or 29% from $0.6 million for the three months ended June 30, 2005 to $0.7 million for the three months ended June 30, 2006, due to an increase in marketing efforts.
General and administrative expense includes finance, legal and other corporate costs, as well as the salaries and related employee benefits for those employees that support such functions, excluding the costs related to development and deployment of the next generation integrated satellite-terrestrial network. General and administrative expenses for the three months ended June 30, 2006 were $3.4 million compared to $4.1 million for the three months ended June 30, 2005, a decrease of $0.7 million, or 16%. Equity-based compensation expense decreased by $0.6 million, primarily due to the effect of the modification of certain Directors’ options, which was recorded during the three months ended June 30, 3005. In addition, there was a $0.1 million decline in legal fees.
Depreciation and amortization expense consists of the depreciation of property and equipment and the amortization of our intangible assets. Our intangible assets and goodwill arose primarily as a result of our 2001 acquisition of the Motient and TMI satellite businesses. Depreciation and amortization expense for the three months ended June 30, 2006 was $3.3 million compared to $3.7 million in the three months ended June 30, 2005, a decrease of $0.4 million as a result of certain assets being fully depreciated in the three months ending June 30, 2006.
Interest expense is comprised of the interest paid on our vendor note payable, and amortization of the discount and debt issuance costs on our senior secured discount notes. Interest expense for the three months ended June 30, 2006 increased to $15.0 million from $30,000 for the three months ended June 30, 2005, which was primarily the result of the issuance of senior secured discount notes on March 30, 2006. We expect that our interest expense, and therefore net loss, will continue to increase in 2006 and thereafter based on the accretion.
Interest income relates to interest we earn on cash, cash equivalents, restricted cash and short-term investments. Interest income for the three months ended June 30, 2006 increased to $6.4 million from $0.8 million for the three months ended June 30, 2005, an increase of $5.4 million. This increase was due to interest earned on funds received from issuing senior secured discount notes in March 2006 and to a lesser extent, improved yields on investments.
In connection with the distribution of our equity interests in TerreStar to our limited partners, we entered into a Management Services & Shared Facilities Agreement, whereby we and TerreStar agreed to provide each other with certain management-related services and other services incident thereto, including, but not limited to, shared intellectual property development, assistance with general management activities, the provision of personnel, as needed, to carry out such general management activities as well as access to our respective facilities and services related thereto. The agreement may be terminated by either party with respect to any service upon 60 days' written notice to the other party. The party receiving any services is obligated to reimburse the providing party for all costs of any services provided, including the portion of employee time associated with the services. For the three months ended June 30, 2006, we recognized $0.4 million of revenue related to services provided to TerreStar under this agreement as compared to $0.6 million of revenue for the three months ended June 30, 2005. The decrease was due to a lower level of research and development activity during the current period and a reduction of management-related services and fees.
Loss from Discontinued Operations
The results of operations of TerreStar, which was spun-off in May 2005 as described above, are reflected in loss from discontinued operations. Loss from discontinued operations was $0.7 million for the three months ended June 30, 2005.
Six months ended June 30, 2006 compared to the six months ended June 30, 2005
Revenues
Revenues for the six months ended June 30, 2006 increased to $17.5 million from $14.7 million for the six months ended June 30, 2005, an increase of $2.8 million, or 19%, due to an increase in equipment sales of $2.8 million resulting from the completion and availability of our new G2 terminal.
Operating Expenses
Satellite Operations and Cost of Services
Operations costs for the six months ended June 30, 2006 were $10.8 million compared to $7.3 million for the six months ended June 30, 2005, an increase of $3.5 million or 47%. This increase was primarily the result of a $2.6 million increase for cost of equipment sold, due to an increase in equipment sales. Employee related expenses increased $1.1 million due to an increase in staffing. Facility and general expenses increased by $0.6 million primarily due to our increased rent expense for our expanded headquarters in Reston, and to a lesser extent, due to increased staffing. Offsetting these increases was a reduction of $0.9 million for telemetry, tracking and control and network maintenance expenses.
Next Generation Expenditures
Next generation expenditures relate to the development and deployment of a next generation integrated satellite-terrestrial network. Next generation expenses increased $2.1 million or 25% to $10.7 million for the six months ended June 30, 2006 from $8.6 million for the six months ended June 30, 2005. During the six months ended June 30, 2006, employee related expenses increased by $1.0 million due to increased staffing. Legal and regulatory expenses increased $2.4 million of which $2.3 million relates to the write-off of our performance bond with the FCC as a result of the relinquishment of our satellite license and patent costs increased by $0.8 million. These increases were offset by a reduction of research and development expenses by $2.0 million.
Sales and Marketing
Sales and marketing costs increased $0.1 million or 12% from $1.3 million for the six months ended June 30, 2005 to $1.4 million for the six months ended June 30, 2006, due to an increase in marketing efforts.
General and Administrative Expense
General and administrative expenses for the six months ended June 30, 2006 were $9.8 million compared to $8.9 million for the six months ended June 30, 2005, an increase of $0.9 million, or 10%. Equity-based compensation expense increased by $1.0 million. The six month period ended June 30, 2005 included $2.5 million of unit-based payment expense resulting from the change of control deemed to have occurred during the period. The six month period ended June 30, 2006 included $3.5 million of unit-based payment expense related to the modification of an executive’s employment agreement.
Depreciation and Amortization Expense
Depreciation and amortization expense for the six months ended June 30, 2006 was $7.2 million compared to $8.3 million in the six months ended June 30, 2005, a decrease of $1.1 million as a result of certain assets being fully depreciated in the six months ending June 30, 2006.
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Other Income and Expenses
Interest Expense
Interest expense for the six months ended June 30, 2006 increased to $15.3 million from $0.1 million for the six months ended June 30, 2005, which was primarily the result of the issuance of senior secured discount notes on March 30, 2006. We expect that our interest expense, and therefore net loss, will continue to increase in 2006 and thereafter.
Interest Income
Interest income for the six months ended June 30, 2006 increased to $7.6 million from $1.4 million for the six months ended June 30, 2005, an increase of $6.2 million. This increase was due to interest earned on funds received and invested after issuing the senior secured discount notes in March 2006.
Management Fee from TerreStar
For the six months ended June 30, 2006, we recognized $1.1 million related to services provided to TerreStar as compared to $0.6 million for the six months ended June 30, 2005. As TerreStar was not spun off until May 2005, we received a management fee only for May and June of 2005.
Loss from Discontinued Operations
The results of operations of TerreStar, which was spun-off in May 2005 as described above, are reflected in loss from discontinued operations. Loss from discontinued operations was $9.6 million for the six months ended June 30, 2005.
Liquidity and Capital Resources
Our principal sources of liquidity are our cash, cash equivalents, short-term investments and accounts receivable. Our primary cash needs will be for working capital, capital expenditures and debt service and we believe that our existing cash resources will be sufficient to satisfy our anticipated cash requirements through at least the next 12 months. However, our ability to generate cash in the future is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control.
We have financed our operations through the private placement of debt and equity securities and vendor financing. At June 30, 2006 we had $507.0 million of cash, cash equivalents and short-term investments compared to $112.2 million at December 31, 2005, excluding restricted cash. The outstanding balance on our vendor note payable was $0.6 million on June 30, 2006 compared to $0.7 million at December 31, 2005. The outstanding balance of our Senior Secured Discount Notes issued on March 30, 2006 was $451.7 million on June 30, 2006.
We estimate that the total cost to develop and construct the two satellite components of our next generation integrated satellite-terrestrial network in the United States and Canada, including the costs of the satellites, their launch, launch insurance, and associated ground segment will be approximately $1.1 billion. This estimate does not include approximately $250 million to construct a spare satellite that would not be launched ("ground spare") but is required by the terms of our FCC authorization. While our ATC authorizations currently contemplate the construction of a ground spare, we expect to apply to the FCC for a waiver of this requirement based on our proposal to use the two new North American satellites as in-orbit spares for each other, replicating the manner in which we operate today with our existing satellites.
In addition, we will require significant additional funds to construct the terrestrial component of our network. We plan to pursue a top 50 market terrestrial footprint, and we expect that each market could require between $20 million and $60 million to establish terrestrial coverage. We estimate that the total cost to deploy the
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terrestrial portion of the network could range between $500 million and $2.6 billion depending on the choice of air interface technology, the number of markets deployed, the scope of the terrestrial build within each market and the targeted service offering (limited mobile, portable or fully mobile).
Our plan for a South American satellite, for which we have also contracted with Boeing, may cause us to incur additional expenditures of approximately $540 million, depending upon how such a plan is pursued. In May 2006 we entered into a letter agreement outlining the terms of an amendment to our contract with Boeing by accelerating by approximately eight months the construction, launch and operations of the two North American satellites, and deferring the construction and launch schedule for a South American satellite (MSV-SA) to the third delivery position. Such letter agreement, when finalized, may result in the potential loss of certain amounts that have been previously capitalized, although we believe that such potential loss is not probable and if such loss were to occur, would not have a material impact on our consolidated financial position or results of operations. As a result of this letter agreement, we were required to surrender its FCC authorization for MSV-SA to the FCC and forfeit the $2.25 million remaining balance on the performance bond associated with that authorization. To pursue construction and delivery of MSV-SA on the new schedule, we will be required to obtain a new FCC authorization for such satellite, which may not be granted.
The cost of building and deploying our next generation integrated satellite-terrestrial network could exceed these estimates. For example, if we elect to defer payments under our satellite construction contract and/or if we exercise certain options to buy additional satellites or other equipment or services, our costs for the satellite component of our network will increase, possibly significantly. The magnitude of the terrestrial wireless network capital requirement depends upon a number of factors including: choice of wireless technology; target applications (for more limited mobility to full mobility); the general pace of construction; and the efficiency of the business case in the initially deployed markets. We intend to manage the terrestrial wireless build-out to be as success-based as possible, thereby moderating capital requirements. However, we may not have control over each of these factors as our strategy involves working with various strategic and distribution partners who may have varying degrees of influence on these decisions in exchange for capital contributions and other commitments. In all scenarios, we will require significant additional capital, beyond our current resources.
We will need significant additional financing in the future. This additional financing may take the form of loans under a credit facility, the issuance of bonds or other types of debt securities, the issuance of equity securities or a combination of the foregoing. Debt or additional equity financing may not be available when needed on terms favorable to us or at all. Any debt financing we obtain may impose various restrictions and covenants on us which could limit our ability to respond to market conditions, provide for unanticipated capital investments or take advantage of business opportunities. We may also be subject to significant interest expense under the terms of any debt we incur.
We continued to make payments to Boeing under the original contract, as accelerated, and contemplated in the letter agreement. As a result of the letter agreement there will be a revised payment plan. We expect future maximum contractual payments under this contract, including all potential performance incentives and related interest payments on the incentives, not including options or full construction for MSV-SA, are as follows for the years ended December 31, (in thousands):
| 2006 | | $ 88,360 |
| 2007 | | 267,270 |
| 2008 | | 190,690 |
| 2009 | | 74,970 |
| 2010 | | 14,056 |
| Thereafter | | 178,532 |
| | | $813,878 |
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Senior Secured Discount Notes
In March 2006, we issued Senior Secured Discount Notes, with an aggregate principal amount of $750.0 million at maturity, generating gross proceeds of $436.2 million. Interest on the notes will accrete from the issue date at a rate of 14.0% per annum, until they reach full principal amount at April 1, 2010 (the Senior Secured Discount Notes). All of our domestic subsidiaries, MSV Corp. and MSV Canada, a consolidated variable interest entity for which we are the primary beneficiary, jointly and severally guarantee the Senior Secured Discount Notes. We will be required to accrue and pay cash interest on the notes for all periods after April 1, 2010 at a rate of 14.0% per annum, and cash interest payments will be payable in arrears semiannually on April 1 and October 1, commencing on October 1, 2010. The Senior Secured Discount Notes will mature on April 1, 2013. We may redeem some or all of the Senior Secured Discount Notes anytime after April 1, 2010 at a redemption price starting at 107% of the accreted value of the Senior Secured Discount Notes and declining to par after April 1, 2012. In addition, at any time before April 1, 2009, we may redeem up to 35% of the aggregate principal amount at maturity of the Senior Secured Discount Notes with the net proceeds of certain equity offerings at a redemption price equal to 114.0% of the accreted value of the Senior Secured Discount Notes plus interest, if any, if at least 65% of the originally issued aggregate principal amount of the Senior Secured Discount Notes remain outstanding. At any time before April 1, 2010, we may redeem all or a portion of the Senior Secured Discount Notes on one or more occasions at a redemption price equal to 100% of the accreted value plus a premium computed using a discount rate equal to the rate on United States Treasury securities maturing on or about April 1, 2010 plus 50 basis points. Upon the occurrence of certain change of control events, each holder of Senior Secured Discount Notes may require us to repurchase all or a portion of its Senior Secured Discount Notes at a price of 101% of the accreted value, plus, after April 1, 2010, accrued interest. The Senior Secured Discount Notes are secured by substantially all of our assets and rank equally in right of payment with our vendor note payable.
The terms of the Senior Secured Discount Notes require us to comply with certain covenants that restrict some of our corporate activities, including our ability to incur additional debt, pay dividends, create liens, make investments, sell assets, make capital expenditures, repurchase equity or subordinated debt, and engage in specified transactions with affiliates. In addition, we are required to maintain a minimum leverage ratio of 6.0 to 1.0. Noncompliance with any of the covenants without cure or waiver would constitute an event of default under the Senior Secured Discount Notes. An event of default resulting from a breach of a covenant may result, at the option of the lenders, in an acceleration of the principal and interest outstanding. The Senior Secured Discount Notes also contain other customary events of default (subject to specified grace periods), including defaults based on events of bankruptcy and insolvency, and nonpayment of principal, interest or fees when due. We were in compliance with the covenants of the Senior Secured Discount Notes as of June 30, 2006. As of June 30, 2006 we held hedge contracts that totaled $ , all of which were ineffective. We recognized a gain of approximately $80,000 during the six months ended June 30, 2006. We believe that the income or loss resulting from changes in the fair value of such instruments will not have a material impact on our financial position or results of operations in future periods.
Recently Issued Accounting Standards
In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards ("SFAS") No. 123(R), "Share-Based Payment" (SFAS No. 123(R)), a revision of SFAS No. 123. SFAS No. 123(R) requires entities to recognize compensation expense for all share-based payments to employees, including stock options, based on the estimated fair value of the instrument on the date it is granted. Effective January 1, 2006, we adopted the provisions of SFAS No. 123(R) using the prospective transition method, as we had primarily used the minimum-value method for disclosure only purposes. Accordingly, we record equity-based compensation expense for all awards granted and modified after January1, 2006 under the provisions of SFAS No. 123(R). Before January 1, 2006 we accounted for equity-based awards using the intrinsic value method as allowed by Accounting Principles Board ("APB") Opinion No. 25. We will continue to recognize equity-based compensation expense for all awards granted to employees prior to January 1, 2006 that are unvested on January 1, 2006 based on their intrinsic value on the grant date. For all options granted or
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modified after January 1, 2006, we will recognize compensation expense based on their fair value. We estimated fair value using the Black-Scholes-Merton pricing model, and assumed a weighted average volatility of 47.7% for the six months ended June 30, 2006, based on our analysis of comparable public companies, including those that hold limited partner interest in MSV. In addition, we recognized equity-based compensation expense of approximately $951,000 for grants of TerreStar options to certain employees made prior to the spin-off of TerreStar for the six months ended June 30, 2006. If the potential consolidation of ownership described above were consummated we expect to incur approximately $1.3 million of equity-based compensation expense for TerreStar options, as a result of accelerated vesting of these options due to a change of control.
As we adopted SFAS No. 123(R) using the prospective method, there is no impact to our financial position as of December 31, 2005 or June 30, 2006. As of June 30, 2006, the total equity-based compensation expense related to non-vested unit options not yet recognized was $10.1 million, which we expect to recognize over the weighted average period of approximately 2.5 years, based on the current vesting schedule. We expect to recognize equity-based compensation expense of $3.0 million during the remainder of 2006, although the ultimate impact may change depending on the occurrence of future events and levels of equity-based awards in the future.
Quantitati ve and Qualitative Disclosure about Market Risk
Foreign Currency Exchange Rate Risk
The United States dollar is the functional currency for our consolidated financials. The functional currency of our existing Canadian subsidiary and two Canadian joint ventures is the Canadian dollar. The financial statements of these entities are translated to United States dollars using period-end rates for assets and liabilities, and the weighted-average rate for the period for all expenses and revenues. During the normal course of operating our current business, we are exposed to market risks associated with fluctuations in foreign currency exchange rates, primarily the Canadian dollar and the Euro. To reduce the impact of these risks on our earnings and to increase the predictability of cash flows, we use natural offsets in receipts and disbursements within the applicable currency as the primary means of reducing the risk. When natural offsets are not sufficient, from time to time, we enter into certain derivative contracts to buy and sell foreign currencies. Our foreign currency management policy prohibits speculative trading and allows for hedges to be entered into only when a future foreign currency requirement is identified. These contracts generally have durations of less than one year. We account for derivatives in accordance with SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," as amended, which requires the recognition of all derivatives as either assets or liabilities measured at fair value with changes in fair value of derivatives other than hedges reflected as current-period income (loss) unless the derivatives qualify as hedges of future cash flows. For derivatives qualifying as hedges of future cash flows, the effective portion of changes in fair value is recorded temporarily in equity and then recognized in earnings along with the related effects of the hedged items. Any ineffective portion of hedges is reported in earnings as it occurs. As of June 30, 2006 we held hedge contracts that totaled approximately $3.2 million, all of which were ineffective. We recognized a gain of approximately $80,000 during the six months ended June 30 20006.
Interest Rate Risk
Changes in interest rates affect the fair value of our fixed rate debt. The fair value of our Senior Secured Discount Notes at June 30, 2006 was approximately $412.3 million. Based on balances outstanding at June 30, 2006, a 1% increase or decrease in interest rates, assuming similar terms and similar assessment of risk by our lenders, would change the estimated market value, or the estimated price at which the Senior Secured Discount Notes would trade, by approximately $23.2 million and $24.9 million, respectively at June 30, 2006. We do not have cash flow exposure to changing interest rates on our Senior Secured Discount Notes because the interest rate for these securities is fixed.
This sensitivity analysis provides only a limited, point-in-time view of the market risk sensitivity of certain of our financial instruments. The actual impact of changes in market interest rates on Senior Secured Discount Notes may differ significantly from the impact show in this sensitivity analysis.
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