communications equipment division is now focused strategically on selective engagements with customers, including the U.S. government, servicing the networks of our existing customers, maintaining certain centralized business operations and supporting the Broadwing network.

Critical Accounting Policies

We have identified the following critical accounting policies that affect the more significant judgments and estimates used in the preparation of our consolidated financial statements. Some of these policies were adopted upon the Broadwing acquisition. The preparation of our consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and judgments that affect our reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to inventory obsolescence, asset impairment, revenue recognition, product warranty liabilities, allowance for doubtful accounts, communication service costs accruals and

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contingencies and litigation. We state these accounting policies in the notes to the annual consolidated financial statements and at relevant sections in this MD&A. These estimates are based on the information that is currently available to us and on various other assumptions that we believe to be reasonable under the circumstances. Actual results could vary from those estimates under different assumptions or conditions and the variances could be material.

Revenue Recognition-Communications Services. Switched services are billed monthly in arrears, while the revenue is recognized as the services are provided. Customers are billed in advance for month-to-month dedicated network services, including certain data and broadband transport, while associated revenue is deferred and recognized as the services are provided. Indefeasible right-of-use, or IRU agreements represent the lease of network capacity or dark fiber and are recorded as deferred revenue at the earlier of the acceptance of the applicable portion of the network by the customer or the receipt of cash. The buyer of IRU services typically pays cash upon execution of the contract, and the associated IRU revenue is then recognized over the life of the agreement as services are provided, beginning on the date of customer acceptance. In the event the buyer of an IRU terminates a contract prior to the contract expiration and releases us from the obligation to provide future services, the remaining unamortized deferred revenue is recognized in the period in which the contract is terminated. Fees billed in connection with a service installation are deferred and recognized ratably over estimated contract lives.

Revenue Recognition-Communications Equipment Sales and Services. Revenue from communications equipment sales is recognized upon execution of a contract and the completion of all delivery obligations provided that there are no uncertainties regarding customer acceptance and collectibility is deemed probable. If uncertainties exist, revenue is recognized when such uncertainties are resolved. Customer contracts generally include extensive lab and field trial testing and some include other acceptance criteria.

Allowance for Bad Debt. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. We determine the estimate of the allowance for doubtful accounts based on a variety of factors, including the length of time receivables are past due, the customers' financial condition, and historical experience. If the financial condition of our customers were to deteriorate or other circumstances occur that result in an impairment of customers' ability to make payments, additional allowances may be required.

Asset Impairment and Other Charges. Due to continued unfavorable economic conditions in the communications equipment industry and continued lack of expected equipment sales, our board of directors approved plans from 2001 through 2004 for the restructuring of our communications equipment division operations, including the consolidation of facilities, reduction in the number of employees and the outsourcing of a majority of our manufacturing capabilities. These decisions, as well as reductions in projected communications equipment sales and cash flows, have resulted in various asset impairment charges, including certain intangible assets, which are based on recoverability estimates and estimated fair values. If actual market conditions are less favorable than those projected by management or if events occur or circumstances change that would reduce the estimated recoverability of our assets, additional restructuring and impairment charges may be required.

Intangible Assets. We have recorded intangible assets resulting from our acquisitions. We account for intangible assets under SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS 142 requires that goodwill and other intangible assets with an indefinite life be tested for impairment at least annually. The impairment test is a two-step process that requires intangible assets to be allocated to reporting units. In the first step, the fair value of the reporting unit is compared with the carrying value of the reporting unit. If the fair value of the reporting unit is less than the carrying value of the reporting unit, an impairment may exist, and the second step of the test is performed. In the second step, the fair value of

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the intangible asset is compared with the carrying value, and an impairment loss will be recognized to the extent that the carrying value exceeds the fair value. We are required to review the recoverability of our intangible assets with indefinite lives at least annually. If actual market conditions are less favorable than those projected by management or if events occur or circumstances change that would reduce the estimated recoverability of these assets, impairment charges may be required.

Litigation. We and our subsidiaries from time to time are subject to pending and threatened litigation arising in the ordinary course of business. We accrue for losses on our balance sheet when and if appropriate. Although the ultimate outcome of legal proceedings cannot be projected with certainty, management believes that the outcome of current proceedings will not have a material adverse effect on the Company's business, financial condition or results of operations.

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Results of Operations

Selected financial data (in thousands):

Three months ended June 30, 2003 compared to three months ended June 30, 2004

                                                                          Three Months Ended
                                               June 30,                                 June 30,
                                                 2003                                     2004
                                               ---------        --------------------------------------------------------
                                                                 Communications          Communication
                                                 Total             Equipment*              Services              Total
                                               ---------        ----------------        ---------------        ---------
Communications services                        $  26,697        $            -          $       141,405        $ 141,405
Communications equipment                             320                     725                    -                725
                                               - ------- -      -- ------------- -      -- ------------ -      - ------- -
Total revenue                                     27,017                     725                141,405          142,130
                                               - ------- -      -- ------------- -      -- ------------ -      - ------- -
Operating expenses:
Cost of revenue:
Communications services (excluding
depreciation and amortization)                    18,035                     -                   97,147           97,147
Communications equipment                           3,428                     242                    -                242
                                               - ------- -      -- ------------- -      -- ------------ -      - ------- -
Total cost of revenue                             21,463                     242                 97,147           97,389
                                               - ------- -      -- ------------- -      -- ------------ -      - ------- -
Research and development, excluding
equity-based expense                              12,124                   3,852                    -              3,852
Selling, general and administrative,
excluding equity-based expense                    20,626                   7,215                 54,026           61,241
Depreciation                                       6,490                   1,426                  4,548            5,974
Amortization                                       1,976                     -                    1,040            1,040
Equity-based expense                               5,351                   2,667                    -              2,667
Restructuring and other charges                    7,797                     194                    -                194
                                               - ------- -      -- ------------- -      -- ------------ -      - ------- -
Total operating expenses                          75,827                  15,596                156,761          172,357
                                               - ------- -      -- ------------- -      -- ------------ -      - ------- -
Operating loss                                   (48,810 )               (14,871 )              (15,356 )        (30,227 )

Interest expense, net of capitalized
amounts                                              (91 )               (10,569 )                 (101 )        (10,670 )
Other income and expense, net                      3,090                   2,739                     79            2,818
                                               - ------- -      -- ------------- -      -- ------------ -      - ------- -
Net loss before minority interest                (45,811 )               (22,701 )              (15,378 )        (38,079 )
Minority interest                                     19                     -                      -                -
                                               - ------- -      -- ------------- -      -- ------------ -      - ------- -
Net loss                                       $ (45,792 )      $        (22,701 )      $       (15,378 )      $ (38,079 )
                                               - ------- -      -- ------------- -      -- ------------ -      - ------- -

* The communications equipment division includes certain costs associated with centralized business operations and support of our communications services division.

Revenue. Revenue increased to $142.1 million for the three months ended June 30, 2004 from $27.0 million for the three months ended June 30, 2003, primarily due to the inclusion of approximately $141.4 million in revenue associated with our communications services division, which reflects a full quarter's results in the current year.

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Communication Services Revenue. Communications services revenue consists of the sale of data and Internet, broadband transport and voice communication services. Data and Internet sales consist of high-speed data transport utilizing technology based on Internet protocol ("IP") and ATM/frame relay. Broadband transport services consist of long-haul transmission of data, voice and Internet traffic over dedicated circuits. Voice services consist of dedicated and billed minutes of use, primarily for the transmission of voice long distance services on behalf of wholesale and retail customers.

                                                                       Three Months Ended
                                                  September 30,       December 31,      March 31,     June 30,
                                                      2003                2003            2004          2004
                                                 ---------------     --------------     ---------     ---------
Data and internet services                       $        34,053     $       34,037     $  34,300     $  35,964
Broadband transport                                       56,272             57,136        57,969        59,323
Voice services                                            52,799             49,181        49,410        46,118
                                                 -- ------------     -- -----------     - -------     - -------
Total communications services revenue            $       143,124     $      140,354     $ 141,679     $ 141,405
                                                 -- ------------     -- -----------     - -------     - -------

Communications Services revenue increased to $141.4 million for the three months ended June 30, 2004 from $26.7 for the three months ended June 30, 2003 reflecting the June 13, 2003 Broadwing acquisition. Prior to the acquisition, Broadwing Communications Services, Inc. revenue had declined substantially as a result of the downturn within the communications industry and intense price competition. Since the date of acquisition, despite continued competitive pricing pressures, we have seen incremental growth of revenue in data and Internet and broadband transport services reflecting net customer additions. Competitive pricing pressures continue to negatively impact voice revenue, which have resulted in renewal of certain contracts at lower rates as well as the termination of wholesale service agreements with higher credit risk customers. To address these issues, we focus our efforts on selling to larger customers with complex communications needs, developing new products that differentiate Broadwing from its competition and reducing our communications service costs to allow us to better compete on the sale of price sensitive products.

The Company has entered into various services agreements with Cincinnati Bell Telecommunications Services, Inc. ("Cincinnati Bell"), a 2% owner of Broadwing Communications, LLC, in which each party performs services on behalf of the other, including carrier services, as part of the original purchase agreement. Effective June 13, 2004, as required under the terms of the agreement, our contract to provide carrier services to Cincinnati Bell was renegotiated resulting in overall decreases in rates to current market levels. This rate reduction resulted in a decrease in revenue for the three months ended June 30, 2004 of approximately $1.5 million. We expect revenue in future periods to be negatively impacted by the rate reduction, as well depending on, among other things, changes in traffic volume levels.

The Company anticipates an increase in revenue in future periods as a result of the acquisition of Focal Communications Corporation ("Focal"), which is expected to close on or about September 1, 2004. Focal generates revenue primarily from local phone service, long distance phone service, Internet service, collocation, private line sales, other data services and inter-carrier compensation. We believe that the combined companies will be able to offer a broader range of products than currently offered by either company on a standalone basis. Broadwing will enable Focal to offer bundled data and voice services to its existing customers who subscribe primarily to voice services today.

Significant portions of Broadwing Communication Services, Inc.'s historical revenue was generated through indefeasible right-of-use agreements ("IRU"), whereby the customer leases network capacity or dark fiber. The buyer of IRU services typically pays cash upon the execution of the contract, and the associated revenue is deferred and recognized over the life of the agreement. At the date of acquisition, the Company recorded the deferred revenue associated with acquired IRU contracts at fair

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value, which was substantially less than historical book value. As a result, revenue from IRU's is significantly less than those previously reported by Broadwing Communications Services, Inc. IRU revenue totaled $4.3 million and $0.7 million for the three months ended June 30, 2004 and 2003, respectively.

Communications Equipment Revenue. Communications equipment revenue increased to $0.7 million for the three months ended June 30, 2004 from $0.3 million for the three months ended June 30, 2003. The majority of communications equipment revenue for the current quarter relates to transmission cards. For the three months ended June 30, 2004, equipment revenue is associated with two customers:
$0.6 million related to Qwest Communications and $0.1 million associated with the U.S. Federal Government. Due to limited customers and unpredictability of new orders or customers, our future communications equipment revenue cannot be predict.

Cost of Revenue. Cost of revenue increased to $97.4 million for the three months ended June 30, 2004 from $21.5 million for the three months ended June 30, 2003, primarily due to the inclusion of approximately $97.1 million in costs associated with our communications services division.

Communications Services Cost of Revenue. Communications services cost of revenue primarily reflects access charges paid to local exchange carriers and other providers and transmission lease payments to other carriers. Communications services cost of revenue increased to $97.1 million for the three months ended June 30, 2004 from $18.0 million for the three months ended June 30, 2003, primarily due to the inclusion of a full quarter's results in the current year quarter. As a percentage of revenue, telecommunication cost of service remained flat at 69 percent for the three months ended June 30, 2004 as compared to the three months ended March 31, 2004, and decreased from 74 percent for the three-month period ended December 31, 2003. The improvement in our costs, as compared to prior year quarters, reflects the impact of access service agreements entered into in late 2003 and early 2004 with more favorable pricing terms, as well as approximately $4.4 million and $0.9 million related to favorable dispute settlements for the three months ended June 30, 2004 and March 31, 2004, respectively. These benefits have been offset in part by an increase in costs due to temporary charges of approximately $3.8 million and $1.7 million included in the quarter ended June 30, 2004 and March 31, 2004, respectively, associated with network migration capital projects that are expected to improve network efficiencies by reducing the access charges we incur in future periods. We expect to incur additional costs in the third quarter related to these initiatives.

Communications Equipment Cost of Revenue. Communications equipment cost of revenue decreased to $0.2 million for the three months ended June 30, 2004 from $3.4 million for the three months ended June 30, 2003. Communications equipment cost of revenue consists of component costs, direct compensation costs, warranty and other contractual obligations, inventory obsolescence costs and manufacturing overhead including depreciation. Communications equipment cost of revenue for the three-months ended June 30, 2003 included approximately $3.3 million associated with inventory impairment charges for adjustments made to 2003 estimates. Excluding these charges, as a percentage of communications equipment revenue, cost of communications equipment remained flat at 33 percent during the current quarter as compared to the prior year quarter. We expect future communications equipment cost of revenue to fluctuate significantly due to the unpredictable mix and timing in equipment sales.

Research and Development Expense, Excluding Equity-Based Expense. Research and development expense, excluding equity-based expense, consists primarily of salaries and related personnel costs, test and prototype expenses related to the design of our hardware and software products, laboratory costs and facilities costs. All costs related to product development, both hardware and software, are recorded as expenses in the period in which they are incurred. Due to the timing . . .

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