UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549-0001
FORM 10-Q
(MARK ONE)
ý QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2005
OR
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission File Number 000-50706
ESCHELON TELECOM, INC.
(Exact name of registrant as specified in its charter)
Delaware |
| 41-1843131 |
(State or other jurisdiction of |
| (I.R.S. Employer |
incorporation or organization) |
| Identification No.) |
|
|
|
730 Second Avenue |
| 55402 |
(Address of principal executive offices) |
| (Zip Code) |
Registrant’s telephone number, including area code: (612) 376-4400
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 the filing requirements for the past 90 days. Yes ý No o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes o No ý
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No ý
As of November 10, 2005, the number of outstanding shares of the Registrant’s Common Stock, par value $.01 per share, was 14,631,970 shares.
ESCHELON TELECOM, INC.
INDEX TO FORM 10-Q
2
Item 1. Financial Statements
Eschelon Telecom, Inc.
(In Thousands, Except Share and Per Share Amounts)
|
| December 31, |
| September 30, |
| ||
|
| 2004 |
| 2005 |
| ||
|
|
|
| (Unaudited) |
| ||
Assets |
|
|
|
|
| ||
Current assets: |
|
|
|
|
| ||
Cash and cash equivalents |
| $ | 26,435 |
| $ | 14,117 |
|
Restricted cash |
| 722 |
| 829 |
| ||
Available-for-sale securities |
| 6,194 |
| 15,878 |
| ||
Accounts receivable, net of allowance for doubtful accounts of $817 and $522, respectively |
| 18,941 |
| 22,822 |
| ||
Other receivables |
| 2,976 |
| 3,484 |
| ||
Inventories |
| 2,873 |
| 2,979 |
| ||
Prepaid expenses |
| 2,410 |
| 2,324 |
| ||
Discontinued assets held for sale |
| — |
| 703 |
| ||
Total current assets |
| 60,551 |
| 63,136 |
| ||
|
|
|
|
|
| ||
Property and equipment, net |
| 102,849 |
| 102,763 |
| ||
|
|
|
|
|
| ||
Other assets |
| 1,985 |
| 1,902 |
| ||
Goodwill |
| 38,776 |
| 38,776 |
| ||
Intangible assets, net |
| 32,958 |
| 30,497 |
| ||
Total assets |
| $ | 237,119 |
| $ | 237,074 |
|
|
|
|
|
|
| ||
Liabilities and stockholders’ equity (deficit) |
|
|
|
|
| ||
Current liabilities: |
|
|
|
|
| ||
Accounts payable |
| $ | 13,801 |
| $ | 16,679 |
|
Accrued telecommunication costs |
| 2,190 |
| 2,161 |
| ||
Accrued office rent |
| 2,336 |
| 2,210 |
| ||
Accrued interest expense |
| 4,070 |
| 400 |
| ||
Accrued expenses |
| 5,998 |
| 6,326 |
| ||
Deferred revenue |
| 7,300 |
| 7,826 |
| ||
Accrued compensation expenses |
| 3,588 |
| 3,295 |
| ||
Capital lease obligation, current maturities |
| 1,629 |
| 662 |
| ||
Discontinued liabilities held for sale |
| — |
| 1,710 |
| ||
Total current liabilities |
| 40,912 |
| 41,269 |
| ||
|
|
|
|
|
| ||
Long-term liabilities: |
|
|
|
|
| ||
Commitments and contingencies |
|
|
|
|
| ||
Other long-term liabilities |
| 630 |
| 811 |
| ||
Capital lease obligation, less current maturities |
| 2,824 |
| 4,972 |
| ||
Notes payable |
| 137,778 |
| 91,447 |
| ||
Total liabilities |
| 182,144 |
| 138,499 |
| ||
|
|
|
|
|
| ||
Series A convertible preferred stock, $0.01 par value per share; 100,000,000 shares authorized; issued and outstanding shares - 77,526,136 at December 31, 2004 |
| 48,155 |
| — |
| ||
|
|
|
|
|
| ||
Series B convertible preferred stock, $0.01 par value per share; 25,000,000 shares authorized; issued and outstanding shares - 20,000,000 at December 31, 2004 |
| 15,000 |
| — |
| ||
|
|
|
|
|
| ||
Stockholders’ equity (deficit): |
|
|
|
|
| ||
Common stock, $0.01 par value per share; 200,000,000 shares authorized; issued and outstanding shares – 351,134 shares at December 31, 2004; and 14,631,539 at September 30, 2005 |
| 4 |
| 146 |
| ||
Additional paid-in capital |
| 115,876 |
| 249,502 |
| ||
Accumulated other comprehensive income |
| 30 |
| 87 |
| ||
Accumulated deficit |
| (124,056 | ) | (149,920 | ) | ||
Deferred compensation |
| (34 | ) | (1,240 | ) | ||
Total stockholders’ equity (deficit) |
| (8,180 | ) | 98,575 |
| ||
Total liabilities and stockholders’ equity (deficit) |
| $ | 237,119 |
| $ | 237,074 |
|
See accompanying notes.
3
Eschelon Telecom, Inc.
Unaudited Consolidated Statements of Operations
(In Thousands, Except Share and Per Share Amounts)
|
| Three months ended |
| Nine months ended |
| ||||||||
|
| 2004 |
| 2005 |
| 2004 |
| 2005 |
| ||||
Revenue: |
|
|
|
|
|
|
|
|
| ||||
Network services |
| $ | 33,476 |
| $ | 51,181 |
| $ | 98,333 |
| $ | 149,944 |
|
Business telephone systems |
| 7,086 |
| 6,731 |
| 19,575 |
| 19,422 |
| ||||
Total revenue |
| 40,562 |
| 57,912 |
| 117,908 |
| 169,366 |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Cost of revenue: |
|
|
|
|
|
|
|
|
| ||||
Network services |
| 11,736 |
| 20,701 |
| 35,093 |
| 65,603 |
| ||||
Business telephone systems |
| 4,305 |
| 4,093 |
| 11,785 |
| 11,914 |
| ||||
Total cost of revenue |
| 16,041 |
| 24,794 |
| 46,878 |
| 77,517 |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Gross profit: |
|
|
|
|
|
|
|
|
| ||||
Network services |
| 21,740 |
| 30,480 |
| 63,240 |
| 84,341 |
| ||||
Business telephone systems |
| 2,781 |
| 2,638 |
| 7,790 |
| 7,508 |
| ||||
Total gross profit |
| 24,521 |
| 33,118 |
| 71,030 |
| 91,849 |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Operating expenses: |
|
|
|
|
|
|
|
|
| ||||
Sales, general and administrative |
| 18,423 |
| 22,378 |
| 51,949 |
| 67,823 |
| ||||
Depreciation and amortization |
| 7,493 |
| 9,011 |
| 22,705 |
| 26,292 |
| ||||
Operating income (loss) |
| (1,395 | ) | 1,729 |
| (3,624 | ) | (2,266 | ) | ||||
|
|
|
|
|
|
|
|
|
| ||||
Other income (expense): |
|
|
|
|
|
|
|
|
| ||||
Interest income |
| 45 |
| 269 |
| 83 |
| 502 |
| ||||
Interest expense |
| (2,837 | ) | (14,798 | ) | (7,911 | ) | (24,612 | ) | ||||
Gain on extinguishment of debt |
| — |
| — |
| 18,195 |
| — |
| ||||
Other income (expense) |
| (138 | ) | (113 | ) | (161 | ) | (59 | ) | ||||
Income (loss) before taxes |
| (4,325 | ) | (12,913 | ) | 6,582 |
| (26,435 | ) | ||||
Income taxes |
| (4 | ) | — |
| (4 | ) | — |
| ||||
Net income (loss) before discontinued operation |
| (4,329 | ) | (12,913 | ) | 6,578 |
| (26,435 | ) | ||||
Income from discontinued operation |
| — |
| 460 |
| — |
| 571 |
| ||||
Net income (loss) |
| (4,329 | ) | (12,453 | ) | 6,578 |
| (25,864 | ) | ||||
Less preferred stock dividends |
| (863 | ) | — |
| (2,572 | ) | — |
| ||||
Net income (loss) applicable to common stockholders |
| $ | (5,192 | ) | $ | (12,453 | ) | $ | 4,006 |
| $ | (25,864 | ) |
|
|
|
|
|
|
|
|
|
| ||||
Net income (loss) per share: |
|
|
|
|
|
|
|
|
| ||||
Basic |
| $ | (17.62 | ) | $ | (1.49 | ) | $ | 14.14 |
| $ | (8.53 | ) |
Diluted |
| $ | (17.62 | ) | $ | (1.49 | ) | $ | 1.56 |
| $ | (8.53 | ) |
|
|
|
|
|
|
|
|
|
| ||||
Weighted average number of shares outstanding: |
|
|
|
|
|
|
|
|
| ||||
Basic |
| 294,702 |
| 8,329,636 |
| 283,268 |
| 3,033,623 |
| ||||
Diluted |
| 294,702 |
| 8,329,636 |
| 8,132,679 |
| 3,033,623 |
|
See accompanying notes.
4
Eschelon Telecom, Inc.
Unaudited Consolidated Statements of Cash Flows
(In Thousands)
|
| Nine months ended |
| ||||
|
| 2004 |
| 2005 |
| ||
Operating activities |
|
|
|
|
| ||
Net income (loss) |
| $ | 6,578 |
| $ | (25,864 | ) |
Adjustments to reconcile net income (loss) to net cash provided by operating activities: |
|
|
|
|
| ||
Depreciation and amortization expense |
| 22,705 |
| 26,292 |
| ||
Other non-cash items |
| 2,212 |
| 7,940 |
| ||
Gain on extinguishment of debt |
| (18,195 | ) | — |
| ||
Changes in operating assets and liabilities: |
|
|
|
|
| ||
Restricted cash |
| (651 | ) | (107 | ) | ||
Accounts receivable |
| 171 |
| (4,643 | ) | ||
Inventories |
| 15 |
| (106 | ) | ||
Other current assets and deposits |
| 47 |
| (439 | ) | ||
Discontinued assets held for sale, net of liabilities |
| — |
| 1,223 |
| ||
Accounts payable and accrued expenses |
| 2,425 |
| (619 | ) | ||
Deferred revenue |
| 762 |
| 526 |
| ||
Accrued compensation expense |
| (949 | ) | (293 | ) | ||
Net cash provided by operating activities |
| 15,120 |
| 3,910 |
| ||
|
|
|
|
|
| ||
Investing activities |
|
|
|
|
| ||
Purchase of net assets held for sale |
| — |
| (216 | ) | ||
Purchases of available-for-sale securities |
| (4,357 | ) | (29,744 | ) | ||
Proceeds from sale of available-for-sale securities |
| — |
| 20,315 |
| ||
Purchases of property and equipment |
| (10,130 | ) | (14,173 | ) | ||
Cash paid for customer installation costs |
| (8,442 | ) | (10,103 | ) | ||
Proceeds from sales of assets |
| 25 |
| 238 |
| ||
Net cash used in investing activities |
| (22,904 | ) | (33,683 | ) | ||
|
|
|
|
|
| ||
Financing activities |
|
|
|
|
| ||
Proceeds from issuance of notes payable |
| 84,813 |
| — |
| ||
Payments made on bank debt and capital lease obligations |
| (66,599 | ) | (50,780 | ) | ||
Proceeds from issuance of stock, net of fees |
| 7 |
| 68,583 |
| ||
Increase in debt issuance costs |
| (4,635 | ) | (348 | ) | ||
Net cash provided by financing activities |
| 13,586 |
| 17,455 |
| ||
|
|
|
|
|
| ||
Net increase (decrease) in cash and cash equivalents |
| 5,802 |
| (12,318 | ) | ||
Cash and cash equivalents at beginning of period |
| 8,606 |
| 26,435 |
| ||
Cash and cash equivalents at end of period |
| $ | 14,408 |
| $ | 14,117 |
|
|
|
|
|
|
| ||
Supplemental cash flow information |
|
|
|
|
| ||
Cash paid for interest |
| $ | 6,394 |
| $ | 18,317 |
|
|
|
|
|
|
| ||
Supplemental noncash activities |
|
|
|
|
| ||
Equipment purchases under capital leases |
| $ | 1,872 |
| $ | 2,785 |
|
Value of common stock issued to management and certain members of board of directors |
| $ | 14 |
| $ | 27 |
|
See accompanying notes.
5
Eschelon Telecom, Inc.
Notes to Consolidated Financial Statements
(In Thousands, Except Share and Per Share Amounts)
(Unaudited)
1.) Summary of Significant Accounting Policies
Basis of Presentation
The accompanying unaudited consolidated financial statements of Eschelon Telecom, Inc. and its subsidiaries (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X promulgated by the United States Securities and Exchange Commission (the “SEC”). Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal and recurring adjustments and accruals) considered necessary for a fair presentation for the periods indicated have been included. Operating results for the three and nine month periods ended September 30, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005. The consolidated balance sheet at December 31, 2004 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. These financial statements should be read in conjunction with the Company’s audited financial statements and related notes thereto for the year ended December 31, 2004 included in the Eschelon Telecom, Inc. Form 10-K filed with the Securities and Exchange Commission on March 31, 2005.
Reclassifications
Certain prior year items have been reclassified to conform to current year presentation.
Available-for-Sale Securities
Short-term investments are comprised of municipal and United States government debt securities with maturities of more than three months but less than one year. In accordance with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, and based on the Company’s intentions regarding these instruments, all investments in debt securities are classified as available-for-sale and accounted for at fair value. Fair value is determined by quoted market prices, with unrealized gains and losses reported as a separate component of stockholders’ deficit. The Company uses the specific identification of securities sold method to recognize realized gains and losses in earnings.
The cost basis, fair value and gross unrealized gains of the investment securities available-for-sale as of September 30, 2005 and December 31, 2004, are as follows:
|
|
|
|
|
| Gross |
| Gross |
| ||||
|
|
|
|
|
| Unrealized |
| Unrealized |
| ||||
|
|
|
|
|
| Holding |
| Holding |
| ||||
|
| Cost Basis |
| Fair Value |
| Gains |
| (Losses) |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Available-for-sale securities as of September 30, 2005 |
| $ | 15,791 |
| $ | 15,878 |
| $ | 108 |
| $ | (21 | ) |
|
|
|
|
|
|
|
|
|
| ||||
Available-for-sale securities as of December 31, 2004 |
| $ | 6,164 |
| $ | 6,194 |
| $ | 30 |
| $ | — |
|
Debt securities as of September 30, 2005 have maturities of less than twelve months.
Property and Equipment
Property and equipment, including leasehold improvements, are stated at cost. All internal costs directly related to the construction of the switches and operating and support systems, including compensation of certain employees, are capitalized. Depreciation is provided using the straight-line method over the estimated useful lives of the assets. Leasehold improvements are amortized over the shorter of the related lease term or the estimated useful life of the asset.
6
Property and equipment consist of the following:
|
| December 31, |
| September 30, |
| ||
|
| 2004 |
| 2005 |
| ||
|
|
|
|
|
| ||
Vehicles |
| $ | 590 |
| $ | 1,170 |
|
Office furniture and equipment |
| 16,746 |
| 18,469 |
| ||
Computer equipment and software |
| 34,534 |
| 40,097 |
| ||
Leasehold improvements |
| 19,504 |
| 19,819 |
| ||
Switching and data equipment and software |
| 99,736 |
| 107,641 |
| ||
|
| 171,110 |
| 187,196 |
| ||
Less accumulated depreciation |
| (68,261 | ) | (84,433 | ) | ||
|
| $ | 102,849 |
| $ | 102,763 |
|
Goodwill and Other Intangible Assets
Goodwill represents the excess of cost over the fair value of net assets acquired.
Intangibles consist of customer installation costs, debt issuance costs and non-compete agreements. The customer installation costs are being amortized over a period of 48 months, which approximates the average life of a customer contract. Debt issuance costs are being amortized over the term of the respective debt obligation. Non-compete agreement costs represent costs associated with various agreements the Company has entered into with existing management of the companies it has acquired and a settlement agreement with a former employee of the Company. These costs are being amortized over the terms of the agreements.
On September 15, 2005, the Company redeemed 35% of its outstanding 8 3/8% senior second secured notes due March 15, 2010. In connection with the redemption, the Company wrote off a proportionate amount of the associated debt issuance costs resulting in a net decrease to intangible assets and a corresponding increase to interest expense of $2,597.
Intangible assets consist of the following:
|
| December 31, |
| September 30, |
| ||
|
| 2004 |
| 2005 |
| ||
|
|
|
|
|
| ||
Customer installation costs |
| $ | 64,087 |
| $ | 74,204 |
|
Debt issuance costs |
| 8,368 |
| 5,665 |
| ||
Non-compete agreements |
| 15 |
| 315 |
| ||
|
| 72,470 |
| 80,184 |
| ||
Less accumulated amortization |
| (39,512 | ) | (49,687 | ) | ||
|
| $ | 32,958 |
| $ | 30,497 |
|
Notes Payable
On September 15, 2005, the Company redeemed $50,630 accreted value ($57,750 principal amount) of the Company’s 8 3/8% senior second secured notes due March 15, 2010 at a redemption price of 112% of the accreted value. The $6,076 accreted-value premium was recorded as interest expense. Proceeds from the Company’s initial public offering of the Company’s common stock (see Note 4) were used to redeem the notes.
Stock-Based Compensation
The Company accounts for its stock-based employee compensation under the recognition and measurement principles of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. Under APB No. 25, when the exercise price of stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized in the consolidated statement of operations.
In preparation for the Company’s initial public offering of its common stock (see Note 4), the Company’s board of directors assessed its prior contemporaneous determinations of fair value for stock option and stock grants made since May 2004 and made adjustments to these prior determinations of fair value. As a
7
result of these retrospective adjustments to fair value, the Company recognized compensation expense associated with such stock option and stock grants of $784 in the nine months ended September 30, 2005. The Company will record a total of $1,219 of additional compensation expense through July 2009, at which point all such stock options are fully vested.
The following table illustrates the effect on net income (loss) per share if the company had applied the fair value recognition provision of Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation:
8
|
| Three months ended |
| Nine months ended |
| ||||||||
|
| 2004 |
| 2005 |
| 2004 |
| 2005 |
| ||||
Net income (loss) applicable to common stockholders, as reported |
| $ | (5,192 | ) | $ | (12,453 | ) | $ | 4,006 |
| $ | (25,864 | ) |
Add: Stock-based employee compensation expense included in reported net income (loss) |
| — |
| 148 |
| 20 |
| 796 |
| ||||
Deduct: Total stock-based employee compensation expense determined under fair value-based methods for all awards |
| (2 | ) | (123 | ) | (49 | ) | (412 | ) | ||||
Pro forma net income (loss) applicable to common stockholders |
| $ | (5,194 | ) | $ | (12,428 | ) | $ | 3,977 |
| $ | (25,480 | ) |
|
|
|
|
|
|
|
|
|
| ||||
Net income (loss) per share: |
|
|
|
|
|
|
|
|
| ||||
Basic - as reported |
| $ | (17.62 | ) | $ | (1.49 | ) | $ | 14.14 |
| $ | (8.53 | ) |
Basic - pro forma |
| $ | (17.62 | ) | $ | (1.49 | ) | $ | 14.04 |
| $ | (8.40 | ) |
|
|
|
|
|
|
|
|
|
| ||||
Diluted - as reported |
| $ | (17.62 | ) | $ | (1.49 | ) | $ | 1.56 |
| $ | (8.53 | ) |
Diluted - pro forma |
| $ | (17.62 | ) | $ | (1.49 | ) | $ | 1.55 |
| $ | (8.40 | ) |
Pro forma information regarding net income (loss) and net income (loss) per share is required by SFAS No. 123, and has been determined as if the Company had accounted for its employee stock options under the fair value method of SFAS No. 123. The fair value of these options was estimated at the date of grant using the Black-Scholes option pricing model with the following assumptions for the three and nine-month periods ended September 30, 2004 and 2005:
|
| Three months ended |
| Nine months ended |
| ||||
|
| 2004 |
| 2005 |
| 2004 |
| 2005 |
|
Expected dividend yield |
| — |
| — |
| — |
| — |
|
Expected stock price volatility |
| 25 | % | 25 | % | 25 | % | 25 | % |
Risk-free interest rate |
| 3.47 | % | 3.84%-4.08 | % | 3.25%-3.88 | % | 3.71%-4.24 | % |
Expected life of options |
| 5 years |
| 5 years |
| 5 years |
| 5 years |
|
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions. Because the Company’s employee stock options have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.
Net Income (Loss) Per Share
Basic earnings per share is computed based on the weighted average number of common shares outstanding. Diluted earnings per share is computed based on the weighted average number of common shares outstanding adjusted by the number of additional shares that would have been outstanding had the potentially dilutive common shares been issued. Potentially dilutive shares of common stock include stock options, unvested restricted stock grants, Series A Convertible Preferred Stock and Series B Convertible Preferred Stock. During periods in which a net loss is incurred, diluted earnings per share amounts are the same as basic per share amounts because the effect of all options, unvested restricted stock grants, Series A Convertible Preferred Stock and Series B Convertible Preferred Stock is anti-dilutive.
The following table presents a reconciliation of the numerators and denominators of basic and diluted earnings per common share:
9
|
| Three months ended |
| Nine months ended |
| ||||||||
|
| 2004 |
| 2005 |
| 2004 |
| 2005 |
| ||||
Numerator: |
|
|
|
|
|
|
|
|
| ||||
Net income (loss) applicable to common stockholders, as reported |
| $ | (5,192 | ) | $ | (12,453 | ) | $ | 4,006 |
| $ | (25,864 | ) |
Add: Cumulative preferred stock dividends |
| — |
| — |
| 8,698 |
| — |
| ||||
Deduct: Unrecognized deferred compensation expense |
| — |
| — |
| (34 | ) | — |
| ||||
Numerator for diluted earnings per share |
| $ | (5,192 | ) | $ | (12,453 | ) | $ | 12,670 |
| $ | (25,864 | ) |
|
|
|
|
|
|
|
|
|
| ||||
Denominator: |
|
|
|
|
|
|
|
|
| ||||
Weighted average common shares outstanding |
| 294,702 |
| 8,329,636 |
| 283,268 |
| 3,033,623 |
| ||||
Effect of dilutive securities: |
|
|
|
|
|
|
|
|
| ||||
Restricted stock grants |
| — |
| — |
| 29,369 |
| — |
| ||||
Employee stock options |
| — |
| — |
| 333,724 |
| — |
| ||||
Series A convertible preferred stock |
| — |
| — |
| 7,486,318 |
| — |
| ||||
Denominator for diluted earnings per share |
| 294,702 |
| 8,329,636 |
| 8,132,679 |
| 3,033,623 |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Net income (loss) per share: |
|
|
|
|
|
|
|
|
| ||||
Basic - as reported |
| $ | (17.62 | ) | $ | (1.49 | ) | $ | 14.14 |
| $ | (8.53 | ) |
Diluted - as reported |
| $ | (17.62 | ) | $ | (1.49 | ) | $ | 1.56 |
| $ | (8.53 | ) |
New Accounting Pronouncements
In December 2004, as amended on April 14, 2005, the Financial Accounting Standards Board issued SFAS No. 123R, Share-Based Payment: an amendment of FASB Statement No. 123 and FASB Statement No. 95, which requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Prior to SFAS No. 123R, only certain pro forma disclosures of fair value were required. SFAS 123R must be adopted no later than the beginning of the first fiscal year beginning after June 15, 2005. We will adopt SFAS 123R on January 1, 2006.
SFAS 123R permits companies to adopt one of two methods: (1) A “modified prospective” method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS 123R for all share-based payments granted after the effective date and (b) based on the requirements of SFAS 123 for all awards granted to employees prior to the effective date of SFAS 123R that remain unvested on the effective date or (2) A “modified retrospective” method that includes the requirements of the modified prospective method described above, but also permits entities to restate based on the amounts previously recognized under FAS 123 for purposes of pro forma disclosures either (a) all prior periods presented or (b) prior interim periods of the year of adoption. We are currently in the process of evaluating the two option valuation methods and the potential impact on our financial statements.
In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets. SFAS No. 153 addresses the measurement of exchange of nonmonetary assets. SFAS 153 eliminates the exception from fair value measurement for nonmonetary exchanges of similar productive assets in paragraph 21(b) of APB Opinion No. 29, Accounting for Nonmonetary Transactions, and replaces it with an exception for exchanges that do not have commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. SFAS No. 153 is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. We are evaluating the potential impact of our adoption of SFAS No. 153 on our consolidated financial statements.
2.) Acquisitions
Advanced TelCom, Inc.
On December 31, 2004, the Company acquired all of the outstanding common stock of Advanced TelCom, Inc. (“ATI”) for $45,495, net of cash acquired. The results of ATI have been included in the consolidated financial statements since that date. As a result of the acquisition, the Company strengthened its presence in six markets, entered into six adjacent markets, entered one new market and created significant opportunities for cost savings and increased profitability.
10
The Company allocated the purchase price on a preliminary basis using the information then available. The allocation of the purchase price will be finalized in the fourth quarter of 2005. Upon completion of the final purchase price allocation, an additional portion of the excess purchase price may be allocated to certain intangibles that are separable from goodwill. The Company accrued $2,531 in acquisition related expenses, which include severance benefits, relocation costs and contract termination fees. At September 30, 2005 the balance in the acquisition reserve was as follows:
Balance at December 31, 2004 |
| $ | 2,531 |
|
Payments |
| (995 | ) | |
Balance at September 30, 2005 |
| $ | 1,536 |
|
The following unaudited pro forma financial information was prepared in accordance with SFAS No. 141, Business Combinations, and assumes the acquisition had occurred at the beginning of the periods presented. The unaudited pro forma information is provided for informational purposes only. These pro forma results are based upon the respective historical financial statements of the respective companies, and do not incorporate, nor do they assume, any benefits from cost savings or synergies of operations of the combined company. The pro forma results of operations do not necessarily reflect the results that would have occurred had the acquisition occurred at the beginning of the periods presented or the results which may occur in the future.
The pro forma combined results of continuing operations for the three and nine months ended September 30, 2004 are as follows:
|
| Three months ended |
| Nine months ended |
| ||
Revenue |
| $ | 55,586 |
| $ | 162,890 |
|
Net income |
| (2,832 | ) | 13,265 |
| ||
Net income per share – basic |
| (9.61 | ) | 46.83 |
| ||
Net income per share – diluted |
| (9.61 | ) | 2.38 |
| ||
General Electric Business Productivity Solutions
On October 13, 2004 the Company entered into an agreement with General Electric Capital Corporation to purchase substantially all of the assets of General Electric Business Productivity Solutions (GEBPS) for $100. The transaction closed on March 31, 2005 and is being accounted for as a discontinued operation. GEBPS constitutes a group of assets that can be clearly distinguished operationally and for financial reporting purposes from the rest of the Company. Management has determined that this group of assets does not fit the Company’s future business model and is committed to sell the net assets. The Company believes that the assets will be sold within the next twelve months. At March 31, 2005 the Company determined that the plan of sale criteria in SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, had been met and classified the assets and liabilities accordingly on the balance sheet.
3.) Benefit Contribution Plan
The Company has a defined contribution salary deferral plan covering substantially all employees under Section 401(k) of the Internal Revenue Code. The Company contributes an amount equal to 45 cents for each dollar contributed by each employee up to a maximum of 6% of each employee’s compensation. The Company recognized expense for contributions to the plan for the three months ended September 30, 2004 and 2005 of $199 and $259, respectively, and for the nine months ended September 30, 2004 and 2005 of $575 and $728, respectively.
11
4.) Capital Stock
Initial Public Offering
On August 9, 2005, the Company consummated an initial public offering of 5,357,143 of the Company’s common stock at $14.00 per share. Net proceeds from the offering, after deducting underwriting discounts and commissions, were $69,750. Proceeds were used to redeem $50,630 accreted value ($57,750 principal amount) of the Company’s 8 3/8% senior second secured notes due March 15, 2010; to pay a $6,076 premium due upon redemption of the notes; and to pay $1,379 of fees and expenses associated with the offering. Approximately $805 will be used for the payment of additional fees and expenses associated with the offering and approximately $10,860 will be used for general corporate purposes, including the expansion of the Company’s colocation network.
Preferred Stock
As a result of the Company’s initial public offering of common stock on August 9, 2005, all of the Company’s then-outstanding shares of convertible preferred stock and accumulated dividends were automatically converted to common stock.
Prior to the conversion, under the terms of the Company’s Series A Convertible Preferred Stock and Series B Convertible Preferred Stock (collectively, Preferred Stock), the holders were entitled to receive, when and if declared by the Board of Directors, cumulative dividends on each share of Preferred Stock at the rate of 8% per year which accrued daily and, to the extent not paid, accumulated quarterly in arrears. At December 31, 2004 dividends in arrears were $8,777.
After the conversion, the Company has 125,000,000 of undesignated preferred shares authorized and no shares of preferred stock outstanding.
Stock Options
In November 2002, the Board of Directors approved the Eschelon Telecom, Inc. Stock Option Plan of 2002 (the “2002 Plan”). A total of 1,632,414 shares of the Company’s common stock have been reserved for issuance under the 2002 Plan. At September 30, 2005, the Company had 1,150,507 options outstanding and 192,255 shares of restricted common stock issued to certain directors and members of management under the 2002 Plan.
Restricted Common Stock
In February 2003, the Company granted 183,399 shares of restricted common stock to certain of its directors and members of management. The fair value per share of this restricted stock was $0.68. The Company records compensation expense as the restrictions are removed from the stock and recognizes compensation expense over the vesting period. In February 2004, 29,958 shares vested resulting in compensation expense of $20. In February 2005, 17,941 shares vested resulting in compensation expense of $12. In March 2005, the Company granted 8,856 shares of restricted common stock to a member of its board of directors. The fair value per share of this restricted stock was $2.71. The Company recorded related compensation expense of $24. In July 2005, the Company granted 494 shares of restricted common stock to a former member of its board of directors as compensation for 494 shares of unvested restricted common stock that was forfeited when membership on the board of directors ended. The fair value per share of this restricted stock was $6.77. The Company recorded related compensation expense of $3.
5.) Reverse Stock Split
The Company completed a 0.0738-for-one reverse stock split affecting all outstanding shares of common stock on August 2, 2005. All share and per share data have been adjusted to reflect the stock split.
6.) Condensed Consolidating Financial Information
The Company’s 8 3/8% senior second secured notes due 2010 issued by Eschelon Operating Company are fully and unconditionally guaranteed jointly and severally by the Company and all existing subsidiaries and the indenture governing the notes requires that any future subsidiaries that are organized in the United States must also guarantee the notes on the same basis.
12
The following tables present condensed consolidating balance sheets at December 31, 2004 and September 30, 2005 and condensed consolidating statements of operations for the three and nine-month periods ended September 30, 2004 and 2005.
13
Unaudited Condensed Consolidating Balance Sheets
As of December 31, 2004
(In Thousands)
|
|
|
| Eschelon |
|
|
|
|
|
|
| |||||
|
| Eschelon |
| Operating |
| Guarantor |
|
|
|
|
| |||||
|
| Telecom, Inc. |
| Company |
| Subsidiaries |
| Eliminations |
| Consolidated |
| |||||
|
|
|
|
|
|
|
|
|
|
|
| |||||
Assets |
|
|
|
|
|
|
|
|
|
|
| |||||
Current assets: |
|
|
|
|
|
|
|
|
|
|
| |||||
Cash and cash equivalents |
| $ | 26,332 |
| $ | — |
| $ | 103 |
| $ | — |
| $ | 26,435 |
|
Restricted cash |
| 722 |
| — |
| — |
| — |
| 722 |
| |||||
Available-for-sale securities |
| 6,194 |
| — |
| — |
| — |
| 6,194 |
| |||||
Accounts receivable |
| — |
| — |
| 18,941 |
| — |
| 18,941 |
| |||||
Other receivables |
| — |
| — |
| 2,976 |
| — |
| 2,976 |
| |||||
Inventories |
| — |
| — |
| 2,873 |
| — |
| 2,873 |
| |||||
Prepaid expenses |
| 1,227 |
| — |
| 1,183 |
| — |
| 2,410 |
| |||||
Total current assets |
| 34,475 |
| — |
| 26,076 |
| — |
| 60,551 |
| |||||
|
|
|
|
|
|
|
|
|
|
|
| |||||
Property and equipment, net |
| 82,550 |
| — |
| 20,299 |
| — |
| 102,849 |
| |||||
|
|
|
|
|
|
|
|
|
|
|
| |||||
Investment in affiliates |
| 58,998 |
| — |
| — |
| (58,998 | ) | — |
| |||||
Other assets |
| 1,042 |
| — |
| 943 |
| — |
| 1,985 |
| |||||
Goodwill |
| — |
| — |
| 38,776 |
| — |
| 38,776 |
| |||||
Intangible assets, net |
| 20,438 |
| — |
| 12,520 |
| — |
| 32,958 |
| |||||
Total assets |
| $ | 197,503 |
| $ | — |
| $ | 98,614 |
| $ | (58,998 | ) | $ | 237,119 |
|
|
|
|
|
|
|
|
|
|
|
|
| |||||
Liabilities and stockholders’ equity (deficit) |
|
|
|
|
|
|
|
|
|
|
| |||||
Current liabilities: |
|
|
|
|
|
|
|
|
|
|
| |||||
Accounts payable |
| $ | 4,314 |
| $ | — |
| $ | 9,487 |
| $ | — |
| $ | 13,801 |
|
Accrued telecommunication costs |
| — |
| — |
| 2,190 |
| — |
| 2,190 |
| |||||
Accrued office rent |
| 1,722 |
| — |
| 614 |
| — |
| 2,336 |
| |||||
Accrued interest expense |
| — |
| 4,069 |
| 1 |
| — |
| 4,070 |
| |||||
Other accrued expenses |
| 489 |
| — |
| 5,509 |
| — |
| 5,998 |
| |||||
Deferred revenue |
| — |
| — |
| 7,300 |
| — |
| 7,300 |
| |||||
Accrued compensation expenses |
| 2,172 |
| — |
| 1,416 |
| — |
| 3,588 |
| |||||
Capital lease obligation, current maturities |
| 1,526 |
| — |
| 103 |
| — |
| 1,629 |
| |||||
Total current liabilities |
| 10,223 |
| 4,069 |
| 26,620 |
| — |
| 40,912 |
| |||||
|
|
|
|
|
|
|
|
|
|
|
| |||||
Long-term liabilities: |
|
|
|
|
|
|
|
|
|
|
| |||||
Other long-term liabilities |
| 76 |
| — |
| 554 |
| — |
| 630 |
| |||||
Capital lease obligation, less current maturities |
| 2,607 |
| — |
| 217 |
| — |
| 2,824 |
| |||||
Notes payable |
| — |
| 137,778 |
| — |
| — |
| 137,778 |
| |||||
Due to (from) affiliates |
| 235,611 |
| (182,260 | ) | (53,351 | ) | — |
| — |
| |||||
Total liabilities |
| 248,517 |
| (40,413 | ) | (25,960 | ) | — |
| 182,144 |
| |||||
|
|
|
|
|
|
|
|
|
|
|
| |||||
Convertible preferred stock |
| 63,155 |
| — |
| — |
| — |
| 63,155 |
| |||||
Stockholders’ equity (deficit) |
| (114,169 | ) | 40,413 |
| 124,574 |
| (58,998 | ) | (8,180 | ) | |||||
Total liabilities and stockholders’ equity (deficit) |
| $ | 197,503 |
| $ | — |
| $ | 98,614 |
| $ | (58,998 | ) | $ | 237,119 |
|
14
Unaudited Condensed Consolidating Balance Sheets
As of September 30, 2005
(In Thousands)
|
|
|
| Eschelon |
|
|
|
|
|
|
| |||||
|
| Eschelon |
| Operating |
| Guarantor |
|
|
|
|
| |||||
|
| Telecom, Inc. |
| Company |
| Subsidiaries |
| Eliminations |
| Consolidated |
| |||||
|
|
|
|
|
|
|
|
|
|
|
| |||||
Assets |
|
|
|
|
|
|
|
|
|
|
| |||||
Current assets: |
|
|
|
|
|
|
|
|
|
|
| |||||
Cash and cash equivalents |
| $ | 13,834 |
| $ | — |
| $ | 283 |
| $ | — |
| $ | 14,117 |
|
Restricted cash |
| 829 |
| — |
| — |
| — |
| 829 |
| |||||
Available-for-sale securities |
| 15,878 |
| — |
| — |
| — |
| 15,878 |
| |||||
Accounts receivable |
| — |
| — |
| 22,822 |
| — |
| 22,822 |
| |||||
Other receivables |
| — |
| — |
| 3,484 |
| — |
| 3,484 |
| |||||
Inventories |
| — |
| — |
| 2,979 |
| — |
| 2,979 |
| |||||
Prepaid expenses |
| 847 |
| — |
| 1,477 |
| — |
| 2,324 |
| |||||
Discontinued assets held for sale |
| — |
| — |
| 703 |
| — |
| 703 |
| |||||
Total current assets |
| 31,388 |
| — |
| 31,748 |
| — |
| 63,136 |
| |||||
|
|
|
|
|
|
|
|
|
|
|
| |||||
Property and equipment, net |
| 82,629 |
| — |
| 20,134 |
| — |
| 102,763 |
| |||||
|
|
|
|
|
|
|
|
|
|
|
| |||||
Investment in affiliates |
| 58,998 |
| — |
| — |
| (58,998 | ) | — |
| |||||
Other assets |
| 962 |
| — |
| 940 |
| — |
| 1,902 |
| |||||
Goodwill |
| — |
| — |
| 38,776 |
| — |
| 38,776 |
| |||||
Intangible assets, net |
| 18,355 |
| — |
| 12,142 |
| — |
| 30,497 |
| |||||
Total assets |
| $ | 192,332 |
| $ | — |
| $ | 103,740 |
| $ | (58,998 | ) | $ | 237,074 |
|
|
|
|
|
|
|
|
|
|
|
|
| |||||
Liabilities and stockholders’ equity (deficit) |
|
|
|
|
|
|
|
|
|
|
| |||||
Current liabilities: |
|
|
|
|
|
|
|
|
|
|
| |||||
Accounts payable |
| $ | 15,003 |
| $ | — |
| $ | 1,676 |
| $ | — |
| $ | 16,679 |
|
Accrued telecommunication costs |
| — |
| — |
| 2,161 |
| — |
| 2,161 |
| |||||
Accrued office rent |
| 1,546 |
| — |
| 664 |
| — |
| 2,210 |
| |||||
Accrued interest expense |
| — |
| 399 |
| 1 |
| — |
| 400 |
| |||||
Other accrued expenses |
| 1,478 |
| — |
| 4,848 |
| — |
| 6,326 |
| |||||
Deferred revenue |
| — |
| — |
| 7,826 |
| — |
| 7,826 |
| |||||
Accrued compensation expenses |
| 2,005 |
| — |
| 1,290 |
| — |
| 3,295 |
| |||||
Capital lease obligation, current maturities |
| 553 |
| — |
| 109 |
| — |
| 662 |
| |||||
Discontinued liabilities held for sale |
| — |
| — |
| 1,710 |
| — |
| 1,710 |
| |||||
Total current liabilities |
| 20,585 |
| 399 |
| 20,285 |
| — |
| 41,269 |
| |||||
|
|
|
|
|
|
|
|
|
|
|
| |||||
Long-term liabilities: |
|
|
|
|
|
|
|
|
|
|
| |||||
Other long-term liabilities |
| 811 |
| — |
| — |
| — |
| 811 |
| |||||
Capital lease obligation, less current maturities |
| 4,838 |
| — |
| 134 |
| — |
| 4,972 |
| |||||
Notes payable |
| — |
| 91,447 |
| — |
| — |
| 91,447 |
| |||||
Due to (from) affiliates |
| 199,734 |
| (111,735 | ) | (87,999 | ) | — |
| — |
| |||||
Total liabilities |
| 225,968 |
| (19,889 | ) | (67,580 | ) | — |
| 138,499 |
| |||||
|
|
|
|
|
|
|
|
|
|
|
| |||||
Convertible preferred stock |
| — |
| — |
| — |
| — |
| — |
| |||||
Stockholders’ equity (deficit) |
| (33,636 | ) | 19,889 |
| 171,320 |
| (58,998 | ) | 98,575 |
| |||||
Total liabilities and stockholders’ equity (deficit) |
| $ | 192,332 |
| $ | — |
| $ | 103,740 |
| $ | (58,998 | ) | $ | 237,074 |
|
15
Unaudited Condensed Consolidating Statement of Operations
For the Three Months Ended September 30, 2004
(In Thousands)
|
| Eschelon |
| Eschelon |
| Guarantor |
| Consolidated |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Revenue: |
|
|
|
|
|
|
|
|
| ||||
Network services |
| $ | — |
| $ | — |
| $ | 33,476 |
| $ | 33,476 |
|
Business telephone systems |
| — |
| — |
| 7,086 |
| 7,086 |
| ||||
|
| — |
| — |
| 40,562 |
| 40,562 |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Cost of revenue: |
|
|
|
|
|
|
|
|
| ||||
Network services |
| — |
| — |
| 11,736 |
| 11,736 |
| ||||
Business telephone systems |
| — |
| — |
| 4,305 |
| 4,305 |
| ||||
|
| — |
| — |
| 16,041 |
| 16,041 |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Gross profit: |
|
|
|
|
|
|
|
|
| ||||
Network services |
| — |
| — |
| 21,740 |
| 21,740 |
| ||||
Business telephone systems |
| — |
| — |
| 2,781 |
| 2,781 |
| ||||
|
| — |
| — |
| 24,521 |
| 24,521 |
| ||||
Operating expenses: |
|
|
|
|
|
|
|
|
| ||||
Sales, general and administrative |
| 10,376 |
| — |
| 8,047 |
| 18,423 |
| ||||
Depreciation and amortization |
| 4,891 |
| — |
| 2,602 |
| 7,493 |
| ||||
Total operating expenses |
| 15,267 |
| — |
| 10,649 |
| 25,916 |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Operating income (loss) |
| (15,267 | ) | — |
| 13,872 |
| (1,395 | ) | ||||
Other income (expense) |
| (376 | ) | (2,549 | ) | (5 | ) | (2,930 | ) | ||||
Income (loss) before income taxes |
| (15,643 | ) | (2,549 | ) | 13,867 |
| (4,325 | ) | ||||
Income taxes |
| (4 | ) | — |
| — |
| (4 | ) | ||||
Net income (loss) |
| $ | (15,647 | ) | $ | (2,549 | ) | $ | 13,867 |
| $ | (4,329 | ) |
16
Unaudited Condensed Consolidating Statement of Operations
For the Three Months Ended September 30, 2005
(In Thousands)
|
| Eschelon |
| Eschelon |
| Guarantor |
| Consolidated |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Revenue: |
|
|
|
|
|
|
|
|
| ||||
Network services |
| $ | — |
| $ | — |
| $ | 51,181 |
| $ | 51,181 |
|
Business telephone systems |
| — |
| — |
| 6,731 |
| 6,731 |
| ||||
|
| — |
| — |
| 57,912 |
| 57,912 |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Cost of revenue: |
|
|
|
|
|
|
|
|
| ||||
Network services |
| — |
| — |
| 20,701 |
| 20,701 |
| ||||
Business telephone systems |
| — |
| — |
| 4,093 |
| 4,093 |
| ||||
|
| — |
| — |
| 24,794 |
| 24,794 |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Gross profit: |
|
|
|
|
|
|
|
|
| ||||
Network services |
| — |
| — |
| 30,480 |
| 30,480 |
| ||||
Business telephone systems |
| — |
| — |
| 2,638 |
| 2,638 |
| ||||
|
| — |
| — |
| 33,118 |
| 33,118 |
| ||||
Operating expenses: |
|
|
|
|
|
|
|
|
| ||||
Sales, general and administrative |
| 10,643 |
| — |
| 11,735 |
| 22,378 |
| ||||
Depreciation and amortization |
| 5,666 |
| — |
| 3,345 |
| 9,011 |
| ||||
Total operating expenses |
| 16,309 |
| — |
| 15,080 |
| 31,389 |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Operating income (loss) |
| (16,309 | ) | — |
| 18,038 |
| 1,729 |
| ||||
Other income (expense) |
| (2,978 | ) | (11,695 | ) | 31 |
| (14,642 | ) | ||||
Income (loss) before income taxes |
| (19,287 | ) | (11,695 | ) | 18,069 |
| (12,913 | ) | ||||
Income taxes |
| — |
| — |
| — |
| — |
| ||||
Net income (loss) before discontinued operation |
| (19,287 | ) | (11,695 | ) | 18,069 |
| (12,913 | ) | ||||
Income from discontinued operation, net of tax |
| — |
| — |
| 460 |
| 460 |
| ||||
Net income (loss) |
| $ | (19,287 | ) | $ | (11,695 | ) | $ | 18,529 |
| $ | (12,453 | ) |
17
Unaudited Condensed Consolidating Statement of Operations
For the Nine Months Ended September 30, 2004
(In Thousands)
|
| Eschelon |
| Eschelon |
| Guarantor |
| Consolidated |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Revenue: |
|
|
|
|
|
|
|
|
| ||||
Network services |
| $ | — |
| $ | — |
| $ | 98,333 |
| $ | 98,333 |
|
Business telephone systems |
| — |
| — |
| 19,575 |
| 19,575 |
| ||||
|
| — |
| — |
| 117,908 |
| 117,908 |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Cost of revenue: |
|
|
|
|
|
|
|
|
| ||||
Network services |
| — |
| — |
| 35,093 |
| 35,093 |
| ||||
Business telephone systems |
| — |
| — |
| 11,785 |
| 11,785 |
| ||||
|
| — |
| — |
| 46,878 |
| 46,878 |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Gross profit: |
|
|
|
|
|
|
|
|
| ||||
Network services |
| — |
| — |
| 63,240 |
| 63,240 |
| ||||
Business telephone systems |
| — |
| — |
| 7,790 |
| 7,790 |
| ||||
|
| — |
| — |
| 71,030 |
| 71,030 |
| ||||
Operating expenses: |
|
|
|
|
|
|
|
|
| ||||
Sales, general and administrative |
| 28,430 |
| — |
| 23,519 |
| 51,949 |
| ||||
Depreciation and amortization |
| 14,863 |
| — |
| 7,842 |
| 22,705 |
| ||||
Total operating expenses |
| 43,293 |
| — |
| 31,361 |
| 74,654 |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Operating income (loss) |
| (43,293 | ) | — |
| 39,669 |
| (3,624 | ) | ||||
Other income (expense) |
| (805 | ) | 11,027 |
| (16 | ) | 10,206 |
| ||||
Income (loss) before income taxes |
| (44,098 | ) | 11,027 |
| 39,653 |
| 6,582 |
| ||||
Income taxes |
| (4 | ) | — |
| — |
| (4 | ) | ||||
Net income (loss) |
| $ | (44,102 | ) | $ | 11,027 |
| $ | 39,653 |
| $ | 6,578 |
|
18
Unaudited Condensed Consolidating Statement of Operations
For the Nine Months Ended September 30, 2005
(In Thousands)
|
| Eschelon |
| Eschelon |
| Guarantor |
| Consolidated |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Revenue: |
|
|
|
|
|
|
|
|
| ||||
Network services |
| $ | — |
| $ | — |
| $ | 149,944 |
| $ | 149,944 |
|
Business telephone systems |
| — |
| — |
| 19,422 |
| 19,422 |
| ||||
|
| — |
| — |
| 169,366 |
| 169,366 |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Cost of revenue: |
|
|
|
|
|
|
|
|
| ||||
Network services |
| — |
| — |
| 65,603 |
| 65,603 |
| ||||
Business telephone systems |
| — |
| — |
| 11,914 |
| 11,914 |
| ||||
|
| — |
| — |
| 77,517 |
| 77,517 |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Gross profit: |
|
|
|
|
|
|
|
|
| ||||
Network services |
| — |
| — |
| 84,341 |
| 84,341 |
| ||||
Business telephone systems |
| — |
| — |
| 7,508 |
| 7,508 |
| ||||
|
| — |
| — |
| 91,849 |
| 91,849 |
| ||||
Operating expenses: |
|
|
|
|
|
|
|
|
| ||||
Sales, general and administrative |
| 31,768 |
| — |
| 36,055 |
| 67,823 |
| ||||
Depreciation and amortization |
| 16,354 |
| — |
| 9,938 |
| 26,292 |
| ||||
Total operating expenses |
| 48,122 |
| — |
| 45,993 |
| 94,115 |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Operating income (loss) |
| (48,122 | ) | — |
| 45,856 |
| (2,266 | ) | ||||
Other income (expense) |
| (3,705 | ) | (20,524 | ) | 60 |
| (24,169 | ) | ||||
Income (loss) before income taxes |
| (51,827 | ) | (20,524 | ) | 45,916 |
| (26,435 | ) | ||||
Income taxes |
| — |
| — |
| — |
| — |
| ||||
Net income (loss) before discontinued operation |
| (51,827 | ) | (20,524 | ) | 45,916 |
| (26,435 | ) | ||||
Income from discontinued operation, net of tax |
| — |
| — |
| 571 |
| 571 |
| ||||
Net income (loss) |
| $ | (51,827 | ) | $ | (20,524 | ) | $ | 46,487 |
| $ | (25,864 | ) |
19
7.) Subsequent Event
On August 9, 2005 the Company entered into an agreement with Manhattan Telecommunications Corporation to sell Business Productivity Solutions, Inc. (BPS). BPS is a wholly-owned subsidiary of Eschelon Operating Company and is being accounted for as a discontinued operation held for sale. The transaction closed on October 1, 2005.
20
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking and Cautionary Statements
We make “forward-looking statements” throughout this document. Whenever you read a statement that is not solely a statement of historical fact (such as when we state that we “may,” “will” or “plan to” perform in a certain manner or that we “intend,” “believe,” “expect,” “anticipate,” “estimate” or “project” that an event will occur, or the negative thereof, and other similar statements), you should understand that our expectations may not be correct, although we believe that they are reasonable. You should also understand that our plans may change. We do not guarantee that the events described in this document will happen as described or that any trends noted in this document will continue.
Forward-looking statements, such as those regarding management’s present plans or expectations for new product offerings, capital expenditures, cost-saving strategies and growth are not guarantees of future performance. They involve risks and uncertainties relative to return expectations and related allocation of resources, and changing economic or competitive conditions, as well as the negotiation of agreements with third parties and other factors discussed herein, which could cause actual results to differ from present plans or expectations, and such differences could be material. Similarly, forward-looking statements regarding management’s present expectations for operating results and cash flow involve risks and uncertainties relative to these and other factors, such as the ability to increase revenues and/or to achieve cost reductions and other factors discussed herein, which also would cause actual results to differ from present plans. Such differences could be material. All forward-looking statements attributable to us or by any persons acting on our behalf are expressly qualified in their entirety by these cautionary statements.
As such, actual results or circumstances may vary materially from such forward-looking statements or expectations. Readers are also cautioned not to place undue reliance on these forward-looking statements which speak only as of the date these statements were made. Except as required by law, we do not have any obligation to update these forward-looking statements, even if our situation changes in the future.
Company Overview
We are a leading facilities-based provider of voice and data services and business telephone systems in 19 markets in the western United States. As a facilities-based competitive communications services provider, we provide services to our customers primarily through our own network of owned telecommunications switches and related equipment and primarily leased telecommunications lines, or transport. We target the small and medium-sized business segment and currently serve over 50,000 customers, primarily within the local service territory of Qwest. We believe that we are either the first or second largest competitive communications services provider targeting the small and medium-sized business segment, with an estimated range of 6% to 15% of the market share in each of our markets, based on internally derived market share data as of April 28, 2005.
We measure our operational performance using a variety of indicators including revenue growth, the percentage of our revenue that comes from customers that we serve on-switch, gross margin percentage, operating expenses as a percentage of revenue and access line churn rates. We monitor key operating and customer service metrics to improve customer service, maintain the quality of our network and reduce costs.
ATI generated approximately $59.3 million of revenue in 2004. Through this acquisition, we strengthened our presence in six of the markets we already served, entered into six adjacent markets, entered into one new market and created significant opportunities for cost savings and increased profitability. By combining our businesses, we have been able to achieve a size and scale that we believe will provide us with a competitive advantage in our markets and significant opportunities for cost savings and improved cash flow. We are in the process of integrating ATI’s operational, financial and support systems with ours. We expect that ATI will be substantially integrated by the end of 2005.
The telecommunications industry is highly competitive. We believe we compete principally by offering superior customer service, accurate billing, a broad set of services and systems and competitive pricing. We compete with the Regional Bell Operating Companies (RBOCs), other competitive communications services providers, and long distance and data service providers. While we compete with wireless providers to a limited extent, we do not believe they are a competitive threat in the market, nor are they likely to be in the near future, because of the different service standards that business customers require.
21
Key Components of Results of Operations
Revenue. Network services revenue consists primarily of local dial tone, switched access lines, long distance, access charges and data service. Revenue from local telephone service consists of charges for basic local service, including dedicated T1 access, and custom-calling features such as call waiting and call forwarding. Revenue from long distance service consists of per-minute-of-use charges for a full range of traditional switched and dedicated long distance, toll-free calling, international, calling card and operator services. Carrier access revenue consists primarily of usage charges that we bill long distance carriers to originate and terminate calls to and from our customers. In addition, in some of our markets we currently charge other local exchange carriers usage charges to originate and terminate local calls to and from certain customers (otherwise known as reciprocal compensation). Revenue from data services consists primarily of monthly usage fees for Internet access services. We typically commit our customers to contracts ranging from one to three years and provide discounts for longer terms. Network services comprised 88.5% of our revenue for the nine months ended September 30, 2005 revenue and represents a predominantly recurring revenue stream.
Monthly recurring network services revenue is recognized in the month the services are used. In the case of local service revenue, monthly recurring local services charges are billed in advance but accrued for and recognized on a prorated basis based on length of service in any given month. Non-recurring revenues from network services are recognized over the average life of the customers. Long distance and access charges are billed in arrears but accrued based on monthly average usage. We have a small amount of revenues from reciprocal compensation due to our bill-and-keep arrangements with Qwest. Under a bill-and-keep arrangement with another carrier, we have a reciprocal agreement whereby we do not pay the other carrier to complete our customers’ local calls to their customers and vice versa. While we currently bill approximately $0.3 million in annual revenue from reciprocal compensation from Qwest and SBC Communications Inc. related to ATI customers, we are evaluating whether to seek a bill-and-keep arrangement with Qwest and /or SBC for the ATI traffic. We do not have any wholesale revenue other than access revenue and this reciprocal compensation.
Business telephone systems revenue consists of revenue from the sale of telephone equipment and the servicing of telephone equipment systems. Telephone equipment revenue is recognized upon delivery, completion of the installation and acceptance by the customer. Business telephone systems revenue is recognized upon completion of service or, in the case of maintenance agreements, is spread equally over the life of the maintenance contract, which typically ranges from one to two years.
Cost of Revenue. Our network services cost of revenue consists primarily of the cost of operating and maintaining our network facilities. The network components for our facilities-based business include the cost of:
• leasing local loops and digital T1 lines that connect our customers to our network;
• leasing high capacity digital lines that connect our switching equipment to our colocations;
• leasing high capacity digital lines that interconnect our network with the RBOCs;
• leasing space in the RBOC central offices for colocating our equipment;
• signaling system network connectivity;
• leasing our ATM long-haul Internet backbone network; and
• Internet transit and peering, which is the cost of delivering Internet traffic from our customers to the public Internet.
The costs to lease local loops, digital T1 lines and high capacity digital interoffice facilities from the RBOCs vary by carrier and by state and are regulated under federal and state laws. In virtually all areas, we lease local loops, T1 lines and interoffice transport facilities from the RBOCs. We lease interoffice transport facilities from carriers other than the RBOCs where possible in order to lower costs and improve network redundancy; however, in most cases, the RBOCs are our only source for local loops and T1 lines. Prior to January 2005, we purchased, on a wholesale or negotiated basis, unbundled network elements platform, or UNE-P, and customized network element packages, or UNE-E, from Qwest. We entered into a three-year agreement in
22
January 2005 with Qwest for the provision of their Platform Plus, or QPP, product which replaced UNE-P and UNE-E. The UNE-P and UNE-E agreements were terminated with the adoption of the QPP agreement, and all UNE-E and UNE-P lines were moved to QPP on January 1, 2005.
Our network services cost of revenue also includes the fees we pay for long distance, data and other services. We have entered into long-term wholesale purchasing agreements for these services. Some of these agreements, including our agreement with MCI, also contain significant termination penalties and/or minimum usage volume commitments. In the event we fail to meet these minimum volume commitments, we may be obligated to pay underutilization charges. We do not anticipate having to pay any underutilization charges in the foreseeable future.
We carefully review all of our vendor invoices and frequently dispute inaccurate or inappropriate charges. In cases where we dispute certain charges, we frequently pay only undisputed amounts on vendor invoices in order to pay proper amounts owed. Our single largest vendor is Qwest, to which we paid $34.4 million for the nine months ended September 30, 2005. We use significant estimates to determine the level of success in dispute resolution and consider past historical experience, basis of dispute and current relationship with vendors and aging of prior disputes in quantifying our estimates.
We account for all of our network depreciation in depreciation and amortization expense and do not have any depreciation expense in cost of revenue.
Our most significant business telephone systems costs of revenue are the equipment purchased from manufacturers and labor for service and equipment installation. To take advantage of volume purchase discounts, we purchase equipment primarily from three manufacturers pursuant to master purchase agreements we have with these manufacturers. For all business telephone systems installations, our policy is to require a 30% deposit before ordering the equipment so our risk of excess inventory or inventory obsolescence is low. Business telephone systems cost of revenue also includes salaries and benefits of field technicians as well as vehicle and incidental expenses associated with equipment installation, maintenance and service provisioning.
Sales, General and Administrative. Sales, general and administrative expenses are comprised primarily of salaries and benefits, bonuses, commissions, occupancy costs, sales and marketing expenses, bad debt, billing and professional services.
Determining our allowance for doubtful accounts receivable requires significant estimates. We consider two primary factors in determining the proper level of the allowance, including historical collections experience and the aging of the accounts receivable portfolio. We perform a rigorous credit review process on each new customer that involves reviewing the customer’s current service provider bill and payment history, matching customers with the National Telecommunications Data Exchange database for delinquent customers and, in some cases, requesting credit reviews through Dun and Bradstreet. For each of the nine months ended September 30, 2004 and 2005, our bad debt expense as a percentage of revenue was 0.4%.
Depreciation and Amortization. Our depreciation and amortization expense currently includes depreciation for network related voice and data equipment, back office systems, furniture, fixtures, leasehold improvements, office equipment and computers. All internal costs directly related to the expansion of our network and operating and support systems, including salaries of certain employees, are capitalized and depreciated over the lives of the switches or systems, as the case may be. Capitalized customer installation costs are amortized over the approximate average life of a customer, which is currently 48 months. Detailed annual time studies are used to determine labor capitalization. These time studies are based on employee time sheets for those engaged in capitalizable activities.
23
Results of Operations
Subsequent to our announcement of operating results on November 2, 2005, we revised our previously reported results of operations for the three and nine months ended September 30, 2005. The change is the result of writing off a proportionate amount of our debt issuance costs in connection with the redemption of 35% of our outstanding senior second secured notes on September 15, 2005. As a result, we recorded $2.6 million of non-cash interest expense which increased interest expense to $14.8 million and $24.6 million in the three and nine months ended September 30, 2005, respectively, and our net loss to $12.5 million and $25.9 million for the three and nine months ended September 30, 2005, respectively.
Selected consolidated financial and operating data for the three and nine-month periods ended September 30, 2004 and 2005 is as follows (dollars in thousands, except per unit amounts):
|
| Three months ended September 30, |
| Nine months ended September 30, |
| ||||||||||||
|
| 2004 |
| 2005 |
| % Change |
| 2004 |
| 2005 |
| % Change |
| ||||
|
| (unaudited) |
| (unaudited) |
|
|
| (unaudited) |
| (unaudited) |
|
|
| ||||
Total revenue |
| $ | 40,562 |
| $ | 57,912 |
| 42.8 | % | $ | 117,908 |
| $ | 169,366 |
| 43.6 | % |
Total gross margin (%) |
| 60.5 | % | 57.2 | % | (5.4 | )% | 60.2 | % | 54.2 | % | (10.0 | )% | ||||
Capital expenditures |
| $ | 6,616 |
| $ | 8,697 |
| 31.5 | % | $ | 20,445 |
| $ | 27,063 |
| 32.4 | % |
Cash, restricted cash and available-for-sale securities |
| $ | 19,420 |
| $ | 30,824 |
| 58.7 | % | $ | 19,420 |
| $ | 30,824 |
| 58.7 | % |
|
|
|
|
|
|
|
|
|
|
|
|
|
| ||||
Voice lines in service |
| 167,263 |
| 265,132 |
| 58.5 | % | 167,263 |
| 265,132 |
| 58.5 | % | ||||
Data lines in service |
| 70,165 |
| 140,744 |
| 100.6 | % | 70,165 |
| 140,744 |
| 100.6 | % | ||||
Total lines in service |
| 237,428 |
| 405,876 |
| 70.9 | % | 237,428 |
| 405,876 |
| 70.9 | % | ||||
Percent of lines on switch |
| 79.2 | % | 84.6 | % | 6.8 | % | 79.2 | % | 84.6 | % | 6.8 | % | ||||
Lines sold |
| 23,076 |
| 29,043 |
| 25.9 | % | 65,312 |
| 82,318 |
| 26.0 | % | ||||
Average monthly access line churn |
| 1.54 | % | 1.20 | % | (22.6 | )% | 1.54 | % | 1.36 | % | (11.4 | )% | ||||
Average monthly network services revenue per line |
| $ | 47.92 |
| $ | 42.31 |
| (11.7 | )% | $ | 49.10 |
| $ | 42.37 |
| (13.7 | )% |
|
|
|
|
|
|
|
|
|
|
|
|
|
| ||||
Total employees |
| 933 |
| 1,109 |
| 18.8 | % | 933 |
| 1,109 |
| 18.8 | % | ||||
Quota-carrying network service salespeople |
| 165 |
| 191 |
| 15.8 | % | 165 |
| 191 |
| 15.8 | % | ||||
Quota-carrying BTS salespeople |
| 37 |
| 39 |
| 5.4 | % | 37 |
| 39 |
| 5.4 | % | ||||
Total quota-carrying salespeople |
| 202 |
| 230 |
| 13.9 | % | 202 |
| 230 |
| 13.9 | % |
Three Months Ended September 30, 2005 Compared to Three Months Ended September 30, 2004
Revenue. Revenue for the three months ended September 30, 2004 and 2005 is as follows:
|
| 2004 |
| 2005 |
| % Change |
| ||
|
| (unaudited) |
| (unaudited) |
|
|
| ||
Revenue (in millions): |
|
|
|
|
|
|
| ||
Voice and data services |
| $ | 25.0 |
| $ | 39.0 |
| 55.8 | % |
Long distance |
| 5.4 |
| 8.8 |
| 63.9 | % | ||
Access |
| 3.1 |
| 3.4 |
| 10.4 | % | ||
Total network services |
| 33.5 |
| 51.2 |
| 52.9 | % | ||
Business telephone systems |
| 7.1 |
| 6.7 |
| (5.0 | )% | ||
Total revenue |
| $ | 40.6 |
| $ | 57.9 |
| 42.8 | % |
Network services revenue was $51.2 million for the three months ended September 30, 2005, an increase of 52.9% from $33.5 million in the same period of 2004. The increase in revenue was primarily due to the inclusion of ATI, which was acquired on December 31, 2004. Over the past 12 months the number of voice lines in service increased by 58.5% to 265,132 at September 30, 2005 and the number of data lines in service increased by 100.6% to 140,744 at September 30, 2005. The growth in access lines was partially offset by declines in pre-subscribed interexchange carrier charge (PICC) revenue, access revenue per minute of use and a decline in data revenue per line. The decline in PICC revenue was due to
24
our dispute with Global Crossing which was resolved in June, 2005. As a result of that dispute, we elected not to record PICC revenue beginning in November 2004. The PICC revenue impact was approximately $0.8 million for the three months ended September 30, 2005 as compared to the three months ended September 30, 2004. Access revenue per minute of use declined as a result of the scheduled FCC reduction of interstate rate levels in June 2004. Data revenue per line declined due to a combination of customers purchasing more bandwidth at discounted prices and general pricing pressures for data services in our markets. We expect all of the above trends in line growth, PICC revenue, access rates and data revenue per line to continue for the foreseeable future. As we continue to grow, our size and average monthly access line churn will begin to limit our access line growth rate on both an absolute and a percentage basis unless we increase our sales force and extend our network footprint.
Business telephone systems (BTS) revenue was $6.7 million for the three months ended September 30, 2005, a decrease of 5.0% from $7.1 million in the same period of 2004. The decrease in revenue was primarily due to a decrease in revenue from new systems. We cannot predict future trends in capital spending by small and medium-sized business customers which drives our BTS revenue.
Cost of Revenue. Cost of revenue for the three months ended September 30, 2004 and 2005 is as follows:
|
| 2004 |
| 2005 |
| % Change |
| ||
|
| (unaudited) |
| (unaudited) |
|
|
| ||
Cost of revenue (in millions): |
|
|
|
|
|
|
| ||
Network services |
| $ | 11.7 |
| $ | 20.7 |
| 76.4 | % |
Business telephone systems |
| 4.3 |
| 4.1 |
| (4.9 | )% | ||
Total cost of revenue |
| $ | 16.0 |
| $ | 24.8 |
| 54.6 | % |
Network services cost of revenue was $20.7 million for the three months ended September 30, 2005, an increase of 76.4% from $11.7 million in the same period of 2004. The increase was primarily due to the inclusion of ATI. As a percentage of related revenue, network services cost of revenue for the three months ended September 30, 2005 increased to 40.4% from 35.1% for the same period of 2004.
BTS cost of revenue was $4.1 million for the three months ended September 30, 2005, a decrease of 4.9% from $4.3 million in the same period of 2004. Materials cost decreased due in part to lower new systems sales in the three months ended September 30, 2005 from the same period of 2004. As a percentage of related revenue, BTS cost of revenue for each of the three-month periods ended September 30, 2004 and 2005 was 60.8%. We do not expect future improvements in BTS cost of revenue as a percentage of related revenue unless we are able to significantly increase BTS new systems sales and therefore achieve greater volume discounts or economies of scale in our workforce.
Gross Profit. Gross profit for the three months ended September 30, 2004 and 2005 is as follows:
|
| 2004 |
| 2005 |
| % Change |
| ||
|
| (unaudited) |
| (unaudited) |
|
|
| ||
Gross profit (in millions): |
|
|
|
|
|
|
| ||
Network services |
| $ | 21.7 |
| $ | 30.5 |
| 40.2 | % |
Business telephone systems |
| 2.8 |
| 2.6 |
| (5.1 | )% | ||
Total gross profit |
| $ | 24.5 |
| $ | 33.1 |
| 35.1 | % |
The increase in gross profit for the three months ended September 30, 2005, from the same period of 2004, is primarily due to the inclusion of ATI.
Sales, General and Administrative Expense. Sales, general and administrative expenses were $22.4 million for the three months ended September 30, 2005, an increase of 21.5% from $18.4 million in the same period of 2004. This increase was primarily due to the inclusion of sales, general and administrative expenses of ATI. As a percentage of revenue, sales, general and administrative expenses for the three months ended September 30, 2005 declined to 38.6% from 45.4% in the same period of 2004 due to the improved efficiency of our existing operations resulting from our fixed cost structure supporting a higher level of revenue. We expect this trend to continue as we add more access lines with only modest increases in our employee base.
25
Depreciation and Amortization. Depreciation and amortization expense was $9.0 million for the three months ended September 30, 2005, an increase of 20.2% from $7.5 million in the same period of 2004. This increase was primarily due to the inclusion of ATI. As a percentage of revenue, depreciation and amortization decreased to 15.6% for the three months ended September 30, 2005 from 18.5% for the same period of 2004.
Interest. Interest expense was $14.8 million for the three months ended September 30, 2005, an increase of 421.6% from $2.8 million in the same period of 2004. On September 15, 2005, we redeemed 35% of our then outstanding 8 3/8% senior second secured notes due 2010 at a redemption price of 112% of the accreted value. Interest expense for the three months ended September 30, 2005 includes a $6.1 million accreted-value premium and a $1.5 million original-issue discount catch-up paid upon redemption of the notes and $2.6 million of non-cash interest expense for the write-off of a proportionate amount of debt issuance costs. The remaining increase was primarily due to higher interest expense as a result of having a higher average outstanding debt balance for the three months ended September 30, 2005 compared to the three months ended September 30, 2004.
Net Income (Loss). Net loss for the three months ended September 30, 2005 was $12.5 million compared to a net loss of $4.3 million in the same period of 2004. This increase in net loss is primarily due to additional interest expense mentioned above.
Nine Months Ended September 30, 2005 versus Nine Months Ended September 30, 2004
Revenue. Revenue for the nine months ended September 30, 2004 and 2005 is as follows:
|
| 2004 |
| 2005 |
| % Change |
| ||
|
| (unaudited) |
| (unaudited) |
|
|
| ||
Revenue (in millions): |
|
|
|
|
|
|
| ||
Voice and data services |
| $ | 72.6 |
| $ | 114.1 |
| 57.1 | % |
Long distance |
| 16.0 |
| 26.0 |
| 62.7 | % | ||
Access |
| 9.7 |
| 9.8 |
| 0.8 | % | ||
Total network services |
| 98.3 |
| 149.9 |
| 52.5 | % | ||
Business telephone systems |
| 19.6 |
| 19.4 |
| (0.8 | )% | ||
Total revenue |
| $ | 117.9 |
| $ | 169.3 |
| 43.6 | % |
Network services revenue was $149.9 million for the nine months ended September 30, 2005, an increase of 52.5% from $98.3 million in the same period of 2004. The increase in revenue was primarily due to the inclusion of ATI, which was acquired on December 31, 2004. Over the past 12 months the number of voice lines in service increased by 58.5% to 265,132 at September 30, 2005 and the number of data lines in service increased by 100.6% to 140,744 at September 30, 2005. The growth in access lines was partially offset by declines in pre-subscribed interexchange carrier charge (PICC) revenue, access revenue per minute of use and a decline in data revenue per line. The decline in PICC revenue was due to our dispute with Global Crossing which was resolved in June, 2005. As a result of that dispute, we elected not to record PICC revenue beginning in November 2004. The PICC revenue impact was approximately $2.4 million for the nine months ended September 30, 2005 as compared to the nine months ended September 30, 2004. Access revenue per minute of use declined as a result of the scheduled FCC reduction of interstate rate levels in June 2004. Data revenue per line declined due to a combination of customers purchasing more bandwidth at discounted prices and general pricing pressures for data services in our markets. We expect all of the above trends in line growth, PICC revenue, access rates and data revenue per line to continue for the foreseeable future. As we continue to grow, our size and average monthly access line churn will begin to limit our access line growth rate on both an absolute and a percentage basis unless we increase our sales force and extend our network footprint.
BTS revenue was $19.4 million for the nine months ended September 30, 2005, a decrease of 0.8% from $19.6 million in the same period of 2004. We cannot predict future trends in capital spending by small and medium-sized business customers.
26
Cost of Revenue. Cost of revenue for the nine months ended September 30, 2004 and 2005 is as follows:
|
| 2004 |
| 2005 |
| % Change |
| ||
|
| (unaudited) |
| (unaudited) |
|
|
| ||
Cost of revenue (in millions): |
|
|
|
|
|
|
| ||
Network services |
| $ | 35.1 |
| $ | 65.6 |
| 86.9 | % |
Business telephone systems |
| 11.8 |
| 11.9 |
| 1.1 | % | ||
Total cost of revenue |
| $ | 46.9 |
| $ | 77.5 |
| 65.4 | % |
Network services cost of revenue was $65.6 million for the nine months ended September 30, 2005, an increase of 86.9% from $35.1 million in the same period of 2004. The increase was primarily due to the inclusion of ATI and recording approximately $4.7 million in costs related to the settlement with Global Crossing in June 2005. As a percentage of related revenue, network services cost of revenue for the nine months ended September 30, 2005 was 43.8% compared to 35.7% for the same period of 2004.
BTS cost of revenue was $11.9 million for the nine months ended September 30, 2005, an increase of 1.1% from $11.8 million in the same period of 2004. As a percentage of related revenue, BTS cost of revenue for the nine months ended September 30, 2005 increased to 61.3% from 60.2% for the same period of 2004. We do not expect future improvements in BTS cost of revenue as a percentage of related revenue unless we are able to significantly increase BTS new systems sales and therefore achieve greater volume discounts or economies of scale in our workforce.
Gross Profit. Gross profit for the nine months ended September 30, 2004 and 2005 is as follows:
|
| 2004 |
| 2005 |
| % Change |
| ||
|
| (unaudited) |
| (unaudited) |
|
|
| ||
Gross profit (in millions): |
|
|
|
|
|
|
| ||
Network services |
| $ | 63.2 |
| $ | 84.3 |
| 33.4 | % |
Business telephone systems |
| 7.8 |
| 7.5 |
| (3.6 | )% | ||
Total gross profit |
| $ | 71.0 |
| $ | 91.8 |
| 29.3 | % |
The increase in gross profit for the nine months ended September 30, 2005, from the same period of 2004, is primarily due to the inclusion of ATI which was partially offset by approximately $4.7 million in costs related to the settlement with Global Crossing in June 2005.
Sales, General and Administrative Expense. Sales, general and administrative expenses were $67.8 million for the nine months ended September 30, 2005, an increase of 30.6% from $51.9 million in the same period of 2004. This increase was primarily due to the inclusion of sales, general and administrative expenses of ATI. As a percentage of revenue, sales, general and administrative expenses for the nine months ended September 30, 2005 declined to 40.0% from 44.1% in the same period of 2004 due to the improved efficiency of our existing operations resulting from our fixed cost structure supporting a higher level of revenue. We expect this trend to continue as we add more access lines with only modest increase in our employee base.
Depreciation and Amortization. Depreciation and amortization expense was $26.3 million for the nine months ended September 30, 2005, an increase of 15.8% from $22.7 million in the same period of 2004. This increase was primarily due to the inclusion of ATI. As a percentage of revenue, depreciation and amortization decreased to 15.5% for the nine months ended September 30, 2005 from 19.3% for the same period of 2004.
Interest. Interest expense was $24.6 million for the nine months ended September 30, 2005, an increase of 211.1% from $7.9 million in the same period of 2004. On September 15, 2005, we redeemed 35% of our then outstanding 8 3/8% senior second secured notes due 2010 at a redemption price of 112% of the accreted value. Interest expense for the nine months ended September 30, 2005 includes a $6.1 million accreted-value premium and a $1.5 million original-issue discount catch-up paid upon redemption of the notes and $2.6 million of non-cash interest expense for the write-off of a proportionate amount of debt issuance costs. The remaining increase was primarily due to higher
27
interest expense as a result of having a higher average outstanding debt balance for the nine months ended September 30, 2005 compared to the nine months ended September 30, 2004.
Net Income (Loss). Net loss for the nine months ended September 30, 2005 was $25.9 million compared to net income of $6.6 million in the same period of 2004. Net income for the nine months ended September 30, 2004 included a gain on extinguishment of debt of $18.2 million. The gain on the extinguishment of debt was the result of paying off our bank facility. In June 2002, we restructured our bank facility and because the future cash flows could not be calculated with certainty, the gain was deferred. As a result of the repayment, the excess carrying value of $20.9 million and debt issuance costs of $2.7 million resulted in the $18.2 million gain on extinguishment of debt. Net income also decreased due to recording approximately $4.7 million in costs related to the settlement with Global Crossing in June 2005 and the additional interest expense mentioned above.
Liquidity and Capital Resources
Principal Sources and Uses of Liquidity. Our principal sources of liquidity are cash from operations and our cash and cash equivalents and available-for-sale securities. Our principal liquidity requirements consist of debt service, capital expenditures and working capital.
Cash Flows Provided by Operating Activities. Cash provided by operating activities was $3.9 million for the nine months ended September 30, 2005 compared to cash provided by operating activities of $15.1 million for the same period of 2004. The decrease in cash provided by operating activities was primarily due to the additional interest expense paid upon redemption of 35% our senior second secured notes and due to the increase in cost of revenue related to the settlement with Global Crossing in June 2005.
Cash Flows Used in Investing Activities. Cash used in investing activities was $33.7 million for the nine months ended September 30, 2005 compared to $22.9 million for the same period of 2004. The cash used in investing activities was for the maintenance and expansion of our network and back office systems and for the investment in available-for-sale securities with maturity dates of less than twelve months.
Cash Flows Provided by Financing Activities. Cash provided by financing activities was $17.5 million for the nine months ended September 30, 2005. The initial public offering of our common stock on August 9, 2005 generated approximately $68.4 million after deducting underwriting discounts and commissions and fees and expenses associated with the offering. A portion of the net proceeds was used to redeem approximately $50.6 million accreted value ($57.8 million principal amount) of our 8 3/8% senior second secured notes on September 15, 2005. We also used cash for payments on capital lease obligations and for debt issuance costs.
For the nine months ended September 30, 2004, net cash provided by financing activities was $13.6 million. The net proceeds from the issuance of the senior second secured notes in March 2004 generated approximately $13.2 million, which is net of a $1.6 million prepayment penalty. We also used cash for payments on capital lease obligations and for debt issuance costs.
Capital Requirements. For the nine months ended September 30, 2005, we spent $27.1 million on capital expenditures. We expect to spend approximately $40.0 million on capital expenditures in 2005.
Based on our current level of operations and anticipated growth, we believe that our existing cash, cash equivalents and short-term investments will be sufficient to fund our operations and we do not currently anticipate the need to raise additional financing to fund capital expenditures or operations for at least the next 12 months.
28
Item 3. Quantitative and Qualitative Disclosures About Market Risk
We are not exposed to market risks from changes in foreign currency exchange rates or commodity prices. We do not hold any derivative financial instruments nor do we hold any securities for trading or speculative purposes.
We are exposed to changes in interest rates on our investments in cash equivalents and short-term investments. All of our investments have maturities of less than twelve months which reduces our exposure to long-term interest rate changes. Interest income for the three and nine-month periods ended September 30, 2005 was $0.3 million and $0.5 million, respectively, therefore not exposing us to any meaningful interest income risk had rates dropped. We had $91.4 million in senior second secured notes outstanding as of September 30, 2005. These notes are at a fixed interest rate and are therefore not exposed to any interest rate risk.
Item 4: Controls and Procedures
Evaluation of disclosure controls and procedures. Our management, under the direction and with the participation of Richard A. Smith, our President and Chief Executive Officer, and Geoffrey M. Boyd, our Chief Financial Officer, performed an evaluation of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15 under the Securities Exchange Act of 1934). Based on that evaluation, Messers. Smith and Boyd concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective in alerting them timely to material information relating to our company (including our consolidated subsidiaries) required to be included in our periodic Exchange Act filings.
Changes in internal controls over financial reporting. During the quarter ended September 30, 2005, there have been no changes in our internal controls over financial reporting that materially affected, or are reasonably likely to materially affect, our reported financial results.
29
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
There are no material developments since the second quarter Form 10-Q was filed on August 15, 2005.
We are party from time to time to ordinary course disputes that we do not believe to be material.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
We relied upon Rule 701 promulgated under the Securities Act to issue the following securities:
On July 1, 2005, we issued to an accredited investor, under the Eschelon Telecom, Inc. Stock Option Plan of 2002, 494 shares of restricted common stock.
On July 1, 2005, we granted to 56 participants, under the Eschelon Telecom, Inc. Stock Option Plan of 2002, options to purchase an aggregate of 7,218 shares of common stock, at an exercise price of $6.77 per share. These options generally vest 20% upon the initial grant and 20% per year over four years from the date of grant.
On August 18, 2005, we granted to 662 participants, under the Eschelon Telecom, Inc. Stock Option Plan of 2002, options to purchase an aggregate of 180,652 shares of common stock, at an exercise price of $12.19 per share. These options generally vest 20% upon the initial grant and 20% per year over four years from the date of grant.
On August 18, 2005, we granted to a member of the board of directors, under the Eschelon Telecom, Inc. Stock Option Plan of 2002, options to purchase an aggregate of 15,000 shares of common stock, at an exercise price of $12.19 per share. These options vest 33 1/3% upon the initial grant and 33 1/3% per year over two years from the date of grant.
On August 4, 2005, the Securities and Exchange Commission declared effective our Registration Statement on Form S-1 (File No. 333-124703). The offering date was August 9, 2005. The offering has terminated and all of the securities registered have been sold. The managing underwriters were Lehman Brothers, Jefferies & Company, Inc. and UBS Investment Bank. Our registration was for 5,357,143 shares of our common stock, par value $0.01 per share. We sold 5,357,143 shares for $14.00 per share, generating approximately $75.0 million in gross proceeds for us. After deducting underwriting discounts and commissions of $5.3 million and $2.2 million for estimated fees and expenses associated with the offering, our net proceeds are approximately $67.6 million. None of the payments for underwriting discounts and commissions and other transaction expenses represented direct or indirect payment to any of our directors, officers, persons owning 10% or more of any class of our equity securities or other affiliates.
From the effective date of the registration statement through September 30, 2005, the following table identifies the purposes and approximate amounts of the net proceeds paid directly or indirectly to others (dollars in millions):
Redemption of 8 3/8% senior second secured notes due March 15, 2010 |
| $ | 56.7 |
|
Total use of net proceeds through September 30, 2005 |
| $ | 56.7 |
|
Item 3. Defaults Upon Senior Securities
None.
Item 4. Submission of Matters to a Vote of Security Holders
On July 1, 2005, pursuant to written consent, the Company’s stockholders approved the following matters by the vote indicated below:
(i) Reverse stock split of the Company’s common stock.
FOR |
| AGAINST |
| ABSTAIN |
|
7,972,417 |
| 4,269 |
| 331,800 |
|
30
(ii) Adoption of the Company’s seventh amended and restated certificate of incorporation.
FOR |
| AGAINST |
| ABSTAIN |
|
7,971,278 |
| 4,416 |
| 332,792 |
|
(iii) Adoption of the amended and restated bylaws of the Company.
FOR |
| AGAINST |
| ABSTAIN |
|
7,972,802 |
| 4,406 |
| 331,278 |
|
(iv) Approval of the form of indemnification agreement for the Company’s directors.
FOR |
| AGAINST |
| ABSTAIN |
|
7,969,650 |
| 4,406 |
| 334,430 |
|
None.
31
Exhibit |
| Description |
31.1 |
| Certification by Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
31.2 |
| Certification by Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
32.1 |
| Certification by Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
32.2 |
| Certification by Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
32
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.
| Eschelon Telecom, Inc. | ||
|
|
| |
Date: November 14, 2005 | By: | /S/ Geoffrey M. Boyd |
|
|
|
| |
| Name: | Geoffrey M. Boyd | |
| Title: | Chief Financial Officer | |
|
| (Principal Financial and |
33