UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
| x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the quarterly period ended June 30, 2011
OR
| ¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
Commission File Number: 000-23269
AboveNet, Inc.
(Exact Name of Registrant as Specified in Its Charter)
| DELAWARE | 11-3168327 | |
(State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) |
360 HAMILTON AVENUE
WHITE PLAINS, NY 10601
(Address of Principal Executive Offices)
(914) 421-6700
(Registrant’s Telephone Number, Including Area Code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer x | Accelerated filer ¨ | Non-accelerated filer ¨ | Smaller reporting company ¨ |
(Do not check if a small reporting company) | |||
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
The number of shares of the registrant’s common stock, par value $0.01 per share, outstanding as of August 4, 2011, was 25,821,393.
Table of Contents
ABOVENET, INC.
INDEX
| Page | ||
| Part I. | FINANCIAL INFORMATION | |
| Item 1. | Financial Statements | |
| Consolidated Balance Sheets | ||
| As of June 30, 2011 (Unaudited) and December 31, 2010 | 1 | |
| Consolidated Statements of Operations (Unaudited) | ||
| Three and Six month periods ended June 30, 2011 and 2010 | 2 | |
| Consolidated Statements of Comprehensive Income (Unaudited) | ||
| Three and Six month periods ended June 30, 2011 and 2010 | 3 | |
| Consolidated Statement of Shareholders’ Equity (Unaudited) | ||
| Six month period ended June 30, 2011 | 4 | |
| Consolidated Statements of Cash Flows (Unaudited) | ||
| Six month periods ended June 30, 2011 and 2010 | 5 | |
| Notes to Unaudited Consolidated Financial Statements | 6 | |
| Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations | 33 |
| Item 3. | Quantitative and Qualitative Disclosures about Market Risk | 60 |
| Item 4. | Controls and Procedures | 61 |
| Part II. | OTHER INFORMATION | |
| Item 1. | Legal Proceedings | 62 |
| Item 1A. | Risk Factors | 62 |
| Item 6. | Exhibits | 63 |
| Signatures | 64 | |
| Exhibit Index | ||
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
ABOVENET, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in millions, except share and per share information)
| June 30, 2011 | December 31, 2010 | |||||||
| (Unaudited) | ||||||||
| ASSETS: | ||||||||
| Current assets: | ||||||||
| Cash and cash equivalents | $ | 96.4 | $ | 61.6 | ||||
| Restricted cash and cash equivalents | 4.7 | 3.7 | ||||||
| Accounts receivable, net of allowances for doubtful accounts of $1.9 and $1.8 at June 30, 2011 and December 31, 2010, respectively | 29.7 | 27.5 | ||||||
| Prepaid costs and other current assets | 12.2 | 14.8 | ||||||
| Total current assets | 143.0 | 107.6 | ||||||
| Property and equipment, net of accumulated depreciation and amortization of $321.4 and $285.3 at June 30, 2011 and December 31, 2010, respectively | 577.6 | 540.8 | ||||||
| Deferred tax assets | 129.7 | 149.7 | ||||||
| Other assets | 13.2 | 9.7 | ||||||
| Total assets | $ | 863.5 | $ | 807.8 | ||||
| LIABILITIES: | ||||||||
| Current liabilities: | ||||||||
| Accounts payable | $ | 12.7 | $ | 9.4 | ||||
| Accrued expenses | 80.2 | 71.8 | ||||||
| Deferred revenue - current portion | 25.6 | 27.3 | ||||||
| Note payable - current portion | — | 7.6 | ||||||
| Total current liabilities | 118.5 | 116.1 | ||||||
| Note payable | 55.0 | 42.1 | ||||||
| Deferred revenue | 82.2 | 87.0 | ||||||
| Other long-term liabilities | 9.8 | 10.1 | ||||||
| Total liabilities | 265.5 | 255.3 | ||||||
| Commitments and contingencies | ||||||||
| SHAREHOLDERS’ EQUITY: | ||||||||
| Preferred stock, 9,500,000 shares authorized, $0.01 par value, none issued or outstanding | — | — | ||||||
| Junior preferred stock, 500,000 shares authorized, $0.01 par value, none issued or outstanding | — | — | ||||||
| Common stock, 200,000,000 shares authorized, $0.01 par value, 26,450,871 issued and 25,821,393 outstanding at June 30, 2011 and 26,422,885 issued and 25,799,358 outstanding at December 31, 2010 | 0.3 | 0.3 | ||||||
| Additional paid-in capital | 346.5 | 332.4 | ||||||
| Treasury stock, at cost, 629,478 and 623,527 shares at June 30, 2011 and December 31, 2010, respectively | (23.1 | ) | (22.8 | ) | ||||
| Accumulated other comprehensive loss | (8.1 | ) | (9.2 | ) | ||||
| Retained earnings | 282.4 | 251.8 | ||||||
| Total shareholders’ equity | 598.0 | 552.5 | ||||||
| Total liabilities and shareholders’ equity | $ | 863.5 | $ | 807.8 | ||||
The accompanying notes are an integral part of these consolidated financial statements.
1
ABOVENET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(in millions, except share and per share information)
(Unaudited)
| Three Months Ended June 30, | Six Months Ended June 30, | |||||||||||||||
| 2011 | 2010 | 2011 | 2010 | |||||||||||||
| Revenue | $ | 118.3 | $ | 100.7 | $ | 232.7 | $ | 197.9 | ||||||||
| Costs of revenue (excluding depreciation and amortization, shown separately below) | 40.7 | 34.1 | 80.9 | 67.2 | ||||||||||||
| Selling, general and administrative expenses | 30.4 | 23.0 | 60.2 | 46.6 | ||||||||||||
| Depreciation and amortization | 19.2 | 15.2 | 37.5 | 30.7 | ||||||||||||
| Operating income | 28.0 | 28.4 | 54.1 | 53.4 | ||||||||||||
| Other income (expense): | ||||||||||||||||
| Interest expense | (1.1 | ) | (1.2 | ) | (2.3 | ) | (2.4 | ) | ||||||||
| Other income (expense), net | 0.3 | 0.2 | (0.4 | ) | (0.4 | ) | ||||||||||
| Income before income taxes | 27.2 | 27.4 | 51.4 | 50.6 | ||||||||||||
| Provision for income taxes | 11.1 | 11.1 | 20.8 | 20.7 | ||||||||||||
| Net income | $ | 16.1 | $ | 16.3 | $ | 30.6 | $ | 29.9 | ||||||||
| Income per share, basic: | ||||||||||||||||
| Basic income per share | $ | 0.63 | $ | 0.64 | $ | 1.19 | $ | 1.19 | ||||||||
| Weighted average number of common shares | 25,818,689 | 25,145,224 | 25,811,337 | 25,045,423 | ||||||||||||
| Income per share, diluted: | ||||||||||||||||
| Diluted income per share | $ | 0.60 | $ | 0.62 | $ | 1.14 | $ | 1.14 | ||||||||
| Weighted average number of common shares | 26,837,305 | 26,194,883 | 26,805,236 | 26,205,457 | ||||||||||||
The accompanying notes are an integral part of these consolidated financial statements.
2
ABOVENET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in millions)
(Unaudited)
| Three Months Ended June 30, | Six Months Ended June 30, | |||||||||||||||
| 2011 | 2010 | 2011 | 2010 | |||||||||||||
| Net income | $ | 16.1 | $ | 16.3 | $ | 30.6 | $ | 29.9 | ||||||||
| Foreign currency translation adjustments | (0.1 | ) | (0.3 | ) | 0.5 | (0.5 | ) | |||||||||
| Change in fair value of interest rate swap contracts | — | 0.2 | 0.6 | 0.2 | ||||||||||||
| Comprehensive income | $ | 16.0 | $ | 16.2 | $ | 31.7 | $ | 29.6 | ||||||||
The accompanying notes are an integral part of these consolidated financial statements.
3
ABOVENET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY
(in millions, except share information)
(Unaudited)
| Common Stock | Treasury Stock | Other Shareholders’ Equity | ||||||||||||||||||||||||||||||
| Shares | Amount | Shares | Amount | Additional Paid-in Capital | Accumulated Other Comprehensive Loss | Retained Earnings | Total Shareholders’ Equity | |||||||||||||||||||||||||
| Balance at January 1, 2011 | 26,422,885 | $ | 0.3 | 623,527 | $ | (22.8 | ) | $ | 332.4 | $ | (9.2 | ) | $ | 251.8 | $ | 552.5 | ||||||||||||||||
| Issuance of common stock from vested restricted stock | 15,246 | — | — | — | — | — | — | — | ||||||||||||||||||||||||
| Issuance of common stock from exercise of options to purchase shares of common stock | 12,740 | — | — | — | 0.2 | — | — | 0.2 | ||||||||||||||||||||||||
| Purchase of treasury stock | — | — | 5,951 | (0.3 | ) | — | — | — | (0.3 | ) | ||||||||||||||||||||||
| Foreign currency translation adjustments | — | — | — | — | — | 0.5 | — | 0.5 | ||||||||||||||||||||||||
| Change in fair value of interest rate swap contracts | — | — | — | — | — | 0.6 | — | 0.6 | ||||||||||||||||||||||||
| Amortization of stock-based compensation expense for restricted stock units and employee stock purchase plan | — | — | — | — | 13.9 | — | — | 13.9 | ||||||||||||||||||||||||
| Net income | — | — | — | — | — | — | 30.6 | 30.6 | ||||||||||||||||||||||||
| Balance at June 30, 2011 | 26,450,871 | $ | 0.3 | 629,478 | $ | (23.1 | ) | $ | 346.5 | $ | (8.1 | ) | $ | 282.4 | $ | 598.0 | ||||||||||||||||
The accompanying notes are an integral part of these consolidated financial statements.
4
ABOVENET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in millions)
(Unaudited)
| Six Months Ended June 30, | ||||||||
| 2011 | 2010 | |||||||
| Cash flows provided by operating activities: | ||||||||
| Net income | $ | 30.6 | $ | 29.9 | ||||
| Adjustments to reconcile net income to net cash provided by operations: | ||||||||
| Depreciation and amortization | 37.5 | 30.7 | ||||||
| Loss on sale or disposition of property and equipment, net | 0.1 | — | ||||||
| Provision for equipment impairment | 0.1 | 0.2 | ||||||
| Provision for bad debts | 0.3 | 0.3 | ||||||
| Non-cash stock-based compensation expense | 13.9 | 4.2 | ||||||
| Change in deferred tax assets | 20.3 | 20.5 | ||||||
| Changes in operating working capital: | ||||||||
| Accounts receivable | (2.3 | ) | (0.1 | ) | ||||
| Prepaid costs and other current assets | 2.6 | (5.2 | ) | |||||
| Other assets | 1.6 | (2.4 | ) | |||||
| Accounts payable | 3.0 | (4.5 | ) | |||||
| Accrued expenses | 2.4 | (0.3 | ) | |||||
| Deferred revenue | (6.9 | ) | (6.1 | ) | ||||
| Other long-term liabilities | 0.6 | 0.5 | ||||||
| Net cash provided by operating activities | 103.8 | 67.7 | ||||||
| Cash flows used in investing activities: | ||||||||
| Proceeds from sales of property and equipment | 0.1 | 0.2 | ||||||
| Purchases of property and equipment | (68.4 | ) | (57.5 | ) | ||||
| Net cash used in investing activities | (68.3 | ) | (57.3 | ) | ||||
| Cash flows used in financing activities: | ||||||||
| Proceeds from borrowing under $250 Million Secured Revolving Credit Facility, net of debt acquisition costs | 50.0 | — | ||||||
| Proceeds from exercise of options to purchase shares of common stock | 0.2 | 0.4 | ||||||
| Proceeds from exercise of warrants | — | 1.4 | ||||||
| Change in restricted cash and cash equivalents | (1.0 | ) | — | |||||
| Principal payment - note payable | (49.7 | ) | (3.7 | ) | ||||
| Principal payment - capital lease obligation | (0.2 | ) | — | |||||
| Purchase of treasury stock | (0.3 | ) | (0.3 | ) | ||||
| Net cash used in financing activities | (1.0 | ) | (2.2 | ) | ||||
| Effect of exchange rates on cash | 0.3 | (0.5 | ) | |||||
| Net increase in cash and cash equivalents | 34.8 | 7.7 | ||||||
| Cash and cash equivalents, beginning of period | 61.6 | 165.3 | ||||||
| Cash and cash equivalents, end of period | $ | 96.4 | $ | 173.0 | ||||
| Supplemental cash flow information: | ||||||||
| Cash paid for interest | $ | 1.1 | $ | 1.5 | ||||
| Cash paid for income taxes | $ | 1.3 | $ | 0.3 | ||||
| Supplemental non-cash financing activities: | ||||||||
| Issuance of shares of common stock in cashless exercise of stock purchase warrants | $ | — | $ | 3.9 | ||||
| Non-cash purchase of shares into treasury in cashless exercise of stock purchase warrants | $ | — | $ | 3.9 | ||||
The accompanying notes are an integral part of these consolidated financial statements.
5
ABOVENET, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(in millions, except share and per share information)
NOTE 1: BACKGROUND AND ORGANIZATION
AboveNet, Inc. (which together with its subsidiaries is sometimes hereinafter referred to as the “Company,” “AboveNet,” “we,” “us,” “our” or “our Company”) is a facilities-based provider of technologically advanced, high-bandwidth, fiber optic communications infrastructure and co-location services to communications carriers and corporate and government customers, principally in the United States (“U.S.”) and Europe.
NOTE 2: BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES
A summary of the basis of presentation and the significant accounting policies followed in the preparation of these consolidated financial statements is as follows:
Stock Split
On August 3, 2009, the Board of Directors of the Company authorized a two-for-one common stock split, effected in the form of a 100% stock dividend, which was distributed on September 3, 2009. Each shareholder of record on August 20, 2009 received one additional share of common stock for each share of common stock held on that date. All share and per share information for prior periods, including warrants, options to purchase common shares, restricted stock units, warrant and option exercise prices, shares reserved under the Company’s 2003 Incentive Stock Option and Stock Unit Grant Plan (the “2003 Plan”) and the Company’s 2008 Equity Incentive Plan (the “2008 Plan”), weighted average fair value of options granted, common stock and additional paid-in capital accounts on the consolidated balance sheets and consolidated statement of shareholders’ equity, have been retroactively adjusted, where applicable, to reflect the two-for-one stock split.
Basis of Presentation and Use of Estimates
The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the U.S. (“U.S. GAAP”) and pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). These consolidated financial statements include the accounts of the Company, as applicable. They do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. These unaudited consolidated financial statements should be read in conjunction with the Company’s consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010. Operating results for the six months ended June 30, 2011 are not necessarily indicative of the results that may be expected for the year ending December 31, 2011.
The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the consolidated financial statements, the disclosure of contingent assets and liabilities in the consolidated financial statements and the accompanying notes and the reported amounts of revenue and expenses during the periods presented. Estimates are used when accounting for certain items such as accounts receivable allowances, property taxes, transaction taxes and deferred taxes. The estimates the Company makes are based on historical factors, current circumstances and the experience and judgment of the Company’s management. The Company evaluates its assumptions and estimates on an ongoing basis and may employ outside experts to assist in the Company’s evaluations. Actual amounts and results could differ from such estimates due to subsequent events which could have a material effect on the Company’s financial statements covering future periods.
6
ABOVENET, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)
Principles of Consolidation
The consolidated financial statements include the accounts of the Company, and its wholly-owned subsidiaries. Consolidation is generally required for investments of more than 50% of the outstanding voting stock of an investee, except when control is not held by the majority owner. All significant intercompany accounts and transactions have been eliminated in consolidation.
Revenue Recognition
The Company follows SEC Staff Accounting Bulletin ("SAB") No. 101, “Revenue Recognition in Financial Statements,” (now known as FASB ASC 605-10), as amended by SEC SAB No. 104, “Revenue Recognition,” (also now known as FASB ASC 605-10).
Revenue derived from leasing fiber optic telecommunications infrastructure and the provision of telecommunications and co-location services is recognized as services are provided. Non-refundable payments received from customers before the relevant criteria for revenue recognition are satisfied are included in deferred revenue in the accompanying consolidated balance sheets and are subsequently amortized into income over the fixed contract term.
Prior to October 1, 2009, the Company generally amortized revenue related to installation services on a straight-line basis over the contracted customer relationship (two to twenty years). In the fourth quarter of 2009, the Company completed a study of its historic customer relationship period. As a result, commencing October 1, 2009, the Company began amortizing revenue related to installation services on a straight-line basis generally over the estimated customer relationship period (generally ranging from three to twenty years).
Contract termination revenue is recognized when a customer discontinues service prior to the end of the contract period for which the Company had previously received consideration and for which revenue recognition was deferred. Contract termination revenue is also recognized when customers have made early termination payments to the Company to settle contractually committed purchase amounts that the customer no longer expects to meet or when the Company renegotiates or discontinues a contract with a customer and as a result is no longer obligated to provide services for consideration previously received and for which revenue recognition has been deferred. Additionally, the Company includes receipts of bankruptcy claim settlements from former customers as contract termination revenue when received. Contract termination revenue amounted to $1.0 and $0.6 in the three months ended June 30, 2011 and 2010, respectively, and $3.1 and $1.6 in the six months ended June 30, 2011 and 2010, respectively.
7
ABOVENET, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)
Non-Monetary Transactions
The Company may exchange capacity with other capacity or service providers. In December 2004, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 153, “Exchanges of Nonmonetary Assets - An Amendment of APB Opinion No. 29,” (“SFAS No. 153”), (now known as FASB ASC 845-10). SFAS No. 153 amends Accounting Principles Board Opinion No. 29, “Accounting for Nonmonetary Transactions,” (“APB No. 29”) (also now known as FASB ASC 845-10) to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. SFAS No. 153 is to be applied prospectively for nonmonetary exchanges occurring in fiscal periods beginning after June 15, 2005. The Company’s adoption of SFAS No. 153 on July 1, 2005 did not have a material effect on the consolidated financial position or results of operations of the Company. Prior to the Company’s adoption of SFAS No. 153, nonmonetary transactions were accounted for in accordance with APB No. 29, where an exchange for similar capacity is recorded at a historical carryover basis and dissimilar capacity is accounted for at fair market value with recognition of any gain or loss. There were no gains or losses from nonmonetary transactions for each of the three and six months ended June 30, 2011 and 2010.
Operating Leases
The Company leases office and equipment space, and maintains equipment rentals, right-of-way contracts, building access fees and network capacity under various non-cancelable operating leases. The lease agreements, which expire at various dates through 2030, are subject, in many cases, to renewal options and provide for the payment of taxes, utilities and maintenance. Certain lease agreements contain escalation clauses over the term of the lease related to scheduled rent increases resulting from the pass through of increases in operating costs, property taxes and the effect on costs from changes in consumer price indices. In accordance with SFAS No. 13, “Accounting for Leases,” (now known as FASB ASC 840), the Company recognizes rent expense on a straight-line basis and records a liability representing the difference between straight-line rent expense and the amount payable as an increase or decrease to a deferred liability. Any leasehold improvements related to operating leases are amortized over the lesser of their economic lives or the remaining lease term. Rent-free periods and other incentives granted under certain leases are recorded as reductions to rent expense on a straight-line basis over the related lease terms.
Cash and Cash Equivalents and Restricted Cash and Cash Equivalents
For the purposes of the consolidated statements of cash flows, the Company considers cash in banks and short-term highly liquid investments with an original maturity of three months or less to be cash and cash equivalents. Cash and cash equivalents and restricted cash and cash equivalents are stated at cost, which approximates fair value. Restricted cash and cash equivalents are comprised of amounts that secure outstanding letters of credit issued in favor of various third parties.
Accounts Receivable, Allowance for Doubtful Accounts and Sales Credits
Accounts receivable are customer obligations for services sold to such customers under normal trade terms. The Company’s customers are primarily communications carriers, and corporate enterprise and government customers, located primarily in the U.S. and the United Kingdom (“U.K.”). The Company performs periodic credit evaluations of its customers’ financial condition. The Company provides allowances for doubtful accounts and sales credits. Provisions for doubtful accounts are recorded in selling, general and administrative expenses, while allowances for sales credits are recorded as reductions of revenue. The adequacy of the reserves is evaluated utilizing several factors including length of time a receivable is past due, changes in the customer’s creditworthiness, customer’s payment history, the length of the customer’s relationship with the Company, current industry trends and the current economic climate.
8
ABOVENET, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)
Property and Equipment
Property and equipment owned at September 8, 2003, the effective date (the “Effective Date”) of the amended bankruptcy plan of reorganization of Metromedia Fiber Network, Inc. and substantially all of its domestic subsidiaries (the “Plan of Reorganization”), are stated at their estimated fair values as of the Effective Date based on the Company’s reorganization value, net of accumulated depreciation and amortization incurred since the Effective Date. Purchases of property and equipment subsequent to the Effective Date are stated at cost, net of depreciation and amortization. Major improvements are capitalized, while expenditures for repairs and maintenance are expensed when incurred. Costs incurred prior to a capital project’s completion are reflected as construction in progress and are part of network infrastructure assets, as described below and included in property and equipment on the respective balance sheets. At June 30, 2011 and December 31, 2010, the Company had $53.1 and $54.0, respectively, of construction in progress. Certain internal direct labor costs of constructing or installing property and equipment are capitalized. Capitalized direct labor is determined based upon a core group of project managers, field engineers, network infrastructure engineers and equipment engineers. Capitalized direct labor is based upon time spent on capitalized projects and consists of salary, plus certain related benefits. These individuals’ capitalized labor costs are directly associated with the construction and installation of network infrastructure and equipment and customer installations. The salaries and related benefits of non-engineers and supporting staff that are part of the operations and engineering departments are not considered part of the pool subject to capitalization. Capitalized direct labor amounted to $2.7 and $2.8 for the three months ended June 30, 2011 and 2010, respectively, and was $5.2 and $5.8 in the six months ended June 30, 2011 and 2010, respectively. Depreciation and amortization is provided on a straight-line basis over the estimated useful lives of the assets, with the exception of leasehold improvements, which are amortized over the lesser of the estimated useful life of the improvement or the term of the lease.
Estimated useful lives of the Company’s property and equipment are as follows:
| Network infrastructure assets and storage huts (except for risers and certain project installation costs, which are 5 years) | 20 years | |
| HVAC and power equipment | 12 to 20 years | |
| Transmission and IP equipment | 5 to 7 years | |
| Furniture, fixtures and equipment | 4 to 7 years | |
| Software and computer equipment | 3 to 5 years | |
| Leasehold improvements | Lesser of the estimated useful life of the improvement or the term of the lease |
When property and equipment is retired or otherwise disposed of, the cost and accumulated depreciation is removed from the accounts, and resulting gains or losses are reflected in net income.
From time to time, the Company is required to replace or re-route existing fiber due to structural changes such as construction and highway expansions, which is defined as “relocation.” In such instances, the Company fully depreciates the remaining carrying value of network infrastructure removed or rendered unusable and capitalizes the costs of the new fiber and associated construction placed into service. In certain circumstances, the local municipality or agency is responsible for some or all of such amounts. The Company records its share of relocation costs in property and equipment and records the third party portion of such costs as accounts receivable. The Company capitalized relocation costs amounting to $0.4 and $0.2 for the three months ended June 30, 2011 and 2010, respectively, and $0.9 and $0.4 for the six months ended June 30, 2011 and 2010, respectively. The Company fully depreciated the remaining carrying value of the network infrastructure rendered unusable, which on an original cost basis, totaled $0.06 and $0.15 ($0.03 and $0.07 on a net book value basis) for the three and six months ended June 30, 2011, respectively, and, which on an original cost basis, totaled $0.03 and $0.05 ($0.03 and $0.04 on a net book value basis) for the three and six months ended June 30, 2010, respectively. To the extent that relocation requires only the movement of existing network infrastructure to another location or construction for an insignificant portion of the entire segment, the related costs are included in the Company’s results of operations.
9
ABOVENET, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)
In accordance with SFAS No. 34, “Capitalization of Interest Cost,” (now known as FASB ASC 835-20), interest on certain construction projects would be capitalized. Such amounts were considered immaterial, and accordingly, no such amounts were capitalized during each of the three and six months ended June 30, 2011 and 2010.
In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” (now known as FASB ASC 360-10-35), the Company periodically evaluates the recoverability of its long-lived assets and evaluates such assets for impairment whenever events or circumstances indicate that the carrying amount of such assets (or group of assets) may not be recoverable. Impairment is determined to exist if the estimated future undiscounted cash flows are less than the carrying value of such assets. The Company considers various factors to determine if an impairment test is necessary. The factors include: consideration of the overall economic climate, technological advances with respect to equipment, Company strategy, capital planning and certain operational issues. Since June 30, 2006, no event has occurred nor has the business environment changed to trigger an impairment test for assets in revenue service and operations. The Company also considers the removal of assets from the network as a triggering event for performing an impairment test. Once an item is removed from service, unless it is to be redeployed, it may have little or no future cash flows related to it. The Company performed annual physical counts of such assets that are not in revenue service or operations (e.g., inventory, primarily spare parts) at or around September 30 of each year. With the assistance of a valuation report of the assets in inventory, prepared by an independent third party on a basis consistent with SFAS No. 157, “Fair Value Measurements,” (now known as FASB ASC 820-10), and pursuant to FASB ASC 360-10-35, the Company determined that the fair value of certain of these assets was less than the carrying value and accordingly, recorded a provision for impairment of $0.5 for the year ended December 31, 2010. Additionally, at December 31, 2010, the Company recorded a $1.5 provision for impairment with respect to a discreet group of assets because of certain operational issues. The Company provided allowances for impairment of $0.1 and $0.2 in the six months ended June 30, 2011 and 2010, respectively, which were recorded in the three months ended June 30, 2011 and 2010, respectively.
Treasury Stock
Treasury stock is accounted for under the cost method.
Asset Retirement Obligations
In accordance with SFAS No. 143, “Accounting for Asset Retirement Obligations,” (now known as FASB ASC 410-20), the Company recognizes the fair value of a liability for an asset retirement obligation in the period in which it is incurred if a reasonable estimate of fair value can be made. The Company has asset retirement obligations related to the de-commissioning and removal of equipment, restoration of leased facilities and the removal of certain fiber and conduit systems. Considerable management judgment is required in estimating these obligations. Important assumptions include estimates of asset retirement costs, the timing of future asset retirement activities and the likelihood of contractual asset retirement provisions being enforced. Changes in these assumptions based on future information could result in adjustments to these estimated liabilities.
Asset retirement obligations are generally recorded as “Other long-term liabilities,” are capitalized as part of the carrying amount of the related long-lived assets included in property and equipment, net, and are depreciated over the life of the associated asset. Asset retirement obligations aggregated $7.9 at both June 30, 2011 and December 31, 2010, of which $4.3 was included in “Accrued expenses,” and $3.6 was included in “Other long-term liabilities” at such dates. Accretion expense, which is included in “Interest expense,” amounted to $0.07 for each of the three months ended June 30, 2011 and 2010 and $0.14 for each of the six months ended June 30, 2011 and 2010.
10
ABOVENET, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)
Income Taxes
The Company accounts for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes,” (now known as FASB ASC 740). Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between financial statement carrying amounts of existing assets and liabilities and their respective tax basis, net operating losses and tax credit carryforwards, and tax contingencies. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. After an evaluation of the realizability of the Company’s deferred tax assets, the Company reduced its valuation allowance by $7.3 and $183.0 during the years ended December 31, 2010 and 2009, respectively. See Note 5, “Income Taxes,” for a further discussion of the Company’s provision for income taxes.
The Company is subject to audits by various taxing authorities, and these audits may result in proposed assessments where the ultimate resolution results in the Company owing additional taxes. The Company is required to establish reserves under FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” (now known as FASB ASC 740-10), when the Company believes there is uncertainty with respect to certain positions and the Company may not succeed in realizing the tax benefit. The Company believes that its tax return positions are appropriate and supportable under relevant tax law. The Company has evaluated its tax positions for items of uncertainty in accordance with FASB ASC 740-10 and has determined that its tax positions are highly certain within the meaning of FASB ASC 740-10. The Company believes the estimates and assumptions used to support its evaluation of tax benefit realization are reasonable. Accordingly, no adjustments were made to the consolidated financial statements for each of the three and six months ended June 30, 2011 and 2010.
The Company’s reorganization resulted in a significantly modified capital structure as a result of applying fresh start accounting in accordance with FASB ASC 852-10 on the Effective Date. Fresh start accounting has important consequences on the accounting for the realization of valuation allowances, related to net deferred tax assets that existed on the Effective Date but which arose in pre-emergence periods. Prior to 2009, fresh start accounting required the reversal of these allowances to be recorded as a reduction of intangible assets until exhausted and thereafter as additional paid in capital. Beginning in 2009, in accordance with SFAS141(R), “Business Combinations (Revised),” (now known as FASB ASC 805), future utilization of such benefit will reduce income tax expense. This treatment does not result in any change in liabilities to taxing authorities or in cash flows.
Undistributed earnings of the Company’s foreign subsidiaries are considered to be indefinitely reinvested and therefore, no provision for domestic taxes has been provided thereon. Upon repatriation of those earnings, in the form of dividends or otherwise, the Company could be subject to domestic income taxes, offset (all or in part) by foreign tax credits, related to income and withholding taxes payable to the various foreign countries. Determination of the amount of unrecognized deferred domestic income tax liability is not practicable due to the complexities associated with its hypothetical calculation; however, unrecognized foreign tax credit carryforwards could be available to reduce some portion of the domestic liability.
The Company’s policy is to recognize interest and penalties accrued as a component of operating expense. As of the date of adoption of FASB ASC 740-10, the Company did not have any accrued interest or penalties associated with any unrecognized income tax benefits, nor was any interest expense recognized during each of the three and six months ended June 30, 2011 and 2010.
Foreign Currency Translation and Transactions
The Company’s functional currency is the U.S. dollar. For those subsidiaries not using the U.S. dollar as their functional currency, assets and liabilities are translated at exchange rates in effect at the balance sheet date and income and expense transactions are translated at average exchange rates during the period. Resulting translation adjustments are recorded directly to a separate component of shareholders’ equity and are reflected in the accompanying consolidated statements of comprehensive income. The Company’s foreign exchange transaction gains (losses) are generally included in “Other income (expense), net” in the consolidated statements of operations.
11
ABOVENET, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)
Stock Options
On September 8, 2003, the Company adopted the fair value provisions of SFAS No. 148, “Accounting for Stock-Based Compensation Transition and Disclosure,” (“SFAS No. 148”), (now known as FASB ASC 718-10). SFAS No. 148 amended SFAS No. 123, “Accounting for Stock-Based Compensation,” (“SFAS No. 123”), (also now known as FASB ASC 718-10), to provide alternative methods of transition to SFAS No. 123’s fair value method of accounting for stock-based employee compensation. See Note 7, “Stock-Based Compensation.”
Under the fair value provisions of SFAS No. 123, the fair value of each stock-based compensation award is estimated at the date of grant, using the Black-Scholes option pricing model for stock option awards. The Company did not have a historical basis for determining the volatility and expected life assumptions in the model due to the Company’s limited market trading history; therefore, the assumptions used for these amounts are an average of those used by a select group of related industry companies. Most stock-based awards have graded vesting (i.e. portions of the award vest at different dates during the vesting period). The Company recognizes the related stock-based compensation expense of such awards on a straight-line basis over the vesting period for each tranche in an award. Upon consummation of the Company’s Plan of Reorganization, all then outstanding stock options were cancelled.
Effective January 1, 2006, the Company adopted SFAS No. 123(R), “Share-Based Payment,” (“SFAS No. 123(R)”), (now known as FASB ASC 718), using the modified prospective method. SFAS No. 123(R) requires all share-based awards granted to employees to be recognized as compensation expense over the vesting period, based on fair value of the award. The fair value method under SFAS No. 123(R) is similar to the fair value method under SFAS No. 123 with respect to measurement and recognition of stock-based compensation expense except that SFAS No. 123(R) requires an estimate of future forfeitures, whereas SFAS No. 123 allowed companies to estimate forfeitures or recognize the impact of forfeitures as they occur. As the Company recognized the impact of forfeitures as they occurred under SFAS No. 123, the adoption of SFAS No. 123(R) did result in different accounting treatment, but it did not have a material impact on the Company’s consolidated financial statements.
There were no options to purchase shares of common stock granted during each of the three and six months ended June 30, 2011 and 2010.
Restricted Stock Units
Compensation cost for restricted stock unit awards that are not performance-based is measured based upon the quoted closing market price for the Company’s stock on the date of grant. The related compensation cost is recognized on a straight-line basis over the vesting period. Compensation expense for performance-based restricted stock unit awards is measured based upon the quoted market price for the Company’s stock on the date that the performance targets have been established and communicated to the grantee. Related compensation cost is recognized based upon a review of the performance targets and determination that such performance targets have been achieved, on a straight-line basis over the vesting period. See Note 7, “Stock-Based Compensation.”
Stock Warrants
In connection with the Plan of Reorganization described in Note 1, “Background and Organization,” the Company issued to holders of general unsecured claims as part of the settlement of such claims (i) five year warrants to purchase 1,418,918 shares of common stock with an exercise price of $10.00 per share, which expired September 8, 2008 (the “Five Year Warrants”) and (ii) seven year warrants to purchase 1,669,316 shares of common stock with an exercise price of $12.00 per share, which expired September 8, 2010 (the “Seven Year Warrants”). The stock warrants were treated as equity upon their exercise based upon the terms of the warrant and cash received. Seven Year Warrants to purchase shares of common stock exercised totaled 18,208 and 437,634 during the three and six months ended June 30, 2010.
12
ABOVENET, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)
Under the terms of the five year and seven year warrant agreements (collectively, the “Warrant Agreements”), if the market price of the Company’s common stock, as defined in the Warrant Agreements, 60 days prior to the expiration date of the respective warrants, was greater than the warrant exercise price, the Company was required to give each warrant holder notice that at the warrant expiration date, the warrants would be deemed to have been exercised pursuant to the net exercise provisions of the respective Warrant Agreements (the “Net Exercise”), unless the warrant holder elected, by written notice, to not exercise its warrants. Under the Net Exercise, shares issued to the warrant holders would be reduced by the number of shares necessary to cover the aggregate exercise price of the shares, valuing such shares at the current market price, as defined in the Warrant Agreements. Any fractional shares, otherwise issuable, would be paid in cash.
At September 8, 2008, the expiration date of the Five Year Warrants, the required conditions were met for the Net Exercise and accordingly, Five Year Warrants to purchase 317,748 shares of common stock were deemed exercised at expiration, of which 212,912 shares were issued to the warrant holders, 104,836 shares were returned to treasury and $0.004 was paid to recipients for fractional shares. In total, Five Year Warrants to purchase 318,526 shares of common stock were deemed exercised on a net exercise basis, of which 213,432 shares were issued to warrant holders, 105,094 shares were returned to treasury and $0.004 was paid to recipients for fractional shares. In addition, Five Year Warrants to purchase 50 shares of common stock were cancelled in accordance with instructions from warrant holders. The exercises of the Five Year Warrants by holders generated cash of $11.0.
At September 8, 2010, the expiration date of the Seven Year Warrants, the required conditions were met for the Net Exercise and accordingly, Seven Year Warrants to purchase 13,626 shares of common stock were deemed exercised at expiration, of which 10,409 shares were issued to warrant holders and 3,217 shares were returned to treasury and $0.004 was paid to recipients for fractional shares. In total, Seven Year Warrants to purchase 443,504 shares of common stock were deemed exercised on a net exercise basis, of which 353,598 shares were issued to the warrant holders, 89,906 shares were returned to treasury and $0.004 was paid to recipients for fractional shares. In addition, Seven Year Warrants to purchase 26 shares of common stock were determined to be undeliverable and were cancelled. The exercises of the Seven Year Warrants by holders generated cash of $14.7.
Derivative Financial Instruments
The Company has utilized and may, from time to time in the future, utilize derivative financial instruments known as interest rate swaps (“derivatives”) to mitigate its exposure to interest rate risk. The Company purchased the first interest rate swap on August 4, 2008 to hedge the interest rate on the initial $24.0 (original principal) term loan under the Secured Credit Facility and the Company purchased a second interest rate swap on November 14, 2008 to hedge the interest rate on the additional $12.0 (original principal) term loan provided by SunTrust Bank. (See Note 4, “Note Payable.”) The Company accounted for the derivatives under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” (now known as FASB ASC 815). FASB ASC 815 requires that all derivatives be recognized in the financial statements and measured at fair value regardless of the purpose or intent for holding them. By policy, the Company has not historically entered into derivatives for trading purposes or for speculation. Based on criteria defined in FASB ASC 815, the interest rate swaps were considered cash flow hedges and were 100% effective. Accordingly, changes in the fair value of derivatives have been recorded each period in other comprehensive income (loss). Changes in the fair value of the derivatives reported in accumulated other comprehensive loss are reclassified into earnings in the period in which earnings are impacted by the variability of the cash flows of the hedged item. The ineffective portion of all hedges, if any, would be recognized in current period earnings. The unrealized net loss recorded in accumulated other comprehensive loss at December 31, 2010 was $0.6 for the interest rate swaps. The mark-to-market value of the cash flow hedges was recorded in current assets, current liabilities, other non-current assets or other long-term liabilities, as applicable, and the offsetting gains or losses in other comprehensive income (loss).
13
ABOVENET, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)
On January 1, 2009, the Company adopted SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities – an amendment of FASB Statement No. 133,” (now known as FASB ASC 815-10). FASB ASC 815-10 changes the disclosure requirements for derivatives and hedging activities. Entities are required to provide enhanced disclosures about (i) how and why an entity uses derivatives; (ii) how derivatives and related hedged items are accounted for under FASB ASC 815; and (iii) how derivatives and related hedged items affect an entity’s financial position and cash flows.
The Company has, when applicable, minimized its credit risk relating to counterparties of its derivatives by transacting with multiple, high quality counterparties, thereby limiting exposure to individual counterparties, and by monitoring the financial condition of its counterparties.
All derivatives were recorded on the Company’s consolidated balance sheets at fair value. Accounting for the gains and losses resulting from changes in the fair value of derivatives depends on the use of the derivative and whether it qualifies for hedge accounting in accordance with FASB ASC 815. At December 31, 2010, net interest rate swap derivative liabilities of $0.6 was included in “Accrued expenses” in the Company’s consolidated balance sheet. The swap agreements were settled in January 2011 as described below.
Derivatives recorded at fair value in the Company’s consolidated balance sheets as of June 30, 2011 and December 31, 2010 consisted of the following:
| Derivative Liabilities | ||||||||
| Derivatives designated as hedging instruments | June 30, 2011 | December 31, 2010 | ||||||
Interest rate swap agreement expiring August 1, 2011 (*) | $ | — | $ | 0.4 | ||||
Interest rate swap agreement expiring November 1, 2011 (*) | — | 0.2 | ||||||
| Total derivatives designated as hedging instruments | $ | — | $ | 0.6 | ||||
| (*) | The derivative liabilities are two interest rate swap agreements with original three year terms, which were included in “Accrued expenses” in the Company’s consolidated balance sheet at December 31, 2010. |
Interest Rate Swap Agreements
The notional amounts provide an indication of the extent of the Company’s involvement in such agreements but do not represent its exposure to market risk. The following table shows the notional amount outstanding, maturity date, and the weighted average receive and pay rates of the interest rate swap agreements as of June 30, 2011 and December 31, 2010.
| Notional Amount | Weighted Average Rate | |||||||||||||||
| June 30, 2011 | December 31, 2010 | Maturity Date | Pay | Receive | ||||||||||||
| $ | — | $ | 18.9 | August 2011 | 3.65 | % | 0.72 | % | ||||||||
| — | 9.5 | November 2011 | 2.635 | % | 0.40 | % | ||||||||||
| $ | — | $ | 28.4 | |||||||||||||
Interest expense under these agreements, and the respective debt instruments that they hedge, are recorded at the net effective interest rate of the hedged transaction.
14
ABOVENET, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)
The notional amounts of the swap arrangements have since been reduced by amounts corresponding to reductions in the outstanding principal balances.
The swap agreements were settled in January 2011 in connection with the repayment of the term loans under the Secured Credit Facility and the closing of the $250 Million Secured Revolving Credit Facility (as such terms are defined in Note 4, “Note Payable,” below). The cost of $0.5 to settle the swap agreements was included in “Other income (expense), net” in the Company’s consolidated statement of operations for the six months ended June 30, 2011.
Fair Value of Financial Instruments
The Company adopted SFAS No. 157, “Fair Value Measurements,” (now known as FASB ASC 820-10), for the Company’s financial assets and liabilities effective January 1, 2008. This pronouncement defines fair value, establishes a framework for measuring fair value, and requires expanded disclosures about fair value measurements. FASB ASC 820-10 emphasizes that fair value is a market-based measurement, not an entity-specific measurement, and defines fair value as the price that would be received to sell an asset or transfer a liability in an orderly transaction between market participants at the measurement date. FASB ASC 820-10 discusses valuation techniques, such as the market approach (comparable market prices), the income approach (present value of future income or cash flow) and the cost approach (cost to replace the service capacity of an asset or replacement cost), which are each based upon observable and unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions. FASB ASC 820-10 utilizes a fair value hierarchy that prioritizes inputs to fair value measurement techniques into three broad levels:
| Level 1: | Observable inputs such as quoted prices for identical assets or liabilities in active markets. |
| Level 2: | Observable inputs other than quoted prices that are directly or indirectly observable for the asset or liability, including quoted prices for similar assets or liabilities in active markets; quoted prices for similar or identical assets or liabilities in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable. |
| Level 3: | Unobservable inputs that reflect the reporting entity’s own assumptions. |
The Company’s investment in overnight money market institutional funds, which amounted to $82.7 and $48.2 at June 30, 2011 and December 31, 2010, respectively, is included in cash and cash equivalents on the accompanying balance sheets and is classified as a Level 1 asset.
The Company was party to two interest rate swaps, which were utilized to modify the Company’s interest rate risk. The Company recorded the mark-to-market value of the interest rate swap contracts of $0.6 (which was included in “Accrued expenses”) in the Company’s consolidated balance sheet at December 31, 2010. The Company used third parties to value each of the interest rate swap agreements at December 31, 2010, as well as its own market analysis to determine fair value. The fair value of the interest rate swap contracts were classified as Level 2 liabilities. The swap agreements were settled in January 2011 in connection with the repayment of the term loans under the Secured Credit Facility and the closing of the $250 Million Secured Revolving Credit Facility. The cost of $0.5 to settle the swap agreements was included in “Other income (expense), net” in the Company’s consolidated statement of operations for the six months ended June 30, 2011.
The Company’s consolidated balance sheets include the following financial instruments: short-term cash investments, trade accounts receivable, trade accounts payable and note payable. The Company believes the carrying amounts in the financial statements approximate the fair value of these financial instruments due to the relatively short period of time between the origination of the instruments and their expected realization or the interest rates which approximate current market rates.
15
ABOVENET, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)
Concentration of Credit Risk
Financial instruments which potentially subject the Company to concentration of credit risk consist principally of short-term cash investments and accounts receivable. The Company does not enter into financial instruments for trading or speculative purposes. The Company’s cash and cash equivalents are invested in investment-grade, short-term investment instruments with high quality financial institutions. The Company’s trade receivables, which are unsecured, are geographically dispersed, and no single customer accounts for greater than 10% of consolidated revenue or accounts receivable, net. The Company performs ongoing credit evaluations of its customers’ financial condition. The allowance for non-collection of accounts receivable is based upon the expected collectability of all accounts receivable. The Company places its cash and cash equivalents primarily in commercial bank accounts in the U.S. Account balances generally exceed federally insured limits.
401(k) and Other Post-Retirement Benefits
The Company has a Profit Sharing and 401(k) Plan (the “Plan”) for its employees in the U.S., which permits employees to make contributions to the Plan on a pre-tax salary reduction basis in accordance with the provisions of the Internal Revenue Code and permits the employer to provide discretionary contributions. All full-time U.S. employees are eligible to participate in the Plan at the beginning of the month following three months of service. Eligible employees may make contributions subject to the limitations defined by the Internal Revenue Code. The Company matches 50% of a U.S. employee’s contributions, up to the amount set forth in the Plan. Matched amounts vest based upon an employee’s length of service. The Company’s subsidiaries in the U.K. have a different plan under which contributions are made up to a maximum of 8% when U.K. employee contributions reach 5% of salary. Under the U.K. plan, contributions are made at two levels. When a U.K. employee contributes 3% or more but less than 5% of their salary to the plan, the Company’s contribution is fixed at 5% of the salary. When a U.K. employee contributes over 5% of their salary to the plan, the Company’s contribution is fixed at 8% of the salary (regardless of the percentage of the contribution in excess of 5%).
The Company contributed $0.4 for each of the three months ended June 30, 2011 and 2010 and contributed $1.1 and $0.9 for the six months ended June 30, 2011 and 2010, respectively, net of forfeitures for its obligations under these plans.
Taxes Collected from Customers
In June 2006, the Emerging Issues Task Force (“EITF”) ratified the consensus on EITF No. 06-3, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation),” (“EITF No. 06-3”), (now known as FASB ASC 605-45). FASB ASC 605-45 requires that companies disclose their accounting policies regarding the gross or net presentation of certain taxes. Taxes within the scope of FASB ASC 605-45 are any taxes assessed by a governmental authority that are directly imposed on a revenue-producing transaction between a seller and a customer and may include, but are not limited to, sales, use, value added and some excise taxes. In addition, if such taxes are significant, and are presented on a gross basis, the amounts of those taxes should be disclosed. The Company adopted EITF No. 06-3 effective January 1, 2007. The Company records Universal Service Fund (“USF”) contributions relating to certain services it provides on a net basis in accordance with the guidelines of EITF No. 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent,” (also now known as FASB ASC 605-45). The Company’s policy is to record all such fees, contributions and taxes within the scope of FASB ASC 605-45 on a net basis.
16
ABOVENET, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)
Recently Issued Accounting Pronouncements
In August 2009, the FASB issued ASU No. 2009-5, "Fair Value Measurements and Disclosures (Topic 820) - Measuring Liabilities at Fair Value." ASU No. 2009-5 provides clarification that in circumstances in which a quoted price in an active market for the identical liability is not available, a reporting entity is required to measure fair value using a valuation technique that uses the quoted price of the identical liability when traded as an asset, quoted prices for similar liabilities or similar liabilities when traded as assets, or another valuation technique that is consistent with the principles of ASC Topic 820. ASU No. 2009-5 is effective for the first reporting period (including interim periods) beginning after issuance. The adoption of ASU No. 2009-5 did not have a material impact on the Company’s financial position, results of operations or cash flows.
In October 2009, the FASB issued ASU No. 2009-13, "Revenue Recognition (Topic 605) - Multiple Deliverable Revenue Arrangements." ASU No. 2009-13 eliminates the residual method of allocation and requires that arrangement consideration be allocated at the inception of the arrangement to all deliverables using the relative selling price method and expands the disclosures related to multiple-deliverable revenue arrangements. ASU No. 2009-13 is effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with earlier adoption permitted. The adoption of ASU No. 2009-13 did not have a material impact on the Company’s financial position, results of operations or cash flows.
In January 2010, the FASB issued ASU No. 2010-02, "Consolidation (Topic 810) - Accounting and Reporting for Decreases in Ownership of a Subsidiary - a Scope Clarification." ASU No. 2010-02 clarifies that the scope of the decrease in ownership provisions of Topic 810 applies to a subsidiary or group of assets that is a business, a subsidiary that is a business that is transferred to an equity method investee or a joint venture or an exchange of a group of assets that constitutes a business for a noncontrolling interest in an entity and does not apply to sales in substance of real estate. ASU No. 2010-02 is effective as of the beginning of the period in which an entity adopts SFAS No. 160 or, if SFAS No. 160 has been previously adopted, the first interim or annual period ending on or after December 15, 2009, applied retrospectively to the first period that the entity adopted SFAS No. 160. The adoption of ASU No. 2010-02 did not have a material impact on the Company’s financial position, results of operations or cash flows.
In January 2010, the FASB issued ASU No. 2010-06, "Fair Value Measurements and Disclosures (Topic 820) - Improving Disclosures about Fair Value Measurements." ASU 2010-06 requires new disclosures regarding transfers in and out of the Level 1 and 2 and activity within Level 3 fair value measurements and clarifies existing disclosures of inputs and valuation techniques for Level 2 and 3 fair value measurements. ASU 2010-06 also includes conforming amendments to employers' disclosures about postretirement benefit plan assets. The new disclosures and clarifications of existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosure of activity within Level 3 fair value measurements, which is effective for fiscal years beginning after December 15, 2010, and for interim periods within those years. The adoption of ASU No. 2010-06 did not have a material impact on the Company’s financial position, results of operations or cash flows.
In February 2010, the FASB issued ASU 2010-09, "Subsequent Events (Topic 855) - Amendments to Certain Recognition and Disclosure Requirements." ASU 2010-09 requires an entity that is an SEC filer to evaluate subsequent events through the date that the financial statements are issued and removes the requirement that an SEC filer disclose the date through which subsequent events have been evaluated. ASU 2010-09 was effective upon issuance. The adoption of ASU 2010-09 had no effect on the Company’s financial position, results of operations or cash flows.
In April 2010, the FASB issued ASU 2010-13, "Compensation - Stock Compensation (Topic 718) - Effect of Denominating the Exercise Price of a Share-Based Payment Award in the Currency of the Market in Which the Underlying Equity Security Trades." ASU 2010-13 provides amendments to Topic 718 to clarify that an employee share-based payment award with an exercise price denominated in the currency of a market in which a substantial portion of the entity's equity securities trades should not be considered to contain a condition that is not a market, performance, or service condition. Therefore, an entity would not classify such an award as a liability if it otherwise qualifies as equity. The amendments in ASU 2010-13 are effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2010. The adoption of ASU 2010-13 did not have a material impact on the Company’s financial position, results of operations or cash flows.
17
ABOVENET, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)
NOTE 3: CHANGE IN ESTIMATE
Effective January 1, 2008, the Company changed the estimated useful lives for its spare parts (which are classified as inventory) from five years to the respective asset class lives of such parts, which range from seven to 20 years. The effect of this change was not material. Effective October 1, 2009, the Company changed the estimated useful lives for certain HVAC and power equipment from 20 years to 12 to 15 years and certain components of infrastructure (risers) from 20 years to five years. Effective January 1, 2010, the Company changed the estimated useful lives for its IP equipment from seven years to five years. Additionally, the Company changed the estimated useful lives for certain capitalized labor from 20 years to seven years. The effect of these changes on the Company’s future operating results will not be material.
NOTE 4: NOTE PAYABLE
$250 Million Secured Revolving Credit Facility
On January 28, 2011, the Company closed a five year $250 secured revolving credit facility (the “$250 Million Secured Revolving Credit Facility”) with the lender parties thereto (the “Lenders”) and SunTrust Bank, as Administrative Agent (the “Administrative Agent”). The Lenders received a first priority security interest in and lien on substantially all of the Company’s domestic assets and 65% of the ownership interest in the Company’s principal foreign subsidiaries. Loans under the $250 Million Secured Revolving Credit Facility bear interest, for any interest period of one, two or three months or if agreed to, longer interest periods at the Company’s option, at either the Base Rate (as defined in the $250 Million Secured Revolving Credit Facility) plus the applicable margin ranging from 1.25% to 2.00%, or alternately, the Adjusted LIBO Rate (as defined in the $250 Million Secured Revolving Credit Facility) plus the applicable margin ranging from 2.25% to 3.00%. The Company is also required to pay an unused commitment fee ranging from 0.375% to 0.50% per annum based on the daily average undrawn portion of the $250 Million Secured Revolving Credit Facility. The applicable margin and the unused commitment fee will be determined based on the Company’s Leverage Ratio based on Consolidated Total Debt to Consolidated EBITDA (each as defined in the $250 Million Secured Revolving Credit Facility).
The $250 Million Secured Revolving Credit Facility includes an uncommitted accordion feature that permits the Company to increase the aggregate principal amount by up to $125.0 through one or more term loans or additional revolving credit, subject to the agreement by one or more Lenders to provide the additional principal amount.
The Company borrowed $55.0 at closing, of which $5.0 was used to pay bank fees and legal expenses, $49.9 was used to repay the Secured Credit Facility (as defined below) and $0.1 was used for general corporate purposes. The initial borrowings under the $250 Million Secured Revolving Credit Facility carried an interest rate of 4.50% (base rate of 3.25% plus applicable margin of 1.25%). The Company converted the interest rate to the Adjusted LIBO Rate option as of February 4, 2011, at which time the interest rate was changed to 2.52% (0.27% Adjusted LIBO Rate plus applicable margin of 2.25%). At June 30, 2011, the $250 Million Secured Revolving Credit Facility carried an interest rate of 2.45% (0.20% Adjusted LIBO Rate plus applicable margin of 2.25%).
The Company has the right to prepay any outstanding loan prior to maturity without premium or penalty.
The Company is required to comply with a number of affirmative, negative and financial covenants. Among other things, these covenants require the Company to provide notices of material events and information regarding collateral, restrict the Company’s ability, subject to certain exceptions and baskets, to incur additional indebtedness, grant liens on assets, undergo fundamental changes, make investments, sell assets, make restricted payments (including the ability to pay dividends) and engage in affiliate transactions, and require the Company to maintain a Leverage Ratio not greater than 2.5 to 1.0 and an Interest Coverage Ratio (as defined in the $250 Million Secured Revolving Credit Facility) of not less than 3.0 to 1.0. At June 30, 2011, based upon the Company’s leverage ratio, as defined, its cash balance and its availability under the facility, $229.4 of retained earnings is unrestricted for dividend purposes and the balance is restricted.
The $250 Million Secured Revolving Credit Facility contains customary events of default (subject to customary grace periods, cure rights and materiality thresholds), including, among others, failure to pay principal, interest or fees, violation of covenants, material inaccuracy of representations and warranties, cross-default and cross-acceleration of material indebtedness, certain bankruptcy and insolvency events, certain judgments, certain ERISA events and change of control.
18
ABOVENET, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)
Following an event of default under the $250 Million Secured Revolving Credit Facility, the Administrative Agent and the Lenders would be entitled to take various actions, including the acceleration of amounts due under the $250 Million Secured Revolving Credit Facility and seek other remedies that may be taken by secured creditors.
The outstanding principal amount of all revolving credit loans, together with accrued and unpaid interest thereon, will be due and payable on January 28, 2016.
In connection with the January 2011 closing of the $250 Million Secured Revolving Credit Facility, the Company also settled the two interest rate swaps at a total cost of $0.5, which is included in “Other expense, net” in the Company’s consolidated statement of operations for the six months ended June 30, 2011. The Company also wrote-off $1.1 in unamortized debt acquisition costs associated with the Secured Credit Facility, which is also included in “Other income (expense), net” in the Company’s consolidated statement of operations for the six months ended June 30, 2011.
As of June 30, 2011, $195.0 was available for borrowings under the $250 Million Secured Revolving Credit Facility.
The Company was in compliance with all of its debt covenants as of June 30, 2011.
Secured Credit Facility
On February 29, 2008, the Company, excluding certain foreign subsidiaries, entered into a Credit and Guaranty Agreement (as amended, the “Credit Agreement”) providing for a $60.0 senior secured credit facility (the “Secured Credit Facility”), consisting of an $18.0 revolving credit facility (the “Revolver”) and a $42.0 term loan facility (the “Term Loan”), which was comprised of $24.0 advanced at closing and up to $18.0 of which originally could be drawn within nine months of closing at the Company’s option (the “Delayed Draw Term Loan”). The Secured Credit Facility was secured by substantially all of the Company’s domestic assets. In September 2008, the Delayed Draw Term Loan option, which was originally scheduled to expire on November 25, 2008, was extended to June 30, 2009 and then subsequently extended to December 31, 2009. The Revolver and the Term Loan each had a term of five years from February 29, 2008. The Company paid an upfront fee of 1.5% ($0.9) of the total amount of the Secured Credit Facility and paid $0.3 to its unaffiliated third party financial advisors who assisted the Company. The Company was also liable for an unused commitment fee of 0.75% per annum. Interest accrued at LIBOR (30, 60, 90 or 180 day rates) or at the announced base rate of the administrative agent at the Company’s option, plus the applicable margins, as defined. The Company chose 30 day LIBOR as the interest rate, plus the applicable margin of 3% effective September 30, 2008. Additionally, the Company was originally required to maintain an unrestricted cash balance at all times of at least $20.0. On February 29, 2008, the Company received proceeds, pursuant to the Term Loan of $24.0, less debt acquisition costs. Under the provisions of the Term Loan, the initial advance was at the base rate of interest, plus the margin (8.25% at February 29, 2008) and converted to LIBOR, plus 3.25% per annum (6.26%) on March 5, 2008.
The Company’s ability to draw upon the available commitments under the Revolver was subject to compliance with all of the covenants contained in the Credit Agreement and the Company’s continued ability to make certain representations and warranties. Among other things, these covenants imposed limits on annual capital expenditures (through 2010), provided that the Company’s net total funded debt ratio could not at any time exceed a specified amount and required that the Company maintained a minimum consolidated fixed charges coverage ratio. In addition, the Credit Agreement prohibited the Company from paying dividends (other than in its own shares or other equity securities) and from making certain other payments, including payments to acquire the Company’s equity securities other than under specified circumstances, which include the repurchase of the Company’s equity securities from employees and directors in an aggregate amount not to exceed $15.0. The Company obtained a waiver from the Lenders to effectuate the dividend paid in December 2010.
19
ABOVENET, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)
On September 26, 2008, the Company executed a joinder agreement to the Secured Credit Facility that added an additional lender and increased the amount of the Secured Credit Facility to $90.0 effective October 1, 2008; the Revolver increased to $27.0, the Term Loan increased to $36.0 and the available Delayed Draw Term Loan increased to $27.0. In connection with the joinder agreement, the Company paid a $0.45 fee at closing and an aggregate of $0.25 of advisory fees. The additional amount of the Term Loan of $12.0 was advanced on October 1, 2008.
Effective August 4, 2008, the Company entered into a swap arrangement under which it fixed its borrowing costs with respect to the $24.0 (original principal) Term Loan outstanding for three years at 3.65%, plus the applicable margin of 3.25%, which was reduced to 3.00% on September 30, 2008. On November 14, 2008, the Company entered into a swap arrangement under which it fixed its borrowing costs with respect to the additional $12.0 (original principal) under the Term Loan borrowed on October 1, 2008 for three years at 2.635% per annum, plus the applicable margin of 3.00%.
On June 29, 2009, the Company and the Lenders entered into an amendment to the Credit Agreement, which extended the availability of the Delayed Draw Term Loan commitments from June 30, 2009 to December 31, 2009, and provided for the reduction of these commitments by $0.81 on each of June 30, 2009, September 30, 2009 and December 31, 2009. In addition, the Company’s obligation to maintain a minimum balance of $20.0 in cash deposits at all times was eliminated.
On December 31, 2009, the Company borrowed $24.57 under the Delayed Draw Term Loan, which carried interest at 30 day LIBOR (0.25750% at December 31, 2010), plus the applicable margin of 3.00%. The Delayed Draw Term Loan provided for payment terms similar to the Term Loan.
The Term Loan provided for monthly payments of interest and quarterly installments of principal of $1.08, which commenced on June 30, 2009. The quarterly installment of principal increased to $1.89 beginning March 31, 2010 to take into consideration the Delayed Draw Term Loan repayment schedule. The aggregate quarterly principal repayment was scheduled to increase to $2.52 on June 30, 2012 with the balance of $32.76, plus accrued unpaid interest, due on February 28, 2013.
Additionally, the Company executed a $1.0 standby letter of credit in favor of the City of New York to secure the Company’s franchise agreement, which is collateralized by $1.0 of availability under the Revolver. The standby letter of credit, originally scheduled to expire May 1, 2010, was renewed and extended.
The Term Loan and the Delayed Draw Term Loan, plus accrued interest, totaling $49.9 were repaid on January 28, 2011 upon the closing of the $250 Million Secured Revolving Credit Facility. The standby letter of credit in favor of the City of New York was terminated in connection with the repayment and replaced by $1.0 standby letter of credit (secured by a $1.0 restricted cash balance) with a term scheduled to expire January 2012, subject to annual renewals at the Company’s option to January 2016.
20
ABOVENET, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)
NOTE 5: INCOME TAXES
Income taxes have been provided based upon the tax laws and rates in the countries in which operations are conducted and income is earned. The provision for income taxes for the three and six months ended June 30, 2011 and 2010 are as follows:
Three Months Ended June 30, | Six Months Ended June 30, | |||||||||||||||
| 2011 | 2010 | 2011 | 2010 | |||||||||||||
| Federal | $ | 9.1 | $ | 9.1 | $ | 16.7 | $ | 17.1 | ||||||||
| State | 1.6 | 1.4 | 3.0 | 2.7 | ||||||||||||
| Foreign | 0.4 | 0.6 | 1.1 | 0.9 | ||||||||||||
| Total provision for income taxes | $ | 11.1 | $ | 11.1 | $ | 20.8 | $ | 20.7 | ||||||||
At the end of each interim period, the Company estimates the annual effective tax rate and applies that rate to its ordinary quarterly earnings. The tax expense or benefit related to significant, unusual or extraordinary items that will be separately reported or reported net of their related tax effect, and are individually computed, are recognized in the interim period in which those items occur. In addition, the effect of changes in enacted tax laws or rates or tax status is recognized in the interim period in which the change occurs.
The computation of the annual estimated effective tax rate at each interim period requires certain estimates and significant judgment including, but not limited to, the expected operating income for the year, projections of the proportion of income earned and taxed in various jurisdictions, permanent and temporary differences, and the likelihood of recovering deferred tax assets generated in the current year. The accounting estimates used to compute the provision for income taxes may change as new events occur, more experience is acquired, additional information is obtained or as the tax environment changes.
For each of the three months ended June 30, 2011 and 2010, the consolidated effective income tax rate was approximately 40.6%. For the six months ended June 30, 2011 and 2010, the effective income tax rates were 40.5% and 40.9%, respectively. The effective tax rate in the U.K. for the six months ended June 30, 2011, based upon consolidated pre-tax income in the U.K., is approximately 34.8%. AboveNet Communications UK Limited (“ACUK”) receives no benefit from the operating loss generated by AboveNet Communications Europe Limited (“ACE”), which files its U.K. income tax return on a stand alone basis. ACE is a foreign disregarded entity whose operating results are consolidated with the U.S. for federal income tax reporting purposes.
As part of the Company’s evaluation of deferred tax assets in the fourth quarter of 2010, the Company recognized a non-cash tax benefit of $7.3 at December 31, 2010 relating to the reduction of certain valuation allowances established in the U.K. The Company believes it is more likely than not that the Company will utilize these deferred tax assets to reduce or eliminate tax payments in future periods. This reduction in valuation allowances had the effect of increasing net income by $7.3 for the year ended December 31, 2010. The Company’s evaluation encompassed (i) a review of its recent history of profitability in the U.K. for the past three years; (ii) a review of internal financial forecasts demonstrating its expected capacity to utilize deferred tax assets; and (iii) a reassessment of tax benefits recognition under FASB ASC 740.
21
ABOVENET, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)
NOTE 6: INCOME PER COMMON SHARE
Basic net income per common share is computed as net income divided by the weighted average number of common shares outstanding for the period. Total weighted average shares utilized in computing basic net income per common share were 25,818,689 and 25,145,224 for the three months ended June 30, 2011 and 2010, respectively. Total weighted average shares utilized in computing diluted net income per common share were 26,837,305 and 26,194,883 for the three months ended June 30, 2011 and 2010, respectively. Dilutive securities include options to purchase shares of common stock, restricted stock units and stock warrants. For each of the three months ended June 30, 2011 and 2010, there were no potentially dilutive securities excluded from the calculation of diluted income per common share. For the six months ended June 30, 2011 and 2010, total weighted average shares utilized in computing basic net income per common share were 25,811,337 and 25,045,423, respectively. For the six months ended June 30, 2011 and 2010, total weighted average shares utilized in computing diluted net income per common share were 26,805,236 and 26,205,457, respectively. For each of the six months ended June 30, 2011 and 2010, there were no potentially dilutive securities excluded from the calculation of diluted income per common share.
NOTE 7: STOCK-BASED COMPENSATION
2008 Equity Incentive Plan
On August 29, 2008, the Board of Directors of the Company approved the Company’s 2008 Plan. The 2008 Plan is administered by the Company’s Compensation Committee. Any employee, officer, director or consultant of the Company or subsidiary of the Company selected by the Compensation Committee is eligible to receive awards under the 2008 Plan. Stock options, restricted stock, restricted and unrestricted stock units and stock appreciation rights may be awarded to eligible participants on a stand alone, combination or tandem basis. 1,500,000 shares of the Company’s common stock were initially reserved for issuance pursuant to awards granted under the 2008 Plan. The number of shares available for grant and the terms of outstanding grants are subject to adjustment for stock splits, stock dividends and other capital adjustments.
Stock-based compensation expense for each period presented relates to share-based awards granted under the Company’s 2008 Plan described above and the Company’s 2003 Plan, and reflect awards outstanding during such period, including awards granted both prior to and during such period. The 2003 Plan became effective on September 8, 2003. Under the 2003 Plan, the Company was authorized to issue, in the aggregate, share-based awards of up to 2,129,912 common shares to employees, directors and consultants who were selected to participate. Under the 2003 Plan, as of June 30, 2011, 1,169,432 common shares had been issued pursuant to vested restricted stock units (including shares repurchased by the Company), 838,856 shares had been issued pursuant to options exercised to purchase common shares, 87,446 common shares were reserved pursuant to outstanding vested options to purchase shares of common stock and 34,178 common shares were cancelled. No shares are available for future grants under the 2003 Plan
Under the 2008 Plan, the Company was authorized to issue share-based awards of up to 1,500,000 common shares in accordance with its terms. As of June 30, 2011, 501,256 common shares were issued pursuant to the delivery of vested restricted stock units (including shares repurchased by the Company), 3,288 common shares had been issued pursuant to the exercise of options to purchase shares of common stock, 9,281 common shares were issued pursuant to the Option Dividend (as defined in Note 8, Shareholders’ Equity,” below) on December 20, 2010, 944,744 were reserved pursuant to outstanding restricted stock units, 6,712 common shares were reserved pursuant to outstanding options to purchase shares of common stock and 34,719 common shares were reserved for future grants.
22
ABOVENET, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)
2011 Equity Incentive Plan
On May 11, 2011, the Board of Directors of the Company adopted the AboveNet, Inc. 2011 Equity Incentive Plan (the “2011 Plan”), which provides for the availability of a maximum of 1,600,000 shares of the Company’s common stock to be awarded to the Company’s employees (including officers), directors and consultants in the form of restricted stock unit awards, restricted stock awards, incentive stock options, non-qualified stock options, stock appreciation rights, performance-based awards and other stock- or cash-based awards. The 2011 Plan was approved by the Company’s stockholders at the Company’s 2011 Annual Meeting of Stockholders held on June 23, 2011. The 2011 Plan will be administered by the Compensation Committee, which will, in its sole discretion, determine which individuals may participate in the 2011 Plan and the type, extent and terms of the awards to be granted. The number of shares available for grant and the terms of outstanding grants are subject to adjustment for stock splits, stock dividends and other capital adjustments.
Stock Options
There were no options to purchase shares of common stock granted during each of the three and six months ended June 30, 2011 and 2010. There was no non-cash stock-based compensation expense recognized with respect to options to purchase shares of common stock during each of the three and six months ended June 30, 2011 and 2010.
Restricted Stock Units
The company did not award any restricted stock units during the three months ended June 30, 2011 and 2010.
On January 25, 2011, the Company granted an aggregate 213,100 restricted stock units; of which 190,000 were granted to the Company’s named executive officers as follows (including the 15,000 restricted stock units granted to Mr. Datta in connection with his appointment as Chief Operating Officer):
| Name | Total | |||
| William G. LaPerch | 65,000 | |||
| Rajiv Datta | 60,000 | |||
| Joseph P. Ciavarella | 21,000 | |||
| Robert Sokota | 21,000 | |||
| John Jacquay | 23,000 | |||
The fair value of each restricted stock unit granted was $59.25, based on the closing price of the Company’s common stock on the New York Stock Exchange on January 25, 2011. The 213,100 restricted stock units are scheduled to vest as follows: 15,000 on November 16, 2011, 132,066 on November 16, 2012 and 66,034 on November 16, 2013.
On December 20, 2010, pursuant to the 2008 Plan, the Company awarded 254,700 restricted stock units to certain employees and the non-employee members of the Board of Directors. The fair value of the grants was $56.82 per share, the closing price of the Company’s common stock on that day. 10,800 of these restricted stock units, all of which were granted to employees, are scheduled to vest on November 16, 2011. Of the balance of 243,900 restricted stock units (including 3,000 restricted stock units to each of the five non-employee members of the Board of Directors), 161,267 are scheduled to vest on November 16, 2012 and 82,633 are scheduled to vest on November 16, 2013.
23
ABOVENET, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)
Additionally, on December 20, 2010, pursuant to the 2008 Plan, the Board of Directors of the Company granted 40,508 restricted stock units pursuant to the RSU Dividend (as defined in Note 8, “Shareholders’ Equity”). 28,656 of such restricted stock units are scheduled to vest on November 15, 2011, 9,360 of such restricted stock units are scheduled to vest on November 16, 2011, 1,246 vested, along with 14,000 previously granted restricted stock units, in February 2011 based upon the attainment of certain performance-based metrics with respect to fiscal year 2010 and up to 1,246 may vest along with up to 14,000 previously granted restricted stock units, on or before March 15, 2012 based upon the attainment of certain performance-based metrics with respect to fiscal year 2011.
On December 2, 2010, pursuant to the 2008 Plan, the Company awarded 5,900 restricted stock units to certain employees. The fair value of the grant was $56.57 per share, the closing of the Company’s stock on that day. Such restricted stock units are scheduled to vest on November 16, 2011.
The Company recognized non-cash stock-based compensation expense related to restricted stock units of $6.8 and $2.1 for the three months ended June 30, 2011 and 2010, respectively, which had the effect of decreasing net income by $0.16 per basic common share and by $0.15 per diluted common share for the three months ended June 30, 2011 and by $0.05 per basic and diluted common share for the three months ended June 30, 2010. The Company recognized non-cash stock-based compensation expense related to restricted stock units of $13.8 and $4.2 for the six months ended June 30, 2011 and 2010, respectively, which had the effect of decreasing net income by $0.32 per basic common share and by $0.31 per diluted common share for the six months ended June 30, 2011 and by $0.10 per basic and diluted common share for the six months ended June 30, 2010.
Additionally, during the six months ended June 30, 2011, the Company delivered 15,246 shares of common stock to its Chief Executive Officer, William LaPerch, pursuant to the 14,000 vested performance-based restricted stock units granted to him in September 2008 and 1,246 restricted stock units granted pursuant to the RSU Dividend. In accordance with the terms of Mr. LaPerch’s stock unit agreement, the Company purchased an aggregate of 5,951 shares of common stock from Mr. LaPerch at $60.24 per share, the closing price of the Company’s common stock on the date of delivery, in order to satisfy minimum tax withholding obligations.
NOTE 8: SHAREHOLDERS’ EQUITY
Dividends
In November 2010, we obtained waivers from our lenders (Societe Generale, SunTrust Bank and CIT Lending Services Corporation) to permit a $5.00 per share dividend. On November 23, 2010, we announced that our Board of Directors declared a special one-time cash dividend of $5.00 per share on our common stock (the “Special Cash Dividend”). The Special Cash Dividend was paid on December 27, 2010 to the stockholders of record at the close of business on December 6, 2010. The aggregate amount of the payment made in connection with the Special Cash Dividend was approximately $129.0. On December 20, 2010, the Company’s Board of Directors granted restricted stock units (the “RSU Dividend”) to holders of unvested restricted stock units on the record date of the Special Cash Dividend in order to provide these holders with an amount that approximated the value of the Special Cash Dividend. In total, the Company granted 40,508 restricted stock units pursuant to the RSU Dividend, of which up to 1,246 restricted stock units vested in February 2011 based upon the achievement of certain performance targets established for fiscal year 2010, 28,656 restricted stock units are scheduled to vest on November 15, 2011, 9,360 are scheduled to vest on November 16, 2011 and up to 1,246 restricted stock units are scheduled to vest on or before March 15, 2012 based upon the achievement of certain performance targets established for fiscal year 2011.
Additionally, on December 20, 2010, the Company’s Board of Directors granted shares of common stock (the “Option Dividend”) to holders of vested unexercised options to purchase shares of common stock in order to provide these holders with an amount that approximated the value of the Special Cash Dividend. On December 27, 2010, the Company delivered 9,281 shares of common stock pursuant to the Option Dividend. Additionally, the Company paid cash to one former employee and to the estate of one deceased employee totaling $0.007. In the fourth quarter of 2010, the Company recorded stock-based compensation expense of $0.5 in connection with the Option Dividend.
24
ABOVENET, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)
Stock Split
On August 3, 2009, the Board of Directors of the Company authorized a two-for-one common stock split, effected in the form of a 100% stock dividend, which was distributed on September 3, 2009. Each shareholder of record on August 20, 2009 received one additional share of common stock for each share of common stock held on that date. All share and per share information for prior periods, including warrants, options to purchase common shares, restricted stock units, warrant and option exercise prices, shares reserved under the 2003 Plan and the 2008 Plan, weighted average fair value of options granted, common stock and additional paid-in capital accounts on the consolidated balance sheets and consolidated statement of shareholders’ equity, have been retroactively adjusted, where applicable, to reflect the two-for-one stock split.
Amendment to the Company’s Amended and Restated Certificate of Incorporation
On June 24, 2010, the Company’s stockholders approved an amendment to the Company’s Amended and Restated Certificate of Incorporation (the “Amendment”) to increase the number of authorized shares of our common stock, par value $0.01 per share, from 30 million to 200 million. The number of authorized shares of preferred stock remained at 10 million.
The increase in the number of our authorized shares of common stock could have an anti-takeover effect by discouraging or hindering efforts to acquire control of the Company. The Company would be able to use the additional shares to oppose a hostile takeover attempt or delay or prevent changes in control or management of the Company. This was not the intent of the Board of Directors in adopting the Amendment, nor has the Amendment been adopted in response to any known threat to acquire control of the Company.
The increase in the authorized shares of common stock became effective upon the filing of the Amendment with the Secretary of State of the State of Delaware on June 24, 2010.
Rights Agreement
On August 3, 2006, the Company entered into a Rights Agreement (the “Rights Agreement”) with American Stock Transfer & Trust Company, as rights agent, which was amended and restated on August 3, 2009 and subsequently amended as of January 26, 2010 (as amended, the “Amended and Restated Rights Agreement”). The Amended and Restated Rights Agreement was ratified by the Company’s stockholders at its annual meeting on June 24, 2010. As a result, the Rights (as defined below) under the Amended and Restated Rights Agreement will remain in effect until August 7, 2012, unless sooner terminated by the Company’s Board of Directors. The following description of the Amended and Restated Rights Agreement does not purport to be complete and is qualified in its entirety by reference to the Amended and Restated Rights Agreement included as Exhibit 4.1 to the Company’s Current Report on Form 8-K filed with the SEC on August 3, 2009, and the Amendment to Amended and Restated Rights Agreement, dated as of January 26, 2010, between AboveNet, Inc. and American Stock Transfer & Trust Company, LLC included as Exhibit 4.1 to the Company’s Current Report on Form 8-K filed with the SEC on January 28, 2010.
In connection with the initial Rights Agreement, the Company’s Board of Directors declared a dividend distribution of one preferred share purchase right (a “Right”) for each then outstanding share of the Company’s common stock, par value $0.01 per share (the “Common Shares”). The dividend was paid on August 7, 2006 to the stockholders of record on that date.
Until the earlier to occur of (i) the date that is 10 days following the date of a public announcement that a person, entity or group of affiliated or associated persons have acquired beneficial ownership of 15% or more of the outstanding Common Shares (an “Acquiring Person”) or (ii) 10 business days (or such later date as may be determined by action of the Company’s Board of Directors prior to such time as any person or entity becomes an Acquiring Person) following the commencement of, or announcement of an intention to commence, a tender offer or exchange offer the consummation of which would result in any person or entity becoming an Acquiring Person (the earlier of such dates being called the “Distribution Date”), the Rights will be evidenced by the Common Share certificates or book-entry shares.
25
ABOVENET, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)
The Rights are not exercisable until the Distribution Date. Each Right, upon becoming exercisable, will entitle the holder to purchase from the Company a specified fraction of a share of the Company’s Series A Junior Participating Preferred Stock (the “Preferred Shares”) at the then effective purchase price. The Rights will expire on August 7, 2012, unless earlier redeemed or exchanged.
The number of outstanding Rights and the number of Preferred Shares issuable upon exercise of the Rights are also subject to adjustment in the event of a stock split of the Common Shares or a stock dividend on the Common Shares payable in Common Shares or subdivisions, consolidation or combinations of the Common Shares occurring, in any case, prior to the Distribution Date. The purchase price payable and the number of preferred shares or other securities or other property issuable upon exercise of the Rights are subject to adjustment from time to time to prevent dilution as described in the Amended and Restated Rights Agreement. As a result of the Company’s stock split discussed above, appropriate adjustments under the Amended and Restated Rights Agreement have been made.
In the event that any person or group of affiliated or associated persons becomes an Acquiring Person, proper provision will be made so that each holder of a Right, other than Rights beneficially owned by the Acquiring Person and its associates and affiliates (which will thereafter be void), will have the right to receive upon exercise, in lieu of Preferred Shares, that number of Common Shares having a market value of two times the then effective exercise price of the Right (or, if such number of shares is not and cannot be authorized, the Company may issue preferred shares, cash, debt, stock or a combination thereof in exchange for the Rights).
In the event that the Company is acquired in a merger or other business combination transaction or 50% or more of its consolidated assets or earning power are sold to an Acquiring Person, its associates or affiliates or certain other persons, proper provision will be made so that each holder of a Right, other than Rights beneficially owned by the Acquiring Person and its associates and affiliates (which will thereafter be void), will thereafter have the right to receive, upon the exercise thereof at the then current exercise price of the Right, in lieu of Preferred Shares, that number of shares of common stock of the acquiring company, which at the time of such transaction will have a market value of two times the then effective exercise price per Right.
At any time after a person becomes an Acquiring Person and prior to the acquisition by such Acquiring Person of 50% or more of the outstanding Common Shares, the Company may exchange the Rights (other than Rights owned by such Acquiring Person or group which have become void), in whole or in part, at an exchange ratio of one share of common stock per Right (or, at the election of the Company, the Company may issue cash, debt, stock or a combination thereof in exchange for the Rights), subject to adjustment.
At any time prior to the earlier of (i) such time that a person has become an Acquiring Person or (ii) the final expiration date, the Company may redeem all, but not less than all, of the outstanding Rights at a price of $0.005 per Right (the “Redemption Price”). The Rights may also be redeemed at certain other times as described in the Amended and Restated Rights Agreement. Immediately upon any redemption of the Rights, the right to exercise the Rights will terminate and the only right of the holders of Rights will be to receive the Redemption Price.
The terms of the Rights may be amended by the Company’s Board of Directors without the consent of the holders of the Rights, except that from and after such time as the rights are distributed no such amendment may adversely affect the interest of the holders of the Rights other than the interests of an Acquiring Person or its affiliates or associates.
Until a Right is exercised, the holder thereof, as such, will have no rights as a stockholder of the Company, including, without limitation, the right to vote or to receive dividends.
26
ABOVENET, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)
2010 Employee Stock Purchase Plan
On June 24, 2010, the Company’s stockholders approved the AboveNet, Inc. 2010 Employee Stock Purchase Plan, which was adopted by the Board of Directors on April 28, 2010 (as amended, the “Stock Purchase Plan”). The Stock Purchase Plan is administered by the Compensation Committee of the Board of Directors. The aggregate number of shares of common stock that may be issued pursuant to the Stock Purchase Plan is 300,000, subject to increase or decrease by reason of stock splits, reclassifications, stock dividends, or similar corporate events as determined by the Compensation Committee.
Eligibility and Participation
All employees of the Company, or any of its designated subsidiaries, who have completed at least ninety (90) days of employment on or before the first day of the applicable offering period are eligible to participate in the Stock Purchase Plan, subject to certain limitations imposed by the Internal Revenue Code and certain other limitations set forth in the Stock Purchase Plan. An employee may not participate in the Stock Purchase Plan if, immediately after he or she joined, he or she would own stock and/or hold rights to purchase stock possessing 5% or more of the total combined voting power or value of all classes of stock of the Company or of any subsidiary of the Company. Officers of the Company that are subject to the reporting requirements of Section 16(a) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) are also not eligible to participate. The Stock Purchase Plan also limits an employee’s rights to purchase stock under all employee stock purchase plans (those subject to Section 423 of the Internal Revenue Code) of the Company and its subsidiaries so that such rights may not accrue at a rate that exceeds $0.025 of fair market value of such stock (determined as of the first day of the offering period) for each calendar year in which such right to purchase stock is outstanding at any time. In addition, no employee may purchase more than 200 shares of common stock under the Stock Purchase Plan in any offering period (and no more than 100 shares of common stock in the offering period for 2010). Employees may withdraw from the Stock Purchase Plan at any time prior to the end of the then current offering period. As of January 16, 2011, the commencement of the current offering period, a total of approximately 680 of the Company’s employees’ were eligible to participate in the Stock Purchase Plan.
Offering Periods; Purchase Price
The Stock Purchase Plan operates by a series of offering periods of approximately 10 months duration commencing on each January 16 and ending on November 15 (except that the 2010 offering period was from September 1, 2010 to November 15, 2010). The purchases are made for participants at the end of each offering period by applying payroll deductions accumulated over the course of the offering period towards such purchases. The payroll deductions accumulated over the course of the offering period are included in “Accrued expenses” in the Company’s consolidated balance sheet. The price at which these purchases will be made will equal 85% of the lesser of the fair market value of the common stock as of the first day of the offering period or the fair market value on the last day of the offering period.
2011 Offering Period
126 employees are participating in the January 16, 2011 to November 16, 2011 offering period. Payroll withholdings to make purchases are expected to be $0.8 over the 2011 offering period. The Company follows FASB Technical Bulletin No. 97-1, “Accounting under Statement 123 for Certain Employee Stock Purchase Plans with a Look-Back Option,” (now known as FASB ASC 718) and SFAS No. 123(R) (also now known as FASB ASC 718) to account for the Stock Purchase Plan. Because the Stock Purchase Plan provides for a discount greater than 5%, it is a compensatory plan and qualifies for fair value accounting. Accordingly, the fair market value of the grant is calculated as of the grant date in accordance with SFAS No. 123(R). Additionally, the fair value of the look-back option is calculated on a similar basis. The Company also estimates future forfeitures (withdrawals) from the Stock Purchase Plan as provided under FASB ASC 718. The Company recognized non-cash stock-based compensation expense with respect to the Stock Purchase Plan of $0.04 and $0.07 for the three and six months ended June 30, 2011, respectively.
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ABOVENET, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)
NOTE 9: LITIGATION
The Company is subject to various legal proceedings and claims which arise in the normal course of business. The Company evaluates, among other things, the degree of probability of an unfavorable outcome and reasonably estimates the amount of potential loss.
Global Voice Networks Limited (“GVN”)
ACUK, the Company’s U.K. operating subsidiary, was a party to a duct purchase and fiber lease agreement (the “Duct Purchase Agreement”) with EU Networks Fiber UK Ltd, formerly GVN. A dispute between the parties arose regarding the extent of the network duct that was sold and fiber that was leased to GVN pursuant to the Duct Purchase Agreement. As a result of this dispute, in 2006, GVN filed a claim against ACUK in the High Court of Justice in London seeking ownership of the disputed portion of the network duct, the right to lease certain fiber and associated damages. In December 2007, the court ruled in favor of GVN with respect to the disputed duct and fiber. In early February 2008, ACUK delivered most of the disputed duct and fiber to GVN. Additionally, under the original ruling, the Company was also required to construct the balance of the disputed duct and fiber and deliver it to GVN pursuant to a schedule ordered by the court. Additional portions of the disputed duct and fiber were constructed and subsequently delivered and other portions are scheduled for delivery. The Company also had certain repair and maintenance obligations that it must perform with respect to such duct. GVN was also seeking to enforce an option requiring ACUK to construct 180 to 200 chambers for GVN along the network. In June 2008, the Company paid $3.0 in damages pursuant to the liability trial. Additionally, the Company reimbursed GVN $1.8 for legal fees. Additionally, the Company’s legal fees aggregated $2.4. Further, the Company has incurred or is obligated for costs totaling $2.7 to build additional network. In early August 2008, the Company reached a settlement agreement under which the Company paid GVN $0.6 and agreed to provide additional construction of duct at an estimated cost of $1.2 and provide GVN limited additional access to ACUK’s network. GVN and ACUK provided mutual releases of all claims against each other, including ACUK’s repair obligation and chamber construction obligations discussed above. The Company recorded a loss on litigation of $11.7 at December 31, 2007. Through December 31, 2010, the Company paid $10.9 in connection with this litigation. During 2010, the Company recorded an additional provision of $0.9 to record additional expenses for repairs covered by the settlement. The obligations were denominated in British Pounds, and accordingly, the amounts have been adjusted for changes in currency translation rates as appropriate. The Company has a remaining accrual balance of $0.7 relating to this litigation included in the Company’s consolidated balance sheets at both June 30, 2011 and December 31, 2010.
NOTE 10: RELATED PARTY TRANSACTIONS
A member of the Company’s Board of Directors, Richard Postma, is also the Co-Chairman, Chief Executive Officer and co-founder of a telecommunications company. The Company sold services and/or material in the normal course of business to this telecommunications company in the amount of $0.1 for each of the three months ended June 30, 2011 and 2010 and $0.2 for each of the six months ended June 30, 2011 and 2010. No amounts were outstanding at each of June 30, 2011 and December 31, 2010. Mr. Postma also serves as the Chief Executive Officer of and holds a minority ownership interest in a construction company. The Company purchased certain installation and construction services totaling $0.002 in 2010, $0.03 in 2009 and $0.13 in 2008 from such construction firm. All activities between the Company and these entities were conducted as independent arm’s length transactions consistent with similar terms and circumstances with any other customers or vendors. All accounts between the two parties are settled in accordance with invoice terms.
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ABOVENET, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)
NOTE 11: SEGMENT REPORTING
SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” (now known as FASB ASC 280-10), defines operating segments as components of an enterprise for which separate financial information is available and which is evaluated regularly by the Company’s chief operating decision maker in deciding how to assess performance and allocate resources. The Company operates its business as one operating segment.
Geographic Information
Below is the Company’s revenue based on the location of the entity providing service. Long-lived assets are based on the physical location of the assets. The following table presents revenue and long-lived asset information for geographic areas:
Three Months Ended June 30, | Six Months Ended June 30, | |||||||||||||||
| 2011 | 2010 | 2011 | 2010 | |||||||||||||
| Revenue | ||||||||||||||||
| United States | $ | 107.4 | $ | 92.1 | $ | 211.5 | $ | 180.5 | ||||||||
| United Kingdom | 12.4 | 9.9 | 24.3 | 20.0 | ||||||||||||
| Other | 0.1 | — | 0.1 | — | ||||||||||||
| Eliminations | (1.6 | ) | (1.3 | ) | (3.2 | ) | (2.6 | ) | ||||||||
| Consolidated Worldwide | $ | 118.3 | $ | 100.7 | $ | 232.7 | $ | 197.9 | ||||||||
| As of | ||||||||
| June 30, 2011 | December 31, 2010 | |||||||
| Long-lived assets | ||||||||
| United States | $ | 531.6 | $ | 502.9 | ||||
| United Kingdom | 46.0 | 37.9 | ||||||
| Consolidated Worldwide | $ | 577.6 | $ | 540.8 | ||||
NOTE 12: OTHER INCOME (EXPENSE), NET
Other income (expense), net consists of the following:
Three Months Ended June 30, | Six Months Ended June 30, | |||||||||||||||
| 2011 | 2010 | 2011 | 2010 | |||||||||||||
| Settlement of interest rate swap agreements and write-off of unamortized debt acquisition costs associated with the repayment of the Secured Credit Facility | $ | — | $ | — | $ | (1.6 | ) | $ | — | |||||||
| (Loss) gain on foreign currency | — | (0.1 | ) | 0.8 | (1.2 | ) | ||||||||||
| Gain on recovery of property taxes previously paid | 0.3 | — | 0.3 | — | ||||||||||||
| Loss on disposition of property and equipment | (0.1 | ) | (0.1 | ) | (0.1 | ) | — | |||||||||
| Gain on settlement or reversal of liabilities | — | — | — | 0.4 | ||||||||||||
| Gain on settlement of insurance claim | — | 0.2 | — | 0.2 | ||||||||||||
| Other | 0.1 | 0.2 | 0.2 | 0.2 | ||||||||||||
| Total | $ | 0.3 | $ | 0.2 | $ | (0.4 | ) | $ | (0.4 | ) | ||||||
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ABOVENET, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)
NOTE 13: COMMITMENTS AND CONTINGENCIES
Appointment of Chief Operating Officer
On January 25, 2011, the Board of Directors of the Company appointed Rajiv Datta, its Senior Vice President and Chief Technology Officer, as the Company’s Chief Operating Officer. In connection with this appointment, the Company’s Board of Directors approved the increase in Mr. Datta’s annual base salary from $0.3 to $0.4 and made a special grant to Mr. Datta of 15,000 restricted stock units, all of which will vest and be delivered on November 16, 2011.
Employment Contracts
The Company maintains employment agreements with its key executives. The agreements include, among other things, certain change in control and severance provisions.
In September 2008, the Company entered into new employment agreements with each of William G. LaPerch, Chief Executive Officer and President; Mr. Datta; John Jacquay, Senior Vice President, Sales and Marketing and Robert Sokota, Senior Vice President and General Counsel (collectively with Mr. Joseph P. Ciavarella described below, the “Named Executive Officers”). Each of the contracts provides for a base rate of compensation, which may increase (but cannot decrease) during the term of the contract. Additionally, each contract provides for incentive cash bonus targets for each of the Named Executive Officers. Each of the Named Executive Officers will generally be entitled to the same benefits offered to the Company’s other executives. Each of the employment contracts provides for the payment of severance and the provision of certain other benefits in connection with certain termination events. The employment contracts also include confidentiality, non-compete and assignment of intellectual property covenants by each of the Named Executive Officers.
In October 2008, the Company entered into an employment agreement with Mr. Joseph P. Ciavarella under which Mr. Ciavarella agreed to become the Company’s Senior Vice President and Chief Financial Officer. The employment agreement is on substantially the same general terms as the September 2008 employment agreements described above.
The employment agreements were amended effective as of January 25, 2011. These amendments (a) extend the term of each Named Executive Officer’s employment agreement from November 16, 2011 through December 31, 2011, subject to automatic extensions for additional one-year periods unless cancelled by any of the Named Executive Officers or the Company in writing at least 120 days prior to the end of the applicable term, and (b) clarify that if the Named Executive Officer is employed by the Company on December 31 of the calendar year in which a bonus is being earned, the Named Executive Officer would be entitled to receive any bonus payable for that year. Mr. Datta’s employment agreement was also amended to reflect his new title and base salary. The employment agreements with each of Messrs. Ciavarella, Jacquay and Sokota were also amended to clarify that if so determined in the discretion of the Company’s Chief Executive Officer, such officer would report to the Company’s Chief Operating Officer.
On April 27, 2011, the Company and John Jacquay, the Company’s Senior Vice President for Sales and Marketing, agreed that Mr. Jacquay would resign from his position as Senior Vice President of Sales and Marketing as of July 15, 2011. Mr. Jacquay will continue to be employed by the Company and will provide services on other projects through December 31, 2011, which is the expiration date of his current employment agreement with the Company (the “Contract Expiration Date”), at which time he will separate from the Company . In connection with his separation from the Company on the Contract Expiration Date, Mr. Jacquay will forfeit any unvested stock units held by him as of that date. The Company and Mr. Jacquay have also agreed that his bonus target amount for 2011 will be $0.3. In the event that the Company achieves the adjusted EBITDA target of $198.2 in 2011, Mr. Jacquay would be paid his bonus target amount on or before March 15, 2012.
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ABOVENET, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)
Internal Revenue Service
In September 2008, the Company was notified by the Internal Revenue Service (the “IRS”) that it was reclassifying certain individuals, classified by the Company as independent contractors, to employees and, accordingly, assessing certain payroll taxes and penalties totaling
$0.3. The Company disputed this position citing relief provided by IRC Section 530 and IRC Section 3509. On January 13, 2009, the IRS made a settlement offer to the Company, which the Company executed on March 10, 2009 and the IRS countersigned on May 11, 2009. Under the terms of the settlement agreement, the Company agreed to pay $0.015 to the IRS to fully discharge any federal employment tax liability it may have owed for 2005. The IRS agreed not to dispute the classification of “such workers” for federal employment tax purposes for any period from January 1, 2005 to March 31, 2009. Beginning April 1, 2009, the Company agreed to treat “Consultants,” as described in the settlement agreement, who perform equivalent duties as employees of the Company as employees. Finally, the Company agreed to extend the statute of limitations with respect to federal employment tax payments for the period covered by the settlement agreement (January 1, 2005 to March 31, 2009) to April 1, 2012.
As a result of certain ongoing litigation with a third party, the Department of Information Technology and Telecommunications of the City of New York (“DOITT”) has informed the Company that they have temporarily suspended any discussions regarding renewals of telecommunications franchises in the City of New York. As a result, it is the Company’s understanding that DOITT has not renewed any recently expired franchise agreement, including the Company’s franchise agreement which expired on December 20, 2008. Prior to the expiration of the Company’s franchise agreement, the Company sought out and received written confirmation from DOITT that the Company’s franchise agreement provides a basis for the Company to continue to operate in the City of New York pending conclusion of renewal discussions. The Company intends to continue to operate under its expired franchise agreement pending any renewal. The Company believes that a number of other operators in the City of New York are operating on a similar basis. Based on the Company’s discussions with DOITT and the written confirmation that the Company has received, the Company does not believe that DOITT intends to take any adverse actions with respect to the operation of any telecommunications providers as the result of their expired franchise agreements and, the Company believes that if it attempted to do so, it would face a number of legal obstacles. Nevertheless, any attempt by DOITT to limit the Company’s operations as the result of its expired franchise agreement could have a material adverse effect on the Company’s business, financial condition and results of operations.
Capital Investments and Network Expansion
The Company, from time to time, commits capital for, among other things, (i) customer capital (to connect customers to the network); (ii) expansion and improvement of infrastructure; and (iii) equipment. The Company also commits capital for investments in selected markets. In 2010, the Company incurred expenses to open up Denver as a market and expand into Paris, Amsterdam and Frankfurt in Europe. Additionally, the Company connected Miami to its long haul network and received a favorable ruling from the Canadian authorities regarding its ability to lease and light fiber for its operations in Toronto. Based on the Company’s success in these markets, the Company may increase its presence in these markets or the Company may develop other markets in the U.S. or internationally. The Company believes it has the liquidity / capacity to execute such plans.
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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in millions, except share and per share information)
Environmental Protection Agency Obligations
The Company recently became aware of certain reports that the Environmental Protection Agency (the “EPA”) requires the Company to file. The reports relate to the storage of sulfuric acid, fuel and lead by the Company. The rules governing the EPA reporting provide for penalties for failure to timely file these reports. The rules include provisions that allow companies to voluntarily disclose the failure to file and potentially mitigate penalties otherwise due. The Company believes that under these provisions, it can mitigate substantially all of the penalties. The Company has made its initial filing and intends to file its status report in early September 2011. Accordingly, the consolidated financial statements included herein do not include an accrual for such penalties as of and for the period ended June 30, 2011.
Lease Amendment
On June 24, 2011, the Company, as lessee, entered into the Fourth Amendment to Lease originally dated April 23, 1999 (the “Lease Amendment”) with respect to the facilities leased by the Company for one of its main POP locations. Under the terms of the Lease Amendment, the expiration date of the lease for a portion of the space was extended from September 30, 2014 to September 30, 2029. Simultaneously, the Company entered into an amendment to a coterminous sublease (the “Sublease”) for a portion of the space extending its term out to September 29, 2029. Under the terms of the Lease Amendment, the Company is obligated for rents aggregating $29.4 commencing October 1, 2014. The sublease provides for sublease rents aggregating $12.0 over the same period. The effect of the Lease Amendment and the sublease renewal is to increase net rent expense from $0.4 per annum to $1.0 per annum, beginning June 2011. Additionally, pursuant to the Lease Amendment, the Company agreed to surrender a portion of the space originally leased through September 30, 2014 in exchange for a release of any remaining financial obligations with respect to such space. The Company expects to vacate this space on or about October 1, 2011. The annual rent associated with this other space is $0.6. The Company anticipates recording a gain of $0.2 upon the abandonment of the space. On June 30, 2011, the Company entered into a ten year lease for replacement space, which provides for rent of $0.6 per annum for the first five years and $0.7 per annum for the second five years of the term. During the term of this lease, the landlord will provide a four month rent holiday and a $0.6 improvement allowance.
NOTE 14: SUBSEQUENT EVENT
On July 11, 2011, the Company terminated the employment of Douglas Jendras, its former Senior Vice President of Operations. On August 3, 2011, Mr. Jendras filed a complaint in the United States District Court for the Southern District of New York alleging breach of his employment contract and seeking damages of $0.4 for salary and benefits and approximately $4.6 and specific performance with respect to 66,738 restricted stock units that were cancelled in connection with the termination of Mr. Jendras’ employment, plus recovery of legal fees and costs, and punitive damages. The Company believes it has meritorious defenses that it intends to pursue vigorously.
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| ITEM 2. | MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |
The following discussion and analysis should be read together with the Company’s consolidated financial statements and related notes appearing in this Quarterly Report on Form 10-Q and in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010.
Business
Overview
AboveNet, Inc. (which together with its subsidiaries is sometimes hereinafter referred to as the “Company,” “AboveNet,” “we,” “us,” “our” or “our Company”) provides high-bandwidth connectivity solutions primarily to large corporate enterprise clients and communication carriers, including Fortune 1000 and FTSE 500 companies, in the United States (“U.S.”) and the United Kingdom (“U.K.”). Our communications infrastructure and global Internet protocol (“IP”) network are used by a broad range of companies such as commercial banks, brokerage houses, insurance companies, investment banks, media companies, social networking companies, web-centric companies, law firms and medical and health care institutions. Our customers rely on our high speed, private optical network for electronic commerce and other mission-critical services, such as business Internet and cloud applications, regulatory compliance, disaster recovery and business continuity. We provide lit broadband services over our metro networks, long haul network and global IP network utilizing equipment that we own and in some cases, lease and operate. In addition, we also provide dark fiber services to selected customers. Unlike competitive local exchange carriers (“CLECs”), we do not provide voice services, services to residential customers or a wide range of lower-bandwidth services. We also sometimes resell equipment and provide certain other services to customers, which are sold at our cost, plus a margin.
We are a facilities-based provider of high-bandwidth connectivity solutions that provides services in 17 markets in the U.S. and four markets in Europe through our fiber-optic networks in metro markets, our long haul network connecting those markets and our IP network. Our metro market networks have significant reach and breadth and span over 2.1 million fiber miles across over 8,500 cable route miles. Our long haul fiber-optic communications network spans over 13,000 cable route miles and interconnects each of our U.S. metro networks and each of our European markets. We operate DWDM equipment over this fiber to provide large amounts of bandwidth capability between our metro networks for our customer needs and for our IP network. We use undersea capacity on the Japan-US Cable Network (“JUS”) to provide connectivity between the U.S. and Japan and capacity on the Trans-Atlantic undersea telecommunications network (“TAT-14”) and other trans-Atlantic cables to provide connectivity from the U.S. to Europe and from London to continental Europe.
We operate a Tier 1 IP network over our metro and long haul networks with connectivity to the U.S., Europe and Japan. Our IP network operates using advanced routers and switches that facilitate the delivery of IP transit services and IP-based virtual private network (“VPN”) services. A hallmark of our IP network is that we have direct connectivity to a large number of IP networks operated by others through peering agreements and to many of the most important bandwidth centers and peering exchanges.
We intend to open Toronto as a market in 2011.
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Business Strategy
Our primary strategy is to become the preferred provider of high-bandwidth connectivity solutions in our target markets. Specifically, we are focused on the sale of high-bandwidth transport solutions to enterprise and carrier customers. The following are the key elements of our strategy:
| · | Use the depth and breadth of our metro networks to provide our solutions, not only in central business districts, but also into the suburbs where many data centers, office parks and back office data center operations reside. |
| · | Leverage our excellent relationships with our customers and our strong balance sheet to invest in customers in ways our competition may find difficult. |
| · | Provided connectivity in Tier 1 markets with a density of enterprise and carrier customers and third party data centers, where many potential customers locate their IT infrastructure. |
| · | Connect to data centers where many enterprise customers locate their information technology infrastructure. |
| · | When needed, differentiate ourselves by providing a high level of customization of our services designed to meet our customer’s requirements. |
| · | Deliver the services we offer over our metro networks, which often provide our customers with a dedicated pair of fibers. This use of dedicated fiber is a low latency, physically secure, flexible and scalable communications solution, which we believe is difficult for many of our competitors to replicate. |
| · | Use our metro fiber assets to drive the adoption of leading edge inter-city wide area network (WAN) services such as IP VPN services and long haul connectivity solutions. |
| · | Intensify our focus on sales to media companies with high-bandwidth requirements. |
| · | Provide the infrastructure services that our customers need as their networks expand through the use of virtualization and cloud services. |
| · | Fulfill the needs of customers that are required to comply with financial and other regulations related to data availability, disaster recovery and business continuity. |
| · | Target Internet connectivity customers that can leverage the scalability and flexibility of fiber access to their premises to drive their electronic commerce and other high-bandwidth applications, such as social networking, gaming and digital media transmission. |
| · | Provide telecommunications carriers, also referred to as carriers, that lack a last mile solution for their customers with a broad array of lit solution alternatives. |
| · | Develop and use independent sales agents as a means to provide our services to a wider array of potential customers. |
We are able to provide high quality, customized services at competitive prices as a result of a number of factors, including:
| · | Our significant experience in providing high-end customized network solutions (such as DWDM) for enterprises and telecommunications carriers. |
| · | Our focus on providing certain core optical and ethernet-based services rather than the full range of more complex legacy telecommunications services. |
| · | Our metro networks typically include fiber cables with 432, and in some cases 864, fibers in each cable, which is substantially more fiber than we believe most of our competitors have installed. This provides us with sufficient fiber inventory to supply dedicated fiber services to customers, as appropriate. |
| · | Our modern networks with advanced fiber-optic technology are less costly to operate and maintain than older copper-based networks. |
| · | Our use of state-of-the-art technology in all elements of our networks, from fiber to optical and IP equipment, provides leading edge solutions to customers. |
| · | The architecture of our metro networks, which facilitates high performance solutions in terms of loss and latency. |
| · | The spare conduit we install, where practical, allows us to install additional fiber-optic cables on many routes without the need for additional rights-of-way. This use of the depth and breadth of our network reduces expansion and upgrade costs in the future, and provides significant capacity for future growth. |
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Our Networks and Technology
Service Coverage
Through our metro, long haul and IP networks, we provide services in and between the following markets:
| · | Boston |
| · | New York City metro |
| · | Philadelphia |
| · | Baltimore |
| · | Washington, D.C./Northern Virginia corridor |
| · | Atlanta |
| · | Miami |
| · | Houston |
| · | Dallas |
| · | Austin |
| · | Denver |
| · | Phoenix |
| · | Los Angeles |
| · | San Francisco Bay area |
| · | Portland |
| · | Seattle |
| · | Chicago |
| · | London |
| · | Paris |
| · | Amsterdam |
| · | Frankfurt |
We operate metro networks in each of these markets, except Miami. Including fiber we own, fiber acquired by us through leases and indefeasible rights-of-use (“IRUs”), as well as fiber provided by us to others through leases and IRUs, our metro networks consist of over 2.1 million fiber miles and over 8,500 cable route miles. Our network footprint typically allows us to serve data centers, enterprise locations, network POPs, central offices, carrier hotels and traffic aggregation points, not just in the central business district but across the entire metropolitan area in each market. Within our metro networks, our infrastructure provides ample opportunity to access many additional buildings by virtue of its extensive footprint coverage and over 6,400 network access points that can be utilized to build laterals or connect to other networks, thereby providing access to additional locations. In Miami, we provide services over our long haul and IP networks. In Paris, Amsterdam and Frankfurt, we provide services over a shared network operating on leased fiber as well as over our long haul and IP networks.
Key Metro Network Attributes
| · | Network Density - Our metro networks typically contain 432 and up to 864 fiber strands in each cable. We believe that this fiber density is significantly greater than that of most of our competitors. This high fiber count allows us to add new customers in a timely and cost effective manner by focusing incremental construction and capital expenditures on the laterals that serve customer premises, as opposed to fiber and capacity upgrades in our core networks. Thus, we have spare network capacity available for future growth to connect an increasing number of customers. |
| · | Modern Fiber – We have deployed modern, high quality optical fiber that can be used for a wide range of network applications. Standard single mode fiber is typically included on most cables while longer routes also contain non-zero dispersion shifted fiber that is optimized for longer distance applications operating in the 1550 nm range. Much of our network is well positioned to support the more stringent requirements of transport at rates of 40 Gbps and above. |
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| · | High Performance Architecture – We design customer networks with direct, optimum routing between key areas and in a manner that minimizes the number of POP locations, which enables us to deliver our services at a high level of performance. Because many of our metro lit services are delivered over dedicated fibers not shared with other customers, a customer’s private network can be optimized for its specific application. Further, by using dedicated fiber, we can deliver our services without the need to transition between various shared or legacy networks. As a result, our customers experience enhanced performance in terms of parameters such as latency and jitter, which can be caused by equipment interface transitions. The use of dedicated fibers for customers also permits us to address future technology changes that may take place on a customer specific basis. |
| · | Extensive Reach – Our metro markets typically have significant footprints and cover a wide geography. For example, the New York market includes a significant Manhattan presence and extends from Stamford, CT in the north through Delaware in the south, covering a large part of New Jersey. Similarly, the San Francisco market extends through to San Jose and the Dallas network incorporates the Fort Worth area. |
On-Net Buildings
Our metro networks connect to over 2,800 buildings in the U.S. and the U.K. through our lateral cables, which cover approximately 1,300 route miles and over 140,000 fiber miles (which are part of the 2.1 million fiber miles previously described). These connected buildings are referred to as on-net buildings.
| · | Enterprise Buildings - Our network extends to over 2,200 enterprise locations, many of which house some of the biggest corporate users of network services in the world. These locations also include many private data centers and hub locations that are mission-critical for our customers. |
| · | Network POPs - We operate over 120 network POPs with functionality ranging from simple, passive cross-connect locations to sites that offer interconnectivity to other service providers and co-location facilities for customer equipment, including over 20 Type 1 POPs. These POPs are typically larger presences located in major carrier hotels complete with network co-location and interconnectivity services. |
| · | Central Offices, Carrier Hotels and Data Centers - Our network connects to over 200 central offices in the markets that we serve. The network also has a presence in most significant carrier hotels within our active markets. We currently connect to buildings containing over 450 data centers, of which over 300 are third party data center locations. |
| · | Additional Buildings - In addition to the on-net buildings that we connect to with our own fiber laterals, we have access to additional buildings through other network providers with which we have agreements to provide fiber connectivity to our customers. |
Long Haul Network
We operate a nationwide long haul network interconnecting each of our markets that spans over 13,000 route miles. With the exception of the route between New York and Washington, D.C., which we constructed and own, the overland portion of our long haul network is based on fiber either leased or acquired, typically under long-term agreements. We have deployed DWDM equipment along this network that provides significant bandwidth capability between our metro networks. This network is based on ultra-long haul technology that requires fewer intermediate regeneration points to deliver our services between major cities and expands our high-bandwidth service capability between our metro markets. We are currently in the process of updating most of the network to at least 40 Gbps capacity from 10 Gbps capacity. We connect the U.S. and European portions of our long haul network with undersea capacity, including capacity on the TAT-14 cable. We also connect our U.S. markets to Tokyo on the JUS cable.
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IP Network
We operate a global Tier 1 IP network with connectivity in the U.S., Europe and Japan. In the U.S., most of our metro networks have multiple IP hubs where we can provide Internet connectivity. We peer and provide connectivity in high-bandwidth data centers and Internet exchange locations, including many of those operated by the major providers, such as Equinix. We have extended our ability to provide IP connectivity through our metro networks by using our fiber to bring our services to a wider set of customers. In addition to the U.S., the IP network has a presence in each of Tokyo, London, Paris, Amsterdam and Frankfurt, including the major exchanges in these markets such as LINX, AMS-IX and JPIX.
The core portion of our IP backbone network is based on multiple 10 Gbps long haul links and utilizes advanced Juniper and Cisco routers and switches to direct traffic to appropriate destinations. Our IP core infrastructure is based on next generation equipment that supports advanced IP services such as VPNs and is optimized to support high-bandwidth customers.
As a Tier 1 IP network provider, we have peering arrangements with most other providers which allow us to exchange traffic with these other IP networks. We have devoted a substantial amount of time and resources to building our substantial peering infrastructure and relationships and we believe that this extensive peering fabric, combined with our advanced network, produces a positive customer experience.
Network Management
Our global network management center (“NMC”) is located in Herndon, Virginia and provides round-the-clock network surveillance, provisioning and customer service. Our metro networks, long haul network, IP network and the private networks we set up for our customers, which link together two or more of their locations, are constantly monitored in order to respond to any degrading network conditions or network outages. The NMC’s staff serves as the focal point for managing our service level agreements, or SLAs, with our customers and coordinating network maintenance activities. Our NMC also serves as our focal point for provisioning new services on our optical network. We work closely with our customers to ensure that all services are turned up in a timely and error free manner.
Rights-of-Way
We obtain right-of-way agreements and governmental authorizations to enable us to install, operate, access and maintain our networks, which are located on both public and private property. In some jurisdictions, a construction permit from the local municipality is all that is required for us to install and operate that portion of the network. In other jurisdictions, a license agreement, permit or franchise may also be required. These licenses, permits and franchises are generally for a term of limited duration. Where necessary, we enter into right-of-way agreements for use of private property, often under multi-year agreements. We lease underground conduit and overhead pole space and license rights-of-way from entities such as incumbent local exchange carriers (“ILECs”), utilities, railroads, state highway authorities, local governments and transit authorities. We strive to obtain rights-of-way that afford us the opportunity to expand our networks as our business further develops.
Services
We provide high-bandwidth connectivity solutions, primarily in three service groups: fiber infrastructure services, metro services and WAN services. We also resell equipment and provide technical services to customers, which are sold at our cost, plus a margin. Unlike competitive local exchange carriers (“CLECs”), we do not provide voice services, services to residential customers or a wide range of lower-bandwidth services.
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Fiber Infrastructure Services
Our fiber infrastructure services focus on the lease of dedicated dark fiber to telecommunications carriers, enterprises, Internet and web-centric businesses and other customers that operate their own networks independent of the incumbent telecom companies. In addition to leasing dark fiber, we offer maintenance of dark fiber networks, the provisioning of co-location and in-building interconnection services, typically at our POP locations, and also provide certain telecommunication services on a time and materials basis.
Our fiber infrastructure services feature:
| · | An extensive network footprint that extends well beyond the central business district in most markets. |
| · | The expertise and capability to add off-net locations to the network in a cost competitive manner. |
| · | Modern, high quality fiber that meets stringent technical requirements. |
| · | Customized ring configurations and redundancy requirements in a private dedicated service. |
| · | 7x24 monitoring of the network by our NMC. |
Demand for fiber services is driven by key business initiatives including business continuity and disaster recovery, network consolidation and convergence, growth of wireless communications, and industry-specific applications such as high definition video transport and patient record management. Typically, Fortune 1000 and FTSE 500 enterprises with data intensive needs in industries such as financial services, social networking, technology, media, retail, energy and healthcare comprise the target customer base for our fiber optic infrastructure offerings.
Metro Services
We offer a number of high-bandwidth metro service offerings in our active metro markets ranging from 100 Mbps to 40 Gbps connectivity. These services range from simple point-to-point ethernet connectivity to complex multi-node wavelength-division multiplexing (“WDM”) solutions. Our metro services have a number of important features that differentiate us from many of our competitors:
| · | A substantial portion of our metro services are deployed over dedicated fiber from end-to-end, or out from a shared router. |
| · | This dedicated fiber provides customers with significant scalability for any increasing traffic demand. |
| · | A service based on dedicated fiber provides a high level of security, a key concern for many high-bandwidth customers across a range of industries. |
| · | Our network architecture is not based on routing through central offices, which reduces network distances between customer locations and the resulting latency. |
| · | Some of our metro services are offered without the need for the customer to provide space and power, which may be difficult or expensive to obtain in many data centers. |
| · | A significant portion of our service offerings are Ethernet-based, not older TDM-based services. |
We offer private, customized optical network deployments that we build for our largest customers with very specific needs. These customers are typically large enterprise companies that have significant bandwidth requirements and value a completely private solution. These solutions often involve extensive network construction to specific critical customer locations such as private data centers and trading platforms with dedicated WDM equipment configured in accordance with the customer’s needs.
In the past several years, we have expanded our metro services capability beyond customers with very high-bandwidth (multiple wave) requirements by offering a number of wave and ethernet products aimed to serve more moderate bandwidth/circuit requirements. These offerings include basic and enhanced wave services, which are based on dedicated, private fiber and equipment infrastructure from end-to-end and provide a solution for customers looking for a WDM-based service between two metro locations. The Basic Wave offering provides our lowest cost wave service, while our Enhanced Wave service has a slightly higher initial cost, but provides the customer substantial ability to expand its service capabilities.
We have also expanded our WDM solutions in a number of markets through our Core Wave offering, which provides wave services through pre-positioned equipment and allows faster turn up of services and greater flexibility of use.
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We also offer a full range of Metro Ethernet services including point-to-point and multi-point service configurations at speeds from 100 Mbps to 10 Gbps (10000 Mbps) speeds. We offer three different classes of our Metro Ethernet services with three different price points (higher, middle and lower) based upon level of service: (1) Private Metro Ethernet which utilizes customer dedicated equipment and fiber to deliver a completely private service with all of the associated operational, performance and security benefits; (2) Dedicated Metro Ethernet which utilizes shared equipment with reserved/guaranteed capacity, delivered to the customer location through dedicated fiber; and (3) Standard Metro Ethernet which utilizes shared equipment on a shared capacity basis, delivered to the customer location through dedicated fiber.
WAN Services
We offer a number of wave, ethernet and IP-based services within our WAN Services offering. Most of these services provide connectivity solutions between our metro markets and target high-bandwidth customers requiring transmission speeds of at least 100 Mbps. In addition, we provide high-speed Internet connectivity to our customers including high-end enterprise, web-centric and carrier/cable companies. Each of our WAN services is differentiated by our significant metro fiber resources that allow us to extend the capability of our core networks to the customer in a secure and cost-effective manner.
Our long haul services provide inter-city connectivity between our metro markets on our ultra-long haul network at a variety of speeds ranging from 1 Gbps to 10 Gbps. Our service offerings require a minimum of regeneration sites, which improves our ability to be competitive from both a price and speed of installation perspective while reducing the number of equipment interfaces required to deliver our service.
The attractiveness of our long haul services to our customers is further enhanced by our ability to extend the service from our long haul POP to the customer’s premises through our metro networks, thereby providing an end-to-end solution. This flexibility and reach enables us to provide our long haul services on a differentiated basis.
We operate a Tier 1 IP network that provides high quality Internet connectivity for enterprise, web-centric, Internet and cable companies. We offer connectivity to the Internet at 100 Mbps, 1 Gbps and 10 Gbps port levels in most of our active metro markets in the U.S. and Europe. We believe our extensive number of peering partners, global reach and uncongested network approach produces a positive experience for our customers. In addition to selling IP connectivity at data centers and other major IP exchanges, we offer our Metro IP service where we combine our metro fiber reach to deliver Internet connectivity to customer premises. This service offering extends our significant IP capability, without the dilutive impact of traditional, shared access methods, to the customer location over dedicated fiber that will support full port speeds.
We also offer a suite of advanced ethernet and IP VPN services that provide connectivity between multiple locations in different cities for our customers. These services provide flexibility such as the ability to prioritize different traffic streams and the ability to converge multiple services across the same infrastructure. These advanced VPN services, which include VPLS services, offer point-to-point and multipoint connectivity solutions based on MPLS technologies with the same high-bandwidth scalability that our IP connectivity service allows. Unlike most of our competitors, these services can be extended from our POPs to customer locations within one of our metro markets through dedicated fiber, thereby avoiding transitions through shared or legacy networks that can reduce performance quality.
Sales and Marketing
Our sales force is based across most of our current U.S. and European service markets, is comprised of approximately 100 sales professionals and is supported by a team of sales engineers who provide technical support during the sales process. Our sales force primarily focuses on enterprise customers, including Fortune 1000 companies in the U.S. and FTSE 500 companies in Europe, that have large bandwidth requirements.
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Our sales strategy includes:
| · | Positioning ourselves as a premier provider of high-bandwidth connectivity solutions. |
| · | Focusing on Fortune 1000 enterprises as well as content rich data companies (i.e. media, health care and financial services) that require customized private optical solutions. |
| · | Expanding our sales reach through independent sales agents who specialize in specific geographic and vertical markets. |
| · | Emphasizing the high quality, cost effective, secure and scalable nature of our private optical solutions. |
| · | Communicating our capabilities through targeted marketing communication campaigns aimed at specific vertical markets to increase our brand awareness in a cost effective manner. |
| · | Providing last mile lit solutions to long haul carriers who lack the capability to provide this to their customers. |
| · | Capitalizing on our presence in over 450 data center locations, which house IT infrastructure for many enterprises and cloud computing capabilities. |
| · | Leveraging our strong balance sheet with a willingness to invest capital to grow with our customers. |
Customers
We serve a broad array of customers including leading companies in the financial services, web-centric, media/entertainment and telecommunications sectors, as well as certain local, state and federal government entities, in some cases through third party integrators. Our networks meet the requirements of many large enterprise customers with high data transfer and storage needs and stringent security demands. Major web-centric companies similarly have needs for significant bandwidth and reliable networks. Media and entertainment companies that deliver bandwidth-intensive video and multimedia applications over their networks are also a growing component of our customer base. Telecommunications service providers continue to utilize our networks to connect to their customers, as well as to data centers and other traffic aggregation points. Key drivers for growth in the consumption of telecommunications and bandwidth services include the increasing demand for disaster recovery and business continuity solutions, the emergence of cloud computing, the fast paced growth of social networking and gaming, compliance requirements under complex regulations such as the Sarbanes-Oxley Act or the Health Insurance Portability and Accountability Act (“HIPAA”) and exponential growth in data transmissions due to new modalities for communications, media distribution and commerce.
Executive Summary
Overview
The components of our operating income are revenue, costs of revenue, selling, general and administrative expenses and depreciation and amortization. Below is a description of these components. We are reporting operating income for the three and six months ended June 30, 2011 and 2010, as shown in our unaudited consolidated statements of operations included elsewhere in this Quarterly Report on Form 10-Q.
The demand for high-bandwidth data transport services continues to increase. We believe that our experience in the provision of these services, our customer base and our robust and extensive network should enable us to take advantage of this growing demand. Although the competitive landscape in our industry is challenging and constantly shifting, we believe that we are well positioned for continued growth in the future.
Key Performance Indicators
Our senior management reviews a group of financial and non-financial performance metrics in connection with the management of our business. These metrics facilitate timely and effective communication of results and key decisions, allowing management to react quickly to changing requirements and changes in our key performance indicators. Some of the key financial indicators we use include cash flow, monthly expense analysis, new customer installations, net new revenue booked, capital committed and expended and net revenue attrition. We define net revenue attrition as the reduction in monthly recurring revenue (“MRR”) for customers with net decreases in MRR (as a result of terminations, price declines and other decreases, which are offset by any increases) divided by total revenue (excluding contract termination revenue) over a given period.
Some of the most important non-financial performance metrics measure headcount, IP traffic growth, installation intervals and network service performance levels. We manage our employee headcount changes to ensure sufficient resources are available to service our customers and control expenses. All employees have been categorized into, and are managed within, integrated groups such as sales, operations, engineering, finance, legal and human resources. Our worldwide headcount was 708 as of June 30, 2011, 616 of which were employed in the U.S., 87 in the U.K., two in the Netherlands and one each in Germany, France and Japan.
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2011 Highlights
Our consolidated revenue increased by $34.8 million, or 17.6%, from $197.9 million for the six months ended June 30, 2010 to $232.7 million for the six months ended June 30, 2011, which included an $8.6 million increase in our domestic metro services. Additionally, in the U.S., our revenue from fiber infrastructure and WAN services increased by $7.2 million and $9.3 million, respectively, for the six months ended June 30, 2011 compared to the six months ended June 30, 2010. Consolidated other revenue (which includes contract termination revenue of $3.1 million) was $9.8 million for the six months ended June 30, 2011, compared to $3.9 million for the six months ended June 30, 2010. Revenue from our foreign operations, primarily in the U.K., increased by $3.8 million for the six months ended June 30, 2011 compared to the six months ended June 30, 2010.
For the six months ended June 30, 2011, we generated operating income of $54.1 million and net income of $30.6 million, compared to operating income of $53.4 million and net income of $29.9 million for the six months ended June 30, 2010. At June 30, 2011, we had $96.4 million of unrestricted cash, compared to $61.6 million of unrestricted cash at December 31, 2010, an increase in liquidity of $34.8 million. The increase in unrestricted cash at June 30, 2011 was primarily attributable to cash provided by operating activities of $103.8 million, partially offset by the use of cash to purchase property and equipment of $68.4 million and the change in restricted cash and cash equivalents of $1.0 million. See below in this Item 2 under “Liquidity and Capital Resources” for further discussion.
For the six months ended June 30, 2011, our cash flow generated by operating activities increased compared to the six months ended June 30, 2010 as a result of the improvement in operating results described above. We believe, based on our business plan, that our existing cash, cash from our operating activities and funds available under our $250 Million Secured Revolving Credit Facility will be sufficient to fund our operations, planned capital expenditures and other liquidity requirements at least through June 30, 2012.
2011 Outlook
We believe that based upon our contracted projects awaiting delivery to customers and our sales pipeline, we will continue to add to our revenue base in 2011. We have access to financing through our $250 Million Secured Revolving Credit Facility, if needed. Sales orders for the year ended December 31, 2010 were higher than sales orders for the year ended December 31, 2009. For the three months ended June 30, 2011, net revenue attrition, as previously defined, increased to 1.2%, compared to 1.0% for the three months ended March 31, 2011 and 0.9% for the three months ended June 30, 2010. We cannot predict our net revenue attrition for the balance of 2011. While most of our revenue is derived from fixed term customer contracts, a meaningful portion of our revenue is generated from orders that are past their contractual expiration date for which we provide services that are billed on a month-to-month basis. To the extent that our fixed term contractual revenue is not renewed or our month-to-month revenue is not extended or put under a new fixed term contract, our revenue growth and cash flow may be negatively affected.
In early 2010, we announced a number of growth initiatives, which included expansion of services to several new markets in the U.S. and Europe. These included connecting Miami to our long haul network, opening the Denver metro market and providing certain services over leased fiber in Paris, Amsterdam and Frankfurt. We commenced delivery of services in these markets in the first quarter of 2011.
In 2010, we also increased our investments in customer capital (capital spent to fulfill customer service orders) for laterals to customer locations (including both enterprise locations and data centers) and backbone network infrastructure investments in our existing markets in order to extend the reach of our networks and improve services to existing and prospective customers and increase revenue opportunities. For 2011, we have, and will continue to make these investments in customer capital and infrastructure to increase the reach of our networks.
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Revenue
Revenue derived from leasing fiber optic data transport infrastructure and the provision of data transport and co-location services is recognized as services are provided. Non-refundable payments received from customers before the relevant criteria for revenue recognition are satisfied are included in deferred revenue in the accompanying consolidated balance sheets and are subsequently amortized into income over the fixed contract term.
A substantial portion of our revenue is derived from multi-year contracts for services we provide. We are often required to make an initial outlay of capital to extend our network and purchase equipment for the provision of services to our customers. Under the terms of most contracts, the customer is required to pay a termination fee or contractual damages (which decline over the contract term) if the contract were terminated by the customer without basis before its expiration to ensure that we recover our initial capital investment, plus an acceptable return. We also derive revenues from annual and month-to-month contracts.
Costs of revenue
Costs of revenue primarily include the following: (i) real estate expenses for all operational sites; (ii) costs incurred to operate our networks, such as licenses, right-of-way, permit fees and professional fees related to our networks; (iii) third party telecommunications, fiber and conduit expenses; (iv) repairs and maintenance costs incurred in connection with our networks; and (v) employee-related costs relating to the operation of our networks.
Selling, General and Administrative Expenses (“SG&A”)
SG&A primarily consist of (i) employee-related costs such as salaries and benefits for employees not directly attributable to the operation of our networks, in addition to stock-based compensation expenses and incentive bonus expenses for all employees; (ii) real estate expenses for all administrative sites; (iii) professional, consulting and audit fees; (iv) certain taxes (other than income taxes), including property taxes and trust fund-related taxes not passed through to customers; and (v) regulatory costs, insurance, telecommunications costs, professional fees, and license and maintenance fees for internal software and hardware.
Depreciation and amortization
Depreciation and amortization consists of the ratable measurement of the use of property and equipment. Depreciation and amortization for network assets commences when such assets are placed in service and is provided on a straight-line basis over the estimated useful lives of the assets, with the exception of leasehold improvements, which are amortized over the lesser of the estimated useful lives or the term of the lease.
Critical Accounting Policies and Estimates
The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the U.S. (“U.S. GAAP”). The preparation of these financial statements in conformity with U.S. GAAP requires management to make judgments, estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenue and expenses during the reporting period. Management continually evaluates its judgments, estimates and assumptions based on historical experience and available information. The following is a discussion of the items within our consolidated financial statements that involve significant judgments, assumptions, uncertainties and estimates. The estimates involved in these areas are considered critical because they require high levels of subjectivity and judgment to account for highly uncertain matters, and if actual results or events differ materially from those contemplated by management in making these estimates, the impact on our consolidated financial statements could be material. For a full description of our significant accounting policies, see Note 2, “Basis of Presentation and Significant Accounting Policies,” to the accompanying consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q.
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Fresh Start Accounting
Our emergence from bankruptcy resulted in a new reporting entity with no retained earnings or accumulated losses, effective as of September 8, 2003. Although the effective date of the amended bankruptcy plan of reorganization of Metromedia Fiber Network, Inc. (“MFN”) and substantially all of its domestic subsidiaries (the “Plan of Reorganization”) was September 8, 2003 (the “Effective Date”), we accounted for the consummation of the Plan of Reorganization as if it occurred on August 31, 2003 and implemented fresh start accounting as of that date. There were no significant transactions during the period from August 31, 2003 to September 8, 2003. Fresh start accounting requires us to allocate the reorganization value of our assets and liabilities based upon their estimated fair values, in accordance with FASB ASC 852-10. We developed a set of financial projections, which were utilized by an expert to assist us in estimating the fair value of our assets and liabilities. The expert utilized various valuation methodologies, including (1) a comparison of the Company and our projected performance to that of comparable companies; (2) a review and analysis of several recent transactions of companies in similar industries to ours; and (3) a calculation of the enterprise value based upon the future cash flows of our projections.
Adopting fresh start accounting resulted in material adjustments to the historical carrying values of our assets and liabilities. The reorganization value was allocated to our assets and liabilities based upon their fair values. We engaged an independent appraiser to assist us in determining the fair market value of our property and equipment. The determination of fair values of assets and liabilities was subject to significant estimates and assumptions. The unaudited fresh start adjustments reflected at September 8, 2003 consisted of the following: (i) reduction of property and equipment; (ii) reduction of indebtedness; (iii) reduction of vendor payables; (iv) reduction of the carrying value of deferred revenue; (v) increase of deferred rent to fair market value; (vi) cancellation of MFN’s common stock and additional paid-in capital, in accordance with the Plan of Reorganization; (vii) issuance of new AboveNet, Inc. common stock and additional paid-in capital; and (viii) elimination of the comprehensive loss and accumulated deficit accounts.
Revenue Recognition
We follow SEC Staff Accounting Bulletin ("SAB") No. 101, “Revenue Recognition in Financial Statements,” (now known as FASB ASC 605-10), as amended by SEC SAB No. 104, “Revenue Recognition,” (also now known as FASB ASC 605-10).
Revenue derived from leasing fiber optic telecommunications infrastructure and the provision of telecommunications and co-location services is recognized as services are provided. Non-refundable payments received from customers before the relevant criteria for revenue recognition are satisfied are included in deferred revenue in the accompanying consolidated balance sheets and are subsequently amortized into income over the fixed contract term.
Prior to October 1, 2009, we generally amortized revenue related to installation services on a straight-line basis over the contracted customer relationship (two to twenty years). In the fourth quarter of 2009, we completed a study of our historic customer relationship period. As a result, commencing October 1, 2009, we began amortizing revenue related to installation services on a straight-line basis generally over the estimated customer relationship period (generally ranging from three to twenty years).
Contract termination revenue is recognized when a customer discontinues service prior to the end of the contract period for which we had previously received consideration and for which revenue recognition was deferred. Contract termination revenue is also recognized when customers have made early termination payments to us to settle contractually committed purchase amounts that the customer no longer expects to meet or when we renegotiate or discontinue a contract with a customer and as a result are no longer obligated to provide services for consideration previously received and for which revenue recognition has been deferred. Additionally, we include receipts of bankruptcy claim settlements from former customers as contract termination revenue when received. Contract termination revenue amounted to $1.0 million and $0.6 million in the three months ended June 30, 2011 and 2010, respectively, and $3.1 million and $1.6 million in the six months ended June 30, 2011 and 2010, respectively.
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Accounts Receivable Reserves
Sales Credit Reserves
During each reporting period, we make estimates for potential future sales credits to be issued in respect of current revenue, related to service interruptions and customer disputes, which are recorded as a reduction in revenue. We analyze historical credit activity and changes in customer demand related to current billing and service interruptions when evaluating our credit reserve requirements. We reserve for known service interruptions as incurred. We review customer disputes and reserve against those we believe to be valid claims. We also estimate a sales credit reserve related to unknown billing errors and disputes based on such historical credit activity. The determination of the general sales credit and customer dispute credit reserve requirements involves significant estimations and assumptions.
Allowance for Doubtful Accounts
During each reporting period, we make estimates for potential losses resulting from the inability of our customers to make required payments. We analyze our reserve requirements using several factors, including the length of time a particular customer’s receivables are past due, changes in the customer’s creditworthiness, the customer’s payment history, the length of the customer’s relationship with us, the current economic climate and current industry trends. A specific reserve requirement review is performed on customer accounts with larger balances. A reserve analysis is also performed on accounts not subject to specific review utilizing the factors previously mentioned. Changes in the financial viability of significant customers, worsening of economic conditions and changes in our ability to meet service level requirements may require changes to our estimate of the recoverability of the receivables. Revenue previously unrecognized, which is recovered through litigation, negotiations, settlements and judgments, is recognized as termination revenue in the period collected. The determination of both the specific and general allowance for doubtful accounts reserve requirements involves significant estimations and assumptions.
Property and Equipment
Property and equipment owned at the Effective Date are stated at their estimated fair values as of the Effective Date based on our reorganization value, net of accumulated depreciation and amortization incurred since the Effective Date. Purchases of property and equipment subsequent to the Effective Date are stated at cost, net of depreciation and amortization. Major improvements are capitalized, while expenditures for repairs and maintenance are expensed when incurred. Costs incurred prior to a capital project’s completion are reflected as construction in progress and are part of network infrastructure assets, as described below and included in property and equipment on the respective balance sheets. At June 30, 2011 and December 31, 2010, we had $53.1 million and $54.0 million, respectively, of construction in progress. Certain internal direct labor costs of constructing or installing property and equipment are capitalized. Capitalized direct labor is determined based upon a core group of project managers, field engineers, network infrastructure engineers and equipment engineers. Capitalized direct labor is based upon time spent on capitalized projects and consists of salary, plus certain related benefits. These individuals’ capitalized labor costs are directly associated with the construction and installation of network infrastructure and equipment and customer installations. The salaries and related benefits of non-engineers and supporting staff that are part of the operations and engineering departments are not considered part of the pool subject to capitalization. Capitalized direct labor amounted to $2.7 million and $2.8 million for the three months ended June 30, 2011 and 2010, respectively, and was $5.2 million and $5.8 million in the six months ended June 30, 2011 and 2010, respectively. Depreciation and amortization is provided on a straight-line basis over the estimated useful lives of the assets, with the exception of leasehold improvements, which are amortized over the lesser of the estimated useful life of the improvement or the term of the lease.
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Estimated useful lives of our property and equipment are as follows:
| Network infrastructure assets and storage huts (except for risers and certain project installation costs, which are 5 years) | 20 years | |
| HVAC and power equipment | 12 to 20 years | |
| Transmission and IP equipment | 5 to 7 years | |
| Furniture, fixtures and equipment | 4 to 7 years | |
| Software and computer equipment | 3 to 5 years | |
| Leasehold improvements | Lesser of the estimated useful life of the improvement or the term of the lease |
When property and equipment is retired or otherwise disposed of, the cost and accumulated depreciation is removed from the accounts, and resulting gains or losses are reflected in net income.
From time to time, we are required to replace or re-route existing fiber due to structural changes such as construction and highway expansions, which is defined as “relocation.” In such instances, we fully depreciate the remaining carrying value of network infrastructure removed or rendered unusable and capitalize the costs of the new fiber and associated construction placed into service. In certain circumstances, the local municipality or agency is responsible for some or all of such amounts. We record our share of relocation costs in property and equipment and record the third party portion of such costs as accounts receivable. We capitalized relocation costs amounting to $0.4 million and $0.2 million in the three months ended June 30, 2011 and 2010, respectively, and $0.9 million and $0.4 million in the six months ended June 30, 2011 and 2010, respectively. We fully depreciated the remaining carrying value of the network infrastructure rendered unusable, which on an original cost basis, totaled $0.06 million and $0.15 million ($0.03 million and $0.07 million on a net book value basis) for the three and six months ended June 30, 2011, respectively, and, which on an original cost basis, totaled $0.03 million and $0.05 million ($0.03 million and $0.04 million on a net book value basis) for the three and six months ended June 30, 2010, respectively. To the extent that relocation requires only the movement of existing network infrastructure to another location or construction for an insignificant portion of the entire segment, the related costs are included in our results of operations.
In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 34, “Capitalization of Interest Cost,” (now known as FASB ASC 835-20), interest on certain construction projects would be capitalized. Such amounts were considered immaterial, and accordingly, no such amounts were capitalized during each of the three and six months ended June 30, 2011 and 2010.
In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” (now known as FASB ASC 360-10-35), we periodically evaluate the recoverability of our long-lived assets and evaluate such assets for impairment whenever events or circumstances indicate that the carrying amount of such assets (or group of assets) may not be recoverable. Impairment is determined to exist if the estimated future undiscounted cash flows are less than the carrying value of such assets. We consider various factors to determine if an impairment test is necessary. The factors include: consideration of the overall economic climate, technological advances with respect to equipment, our strategy, capital planning and certain operational issues. Since June 30, 2006, no event has occurred nor has the business environment changed to trigger an impairment test for assets in revenue service and operations. We also consider the removal of assets from the network as a triggering event for performing an impairment test. Once an item is removed from service, unless it is to be redeployed, it may have little or no future cash flows related to it. We performed annual physical counts of such assets that are not in revenue service or operations (e.g., inventory, primarily spare parts) at or around September 30 of each year. With the assistance of a valuation report of the assets in inventory, prepared by an independent third party on a basis consistent with SFAS No. 157, “Fair Value Measurements,” (now known as FASB ASC 820-10), and pursuant to FASB ASC 360-10-35, we determined that the fair value of certain of these assets was less than the carrying value and accordingly, recorded a provision for impairment of $0.5 million for the year ended December 31, 2010. Additionally, at December 31, 2010, we recorded a $1.5 million provision for impairment with respect to a discreet group of assets because of certain operational issues. We provided allowances for impairment of $0.1 million and $0.2 million in the six months ended June 30, 2011 and 2010, respectively, which were recorded in the three months ended June 30, 2011 and 2010, respectively.
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Asset Retirement Obligations
In accordance with SFAS No. 143, “Accounting for Asset Retirement Obligations,” (now known as FASB ASC 410-20), we recognize the fair value of a liability for an asset retirement obligation in the period in which it is incurred if a reasonable estimate of fair value can be made. We have asset retirement obligations related to the de-commissioning and removal of equipment, restoration of leased facilities and the removal of certain fiber and conduit systems. Considerable management judgment is required in estimating these obligations. Important assumptions include estimates of asset retirement costs, the timing of future asset retirement activities and the likelihood of contractual asset retirement provisions being enforced. Changes in these assumptions based on future information could result in adjustments to these estimated liabilities.
Asset retirement obligations are generally recorded as “Other long-term liabilities,” are capitalized as part of the carrying amount of the related long-lived assets included in property and equipment, net, and are depreciated over the life of the associated asset. Asset retirement obligations aggregated $7.9 million at both June 30, 2011 and December 31, 2010, of which $4.3 million was included in “Accrued expenses,” and $3.6 million was included in “Other long-term liabilities” at such dates. Accretion expense, which is included in “Interest expense,” amounted to $0.07 million for each of the three months ended June 30, 2011 and 2010 and $0.14 million for each of the six months ended June 30, 2011 and 2010.
Derivative Financial Instruments
We have utilized and may, from time to time in the future, utilize derivative financial instruments known as interest rate swaps (“derivatives”) to mitigate our exposure to interest rate risk. We purchased the first interest rate swap on August 4, 2008 to hedge the interest rate on the initial $24.0 million (original principal) term loan under the Secured Credit Facility and we purchased a second interest rate swap on November 14, 2008 to hedge the interest rate on the additional $12.0 million (original principal) term loan provided by SunTrust Bank. See Note 4, “Note Payable,” to the accompanying consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q. We accounted for the derivatives under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” (now known as FASB ASC 815). FASB ASC 815 requires that all derivatives be recognized in the financial statements and measured at fair value regardless of the purpose or intent for holding them. By policy, we have not historically entered into derivatives for trading purposes or for speculation. Based on criteria defined in FASB ASC 815, the interest rate swaps were considered cash flow hedges and were 100% effective. Accordingly, changes in the fair value of derivatives have been recorded each period in other comprehensive income (loss). Changes in the fair value of the derivatives reported in accumulated other comprehensive loss are reclassified into earnings in the period in which earnings are impacted by the variability of the cash flows of the hedged item. The ineffective portion of all hedges, if any, would be recognized in current period earnings. The unrealized net loss recorded in accumulated other comprehensive loss at December 31, 2010 was $0.6 million for the interest rate swaps. The mark-to-market value of the cash flow hedges was recorded in current assets, current liabilities, other non-current assets or other long-term liabilities, as applicable, and the offsetting gains or losses in other comprehensive income (loss).
On January 1, 2009, we adopted SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities – an amendment of FASB Statement No. 133,” (now known as FASB ASC 815-10). FASB ASC 815-10 changes the disclosure requirements for derivatives and hedging activities. Entities are required to provide enhanced disclosures about (i) how and why an entity uses derivatives; (ii) how derivatives and related hedged items are accounted for under FASB ASC 815; and (iii) how derivatives and related hedged items affect an entity’s financial position and cash flows.
We have, when applicable, minimized our credit risk relating to counterparties of our derivatives by transacting with multiple, high quality counterparties, thereby limiting exposure to individual counterparties, and by monitoring the financial condition of our counterparties.
All derivatives were recorded in our consolidated balance sheets at fair value. Accounting for the gains and losses resulting from changes in the fair value of derivatives depends on the use of the derivative and whether it qualifies for hedge accounting in accordance with FASB ASC 815. At December 31, 2010, net interest rate swap derivative liabilities of $0.6 million was included in “Accrued expenses” in our consolidated balance sheet. The swap agreements were settled in January 2011 as described below.
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Derivatives recorded at fair value in our consolidated balance sheets as of June 30, 2011 and December 31, 2010 consisted of the following:
| Derivative Liabilities | ||||||||
| Derivatives designated as hedging instruments | June 30, 2011 | December 31, 2010 | ||||||
Interest rate swap agreement expiring August 1, 2011 (*) | $ | — | $ | 0.4 | ||||
Interest rate swap agreement expiring November 1, 2011 (*) | — | 0.2 | ||||||
| Total derivatives designated as hedging instruments | $ | — | $ | 0.6 | ||||
| (*) | The derivative liabilities are two interest rate swap agreements with original three year terms, which were included in “Accrued expenses” in the Company’s consolidated balance sheet at December 31, 2010. |
Interest Rate Swap Agreements
The notional amounts provide an indication of the extent of our involvement in such agreements but do not represent our exposure to market risk. The following table shows the notional amount outstanding, maturity date, and the weighted average receive and pay rates of the interest rate swap agreements as of June 30, 2011 and December 31, 2010.
Notional Amount (In millions) | Weighted Average Rate | |||||||||||||||
| June 30, 2011 | December 31, 2010 | Maturity Date | Pay | Receive | ||||||||||||
| $ | — | $ | 18.9 | August 2011 | 3.65 | % | 0.72 | % | ||||||||
| — | 9.5 | November 2011 | 2.635 | % | 0.40 | % | ||||||||||
| $ | — | $ | 28.4 | |||||||||||||
Interest expense under these agreements, and the respective debt instruments that they hedge, are recorded at the net effective interest rate of the hedged transaction.
The notional amounts of the swap arrangements have since been reduced by amounts corresponding to reductions in the outstanding principal balances.
The swap agreements were settled in January 2011 in connection with the repayment of the term loans under the Secured Credit Facility and the closing of the $250 Million Secured Revolving Credit Facility (as such terms are defined in Note 4, “Note Payable,” to the accompanying consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q). The cost of $0.5 million to settle the swap agreements was included in “Other income (expense), net” in our consolidated statement of operations for the six months ended June 30, 2011.
Fair Value of Financial Instruments
We adopted SFAS No. 157, “Fair Value Measurements,” (now known as FASB ASC 820-10), for our financial assets and liabilities effective January 1, 2008. This pronouncement defines fair value, establishes a framework for measuring fair value, and requires expanded disclosures about fair value measurements. FASB ASC 820-10 emphasizes that fair value is a market-based measurement, not an entity-specific measurement, and defines fair value as the price that would be received to sell an asset or transfer a liability in an orderly transaction between market participants at the measurement date. FASB ASC 820-10 discusses valuation techniques, such as the market approach (comparable market prices), the income approach (present value of future income or cash flow) and the cost approach (cost to replace the service capacity of an asset or replacement cost), which are each based upon observable and unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect our market assumptions. FASB ASC 820-10 utilizes a fair value hierarchy that prioritizes inputs to fair value measurement techniques into three broad levels:
| Level 1: | Observable inputs such as quoted prices for identical assets or liabilities in active markets. |
| Level 2: | Observable inputs other than quoted prices that are directly or indirectly observable for the asset or liability, including quoted prices for similar assets or liabilities in active markets; quoted prices for similar or identical assets or liabilities in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable. |
| Level 3: | Unobservable inputs that reflect the reporting entity’s own assumptions. |
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Our investment in overnight money market institutional funds, which amounted to $82.7 million and $48.2 million at June 30, 2011 and December 31, 2010, respectively, is included in cash and cash equivalents on the accompanying balance sheets and is classified as a Level 1 asset.
We were party to two interest rate swaps, which were utilized to modify our interest rate risk. We recorded the mark-to-market value of the interest rate swap contracts of $0.6 million (which was included in “Accrued expenses”) in our consolidated balance sheet at December 31, 2010. We used third parties to value each of the interest rate swap agreements at December 31, 2010, as well as our own market analysis to determine fair value. The fair value of the interest rate swap contracts were classified as Level 2 liabilities. The swap agreements were settled in January 2011 in connection with the repayment of the term loans under the Secured Credit Facility and the closing of the $250 Million Secured Revolving Credit Facility. The cost of $0.5 million to settle the swap agreements was included in “Other income (expense), net” in our consolidated statement of operations for the six months ended June 30, 2011.
Our consolidated balance sheets include the following financial instruments: short-term cash investments, trade accounts receivable, trade accounts payable and note payable. We believe the carrying amounts in the financial statements approximate the fair value of these financial instruments due to the relatively short period of time between the origination of the instruments and their expected realization or the interest rates which approximate current market rates.
Concentration of Credit Risk
Financial instruments, which potentially subject us to concentration of credit risk, consist principally of short-term cash investments and accounts receivable. We do not enter into financial instruments for trading or speculative purposes. Our cash and cash equivalents are invested in investment-grade, short-term investment instruments with high quality financial institutions. Our trade receivables, which are unsecured, are geographically dispersed, and no single customer accounts for greater than 10% of consolidated revenue or accounts receivable, net. We perform ongoing credit evaluations of our customers’ financial condition. The allowance for non-collection of accounts receivable is based upon the expected collectability of all accounts receivable. We place our cash and cash equivalents primarily in commercial bank accounts in the U.S. Account balances generally exceed federally insured limits.
Foreign Currency Translation and Transactions
Our functional currency is the U.S. dollar. For those subsidiaries not using the U.S. dollar as their functional currency, assets and liabilities are translated at exchange rates in effect at the applicable balance sheet date and income and expense transactions are translated at average exchange rates during the period. Resulting translation adjustments are recorded directly to a separate component of shareholders’ equity and are reflected in the accompanying consolidated statements of comprehensive income. Our foreign exchange transaction gains (losses) are generally included in “Other income (expense), net” in the consolidated statements of operations.
Income Taxes
We account for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes,” (now known as FASB ASC 740). Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between financial statement carrying amounts of existing assets and liabilities and their respective tax basis, net operating losses and tax credit carryforwards, and tax contingencies. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.
We are subject to audits by various taxing authorities, and these audits may result in proposed assessments where the ultimate resolution results in us owing additional taxes. We are required to establish reserves under FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” (now known as FASB ASC 740-10), when we believe there is uncertainty with respect to certain positions and we may not succeed in realizing the tax benefit. We believe that our tax return positions are appropriate and supportable under relevant tax law. We have evaluated our tax positions for items of uncertainty in accordance with FASB ASC 740-10 and have determined that our tax positions are highly certain within the meaning of FASB ASC 740-10. We believe the estimates and assumptions used to support our evaluation of tax benefit realization are reasonable. Accordingly, no adjustments were made to the consolidated financial statements for each of the three and six months ended June 30, 2011 and 2010.
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Deferred Taxes
Our current and deferred income taxes, and associated valuation allowances, are impacted by events and transactions arising in the normal course of business as well as by both special and non-recurring items. Assessment of the appropriate amount and classification of income taxes is dependent on several factors, including estimates of the timing and realization of deferred income tax on income and deductions. Actual realization of deferred tax assets and liabilities may materially differ from these estimates as a result of changes in tax laws as well as unanticipated future transactions impacting related income tax balances.
The assessment of a valuation allowance on deferred tax assets is based on the likelihood that a portion of our deferred tax assets will be realized in future periods. The weight of all available evidence is considered in determining realizability of our deferred tax assets. Deferred tax liabilities are first applied to the deferred tax assets reducing the need for a valuation allowance. We do not believe that sufficient evidence exists to release the balance of the valuation allowance as of December 31, 2010.
As part of our evaluation of deferred tax assets in the fourth quarter of 2010, we recognized a non-cash tax benefit of $7.3 million at December 31, 2010 relating to the reduction of certain valuation allowances established in the U.K. As part of our evaluation of deferred tax assets in the fourth quarter of 2009, we recognized a non-cash tax benefit of $183.0 million at December 31, 2009 relating to the reduction of certain valuation allowances previously established in the U.S. and the U.K. We believe it is more likely than not that we will utilize these deferred tax assets to reduce or eliminate tax payments in future periods. This reduction in valuation allowances had the effect of increasing net income by $7.3 million and $183.0 million for the years ended December 31, 2010 and 2009, respectively. Our evaluations encompassed (i) reviews of our recent history of profitability in the U.S. and the U.K. for the past three years; and (ii) reviews of internal financial forecasts demonstrating our expected capacity to utilize deferred tax assets. We review our deferred tax assets and liabilities on a quarterly basis as part of our FASB ASC 740 review. Significant and continuous judgment of management is required in determining the provision for income tax, deferred tax assets and liabilities, and related valuation allowances established against the deferred tax assets. It is possible that the valuation allowances could be further adjusted, as necessary.
Stock-Based Compensation
On September 8, 2003, we adopted the fair value provisions of SFAS No. 148, “Accounting for Stock-Based Compensation Transition and Disclosure,” (“SFAS No. 148”), (now known as FASB ASC 718-10). SFAS No. 148 amended SFAS No. 123, “Accounting for Stock-Based Compensation,” (“SFAS No. 123”), (also now known as FASB ASC 718-10), to provide alternative methods of transition to SFAS No. 123’s fair value method of accounting for stock-based employee compensation. See Note 7, “Stock-Based Compensation,” to the accompanying consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q.
Under the fair value provisions of SFAS No. 123, the fair value of each stock-based compensation award is estimated at the date of grant, using the Black-Scholes option pricing model for stock option awards. We did not have a historical basis for determining the volatility and expected life assumptions in the model due to our limited market trading history; therefore, the assumptions used for these amounts are an average of those used by a select group of related industry companies. Most stock-based awards have graded vesting (i.e. portions of the award vest at different dates during the vesting period). We recognize the related stock-based compensation expense of such awards on a straight-line basis over the vesting period for each tranche in an award. Upon consummation of our Plan of Reorganization, all then outstanding stock options were cancelled.
Effective January 1, 2006, we adopted SFAS No. 123(R), “Share-Based Payment,” (“SFAS No. 123(R)”), (now known as FASB ASC 718), using the modified prospective method. SFAS No. 123(R) requires all share-based awards granted to employees to be recognized as compensation expense over the vesting period, based on fair value of the award. The fair value method under SFAS No. 123(R) is similar to the fair value method under SFAS No. 123 with respect to measurement and recognition of stock-based compensation expense except that SFAS No. 123(R) requires an estimate of future forfeitures, whereas SFAS No. 123 permitted companies to estimate forfeitures or recognize the impact of forfeitures as they occurred. As we had recognized the impact of forfeitures as they occurred under SFAS No. 123, the adoption of SFAS No. 123(R) resulted in a change in our accounting treatment, but it did not have a material impact on our consolidated financial statements.
For a description of our stock-based compensation programs, see Note 7, “Stock-Based Compensation,” to the accompanying consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q.
There were no options to purchase shares of common stock granted during each of the three and six months ended June 30, 2011 and 2010.
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Results of Operations for the Six Months Ended June 30, 2011 Compared to the Six Months Ended June 30, 2010
Consolidated Results (dollars in millions for the table set forth below):
| Six Months Ended June 30, | $ Increase/ | % Increase/ | ||||||||||||||
| 2011 | 2010 | (Decrease) | (Decrease) | |||||||||||||
| Revenue | $ | 232.7 | $ | 197.9 | $ | 34.8 | 17.6 | % | ||||||||
| Costs of revenue (excluding depreciation and amortization, shown separately below) | 80.9 | 67.2 | 13.7 | 20.4 | % | |||||||||||
| Selling, general and administrative expenses | 60.2 | 46.6 | 13.6 | 29.2 | % | |||||||||||
| Depreciation and amortization | 37.5 | 30.7 | 6.8 | 22.1 | % | |||||||||||
| Operating income | 54.1 | 53.4 | 0.7 | 1.3 | % | |||||||||||
| Other income (expense): | ||||||||||||||||
| Interest expense | (2.3 | ) | (2.4 | ) | (0.1 | ) | (4.2 | )% | ||||||||
| Other expense, net | (0.4 | ) | (0.4 | ) | — | — | ||||||||||
| Income before income taxes | 51.4 | 50.6 | 0.8 | 1.6 | % | |||||||||||
| Provision for income taxes | 20.8 | 20.7 | 0.1 | 0.5 | % | |||||||||||
| Net income | $ | 30.6 | $ | 29.9 | $ | 0.7 | 2.3 | % | ||||||||
We use the term “consolidated” below to describe the total results of our two geographic segments, the U.S. and the U.K. and others. Throughout this document, unless otherwise noted, amounts discussed are consolidated amounts.
Net Income. Our net income for the six months ended June 30, 2011 was $30.6 million, compared to $29.9 million for the six months ended June 30, 2010, an increase of $0.7 million. The primary reasons for the increase in net income were the increase in revenue of $34.8 million, partially offset by increases in costs of revenue of $13.7 million, selling, general and administrative expenses of $13.6 million and depreciation and amortization of $6.8 million. These changes are discussed more fully below.
Revenue. Consolidated revenue was $232.7 million for the six months ended June 30, 2011, compared to $197.9 million for the six months ended June 30, 2010, an increase of $34.8 million, or 17.6%. Revenue from our U.S. operations increased by $31.0 million, or 17.2%, from $180.0 million for the six months ended June 30, 2010 to $211.0 million for the six months ended June 30, 2011. The principal reason for this increase was the continued growth in each of our metro, fiber infrastructure and WAN services. This continued growth in revenue for each of these services is attributable principally to revenue from service installations exceeding reductions in revenue from contract terminations and any contractual price decreases. U.S. revenue from metro services increased by $8.6 million, or 15.7%, from $54.9 million for the six months ended June 30, 2010 to $63.5 million for the six months ended June 30, 2011, U.S. revenue from fiber infrastructure services increased by $7.2 million, or 8.7%, from $83.2 million for the six months ended June 30, 2010 to $90.4 million for the six months ended June 30, 2011 and U.S. revenue from WAN services increased by $9.3 million, or 24.5%, from $38.0 million for the six months ended June 30, 2010 to $47.3 million for the six months ended June 30, 2011. Other revenue increased by $5.9 million from $3.9 million for the six months ended June 30, 2010 to $9.8 million for the six months ended June 30, 2011, due to increases of $4.3 million in equipment sales and $1.6 million in domestic contract termination revenue. Revenue from our foreign operations, primarily in the U.K., increased by $3.8 million, or 21.2%, from $17.9 million for the six months ended June 30, 2010 to $21.7 million for the six months ended June 30, 2011. The primary reasons for this increase were due to an increase in provisioning of services in the U.K. and a 5.9% increase in the translation rate due to the strengthening of the British pound compared to the U.S. dollar during the six months ended June 30, 2011 compared to the six months ended June 30, 2010.
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Costs of revenue. Consolidated costs of revenue for the six months ended June 30, 2011 was $80.9 million, compared to $67.2 million for the six months ended June 30, 2010, an increase of $13.7 million, or 20.4%. Consolidated costs of revenue as a percentage of revenue was 34.8% for the six months ended June 30, 2011, compared to 34.0% for the six months ended June 30, 2010, resulting in consolidated gross profit margin of 65.2% and 66.0% for the six months ended June 30, 2011 and 2010, respectively. The costs of revenue for our U.S. operations was $73.6 million and $61.0 million for the six months ended June 30, 2011 and 2010, respectively, an increase of $12.6 million, or 20.7%. The increase in domestic costs of revenue for the six months ended June 30, 2011 compared to the six months ended June 30, 2010 was attributable principally to (i) an increase of $3.7 million in amounts rebilled to customers for equipment sales (for which there was a corresponding increase in related revenue); (ii) an increase of $3.2 million in payroll-related expenses due to headcount added since the six months ended June 30, 2010; (iii) an increase of $2.1 million in co-location expenses, to support our IP network services and increase our presence in third party data centers; (iv) an increase of $1.6 million for expenses associated with third party network costs; (v) an increase of $1.2 million for right-of-way expenses (the 2010 amount includes a $0.4 million benefit for the reversal of an amount previously accrued as the result of negotiations with the relevant jurisdiction); and (vi) an increase of $0.9 million for repairs and maintenance charges for our cable and transmission equipment. Additionally, the six month periods ended June 30, 2011 and 2010 include provisions for equipment impairment relating to inventory of $0.1 million and $0.2 million, respectively, which were recorded in the three months ended June 30, 2011 and 2010, respectively. The costs of revenue for our foreign operations was $7.3 million for the six months ended June 30, 2011, compared to $6.2 million for the six months ended June 30, 2010, an increase of $1.1 million, or 17.7%. This increase was primarily due to increases in third party network costs, co-location expenses and leased fiber costs to support our European operations and the needs of our existing customers, payroll-related expenses needed to support our provisioning of services and repairs and maintenance charges, offset by the reversal of accruals of certain business tax rates on installed fiber never assessed. In addition, the results for the six months ended June 30, 2011 compared to the six months ended June 30, 2010 reflect a 5.9% increase in the translation rate of the British pound compared to the U.S. dollar.
Selling, General and Administrative Expenses (“SG&A”). Consolidated SG&A for the six months ended June 30, 2011 was $60.2 million, compared to $46.6 million for the six months ended June 30, 2010, an increase of $13.6 million, or 29.2%. SG&A as a percentage of revenue was 25.9% and 23.5% for the six months ended June 30, 2011 and 2010, respectively. In the U.S., SG&A was $52.8 million for the six months ended June 30, 2011, compared to $41.4 million for the six months ended June 30, 2010, an increase of $11.4 million, or 27.5%. SG&A for our U.S. operations for the six months ended June 30, 2011 compared to the six months ended June 30, 2010 increased primarily due to (i) an increase of $9.2 million in domestic non-cash stock-based compensation expense from $3.7 million for the six months ended June 30, 2010 to $12.9 million for the six months ended June 30, 2011; (ii) an increase of $0.8 million in domestic payroll and payroll-related expenses from $23.7 million for the six months ended June 30, 2010 to $24.5 million for the six months ended June 30, 2011, which is attributable to an increase in sales commissions due to the year over year increase in sales; (iii) an increase of $0.6 million for property taxes; (iv) an increase of $0.5 million in commissions paid to third party sales agents attributable to the increased revenue base on which such commissions are based; and (v) an increase of $0.3 million in occupancy-related expenses. SG&A from our foreign operations was $7.4 million for the six months ended June 30, 2011, compared to $5.2 million for the six months ended June 30, 2010, an increase of $2.2 million, or 42.3%. Our foreign operations reported increases in non-cash stock-based compensation expense, payroll and payroll-related expenses, occupancy expenses, primarily related to the relocation of our London office and a 5.9% increase in the translation rate of the British pound compared to the U.S. dollar.
Depreciation and amortization. Consolidated depreciation and amortization was $37.5 million for the six months ended June 30, 2011, compared to $30.7 million for the six months ended June 30, 2010, an increase of $6.8 million, or 22.1%. Consolidated depreciation and amortization as a percentage of revenue was 16.1% for the six months ended June 30, 2011, compared to 15.5% for the six months ended June 30, 2010. The increase in consolidated depreciation and amortization was primarily attributable to additions of property and equipment for the six months ended June 30, 2011 and the full period effect of depreciation on property and equipment placed into service during 2010, partially offset by the reduction of depreciation with respect to certain assets, which became fully depreciated between the two periods.
Interest income. Interest income, substantially all of which was earned in the U.S., was immaterial for the six months ended June 30, 2011 and 2010 as a result of relatively low average balances available for investment, relatively low interest rates and the Company’s conservative investment strategy.
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Interest expense. Interest expense, substantially all of which was incurred in the U.S., includes interest expense on borrowed amounts under the $250 Million Secured Revolving Credit Facility (which commenced January 28, 2011) and the Secured Credit Facility, which was repaid January 28, 2011, availability fees on the unused portion of the relevant facility during the respective period, the amortization of debt acquisition costs (including upfront fees) related to the relevant facility outstanding during the respective period, interest expense related to a capital lease obligation, interest accrued on certain tax liabilities, interest on the outstanding balance of the deferred fair value rent liabilities established at fresh start and interest accretion relating to asset retirement obligations. Interest expense was $2.3 million for the six months ended June 30, 2011, compared to $2.4 million for the six months ended June 30, 2010, a decrease of $0.1 million, or 4.2%.
Other income (expense), net. Other income (expense), net is composed primarily of income or expense from non-recurring transactions and is not comparative from a trend perspective. Consolidated other income (expense), net was a net expense of $(0.4) million for each of the six months ended June 30, 2011 and 2010. In the U.S., other income (expense), net was a net expense of $(1.3) million for the six months ended June 30, 2011, compared to other income, net of $0.7 million for the six months ended June 30, 2010, a change of $2.0 million. For our foreign operations, other income (expense), net was other income, net of $0.9 million for the six months ended June 30, 2011, compared to other expense, net of $(1.1) million for the six months ended June 30, 2010, a change of $2.0 million. For the six months ended June 30, 2011, consolidated other income (expense), net was comprised of the write-off of unamortized debt acquisition costs of $(1.1) million and the settlement of the two interest rate swaps at a total cost of $(0.5) million, both of which were associated with the Secured Credit Facility (which were recorded in connection with the Company’s closing of the $250 Million Secured Revolving Credit Facility on January 28, 2011), and a net loss on the sale or disposition of property and equipment of $(0.1) million, offset by a net gain on foreign currency of $0.8 million, a net gain arising from the recovery of property taxes previously paid of $0.3 million and other gains of $0.2 million. For the six months ended June 30, 2010, consolidated other income (expense), net was comprised of a net loss on foreign currency of $(1.2) million, offset by gains arising from the settlement or reversal of certain tax liabilities of $0.4 million, a gain from the settlement of an insurance claim of $0.2 million and other gains of $0.2 million.
Provision for income taxes. We recorded a provision for income taxes of $20.8 million and $20.7 million for the six months ended June 30, 2011 and 2010, respectively. The provision for income taxes for each period was calculated at our effective tax rate based upon our pre-tax book income (adjusted for permanent differences in both the U.S. and the U.K.), resulting in an income tax provision of $20.3 million, plus a provision for certain capital-based state taxes of $0.5 million for the six months ended June 30, 2011, and an income tax provision of $20.5 million, plus a provision for certain capital-based state taxes of $0.2 million for the six months ended June 30, 2010.
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Results of Operations for the Three Months Ended June 30, 2011 Compared to the Three Months Ended June 30, 2010
Consolidated Results (dollars in millions for the table set forth below):
| Three Months Ended June 30, | $ Increase/ | % Increase/ | |||||||||||||
| 2011 | 2010 | (Decrease) | (Decrease) | ||||||||||||
| Revenue | $ | 118.3 | $ | 100.7 | $ | 17.6 | 17.5 | % | |||||||
| Costs of revenue (excluding depreciation and amortization, shown separately below) | 40.7 | 34.1 | 6.6 | 19.4 | % | ||||||||||
| Selling, general and administrative expenses | 30.4 | 23.0 | 7.4 | 32.2 | % | ||||||||||
| Depreciation and amortization | 19.2 | 15.2 | 4.0 | 26.3 | % | ||||||||||
| Operating income | 28.0 | 28.4 | (0.4 | ) | (1.4 | )% | |||||||||
| Other income (expense): | |||||||||||||||
| Interest expense | (1.1 | ) | (1.2 | ) | (0.1 | ) | (8.3 | )% | |||||||
| Other income, net | 0.3 | 0.2 | 0.1 | 50.0 | % | ||||||||||
| Income before income taxes | 27.2 | 27.4 | (0.2 | ) | (0.7 | )% | |||||||||
| Provision for income taxes | 11.1 | 11.1 | — | — | |||||||||||
| Net income | $ | 16.1 | $ | 16.3 | $ | (0.2 | ) | (1.2 | )% | ||||||
We use the term “consolidated” below to describe the total results of our two geographic segments, the U.S. and the U.K. and others. Throughout this document, unless otherwise noted, amounts discussed are consolidated amounts.
Net Income. Our net income for the three months ended June 30, 2011 was $16.1 million, compared to $16.3 million for the three months ended June 30, 2010, a decrease of $0.2 million, or 1.2%. The primary reasons for the decrease in net income were the increases in selling, general and administrative expenses of $7.4 million, costs of revenue of $6.6 million and depreciation and amortization of $4.0 million, which offset an increase in revenue of $17.6 million. These changes are discussed more fully below.
Revenue. Consolidated revenue was $118.3 million for the three months ended June 30, 2011, compared to $100.7 million for the three months ended June 30, 2010, an increase of $17.6 million, or 17.5%. Revenue from our U.S. operations increased by $15.3 million, or 16.6%, from $91.9 million for the three months ended June 30, 2010 to $107.2 million for the three months ended June 30, 2011. The principal reason for this increase was the continued growth in each of our metro, fiber infrastructure and WAN services. This continued growth in revenue for each of these services is attributable principally to revenue from service installations exceeding reductions in revenue from contract terminations and any contractual price decreases. U.S. revenue from metro services increased by $4.2 million, or 15.1%, from $27.9 million for the three months ended June 30, 2010 to $32.1 million for the three months ended June 30, 2011, U.S. revenue from fiber infrastructure services increased by $3.3 million, or 7.9%, from $42.0 million for the three months ended June 30, 2010 to $45.3 million for the three months ended June 30, 2011 and U.S. revenue from WAN services increased by $5.1 million, or 26.0%, from $19.6 million for the three months ended June 30, 2010 to $24.7 million for the three months ended June 30, 2011. Other revenue increased by $2.7 million from $2.4 million for the three months ended June 30, 2010 to $5.1 million for the three months ended June 30, 2011, primarily due to increases of $2.3 million in equipment sales and $0.5 million in domestic contract termination revenue offset by $0.1 million chargeback for certain services. Revenue from our foreign operations, primarily in the U.K., increased by $2.3 million, or 26.1%, from $8.8 million (which includes $0.2 million of contract termination revenue) for the three months ended June 30, 2010 to $11.1 million (which includes $0.1 million of contract termination revenue) for the three months ended June 30, 2011. The primary reasons for this increase were due to both an increase in the volume of service provision in the U.K. and a 9.4% increase in the translation rate due to the strengthening of the British pound compared to the U.S. dollar during the three months ended June 30, 2011 compared to the three months ended June 30, 2010.
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Costs of revenue. Consolidated costs of revenue for the three months ended June 30, 2011 was $40.7 million, compared to $34.1 million for the three months ended June 30, 2010, an increase of $6.6 million, or 19.4%. Consolidated costs of revenue as a percentage of revenue was 34.4% for the three months ended June 30, 2011, compared to 33.9% for the three months ended June 30, 2010, resulting in consolidated gross profit margin of 65.6% and 66.1% for the three months ended June 30, 2011 and 2010, respectively. The costs of revenue for our U.S. operations was $37.9 million and $31.1 million for the three months ended June 30, 2011 and 2010, respectively, an increase of $6.8 million, or 21.9%. The increase in domestic costs of revenue for the three months ended June 30, 2011 compared to the three months ended June 30, 2010 was attributable principally to (i) an increase of $2.3 million in amounts rebilled to customers for equipment sales (for which there was a corresponding increase in related revenue); (ii) an increase of $1.5 million in payroll-related expenses due to headcount added since the three months ended June 30, 2010; (iii) an increase of $1.1 million in co-location expenses, to support our IP network services and increase our presence in third party data centers; (iv) an increase of $0.8 million for expenses associated with third party network costs; (v) an increase of $0.8 million for right-of-way expenses (which includes the reversal of $0.4 million during the three months ended June 30, 2010 due to previously accrued right-of-way expenses (as a result of negotiations with the relevant jurisdiction); and (vi) an increase of $0.3 million for repairs and maintenance charges for our cable and transmission equipment. Additionally, the three month periods ended June 30, 2011 and 2010 include provisions for equipment impairment relating to inventory of $0.1 million and $0.2 million, respectively. The costs of revenue for our foreign operations was $2.8 million and $3.0 million for the three months ended June 30, 2011 and 2010, respectively, a decrease of $0.2 million, or 6.7%. There were increases in third party network costs and co-location expenses totaling $0.5 million, offset by a benefit of a reduction in certain business tax rates on fiber of $0.8 million.
Selling, General and Administrative Expenses (“SG&A”). Consolidated SG&A for the three months ended June 30, 2011 was $30.4 million, compared to $23.0 million for the three months ended June 30, 2010, an increase of $7.4 million, or 32.2%. SG&A as a percentage of revenue was 25.7% and 22.8% for the three months ended June 30, 2011 and 2010, respectively. In the U.S., SG&A was $26.4 million for the three months ended June 30, 2011, compared to $20.3 million for the three months ended June 30, 2010, an increase of $6.1 million, or 30.0%. SG&A for our U.S. operations for the three months ended June 30, 2011 compared to the three months ended June 30, 2010 increased primarily due to (i) an increase of $4.5 million in domestic non-cash stock-based compensation expense from $1.8 million for the three months ended June 30, 2010 to $6.3 million for the three months ended June 30, 2011; (ii) an increase of $0.8 million in domestic payroll and payroll-related expenses from $11.5 million for the three months ended June 30, 2010 to $12.3 million for the three months ended June 30, 2011, which is attributable to an increase in sales commissions due to the year over year increase in sales; (iii) an increase of $0.5 million for property taxes; and (iv) an increase of $0.3 million in commissions paid to third party sales agents attributable to the increased revenue base on which such commissions are based. SG&A from our foreign operations was $4.0 million for the three months ended June 30, 2011, compared to $2.7 million for the three months ended June 30, 2010, an increase of $1.3 million, or 48.1%. Our foreign operations reported increases in payroll and payroll-related expenses, non-cash stock-based compensation expense, and occupancy expenses, primarily related to the relocation of our London office.
Depreciation and amortization. Consolidated depreciation and amortization was $19.2 million for the three months ended June 30, 2011, compared to $15.2 million for the three months ended June 30, 2010, an increase of $4.0 million, or 26.3%. Consolidated depreciation and amortization as a percentage of revenue was 16.2% for the three months ended June 30, 2011, compared to 15.1% for the three months ended June 30, 2010. The increase in consolidated depreciation and amortization was primarily attributable to additions of property and equipment for the three months ended June 30, 2011 and the full period effect of depreciation on property and equipment placed into service subsequent to March 31, 2010, partially offset by the reduction of depreciation with respect to certain assets, which became fully depreciated between the two periods.
Interest income. Interest income, substantially all of which was earned in the U.S., was immaterial for the three months ended June 30, 2011 and 2010 as a result of relatively low average balances available for investment, relatively low interest rates and the Company’s conservative investment strategy.
Interest expense. Interest expense, substantially all of which was incurred in the U.S., includes interest expense on borrowed amounts under the $250 Million Secured Revolving Credit Facility (which commenced January 28, 2011) and the Secured Credit Facility, which was repaid January 28, 2011, availability fees on the unused portion of the relevant facility during the respective period, the amortization of debt acquisition costs (including upfront fees) related to the relevant facility outstanding during the respective period, interest expense related to a capital lease obligation, interest accrued on certain tax liabilities, interest on the outstanding balance of the deferred fair value rent liabilities established at fresh start and interest accretion relating to asset retirement obligations. Interest expense was $1.1 million for the three months ended June 30, 2011, compared to $1.2 million for the three months ended June 30, 2010, a decrease of $0.1 million, or 8.3%.
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Other income (expense), net. Other income (expense), net is composed primarily of income or expense from non-recurring transactions and is not comparative from a trend perspective. Consolidated other income (expense), net was other income, net $0.3 million for the three months ended June 30, 2011, compared to other income, net of $0.2 million for the three months ended June 30, 2010. In the U.S., other income (expense), net was other income, net of $0.2 million for each of the three months ended June 30, 2011 and 2010. For our foreign operations, other income (expense), net was other income, net of $0.1 million for the three months ended June 30, 2011. For the three months ended June 30, 2011, consolidated other income (expense), net was comprised of a net gain arising from the recovery of property taxes previously paid of $0.3 million and other gains of $0.1 million, offset by a net loss on the sale or disposition of property and equipment of $(0.1) million. For the three months ended June 30, 2010, consolidated other income (expense), net was comprised of a gain from the settlement of an insurance claim of $0.2 million and other gains of $0.2 million, offset by a net loss on foreign currency of $(0.1) million and a net loss on the sale or disposition of property and equipment of $(0.1) million.
Provision for income taxes. We recorded a provision for income taxes of $11.1 million for each of the three months ended June 30, 2011 and 2010. The provision for income taxes for each period was calculated at our effective tax rate based upon our pre-tax book income (adjusted for permanent differences in both the U.S. and the U.K.), resulting in an income tax provision of $10.8 million, plus a provision for certain capital-based state taxes of $0.3 million for the three months ended June 30, 2011, and an income tax provision of $11.0 million, plus a provision for certain capital-based state taxes of $0.1 million for the three months ended June 30, 2010.
Liquidity and Capital Resources
We had working capital of $24.5 million at June 30, 2011, compared to a working capital deficit of $(8.5) million at December 31, 2010, an increase of $33.0 million. This increase was primarily due to cash generated from operating activities less cash used for purchases of property and equipment, plus the changes in working capital components. The increase in working capital was also impacted by the repayment of the Secured Credit Facility, including the current portion of $7.6 million, with the proceeds from our borrowing under the $250 Million Secured Revolving Credit Facility, which is a non-current liability.
Net cash provided by operating activities was $103.8 million during the six months ended June 30, 2011, compared to $67.7 million during the six months ended June 30, 2010, an increase of $36.1 million. Net cash provided by operating activities during the six months ended June 30, 2011 represents net income, plus the add back to net income of non-cash items deducted in the determination of net income, principally depreciation and amortization of $37.5 million, the change in deferred tax assets of $20.3 million and non-cash stock-based compensation expense of $13.9 million, plus the changes in working capital components. Net cash provided by operating activities during the six months ended June 30, 2010 represents net income, plus the add back to net income of non-cash items deducted in the determination of net income, principally depreciation and amortization of $30.7 million, the change in deferred tax assets of $20.5 million and stock-based compensation expense of $4.2 million, plus the changes in working capital components. The year over year increase in net cash provided by operating activities is primarily due to the increase in net income adjusted for non-cash activities (depreciation and amortization, change in deferred tax assets and non-cash stock-based compensation expense), and the difference in the changes in working capital components, which were a source of cash in the June 30, 2011 period due to the increase in accounts payable, compared to a use of cash in the June 30, 2010 period.
Net cash used in investing activities was $68.3 million during the six months ended June 30, 2011, compared to $57.3 million during the six months ended June 30, 2010, an increase of $11.0 million. Net cash used in investing activities during the six months ended June 30, 2011 was attributable to the purchases of property and equipment of $68.4 million, offset by the proceeds generated from sales of property and equipment of $0.1 million. Net cash used in investing activities during the six months ended June 30, 2010 was attributable to the purchases of property and equipment of $57.5 million, offset by the proceeds generated from sales of property and equipment of $0.2 million. The increase in capital expenditures during the six months ended June 30, 2011 compared to the six months ended June 30, 2010 was attributable to the continued investment in our network during the six months ended June 30, 2011 and the year over year increase in customer orders, which resulted in higher capital expenditures needed to provide service.
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Net cash used in financing activities was $1.0 million during the six months ended June 30, 2011, which is comprised of the payoff of the outstanding principal of the Secured Credit Facility of $49.7 million, the change in restricted cash and cash equivalents of $1.0 million, the purchase of treasury stock of $0.3 million and the principal payment on our capital lease obligation of $0.2 million, offset by the net proceeds from our borrowing under the $250 Million Secured Revolving Credit Facility of $50.0 million and the proceeds from the exercise of options to purchase shares of common stock of $0.2 million. Net cash used in financing activities was $2.2 million during the six months ended June 30, 2010, which is comprised of the principal payment under the Secured Credit Facility of $3.7 million and the purchase of treasury stock of $0.3 million, offset by the proceeds from the exercise of warrants of $1.4 million and the proceeds from the exercise of options to purchase shares of common stock of $0.4 million.
The $250 Million Secured Revolving Credit Facility closed on January 28, 2011. We drew down $55.0 million at closing, of which $49.9 million was used to repay the outstanding Secured Credit Facility (including accrued interest of $0.2 million), $5.0 million was used to pay bank fees and related expenses associated with the $250 Million Secured Revolving Credit Facility and the balance was used for general corporate purposes.
During the six months ended June 30, 2011, we generated cash from operating activities that was sufficient to fund our operating expenses, debt service and expenditures for property and equipment. As discussed in Note 8, “Shareholders’ Equity,” to the accompanying consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q, we paid a Special Cash Dividend in December 2010 totaling $129.0 million, which reduced liquidity. In January 2011, we repaid our Secured Credit Facility, comprised of term loans with $49.7 million outstanding, plus accrued interest of $0.2 million and consummated the $250 Million Secured Revolving Credit Facility described above. The new facility provides us with the flexibility and capability to fund operations, as required. See Note 4, “Note Payable,” to the accompanying consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q for additional information with respect to the $250 Million Secured Revolving Credit Facility. We expect that our cash from operations will continue to exceed our operating expenses and plan to continue to use our net cash from operations, cash reserves and the $250 Million Secured Revolving Credit Facility, as necessary, to fund our operating expenses and future capital projects.
We, from time to time, commit capital for, among other things, (i) customer capital (to connect customers to the network); (ii) expansion and improvement of infrastructure; and (iii) equipment. We also commit capital for investments in selected markets. During 2010 and through early 2011, we opened up Denver as a market and expanded into Paris, Amsterdam and Frankfurt in Europe. Additionally, we connected Miami to our long haul network and received a favorable ruling from the Canadian authorities regarding our ability to lease and light fiber for our operations in Toronto. Based on our success in these markets, we may increase our presence in these markets or we may develop other markets in the U.S. or internationally. We believe we have sufficient financial resources to execute these plans.
For the six months ended June 30, 2011, our cash flow generated by operating activities increased compared to the six months ended June 30, 2010 as a result of the improvement in operating results described above. We believe, based on our business plan, that our existing cash, cash from our operating activities and funds available under our $250 Million Secured Revolving Credit Facility will be sufficient to fund our operations, planned capital expenditures and other liquidity requirements at least through June 30, 2012.
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Segment Results (dollars in millions for the tables set forth below)
Our results (excluding intercompany activity) are segmented according to groupings based on geography.
United States:
Three Months Ended June 30, | $ Increase / | % Increase / | |||||||||||||
| 2011 | 2010 | (Decrease) | (Decrease) | ||||||||||||
| Revenue | $ | 107.2 | $ | 91.9 | $ | 15.3 | 16.6 | % | |||||||
| Costs of revenue (excluding depreciation and amortization, shown separately below) | 37.9 | 31.1 | 6.8 | 21.9 | % | ||||||||||
| Selling, general and administrative expenses | 26.4 | 20.3 | 6.1 | 30.0 | % | ||||||||||
| Depreciation and amortization | 16.7 | 13.6 | 3.1 | 22.8 | % | ||||||||||
| Operating income | 26.2 | 26.9 | (0.7 | ) | (2.6 | )% | |||||||||
| Other (expense) income: | |||||||||||||||
| Interest expense | (1.1 | ) | (1.2 | ) | (0.1 | ) | (8.3 | )% | |||||||
| Other income, net | 0.2 | 0.2 | — | — | |||||||||||
| Income before income taxes | 25.3 | 25.9 | (0.6 | ) | (2.3 | )% | |||||||||
| Provision for income taxes | 10.7 | 10.5 | 0.2 | 1.9 | % | ||||||||||
| Net income | $ | 14.6 | $ | 15.4 | $ | (0.8 | ) | (5.2 | )% | ||||||
United Kingdom and others:
Three Months Ended June 30, | $ Increase / | % Increase / | |||||||||||||
| 2011 | 2010 | (Decrease) | (Decrease) | ||||||||||||
| Revenue | $ | 11.1 | $ | 8.8 | $ | 2.3 | 26.1 | % | |||||||
| Costs of revenue (excluding depreciation and amortization, shown separately below) | 2.8 | 3.0 | (0.2 | ) | (6.7 | )% | |||||||||
| Selling, general and administrative expenses | 4.0 | 2.7 | 1.3 | 48.1 | % | ||||||||||
| Depreciation and amortization | 2.5 | 1.6 | 0.9 | 56.3 | % | ||||||||||
| Operating income | 1.8 | 1.5 | 0.3 | 20.0 | % | ||||||||||
| Other income: | |||||||||||||||
| Other income, net | 0.1 | — | 0.1 | NM | |||||||||||
| Income before income taxes | 1.9 | 1.5 | 0.4 | 26.7 | % | ||||||||||
| Provision for income taxes | 0.4 | 0.6 | (0.2 | ) | (33.3 | )% | |||||||||
| Net income | $ | 1.5 | $ | 0.9 | $ | 0.6 | 66.7 | % | |||||||
NM—not meaningful
The segment results for the three months ended June 30, 2011 and 2010 (above) reflect the elimination of any intercompany sales and charges.
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United States:
Six Months Ended June 30, | $ Increase / | % Increase / | ||||||||||||||
| 2011 | 2010 | (Decrease) | (Decrease) | |||||||||||||
| Revenue | $ | 211.0 | $ | 180.0 | $ | 31.0 | 17.2 | % | ||||||||
| Costs of revenue (excluding depreciation and amortization, shown separately below) | 73.6 | 61.0 | 12.6 | 20.7 | % | |||||||||||
| Selling, general and administrative expenses | 52.8 | 41.4 | 11.4 | 27.5 | % | |||||||||||
| Depreciation and amortization | 32.8 | 27.2 | 5.6 | 20.6 | % | |||||||||||
| Operating income | 51.8 | 50.4 | 1.4 | 2.8 | % | |||||||||||
| Other (expense) income: | ||||||||||||||||
| Interest expense | (2.3 | ) | (2.4 | ) | (0.1 | ) | (4.2 | )% | ||||||||
| Other (expense) income, net | (1.3 | ) | 0.7 | (2.0 | ) | NM | ||||||||||
| Income before income taxes | 48.2 | 48.7 | (0.5 | ) | (1.0 | )% | ||||||||||
| Provision for income taxes | 19.7 | 19.8 | (0.1 | ) | (0.5 | )% | ||||||||||
| Net income | $ | 28.5 | $ | 28.9 | $ | (0.4 | ) | (1.4 | )% | |||||||
United Kingdom and others:
Six Months Ended June 30, | $ Increase / | % Increase / | ||||||||||||||
| 2011 | 2010 | (Decrease) | (Decrease) | |||||||||||||
| Revenue | $ | 21.7 | $ | 17.9 | $ | 3.8 | 21.2 | % | ||||||||
| Costs of revenue (excluding depreciation and amortization, shown separately below) | 7.3 | 6.2 | 1.1 | 17.7 | % | |||||||||||
| Selling, general and administrative expenses | 7.4 | 5.2 | 2.2 | 42.3 | % | |||||||||||
| Depreciation and amortization | 4.7 | 3.5 | 1.2 | 34.3 | % | |||||||||||
| Operating income | 2.3 | 3.0 | (0.7 | ) | (23.3 | )% | ||||||||||
| Other income (expense): | ||||||||||||||||
| Other income (expense), net | 0.9 | (1.1 | ) | 2.0 | NM | |||||||||||
| Income before income taxes | 3.2 | 1.9 | 1.3 | 68.4 | % | |||||||||||
| Provision for income taxes | 1.1 | 0.9 | 0.2 | 22.2 | % | |||||||||||
| Net income | $ | 2.1 | $ | 1.0 | $ | 1.1 | 110.0 | % | ||||||||
NM—not meaningful
The segment results for the six months ended June 30, 2011 and 2010 (above) reflect the elimination of any intercompany sales and charges.
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Financial instruments which potentially subject us to a concentration of credit risk, consist principally of temporary cash investments and accounts receivable. We do not enter into financial instruments for trading or speculative purposes and do not own auction rate notes. We place our cash and cash equivalents in short-term investment instruments with high quality financial institutions (primarily commercial banks) in the U.S. and the U.K. Domestic account balances generally exceed federally insured limits. Our trade receivables, which are unsecured, are geographically dispersed throughout the U.S. and the U.K. and include both large and small corporate entities spanning numerous industries. We perform ongoing credit evaluations of our customers’ financial condition.
Off-balance sheet arrangements
We do not have any off-balance sheet arrangements other than our operating leases. We do not participate in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.
Inflation
We believe that our business is impacted by inflation to the same degree as the general economy.
Certain Factors That May Affect Future Results
Information contained or incorporated by reference in this Quarterly Report on Form 10-Q, in other SEC filings by the Company, in press releases and in presentations by the Company or its management that are not historical by nature constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, which can be identified by the use of forward-looking terminology such as “believes,” “expects,” “plans,” “intends,” “estimates,” “projects,” “could,” “may,” “will,” “should,” or “anticipates” or the negatives thereof, other variations thereon or comparable terminology, or by discussions of strategy. No assurance can be given that future results expressed or implied by the forward-looking statements will be achieved. Such statements are based on management’s current expectations and beliefs and are subject to a number of risks and uncertainties that could cause actual results to differ materially from those expressed or implied by the forward-looking statements. These risks and uncertainties include, but are not limited to, those relating to the Company’s financial and operating prospects, strength of competition and pricing, negative economic trends, rapid technology changes, ability to retain existing customers and attract new ones, outlook of customers, and the Company’s acquisition strategy and ability to integrate acquired companies and assets.
Other factors and risks that may affect the Company’s business and future financial results are detailed in the Company’s SEC filings, including, but not limited to, those described under “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010 and in this Quarterly Report on Form 10-Q. The Company’s business could be materially adversely affected and the trading price of the Company’s common stock could decline if any such risks and uncertainties develop into actual events. The Company cautions you not to place undue reliance on these forward-looking statements, which speak only as of their respective dates. The Company undertakes no obligation to publicly update or revise forward-looking statements to reflect events or circumstances after the date of this Quarterly Report on Form 10-Q or to reflect the occurrence of unanticipated events.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
In the normal course of business, we are exposed to market risk arising from changes in foreign currency exchange rates that could impact our cash flows and earnings. During the six months ended June 30, 2011, our foreign activities accounted for 9.3% of consolidated revenue. Due to the strengthening of the British pound compared to the U.S. dollar, the translation rate for the six months ended June 30, 2011 increased 5.9% compared to the translation rate used for the six months ended June 30, 2010. Due to the strengthening of the British pound compared to the U.S. dollar, the translation rate for the three months ended June 30, 2011 increased 9.4% compared to the translation rate used for the three months ended June 30, 2010. We monitor foreign markets and our commitments in such markets to manage currency and other risks. To date, based upon our level of foreign operations, we have not entered into any hedging arrangement designed to limit exposure to foreign currencies. Because of our European expansion, our level of foreign activities is expected to increase and if it does, we may determine that such hedging arrangements would be appropriate and we will consider such arrangements to minimize risk.
Under the terms of the $250 Million Secured Revolving Credit Facility, which was entered into on January 28, 2011, our borrowings bear interest, for any interest period of one, two or three months or if agreed to, longer interest periods at our option, at either the Base Rate (as defined in the $250 Million Secured Revolving Credit Facility) plus the applicable margin ranging from 1.25% to 2.00%, or alternately, the Adjusted LIBO Rate (as defined in the $250 Million Secured Revolving Credit Facility) plus the applicable margin ranging from 2.25% to 3.00%. At closing, the Company borrowed $55.0 million. The initial borrowings under the $250 Million Secured Revolving Credit Facility carried an interest rate of 4.50% (base rate of 3.25% plus applicable margin of 1.25%). We converted the interest rate to the Adjusted LIBO Rate option as of February 4, 2011, at which time the interest rate was changed to 2.52% (0.27% Adjusted LIBO Rate plus applicable margin of 2.25%). We have not entered into a swap arrangement to fix our borrowing costs under the $250 Million Secured Revolving Credit Facility. Thus, if the operative rate increases, our cost of borrowing will also increase, thereby increasing the costs of our investment strategy. For example, if LIBOR was to increase by 1% for the full year, our borrowing costs would increase by $0.55 million (1% x $55.0 million) based upon the amount of the related debt outstanding at June 30, 2011.
As of June 30, 2011, we had an aggregate $55.0 million outstanding under the $250 Million Secured Revolving Credit Facility. Additionally, we had a $1.2 million capital lease obligation outstanding, which carried a fixed rate of interest of 8.0%, and as a result, we were not exposed to related interest rate risk on this capital lease.
Our interest income is most sensitive to fluctuations in the general level of U.S. interest rates, which affect the interest we earn on our cash and cash equivalents. Our investment policy and strategy are focused on the preservation of capital and supporting our liquidity requirements and requires investments to be short-term and investment grade, primarily rated AAA or better with the objective of minimizing the potential risk of principal loss. Investments in both fixed rate and floating rate interest earning securities carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to a rise in interest rates, while floating rate securities may produce less income than predicted if interest rates fall. We may suffer losses in principal if we are forced to sell securities that have declined in market value due to changes in interest rates. Our investments in cash equivalents are primarily floating rate investments.
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ITEM 4. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
As of June 30, 2011, the Company carried out an assessment, under the supervision of and with the participation of the Company’s Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in the Exchange Act Rules 13a-15(e) and 15d-15(e)). The Chief Executive Officer and the Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of June 30, 2011 to ensure that all information required to be disclosed in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms and is accumulated and communicated to the Company’s management, including the Company’s Chief Executive Officer and the Chief Financial Officer, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.
Changes in Internal Control Over Financial Reporting
There has been no change in internal control over financial reporting that occurred during the quarter ended June 30, 2011 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
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PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The information presented in Note 9, “Litigation,” to the consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q is hereby incorporated by reference.
ITEM 1A. RISK FACTORS
In addition to the other information set forth in this Quarterly Report on Form 10-Q, you should carefully consider the factors discussed under ”Risk Factors” in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010, which could materially affect the Company’s business, financial condition and future operating results. The risks described in the Company’s Annual Report on Form 10-K are not the only risks facing the Company. Additional risks and uncertainties, including those not currently known to the Company or that the Company currently deems to be immaterial could also materially adversely affect the Company’s business, financial condition and future operating results. There have been no material changes in our risk factors from those disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2010.
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ITEM 6. EXHIBITS
| Exhibit No. | Description of Exhibit | |
| 10.1 | AboveNet, Inc. 2011 Equity Incentive Plan (incorporated herein by reference to Form 8-K filed with the Securities and Exchange Commission on June 27, 2011). | |
| 10.2 | Form of Restricted Stock Unit Agreement (incorporated by reference to Form S-8 Registration Statement filed with the Securities and Exchange Commission on August 2, 2011). | |
| 10.3 | Summary of April 27, 2011 Amendment to Employment Agreement between John Jacquay and AboveNet, Inc. | |
| 10.4 | Fourth Amendment of Lease dated as of June 24, 2011, by and between One City Block LLC, as Landlord, and AboveNet Communications, Inc., as Tenant. | |
| 31.1 | Certification of Chief Executive Officer of the Registrant, pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934. | |
| 31.2 | Certification of Chief Financial Officer of the Registrant, pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934. | |
| 32.1 | Certification of Chief Executive Officer of the Registrant, pursuant to 18 U.S.C. Section 1350, as adopted, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. | |
| 32.2 | Certification of Chief Financial Officer of the Registrant, pursuant to 18 U.S.C. Section 1350, as adopted, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. | |
| 101.INS | XBRL Instance Document. | |
| 101.SCH | XBRL Taxonomy Extension Schema Document. | |
| 101.CAL | XBRL Taxonomy Calculation Linkbase Document. | |
| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document. | |
| 101.LAB | XBRL Taxonomy Label Linkbase Document. | |
| 101.PRE | XBRL Taxonomy Presentation Linkbase Document. |
63
SIGNATURES
Pursuant to the requirements 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.
| ABOVENET, INC. | ||
| Date: August 8, 2011 | By: | /s/ William G. LaPerch |
| William G. LaPerch | ||
| President, Chief Executive Officer and Director | ||
| (Principal Executive Officer) |
| Date: August 8, 2011 | By: | /s/ Joseph P. Ciavarella |
| Joseph P. Ciavarella | ||
| Senior Vice President and Chief Financial Officer | ||
| (Principal Financial and Accounting Officer) |
64
EXHIBIT INDEX
| Exhibit No. | Description of Exhibit | |
| 10.1 | AboveNet, Inc. 2011 Equity Incentive Plan (incorporated herein by reference to Form 8-K filed with the Securities and Exchange Commission on June 27, 2011). | |
| 10.2 | Form of Restricted Stock Unit Agreement (incorporated by reference to Form S-8 Registration Statement filed with the Securities and Exchange Commission on August 2, 2011). | |
| 10.3 | Summary of April 27, 2011 Amendment to Employment Agreement between John Jacquay and AboveNet, Inc. | |
| 10.4 | Fourth Amendment of Lease dated as of June 24, 2011, by and between One City Block LLC, as Landlord, and AboveNet Communications, Inc., as Tenant. | |
| 31.1 | Certification of Chief Executive Officer of the Registrant, pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934. | |
| 31.2 | Certification of Chief Financial Officer of the Registrant, pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934. | |
| 32.1 | Certification of Chief Executive Officer of the Registrant, pursuant to 18 U.S.C. Section 1350, as adopted, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. | |
| 32.2 | Certification of Chief Financial Officer of the Registrant, pursuant to 18 U.S.C. Section 1350, as adopted, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. | |
| 101.INS | XBRL Instance Document. | |
| 101.SCH | XBRL Taxonomy Extension Schema Document. | |
| 101.CAL | XBRL Taxonomy Calculation Linkbase Document. | |
| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document. | |
| 101.LAB | XBRL Taxonomy Label Linkbase Document. | |
| 101.PRE | XBRL Taxonomy Presentation Linkbase Document. |