Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis provides information regarding the results of operations and financial condition of the Company and should be read in conjunction with the accompanying condensed consolidated financial statements and notes thereto. This discussion and analysis also should be read in conjunction with
Management’s Discussion and Analysis of Financial Condition and Results of Operations
and the consolidated financial statements included in Part II of our Annual Report on Form 10-K for the year ended
December 31, 2013
. References in this item to “we,” “our,” or “us” are to the Company and its subsidiaries on a consolidated basis unless the context otherwise requires.
In order to assist the reader in understanding certain terms relating to the telecommunications business that are used in this Quarterly Report on Form 10-Q, we refer you to the glossary included following Part III of our Annual Report on Form 10-K for the year ended
December 31, 2013
. Certain terms used in this Item 2 without definition have the meanings given them in Item 1 of this Quarterly Report on Form 10-Q.
Cautions Concerning Forward-Looking Statements
This document contains certain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, Section 21E of the Securities Exchange Act of 1934, as amended, and the Private Securities Litigation Reform Act of 1995, including statements regarding, among other items, our expected financial position, capital expenditures, business and technology trends, fluctuations, the impact of the economic downturn, activities and results, revenue mix and revenue growth, Modified EBITDA and margin trends, the impact of regulatory changes, future tax benefits and expense, expense trends, growth initiatives, increases in sales personnel, future liquidity and capital resources, product plans, share repurchases, debt retirement, future cash balances, growth or stability from particular customer segments, the effects of consolidation in the telecommunications industry, anticipated customer disconnections and customer and revenue churn, market expansion, business and financing plans, and the expected merger with Level 3. These forward-looking statements are based on management’s current expectations and are naturally subject to risks, uncertainties, and changes in circumstances, certain of which are beyond our control. Actual results may differ materially from those expressed or implied by such forward-looking statements.
The words “believe,” “plan,” “target,” “expect,” “intend,” and “anticipate,” and expressions of similar substance identify forward-looking statements. Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that those expectations will prove to be correct. Important factors that could cause actual results to differ materially from the expectations described in this report are set forth under “Risk Factors” in Item 1A and elsewhere in our Annual Report on Form 10-K for the year ended
December 31, 2013
and elsewhere in this report. In addition, actual results may differ from our expectations due to, among other things, the timing of disconnections, churn and service installations which may affect the extent to which those factors impact our results in a particular period, increased competition and pricing pressures, inability to obtain rights to build networks into commercial buildings, economic downturns, which may adversely affect our revenue growth, net income or Modified EBITDA, delays in launching new products that our customers desire, growth initiatives and market expansions that may not result in the intended revenue growth acceleration, delays in connecting new leased fiber to our network, inability of fiber lessors to deliver all fiber contracted for, decreased demand for our products, industry consolidation and other industry conditions, significant increases or decreases in the market prices of our common stock, an ownership change that results in limitations on our use of net operating loss carryforwards ("NOLs") under Section 382 of the Internal Revenue Code, increases in the prices we pay for use of facilities of ILECs, increased costs from healthcare reform and higher taxes or further deregulation of the ILECs or other factors that may adversely affect the cost and availability of ILEC facilities or other facilities that we use to reach certain customer locations, adverse regulatory rulings or legislative developments, interruptions to service delivery or corporate functions due to system failures or cyber-attacks, failure to complete the Level 3 merger and uncertainty among customers and employees regarding the Level 3 merger. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of their dates. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
Overview
We are a leading national provider of managed network services, specializing in business Ethernet, data networking, converged, IP VPN, Internet access, voice, including VoIP, and network security services to enterprise organizations, including public sector entities, and carriers throughout the U.S., including their global locations. Our revenue is derived from business communication services, including data, high-speed Internet access, network and voice services. Our customers include enterprise organizations in a wide variety of industry segments including, among others, the financial services, technology and scientific, health care, distribution, manufacturing and professional services industries, data centers, cloud application providers, public sector entities, system integrators and communications service providers, including ILECs, CLECs, wireless communications companies and cable companies.
Through our subsidiaries, we serve
77
metropolitan markets with local fiber networks that are connected to our regional fiber facilities and national IP backbone. As of
June 30, 2014
, our fiber network spanned approximately
34,000
route miles (the majority of which were metropolitan route miles) connecting to
21,332
buildings served directly by our metropolitan fiber facilities. Included in the total buildings served directly by our local fiber facilities are approximately
550
third party data centers across the country where customers deploy their own equipment or connect to cloud application providers. We are able to extend our reach beyond our fiber networks by providing off-network solutions to customers within and outside our
77
markets. We continue to extend our fiber footprint within our existing markets by connecting our network into additional locations and to expand our data, voice and IP networking capabilities between our markets, supporting secure end-to-end business Ethernet, IP VPN and converged solutions for customers.
Although we analyze revenue by customer type, we present our financial results as one segment across the U.S. because our business is centrally managed.
Level 3 Merger
On June 15, 2014, we entered into an Agreement and Plan of Merger (the "Merger Agreement") with Level 3 and certain of its subsidiaries whereby we agreed to merge with and into a wholly owned subsidiary of Level 3 (the "Level 3 merger").
Upon completion of the Level 3 merger, (i) each issued and outstanding share of our common stock, other than dissenting shares, will be converted into 0.7 shares (the "Stock Consideration") of Level 3's common stock and the right to receive $10.00 in cash (the "Cash Consideration" and, together with the Stock Consideration, the "Merger Consideration"). The Merger Agreement also provides that the (i) issued and outstanding options to purchase our common stock will be exchanged for Merger Consideration, as adjusted to reflect the exercise price of each such outstanding option and (ii) issued and outstanding restricted stock and restricted stock units covering our common stock will vest and be exchanged for Merger Consideration. The Level 3 merger is expected to close during the fourth quarter of 2014, but not before October 4, 2014. The closing of the Level 3 merger is subject to the receipt of certain regulatory and governmental approvals and the satisfaction of certain conditions contained in the Merger Agreement, including the approval of the Level 3 merger by our stockholders and the approval of Level 3's proposed stock issuance and charter amendments by Level 3's stockholders.
Strategic Market Expansion
In November 2013, we announced a strategic market expansion to increase our addressable market by significantly expanding our metropolitan fiber route miles, including entry into five new markets and accelerating the density of our metropolitan fiber footprint in 28 existing markets. Year-to-date through July 30, 2014, we activated our new Salt Lake City and Richmond markets and plan to activate the remaining new markets before the end of 2014. In addition, year-to-date through July 30, 2014 we completed integration and activation of 14 of our 28 existing markets and plan to activate the remaining existing markets before the end of 2014. As part of this expansion, we are also increasing our regional fiber footprint for greater capacity, increased network control and more cost effective connectivity. To facilitate this expansion, we entered into long-term capital leases for fiber that we will light with our own electronics. The initial term of the leases is 20 years, with two ten-year renewals at our option, and automatic annual renewals thereafter until termination by either party.
Revenue Trends
Total Revenue
Our revenue has grown sequentially for the past 39 consecutive quarters through
June 30, 2014
, including throughout various economic cycles. During the three and six months ended June 30, 2014, our sales and service installations grew at a higher rate year-over-year, and our year-over-year revenue growth rate for the three and six months ended June 30, 2014 was 7.8% and 7.4%, respectively, compared to 6.9% and 6.5%, respectively, for the same periods in 2013.
In 2012, we began to experience lower year-over-year quarterly revenue growth rates compared to the same periods in the prior year. In 2013, we commenced several growth initiatives designed to increase our revenue growth rate by focusing on increased sales to capture growing market demand and share. We believe that higher growth in our sales, or "bookings" (i.e., signed contracts), and service installations year over year, as well as our increased revenue growth in 2014 were the result of these growth initiatives. Accordingly, we expect our 2014 annual revenue growth rate to be higher than our 6.4% 2013 annual revenue growth rate, although we may experience fluctuations in our quarterly revenue growth rates.
Due to the time required to obtain or build necessary facilities, obtain rights to install equipment in multi-tenant buildings and other factors related to service installation, some of which are not within our control, there is often a lag between the time that a sale is made, and the time revenue commences. Our installation intervals are generally longer for the more complex solutions delivered to our customers. In some situations, the timing of service installations may be subject to factors that our customers control, such as their readiness for us to install equipment on their premises or the readiness of their equipment. Due
to all of these factors, installation intervals may range between two weeks for single-site, less complex services to 6 to 12 months or longer for the more complex solutions.
We believe that increasing our rate of revenue growth will depend on increasing sales and service installations to keep pace with the growing total base of recurring revenue, retaining revenue from existing customers and a stronger economy. We expect our future revenue growth to be driven in part by greater demand for our data and Internet services due to the increasingly web-based economy that includes IT strategies such as cloud computing, collaboration, data center connectivity and disaster recovery, all of which require the reliable connectivity and network capacity that we provide. We also expect that our advanced service capabilities and expanded national footprint will drive more demand for our existing Ethernet, managed and Internet service suites, enhance our future data and Internet services revenue growth and enable us to serve more customers with multi-point, multi-city locations.
Revenue Reclassification
Beginning January 1, 2014, we are reporting revenue from taxes and fees in a separate line item on our condensed consolidated statements of operations in order to provide better visibility into the impact of changes in those items. Accordingly, revenue from taxes and fees that was previously reported by line of business is now classified as taxes and fees. Revenue from taxes and fees reported by customer type elsewhere in this report has been classified as taxes and fees as well. In addition, we are reporting revenue from dedicated high capacity Ethernet services in data and Internet services rather than network services for better alignment of our service categories, which does not impact revenue by customer type. These reclassifications have been made in the prior year condensed consolidated statements of operations to conform to the current year presentation. Neither of these changes affects total revenue for the current period or prior periods.
Enterprise Customer Revenue
Revenue from enterprise customers has increased sequentially for the past 48 consecutive quarters through
June 30, 2014
and increased 8.7% and 9.0% for the three and six months ended
June 30, 2014
, respectively, as compared to 8.9% and 8.7% for the same periods in
2013
, respectively, primarily due to increased installations of our data and Internet services such as business Ethernet, managed and Internet services. Revenue from our enterprise customers represented 76% of our total revenue in the three and six months ended
June 30, 2014
compared to 75% in the same periods in 2013. We expect our future revenue growth to come primarily from enterprise customers, including our current customer base, largely due to our advanced network capabilities, growth initiatives, including the expansion of our sales and sales support personnel and services portfolio and strategic market expansion.
Carrier Customer Revenue
Our carrier revenue represented 17% of our total revenue in the three and six months ended
June 30, 2014
compared to 18% of our total revenue in the same periods last year. Carrier revenue has been declining as a percentage of revenue due to the higher contribution from enterprise customer revenue coupled with continued disconnections and repricing of carrier contracts upon renewals somewhat offset by higher installed sales of Ethernet services to carriers to serve their end users’ needs as they transition from traditional network services to Ethernet-based technologies. Carrier revenue from wireless providers represented
27%
of total carrier revenue for both the three and six months ended June 30, 2014 compared to 29% and 30% for the three and six months ended June 30, 2013, respectively. We expect that our expanded service offerings to our wholesale customers will continue to contribute to carrier revenue; however, our carrier revenue historically has been impacted by pricing declines in connection with carrier customer contract renewals, disconnections resulting from price competition from other carriers, network grooming and carrier consolidation that inhibits the growth rate of carrier revenue. We expect these impacts on our carrier revenue to continue and to fluctuate from quarter to quarter.
Taxes and Fees
We classify taxes and fees billed to customers and remitted to government authorities on a gross versus net basis in revenue and expense. Taxes and fees represented 6% of our total revenue in the three and six months ended June 30, 2014 compared to 5% in both the three and six months ended June 30, 2013. We expect that revenue from taxes and fees will fluctuate based on changes in rates and growth or declines in revenue subject to these taxes and fees.
Intercarrier Compensation Revenue
Intercarrier compensation revenue, consisting of switched access services and reciprocal compensation, represented 1% of our total revenue in each of the three and six months ended
June 30, 2014
, and is expected to decline in the future due to federal and state mandated rate reductions for terminating traffic and changes in the regulatory regime for intercarrier compensation. Under a 2011 FCC order, intercarrier compensation rates are declining over a six-year period that began in 2012 with rate decreases occurring in the third quarter of each year through 2017. As a result of the FCC order, we expect a reduction
of approximately $3.0 million in intercarrier compensation revenue in the year ended December 31, 2014 compared to 2013, which may be somewhat offset by growth in minutes of use. Approximately $2.0 million of this reduction has already occurred through the six months ended June 30, 2014. In addition, we expect that intercarrier compensation revenue will fluctuate based on variations from period to period in minutes of use originating and terminating on our network and fluctuations in carrier settlements.
Revenue and Customer Churn
Revenue churn, defined as the average lost recurring monthly billing for the period from a customer’s partial or complete disconnection of services (excluding pricing declines upon contract renewals and lost usage revenue) compared to reported revenue, is a measure used by management to evaluate revenue retention. Customer and service disconnections occur as part of the normal course of business and are primarily associated with price competition from other providers, customers moving facilities to other locations and network grooming, business contractions, financial difficulties and consolidation, among other reasons. Revenue churn was 0.9% of monthly revenue in both the three and six months ended
June 30, 2014
, comparable to each of the years ended December 31, 2011, 2012 and 2013, reflecting improvement from the last recessionary period of late 2007 through 2009. We believe that this improvement in revenue churn is a result of improved economic conditions as well as our expanded service portfolio, measures we implemented to increase revenue retention and our customer experience initiatives. As a component of revenue churn, revenue lost from customers fully disconnecting services was
0.2%
for the years ended December 31, 2011, 2012 and 2013 and for each of the three and six months ended
June 30, 2014
. We continue our initiatives to maintain revenue churn that is low relative to our industry, but do not expect contribution to our revenue growth rate from a lower revenue churn rate. If our revenue churn were to increase, our revenue growth would likely be negatively impacted. If we experience another adverse economic cycle, we could experience higher revenue churn that would likely negatively impact our revenue growth. We cannot predict the total impact on revenue from future customer disconnections or the timing of such disconnections or whether these favorable churn trends will continue.
Customer churn, defined as the average monthly customer turnover for the period compared to the average monthly customer count for the period, was
0.8%
for both the three and six months ended
June 30, 2014
compared with 1.0%, 1.0% and 0.9% for the years ended December 31, 2011, 2012 and 2013, respectively. The majority of this churn came from our smaller customers, which we expect will continue.
Pricing
We experience significant price competition from the ILECs, CLECs and cable companies across our service categories that impacts our revenue. We also believe that technology advancements over the years in the telecommunications industry have resulted in lower unit costs for some electronics and equipment that drives customer demand for higher bandwidth at the same or lower prices.
Service agreements in our industry typically range from two to five years, with fixed pricing for the contract term. When contracts are renewed with no changes to the services, pricing is frequently reduced to current market levels as a renewal incentive. The impact of those price reductions on our revenue may fluctuate from quarter to quarter. In addition, during the terms of agreements, customers may purchase additional services or increase or decrease the bandwidth of existing services, subject to applicable early termination charges, depending on their business needs. In some cases, the impact of re-pricing is mitigated by customers' purchase of additional bandwidth or services.
Expenses and Modified EBITDA Trends
Pricing of Special Access Services
We purchase a substantial amount of special access services primarily from ILECs, including services based on the two major technologies available in the industry, Ethernet and TDM, to expand the reach of our network and also provide special access services to customers over our fiber facilities in competition with ILECs. The ILECs have argued before the FCC that the high capacity telecommunications services that they sell, including interstate special access services we buy from them, should no longer be subject to regulations governing price and quality of service. We have advocated that the FCC modify certain of its interstate special access pricing flexibility rules to return these services to price-cap regulation to protect against unreasonable price increases for carriers like us and for regulation of ILEC service quality.
The FCC is reviewing its regulation of special access pricing in a pending proceeding commenced in 2005 that has not yet resulted in proposed rules. In 2012, the FCC suspended the operation of the pricing flexibility triggers, which means that certain ILECs cannot qualify for pricing flexibility in additional geographic areas, pending further FCC review. If the special access services we buy from the ILECs were to be further deregulated, ILECs would have a greater ability to continue to increase the price and reduce the service quality of special access services they sell to us, but we may eventually experience less pricing pressure on the special access service we sell due to higher competitive pricing. As the prices we must pay for
special access services increase, our margins may be pressured. If ILEC price reductions were to occur, we would likely experience downward pressure on the prices we charge our customers for special access services and reductions in the prices we pay ILECs for special access services that we purchase. We cannot predict when the FCC will conclude the proceeding on interstate special access pricing regulation or the impact of any such action.
In addition, the FCC has granted ILEC requests for forbearance from regulation of certain Ethernet and OC-n high capacity services offered by the ILECs as special access, with the result that prices we would pay for those services are no longer price regulated and can increase. We and other carriers are seeking to reverse these forbearance requests. In the meantime, we have secured commercial agreements with the larger ILECs, and continue to pursue agreements with other providers, for those services.
We have expanded our reach by implementing commercial arrangements and connections with the ILECs, other competitive carriers and cable companies for the provision of Ethernet services to deliver certain of our advanced services to end users in areas not directly served by our fiber networks. We also have commercial arrangements with carriers to provide access to our customers' locations in areas outside of our
77
markets. With growing demand for multi-location customer solutions, both within and outside our markets, we are provisioning services to more off-network locations resulting in higher access costs.
Modified EBITDA Trends and Growth Initiatives
We regularly implement various initiatives designed to expand our revenue growth, Modified EBITDA margin (see Note 3 to the table under “Three Months Ended June 30, 2014 Compared to Three Months Ended June 30, 2013--Operating Income and Net Income” for a definition of Modified EBITDA margin) and cash flow that require both capital and operating investments, which can temporarily impact our Modified EBITDA margin until growth in revenue absorbs the increased costs. We believe that these initiatives resulted in growth of our revenue, Modified EBITDA margin and cash flows during the three years ended December 31, 2012.
Modified EBITDA (see Note 2 to the table under “Three Months Ended June 30, 2014 Compared to Three Months Ended June 30, 2013--Operating Income and Net Income” for a definition of Modified EBITDA and reconciliations of Modified EBITDA to net income, which is the most comparable GAAP measure for operating performance, and Modified EBITDA to net cash provided by operations, which is the most comparable GAAP measure for liquidity) grew 7.4%, 8.6% and 2.2% in the years ended December 31, 2011, 2012 and 2013, respectively, each compared to the prior year, and grew 0.7% in both the three and
six months ended June 30,
2014
compared to the same period last year. Modified EBITDA margin was 36.4%, 36.8% and 35.3% for the years ended December 31, 2011, 2012 and 2013, respectively. These margins reflected the absorption of increased costs for network access due to higher prices and greater off-network reach, and costs associated with growth initiatives designed to increase the rate of revenue growth, including further expansion of our sales and sales support staff, and IT and technical personnel. These margins were also impacted by the dilutive effect of taxes and fees that are reported on a gross versus net basis in revenue and expense (see “Revenue” in Note 1 to the condensed consolidated financial statements). Modified EBITDA margin was
33.0%
and 33.2% for the three and six months ended June 30, 2014, respectively, compared to 35.3% and 35.5% in the same periods in the prior year, respectively. The decline was the result of merger-related costs, costs associated with our growth initiatives, taxes and fees and network access costs. Costs associated with growth initiatives had a greater impact on Modified EBITDA margin for the three and six months ended June 30, 2014 and the year ended
December 31, 2013
than in the same periods in 2012 and 2011.
In 2013, our growth initiatives required both capital and operating investments and we continue to make these investments in 2014, including hiring additional sales, sales support and other operational personnel to support our strategic market expansion. For 2014, our investment plans for our growth initiatives and strategic market expansion include an expected increase in sales personnel of 7%; however, we are uncertain of the impact that the recent announcement of the Level 3 merger will have on our ability to meet this objective. Our capital investments in 2013 and 2014 in support of our growth initiatives include new service development, further automation and equipment to integrate and connect the strategic market expansion into our national network and operating infrastructure.
We expect the continued investments and expense associated with our growth initiatives and strategic market expansion (see "Strategic Market Expansion" above) will continue to pressure our Modified EBITDA margin and cash flow in the near term until we can achieve consistently higher service installations and an acceleration of our rate of revenue growth sufficient to absorb these higher costs. We expect our Modified EBITDA margin, excluding merger-related costs, to begin expanding toward the end of 2014 as a result of anticipated higher revenue, as discussed above in "Revenue Trends--Total Revenue". While the growth initiatives described above and market expansion are designed to increase sales in the longer term to accelerate our future revenue growth rate, we cannot assure that these and other initiatives will be sufficient to achieve our objectives of increased revenue growth, margins and cash flow or the timing of such anticipated benefits.
We believe that future margin expansion will come from higher service installations, further leveraging our on-network facilities and increasing the network density of our less mature markets, since historically we have generally experienced margin improvement and increased cash flow from our less dense markets as those markets are expanded through on-net building additions and other network expansions. We believe that our strategic market expansions within our existing markets provide an opportunity to accelerate the increase of network density in many of these existing markets which, if successful, we expect to lead to margin improvement and stronger cash flow generation over time.
The expected reductions in intercarrier compensation revenue discussed above under "Revenue Trends" are also expected to pressure our margins because of the relatively high margins associated with that revenue. Our revenue and margins may also be impacted by, among other risks, economic fluctuations, competitive pressures, higher special access costs including from growth in multi-location customer solutions driven by demand, fuel and energy costs, fluctuations in taxes and fees, merger-related costs and any future inflationary pressures.
Seasonality and Fluctuations
We continue to expect business fluctuations to impact sequential quarterly trends in revenue, margins and cash flow. This includes the timing, as well as any seasonality, of sales and service installations, usage, rate changes, disputes, settlements, repricing for contract renewals and fluctuations in revenue churn, especially from carrier customers, expenses, capital expenditures and taxes and fees. Historically, our expense in the first quarter has been impacted by the resetting of payroll taxes in the new year. Our past experience with quarterly fluctuations may not necessarily be indicative of future results.
Because we generally do not recognize revenue subject to billing disputes until the dispute is resolved, the timing of dispute resolutions and settlements may positively or negatively affect our revenue in a particular quarter. The timing of disconnections may also impact our results in a particular quarter, with disconnections early in the quarter generally having a greater impact. The timing of capital and other expenditures may affect our margins or cash flow. The convergence of any of these or other factors such as fluctuations in usage, increases or decreases in taxes and fees or pricing declines upon contract renewals in a particular quarter may result in our revenue growing more or less than previous trends, may impact our margins and other financial results.
Critical Accounting Policies and Estimates
For a description of our critical accounting policies and estimates, see Item 7 in our Annual Report on Form 10-K for the year ended
December 31, 2013
, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
Results of Operations
The following discussion provides analysis of our results of operations and should be read together with our unaudited condensed consolidated financial statements, including the notes thereto, appearing elsewhere in this report:
Three Months Ended June 30, 2014
Compared to
Three Months Ended June 30, 2013
Revenue
The following table sets forth revenue by line of business presented in thousands of dollars and expressed as a percentage of total revenue:
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|
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Three Months Ended June 30,
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|
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2014
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|
2013
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$ Change
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|
% Change
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Revenue:
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|
|
|
|
|
|
|
|
|
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Data and Internet services
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$
|
253,031
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|
|
60
|
%
|
|
$
|
220,063
|
|
|
56
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%
|
|
$
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32,968
|
|
|
15.0
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%
|
Voice services
|
|
77,919
|
|
|
19
|
%
|
|
76,437
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|
|
20
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%
|
|
1,482
|
|
|
1.9
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%
|
Network services
|
|
56,667
|
|
|
14
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%
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|
64,079
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|
|
17
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%
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|
(7,412
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)
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|
(11.6
|
)%
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Service revenue
|
|
387,617
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|
|
93
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%
|
|
360,579
|
|
|
93
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%
|
|
27,038
|
|
|
7.5
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%
|
Taxes and fees
(1)
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25,412
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|
|
6
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%
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20,622
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|
|
5
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%
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4,790
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|
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23.2
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%
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Intercarrier compensation
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6,674
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|
|
1
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%
|
|
8,282
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|
|
2
|
%
|
|
(1,608
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)
|
|
(19.4
|
)%
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Total revenue
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|
$
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419,703
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|
|
100
|
%
|
|
$
|
389,483
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|
|
100
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%
|
|
$
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30,220
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|
|
7.8
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%
|
___________________
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|
(1)
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We classify taxes and fees billed to customers and remitted to government authorities on a gross versus net basis in revenue and expense. This has no impact on net income or Modified EBITDA but is dilutive to Modified EBITDA margin.
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The primary driver of total revenue growth was increased data and Internet services revenue from installed services to enterprise customers. The increase in data and Internet services revenue primarily resulted from installations of strategic Ethernet and VPN-based services, Internet and other services to enterprise customers, partially offset by revenue churn and re-pricing of renewed customer contracts at lower rates. Strategic services, which includes Ethernet and IP VPN services, comprised
52.8%
of data and Internet services revenue for the
three months ended June 30,
2014
compared to
52.4%
for the
three months ended June 30,
2013
, representing
16.0%
period-over-period growth in revenue from these services.
Voice services revenue increased primarily as a result of installations of converged and other voice services and an increase in usage based services, partially offset by revenue churn. Revenue based on the minutes of service used by customers included in voice services was
3%
of our total revenue for both the
three months ended June 30,
2014
and
2013
.
Network services revenue decreased primarily due to the impact of revenue churn and re-pricing of renewed customer contracts at lower rates, largely from carrier customers.
Revenue from taxes and fees increased, reflecting the initiation of billing for certain regulatory fees not previously charged, growth in revenue to which these charges apply and an increase in rates.
Intercarrier compensation revenue decreased primarily as a result of the impact of an FCC-mandated rate reduction in July 2013.
Costs and Expenses
The major components of costs and expenses were as follows (amounts in thousands):
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Three Months Ended
June 30,
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|
|
|
|
|
2014
|
|
2013
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|
$ Change
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% Change
|
Costs and expenses:
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|
|
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|
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|
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Operating (exclusive of depreciation, amortization and accretion shown separately below)
(1)
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|
$
|
181,391
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|
|
$
|
164,131
|
|
|
$
|
17,260
|
|
|
10.5
|
%
|
Operating expenses as percentage of total revenue
|
|
43.2
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%
|
|
42.1
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%
|
|
|
|
|
Selling, general and administrative
(1)
|
|
108,613
|
|
|
96,438
|
|
|
12,175
|
|
|
12.6
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%
|
Selling, general and administrative expenses as percentage of total revenue
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|
25.9
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%
|
|
24.8
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%
|
|
|
|
|
Depreciation, amortization and accretion
|
|
84,185
|
|
|
75,652
|
|
|
8,533
|
|
|
11.3
|
%
|
Total costs and expenses
|
|
$
|
374,189
|
|
|
$
|
336,221
|
|
|
$
|
37,968
|
|
|
11.3
|
%
|
|
|
|
|
|
|
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(1)
Includes the following non-cash stock-based employee compensation expense:
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Operating
|
|
$
|
545
|
|
|
$
|
545
|
|
|
$
|
—
|
|
|
—
|
%
|
Selling, general and administrative
|
|
$
|
8,107
|
|
|
$
|
7,869
|
|
|
$
|
238
|
|
|
3.0
|
%
|
Operating Expenses.
Our operating expenses consist of costs directly related to the operation and maintenance of our network and the provisioning of our services. These costs, which are net of capitalized labor and overhead costs on capital projects, include the salaries and related expenses of customer care, provisioning, network maintenance, technical field and network operations and engineering personnel, costs to repair and maintain our network, and costs paid to other carriers for access to their facilities, interconnection, and facilities leased and associated utilities. We carry a significant portion of our traffic on our own fiber infrastructure, enhancing our ability to minimize and control costs to purchase network services from other carriers, or access costs. The increase in operating expenses primarily related to higher network access costs as a result of revenue growth including increases in services to customer locations outside our markets, an increase in taxes and fees and higher employee-related costs to support ongoing revenue growth and our growth initiatives as well as annual merit-based salary increases.
Selling, General and Administrative Expenses.
Selling, general and administrative expenses consist of salaries and related costs for employees and other expenses related to sales and marketing, bad debt, IT, billing, regulatory, administrative and legal functions. The increase in these expenses primarily related to higher employee-related costs resulting from expansion of our sales and sales support personnel to support our growth initiatives, annual merit-based salary increases, commissions and incentives, somewhat offset by financing costs incurred in the prior year that did not recur. In addition, selling, general and administrative expenses were impacted by $4.1 million of costs related to the Level 3 merger.
Depreciation, Amortization and Accretion Expense.
The increase in depreciation, amortization and accretion expense was attributable to an increase in property, plant and equipment additions and a reduction in the average useful life of additions, net of the impact of fully depreciated assets.
Operating Income and Net Income
The following table provides the components from operating income to net income for purposes of the discussions that follow (amounts in thousands, except per share amounts):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
June 30,
|
|
|
|
|
|
|
2014
|
|
2013
|
|
$ Change
|
|
% Change
|
Operating income
|
|
$
|
45,514
|
|
|
$
|
53,262
|
|
|
$
|
(7,748
|
)
|
|
(14.5
|
)%
|
Interest expense
|
|
(24,873
|
)
|
|
(21,544
|
)
|
|
3,329
|
|
|
15.5
|
%
|
Debt extinguishment costs
|
|
—
|
|
|
(399
|
)
|
|
(399
|
)
|
|
NM
|
|
Interest income
|
|
109
|
|
|
173
|
|
|
(64
|
)
|
|
(37.0
|
)%
|
Income before income taxes
|
|
20,750
|
|
|
31,492
|
|
|
(10,742
|
)
|
|
(34.1
|
)%
|
Income tax expense
|
|
9,601
|
|
|
14,145
|
|
|
(4,544
|
)
|
|
(32.1
|
)%
|
Net income
|
|
$
|
11,149
|
|
|
$
|
17,347
|
|
|
$
|
(6,198
|
)
|
|
(35.7
|
)%
|
Basic income per common share
|
|
$
|
0.08
|
|
|
$
|
0.12
|
|
|
(0.04
|
)
|
|
(33.3
|
)%
|
Diluted income per common share
|
|
$
|
0.08
|
|
|
$
|
0.11
|
|
|
(0.03
|
)
|
|
(27.3
|
)%
|
Modified EBITDA
(1)(2)
|
|
$
|
138,351
|
|
|
$
|
137,328
|
|
|
$
|
1,023
|
|
|
0.7
|
%
|
Modified EBITDA margin
(1)(2)(3)
|
|
33.0
|
%
|
|
35.3
|
%
|
|
|
|
|
___________________
NM - Not meaningful
|
|
(1)
|
See Note 1 under "Revenue" above.
|
|
|
(2)
|
“Modified EBITDA” is a non-GAAP financial measure and is defined by us as net income (loss) before depreciation, amortization and accretion expense, interest expense, interest income, debt extinguishment costs, other income (loss), impairment charges, income tax expense (benefit), cumulative effect of change in accounting principle, and non-cash stock-based employee compensation expense. Not all of the aforementioned items occur in each reporting period, but have been included in the definition based on historical activity. Modified EBITDA is not intended to replace operating income (loss), net income (loss), cash flow and other measures of financial performance and liquidity reported in accordance with accounting principles generally accepted in the United States. Rather, Modified EBITDA is a measure of operating performance and liquidity that investors may consider in addition to such measures. Our management believes that Modified EBITDA is a standard measure of operating performance and liquidity that is commonly reported and widely used by analysts, investors, and other interested parties in the telecommunications industry because it eliminates many differences in financial, capitalization, and tax structures, as well as non-cash and non-operating charges to earnings. We believe that Modified EBITDA trends are a valuable indicator of whether our operations are able to produce sufficient operating cash flow to fund working capital needs, service debt obligations and fund capital expenditures. We currently use Modified EBITDA for these purposes. Modified EBITDA also is used internally by our management to assess ongoing operations and is a measure used to test compliance with certain covenants of our senior notes, our Revolver and our Term Loan. The definition of EBITDA under our Revolver, our Term Loan and our senior notes differs, but not materially, from the definition of Modified EBITDA used in this table. Modified EBITDA as used in this document may not be comparable to similarly titled measures reported by other companies due to differences in accounting and disclosure policies. The reconciliation between Modified EBITDA and net income (loss), which is the most comparable GAAP measure for operating performance, is as follows (amounts in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended June 30,
|
|
|
2014
|
|
2013
|
Net income
|
|
$
|
11,149
|
|
|
$
|
17,347
|
|
Income tax expense
|
|
9,601
|
|
|
14,145
|
|
Interest income
|
|
(109
|
)
|
|
(173
|
)
|
Interest expense
|
|
24,873
|
|
|
21,544
|
|
Debt extinguishment costs
|
|
—
|
|
|
399
|
|
Depreciation, amortization and accretion
|
|
84,185
|
|
|
75,652
|
|
Non-cash stock-based compensation
|
|
8,652
|
|
|
8,414
|
|
Modified EBITDA
|
|
$
|
138,351
|
|
|
$
|
137,328
|
|
The reconciliation between Modified EBITDA and net cash provided by operations, which is the most comparable GAAP measure for liquidity, is as follows (amounts in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended June 30,
|
|
|
2014
|
|
2013
|
Net cash provided by operations
|
|
$
|
109,280
|
|
|
$
|
124,960
|
|
Income tax expense
|
|
9,601
|
|
|
14,145
|
|
Deferred income taxes
|
|
(9,235
|
)
|
|
(13,672
|
)
|
Interest income
|
|
(109
|
)
|
|
(173
|
)
|
Interest expense
|
|
24,873
|
|
|
21,544
|
|
Discount on debt, amortization of deferred debt issue costs
|
|
(1,599
|
)
|
|
(1,055
|
)
|
Changes in operating assets and liabilities
|
|
5,540
|
|
|
(8,421
|
)
|
Modified EBITDA
|
|
$
|
138,351
|
|
|
$
|
137,328
|
|
|
|
(3)
|
Modified EBITDA margin represents Modified EBITDA as a percentage of revenue.
|
Interest Expense.
The increase in interest expense was largely attributable to the 2022 Mirror Notes and 2023 Notes issued in August 2013 as well as capital leases related to our strategic market expansion, somewhat offset by the retirement of the 2018 Notes and the retirement of the Convertible Debentures.
Debt Extinguishment Costs.
Debt extinguishment costs for the three months ended June 30, 2013 resulted primarily from commissions paid on repurchases by us of the Convertible Debentures. There were no such costs for the three months ended June 30, 2014.
Income before Income Taxes.
The decrease in income before income taxes resulted primarily from higher depreciation, amortization and accretion expense as discussed above.
Income Tax Expense.
The decrease in income tax expense primarily resulted from lower income before income taxes.
Net Income and Modified EBITDA.
The decrease in net income resulted from a decrease in income before income taxes, partially offset by lower income tax expense, as discussed above. Modified EBITDA was largely unchanged as revenue growth was largely offset by higher employee-related costs primarily to support our growth initiatives, costs related to the Level 3 merger and increased commissions and incentives. The decline in Modified EBITDA margin in the three months ended June 30, 2014 compared to the same period in the prior year is attributable to costs related to the Level 3 merger, costs associated with our growth initiatives, taxes and fees and network access costs. For the
three months ended June 30, 2014
and
2013
, Modified EBITDA, together with cash, cash equivalents and investments, has been sufficient to cover our capital expenditures and service our debt. We expect to generate sufficient Modified EBITDA in the foreseeable future to cover our expected capital expenditures and debt service requirements together with cash on hand and borrowing capacity under our existing Revolver.
Six Months Ended June 30, 2014
Compared to
Six Months Ended June 30, 2013
Revenue
The following table sets forth revenue by line of business presented in thousands of dollars and expressed as a percentage of total revenue:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Six Months Ended June 30,
|
|
|
|
|
|
|
2014
|
|
2013
|
|
$ Change
|
|
% Change
|
Revenue:
|
|
|
|
|
|
|
|
|
|
|
|
|
Data and Internet services
|
|
$
|
496,702
|
|
|
60
|
%
|
|
$
|
431,784
|
|
|
56
|
%
|
|
$
|
64,918
|
|
|
15.0
|
%
|
Voice services
|
|
155,280
|
|
|
19
|
%
|
|
152,467
|
|
|
20
|
%
|
|
2,813
|
|
|
1.8
|
%
|
Network services
|
|
115,034
|
|
|
14
|
%
|
|
129,034
|
|
|
17
|
%
|
|
(14,000
|
)
|
|
(10.8
|
)%
|
Service revenue
|
|
767,016
|
|
|
93
|
%
|
|
713,285
|
|
|
93
|
%
|
|
53,731
|
|
|
7.5
|
%
|
Taxes and fees
(1)
|
|
48,164
|
|
|
6
|
%
|
|
41,216
|
|
|
5
|
%
|
|
6,948
|
|
|
16.9
|
%
|
Intercarrier compensation
|
|
12,816
|
|
|
1
|
%
|
|
16,191
|
|
|
2
|
%
|
|
(3,375
|
)
|
|
(20.8
|
)%
|
Total revenue
|
|
$
|
827,996
|
|
|
100
|
%
|
|
$
|
770,692
|
|
|
100
|
%
|
|
$
|
57,304
|
|
|
7.4
|
%
|
___________________
|
|
(1)
|
We classify taxes and fees billed to customers and remitted to government authorities on a gross versus net basis in revenue and expense. This has no impact on net income or Modified EBITDA but is dilutive to Modified EBITDA margin.
|
The primary driver of total revenue growth was increased data and Internet services revenue from installed services to enterprise customers. The increase in data and Internet services revenue primarily resulted from installations of strategic Ethernet and VPN-based services, Internet and other services to enterprise customers, partially offset by revenue churn and re-pricing of renewed customer contracts at lower rates. Strategic services, which includes Ethernet and IP VPN services, comprised
52.9%
of data and Internet services revenue for the
six months ended June 30,
2014
compared to
52.2%
for the
six months ended June 30,
2013
, representing
16.6%
period-over-period growth in revenue from these services.
Voice services revenue increased primarily as a result of installations of converged and other voice services and an increase in usage based services, partially offset by revenue churn. Revenue based on the minutes of service used by customers included in voice services was
3%
of our total revenue for both the
six months ended June 30,
2014
and
2013
.
Network services revenue decreased primarily due to the impact of revenue churn and re-pricing of renewed customer contracts at lower rates, largely from carrier customers.
Revenue from taxes and fees increased reflecting the initiation of billing for certain regulatory fees not previously charged, growth in revenue to which these charges apply and an increase in rates.
Intercarrier compensation revenue decreased primarily as a result of the impact of an FCC-mandated rate reduction in July 2013 as well as lower favorable settlements in the current period as compared to the same period in the prior year.
Costs and Expenses
The major components of costs and expenses were as follows (amounts in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Six Months Ended
June 30,
|
|
|
|
|
|
|
2014
|
|
2013
|
|
$ Change
|
|
% Change
|
Costs and expenses:
|
|
|
|
|
|
|
|
|
Operating (exclusive of depreciation, amortization and accretion shown separately below)
(1)
|
|
$
|
355,430
|
|
|
$
|
325,213
|
|
|
$
|
30,217
|
|
|
9.3
|
%
|
Operating expenses as percentage of total revenue
|
|
42.9
|
%
|
|
42.2
|
%
|
|
|
|
|
Selling, general and administrative
(1)
|
|
215,445
|
|
|
190,000
|
|
|
25,445
|
|
|
13.4
|
%
|
Selling, general and administrative expenses as percentage of total revenue
|
|
26.0
|
%
|
|
24.7
|
%
|
|
|
|
|
Depreciation, amortization and accretion
|
|
166,641
|
|
|
150,047
|
|
|
16,594
|
|
|
11.1
|
%
|
Total costs and expenses
|
|
$
|
737,516
|
|
|
$
|
665,260
|
|
|
$
|
72,256
|
|
|
10.9
|
%
|
|
|
|
|
|
|
|
|
|
(1)
Includes the following non-cash stock-based employee compensation expense:
|
Operating
|
|
$
|
1,084
|
|
|
$
|
1,128
|
|
|
$
|
(44
|
)
|
|
(3.9
|
)%
|
Selling, general and administrative
|
|
$
|
16,954
|
|
|
$
|
16,748
|
|
|
$
|
206
|
|
|
1.2
|
%
|
Operating Expenses.
The increase in operating expenses primarily related to higher network access costs as a result of revenue growth including increases in services to customer locations outside our markets, higher employee-related costs to support ongoing revenue growth, our growth initiatives and annual merit-based salary increases and higher taxes and fees.
Selling, General and Administrative Expenses.
The increase in these expenses primarily related to higher employee-related costs resulting from expansion of our sales and sales support personnel to support our growth initiatives, higher commissions and incentives and annual merit-based salary increases. In addition, $4.1 million of costs related to the Level 3 merger were included in selling, general and administrative expenses for the six months ended June 30, 2014.
Depreciation, Amortization and Accretion Expense.
The increase in depreciation, amortization and accretion expense was attributable to an increase in property, plant and equipment additions and a reduction in the average useful life of additions, net of the impact of fully depreciated assets.
Operating Income and Net Income
The following table provides the components from operating income to net income for purposes of the discussions that follow (amounts in thousands, except per share amounts):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Six Months Ended
June 30,
|
|
|
|
|
|
|
2014
|
|
2013
|
|
$ Change
|
|
% Change
|
Operating income
|
|
$
|
90,480
|
|
|
$
|
105,432
|
|
|
$
|
(14,952
|
)
|
|
(14.2
|
)%
|
Interest expense
|
|
(50,521
|
)
|
|
(49,884
|
)
|
|
637
|
|
|
1.3
|
%
|
Debt extinguishment costs
|
|
(1,282
|
)
|
|
(399
|
)
|
|
883
|
|
|
221.3
|
%
|
Interest income
|
|
257
|
|
|
450
|
|
|
(193
|
)
|
|
(42.9
|
)%
|
Income before income taxes
|
|
38,934
|
|
|
55,599
|
|
|
(16,665
|
)
|
|
(30.0
|
)%
|
Income tax expense
|
|
17,994
|
|
|
25,108
|
|
|
(7,114
|
)
|
|
(28.3
|
)%
|
Net income
|
|
$
|
20,940
|
|
|
$
|
30,491
|
|
|
$
|
(9,551
|
)
|
|
(31.3
|
)%
|
Basic income per common share
|
|
$
|
0.15
|
|
|
$
|
0.20
|
|
|
(0.05
|
)
|
|
(25.0
|
)%
|
Diluted income per common share
|
|
$
|
0.15
|
|
|
$
|
0.20
|
|
|
(0.05
|
)
|
|
(25.0
|
)%
|
Modified EBITDA
(1)(2)
|
|
275,159
|
|
|
273,355
|
|
|
$
|
1,804
|
|
|
0.7
|
%
|
Modified EBITDA margin
(1)(2)(3)
|
|
33.2
|
%
|
|
35.5
|
%
|
|
|
|
|
___________________
NM - Not meaningful
|
|
(1)
|
See Note 1 under "Revenue" above.
|
|
|
(2)
|
See Note 2 above under "Three Months Ended June 30, 2014 Compared to Three Months Ended June 30, 2013--Operating Income and Net Income" for a definition of Modified EBITDA. The reconciliation between Modified EBITDA and net income, which is the most comparable GAAP measure for operating performance, is as follows (amounts in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
Six Months Ended June 30,
|
|
|
2014
|
|
2013
|
Net income
|
|
$
|
20,940
|
|
|
$
|
30,491
|
|
Income tax expense
|
|
17,994
|
|
|
25,108
|
|
Interest income
|
|
(257
|
)
|
|
(450
|
)
|
Interest expense
|
|
50,521
|
|
|
49,884
|
|
Debt extinguishment costs
|
|
1,282
|
|
|
399
|
|
Depreciation, amortization and accretion
|
|
166,641
|
|
|
150,047
|
|
Non-cash stock-based compensation
|
|
18,038
|
|
|
17,876
|
|
Modified EBITDA
|
|
$
|
275,159
|
|
|
$
|
273,355
|
|
The reconciliation between Modified EBITDA and net cash provided by operations, which is the most comparable GAAP measure for liquidity, is as follows (amounts in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
Six Months Ended June 30,
|
|
|
2014
|
|
2013
|
Net cash provided by operations
|
|
$
|
224,505
|
|
|
$
|
206,560
|
|
Income tax expense
|
|
17,994
|
|
|
25,108
|
|
Deferred income taxes
|
|
(17,252
|
)
|
|
(24,289
|
)
|
Interest income
|
|
(257
|
)
|
|
(450
|
)
|
Interest expense
|
|
50,521
|
|
|
49,884
|
|
Discount on debt, amortization of deferred debt issue costs
|
|
(3,212
|
)
|
|
(7,850
|
)
|
Changes in operating assets and liabilities
|
|
2,860
|
|
|
24,392
|
|
Modified EBITDA
|
|
$
|
275,159
|
|
|
$
|
273,355
|
|
|
|
(3)
|
Modified EBITDA margin represents Modified EBITDA as a percentage of revenue.
|
Interest Expense.
The increase in interest expense was largely attributable to the 2022 Mirror Notes and 2023 Notes issued in August 2013 and capital leases related to our strategic market expansion, somewhat offset by the retirement of the 2018 Notes and the Convertible Debentures and discount on the Convertible Debentures becoming fully accreted at the end of the first quarter of 2013.
Debt Extinguishment Costs.
Debt extinguishment costs for the six months ended June 30, 2014 resulted from the redemption of the remaining 2018 Notes and consisted of cash paid for redemption premiums of $0.9 million and non-cash write-offs of unamortized deferred debt issuance costs and issuance discount of $0.4 million. Debt extinguishment costs for the same period in 2013 primarily resulted from commissions paid on repurchases of our Convertible Debentures.
Income before Income Taxes.
The decrease in income before income taxes resulted primarily from higher depreciation, amortization and accretion expense discussed above.
Income Tax Expense.
The decrease in income tax expense primarily resulted from lower income before income taxes.
Net Income and Modified EBITDA.
The decrease in net income resulted from an increase in depreciation, amortization and accretion expense, partially offset by lower income tax expense, as discussed above. Modified EBITDA was largely unchanged as revenue growth was largely offset by costs associated with an increase in personnel primarily to support our growth initiatives, increased commissions and incentives and annual merit-based salary increases as well as costs related to the Level 3 merger. The decline in Modified EBITDA margin in the six months ended June 30, 2014 compared to the same period in the prior year is attributable to costs associated with our growth initiatives, increased commissions and incentives, taxes and
fees, costs related to the Level 3 merger and higher network access costs. For the
six months ended June 30, 2014
and
2013
, Modified EBITDA, together with cash, cash equivalents and investments, has been sufficient to cover our capital expenditures and service our debt.
Liquidity and Capital Resources
Historically, we have generated cash flow from operations consisting primarily of payments received from customers for the provision of our services offset by payments to other telecommunications carriers, payments to employees, and payments for interest and other operating, selling, general and administrative expenses. We have also generated cash from debt and equity financing activities and have used these funds and cash flows from operations to service or repay our debt obligations, make capital expenditures to expand our network, repurchase our common stock and fund acquisitions.
The Merger Agreement contains covenants that limit our ability, among other things, to repurchase our common stock, pay dividends, retire or repurchase our indebtedness and make capital expenditures in excess of our current year forecast during the period prior to closing of the merger, which we refer to as the interim operating covenants.
In September 2013, we completed a tender offer for $406.5 million aggregate principal amount of the 2018 Notes. On March 1, 2014, we redeemed all of the remaining $23.5 million principal amount of 2018 Notes at a redemption price of 104% of the principal amount. The redemption resulted in a total use of cash for the three months ended March 31, 2014 of $24.4 million, which included $
0.9 million
of redemption premiums. Additionally, we used $112.6 million of cash during the six months ended
June 30, 2014
to repurchase our common stock under the $500 million multi-year common stock repurchase program our Board of Directors authorized on August 6, 2013, which was suspended in June 2014 due to the interim operating covenants (see "Possible Future Uses of Cash" below).
The change in our net debt was as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
June 30, 2014
|
|
December 31, 2013
|
|
$ Change
|
|
|
(amounts in thousands)
|
Current portion of debt and capital lease obligations
|
|
$
|
8,147
|
|
|
$
|
32,470
|
|
|
$
|
(24,323
|
)
|
Long term portion of debt and capital lease obligations
|
|
1,914,878
|
|
|
1,916,775
|
|
|
(1,897
|
)
|
Total debt and capital lease obligations
|
|
$
|
1,923,025
|
|
|
$
|
1,949,245
|
|
|
$
|
(26,220
|
)
|
Less: Cash, cash equivalents and short-term investments
|
|
363,727
|
|
|
478,995
|
|
|
(115,268
|
)
|
Net debt
|
|
$
|
1,559,298
|
|
|
$
|
1,470,250
|
|
|
$
|
89,048
|
|
Net debt increased $89.0 million from
December 31, 2013
to
June 30, 2014
, primarily due to capital expenditures, our use of cash to repurchase shares of our common stock and withholding taxes paid by us on behalf of employees in net share settlements of restricted stock, partially offset by cash provided by operating activities and proceeds from employee stock option exercises.
The change in our working capital and working capital ratio were as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
June 30, 2014
|
|
December 31, 2013
|
|
$ Change
|
|
(amounts in thousands)
|
Current assets
|
$
|
549,833
|
|
|
$
|
662,824
|
|
|
$
|
(112,991
|
)
|
Current liabilities
|
294,956
|
|
|
309,296
|
|
|
(14,340
|
)
|
Working capital
|
$
|
254,877
|
|
|
$
|
353,528
|
|
|
$
|
(98,651
|
)
|
Working capital ratio
|
1.86
|
|
|
2.14
|
|
|
N/A
|
|
The decrease in working capital is primarily a result of capital expenditures, repurchases of our common stock and withholding taxes paid by us on behalf of employees in net share settlements of restricted stock, somewhat offset by cash provided by operations, timing of payments to vendors and proceeds from employee stock option exercises.
Cash Flow Activity
Cash and cash equivalents were
$190.2 million
and $420.3 million as of
June 30, 2014
and
2013
, respectively. In addition, we had investments of
$173.6 million
and $194.2 million as of
June 30, 2014
and
2013
, respectively, which were
short-term in nature and generally available to fund our operations. The change in cash and cash equivalents during the periods presented was as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Six Months Ended June 30,
|
|
|
|
|
|
|
2014
|
|
2013
|
|
$ Change
|
|
% Change
|
|
|
(amounts in thousands)
|
|
|
Cash provided by operating activities
|
|
$
|
224,505
|
|
|
$
|
206,560
|
|
|
$
|
17,945
|
|
|
8.7
|
%
|
Cash used in investing activities
|
|
(169,923
|
)
|
|
(220,456
|
)
|
|
50,533
|
|
|
22.9
|
%
|
Cash used in financing activities
|
|
(148,838
|
)
|
|
(372,567
|
)
|
|
223,729
|
|
|
60.1
|
%
|
Decrease in cash and cash equivalents
|
|
$
|
(94,256
|
)
|
|
$
|
(386,463
|
)
|
|
$
|
292,207
|
|
|
75.6
|
%
|
Cash Flow from Operating Activities
The increase in cash provided by operating activities in the
six months ended June 30,
2014
compared to the
six months ended June 30,
2013
primarily related to changes in working capital, which were largely due to the timing of payments to vendors and collection of receivables.
Cash Flow from Investing Activities
The change in cash used in investing activities in the
six months ended June 30,
2014
compared to the
six months ended June 30,
2013
was primarily the result of a net increase in proceeds from the sale and purchase of investments in 2014, somewhat offset by higher capital expenditures in 2014. Our balances of cash, cash equivalents and investments fluctuate over time based on our cash requirements and market interest yields. Cash used for capital expenditures for the
six months ended June 30,
2014
was
$196.0 million
, the majority of which was success-based (see "Capital Expenditures and Requirements" below) compared to
$187.5 million
for the
six months ended June 30,
2013
.
Cash Flow from Financing Activities
Cash used in financing activities for the
six months ended June 30,
2014
primarily consisted of the following:
|
|
•
|
Repurchases of $112.6 million of our common stock;
|
|
|
•
|
Redemption of the remaining 2018 Notes for $24.4 million (including $
0.9 million
of redemption premiums);
|
|
|
•
|
Withholding taxes paid by us on behalf of employees in net share settlements of restricted stock of $18.9 million; and
|
|
|
•
|
Payments of $4.5 million on the Term Loan and capital lease obligations,
|
partially offset by:
|
|
•
|
Proceeds of $10.8 million from employee exercises of stock options.
|
Cash used in financing activities for the
six months ended June 30,
2013
primarily consisted of the following:
|
|
•
|
Repurchases and settlements of conversions of Convertible Debentures of $256.3 million (including $0.5 million of transaction costs);
|
|
|
•
|
Repurchases of $197.3 million of our common stock;
|
|
|
•
|
Withholding taxes paid by us on behalf of employees in net share settlements of restricted stock of $18.3 million; and
|
|
|
•
|
Payments of $2.1 million on the Term Loan and capital lease obligations,
|
partially offset by:
|
|
•
|
Proceeds of $50.9 million from employee exercises of stock options; and
|
|
|
•
|
Net proceeds of $49.7 million from the Term Loan refinancing.
|
Our financing activities from January 1, 2013 through the six months ended June 30, 2014 were comprised of the following:
|
|
•
|
In April 2013, we refinanced our outstanding $461.8 million Term Loan due December 2016 and replaced an undrawn $80 million revolving credit facility expiring December 2014 with a new senior secured credit facility consisting of a $520 million Term Loan due April 2020 and an undrawn $100 million Revolver expiring April 2018. Principal and interest payments on the Term Loan and Revolver, if drawn, are as follows:
|
|
|
•
|
Repayments of the Term Loan are due quarterly in an amount equal to 0.25% of the aggregate principal amount on the last day of each quarter commencing September 30, 2013. Interest on the Term Loan is computed based on a specified Eurodollar rate plus 2.5%. Interest is reset periodically and payable at least quarterly. Based on the Eurodollar rate in effect at June 30, 2014, the effective interest rate was
2.65%
.
|
|
|
•
|
Interest on outstanding amounts under the Revolver, if any, will be computed based on a specified Eurodollar rate plus 1.75% to 2.75% and will be reset periodically and payable quarterly. The Company is required to pay a commitment fee on the undrawn commitment amounts on a quarterly basis of 0.375% to 0.5% per annum. The new senior secured credit facility contains customary affirmative and negative covenants. Most of the Revolver covenants apply whether or not we draw on that facility. In addition, if the Revolver were drawn, certain financial maintenance covenants would apply.
|
|
|
•
|
During the year ended December 31, 2013, we settled the $373.7 million principal amount of Convertible Debentures outstanding as of December 31, 2012 for $552.7 million in cash as a result of our redemptions and conversions by holders of the Convertible Debentures. We also used $0.5 million in cash for transaction costs associated with the retirement of the Convertible Debentures.
|
|
|
•
|
In August 2013, we completed a private offering of $800 million of Senior Notes, including the 2022 Mirror Notes at an offering price of 96.250% of the $450 million principal amount and the 2023 Notes at an offering price of 100% of the $350 million principal amount. The net proceeds from the offering were used to fund the repurchase of $406.5 million principal amount of the 2018 Notes for $438.7 million and for general corporate purposes. In January 2014, we completed exchange offers in which the 2022 Mirror Notes and the 2023 Notes were exchanged for a like principal amount of registered notes with substantially identical terms. Approximately $23.5 million principal amount of the 2018 Notes remained outstanding as of December 31, 2013.
|
|
|
•
|
During the three months ended March 31, 2014, we redeemed the remaining outstanding $23.5 million principal amount of 2018 Notes at a redemption price of 104% of the principal amount, which resulted in $0.9 million of premiums associated with the redemption.
|
Indebtedness Outstanding or Available as of
June 30, 2014
:
|
|
|
|
|
|
|
|
|
|
Instrument
|
|
Principal Amount
Outstanding
|
|
Aggregate Annual
Estimated Interest
Payments
|
|
|
(amounts in thousands)
|
Term Loan, Eurodollar rate + 2.5% due 2020
(1)
|
|
$
|
514,800
|
|
|
$
|
13,642
|
|
5
3
/
8
% Senior Notes due 2022 issued October 2012
|
|
480,000
|
|
|
25,800
|
|
5
3
/
8
% Senior Notes due 2022 issued August 2013
|
|
450,000
|
|
|
24,188
|
|
6
3
/
8
% Senior Notes due 2023
|
|
350,000
|
|
|
22,313
|
|
Undrawn $100 million Revolver expires 2018
(2)
|
|
—
|
|
|
—
|
|
|
|
(1)
|
The aggregate annual estimated interest payments are based on the principal amount outstanding and the effective interest rate of
2.65%
at
June 30, 2014
.
|
|
|
(2)
|
Interest on outstanding amounts, if any, will be computed on a specified Eurodollar rate plus 1.75% to 2.75% and will be reset periodically. We are required to pay a commitment fee on the undrawn commitment amounts on a quarterly basis of 0.375% to 0.5% per annum.
|
The following diagram summarizes our corporate structure in relation to our outstanding indebtedness and credit facility, including our undrawn revolver, as of
June 30, 2014
. The diagram does not depict all aspects of the ownership structure among the operating and holding entities, but rather summarizes the significant elements relative to our debt in order to provide a basic overview.
|
|
a
|
TWTC and substantially all of these subsidiaries guarantee the 2022 Notes, 2022 Mirror Notes and 2023 Notes on an unsecured basis and the Revolver and the Term Loan on a secured basis.
|
|
|
b
|
The assets and equity interests of these subsidiaries are pledged to secure the Revolver and the Term Loan.
|
|
|
c
|
The Term Loan matures in April 2020. The principal amount is reduced by quarterly principal payments.
|
Capital Expenditures and Requirements
Our capital expenditures were $197.4 million in total for the
six months ended June 30,
2014
, or $180.8 million excluding expenditures in connection with integration of the strategic market expansion into our network, compared to $191.8 million of total capital expenditures for the same period in
2013
. We made the majority of capital expenditures in each period for what we deem success-based opportunities that were linked to new installations and related network capacity increases. Success-based spending generally consists of short-to-medium length capital projects, in terms of anticipated time between capital spending and return on investment, driven by customer opportunities. Capital expenditures increased over the prior year period primarily due to capital expenditures related to our strategic market expansion, somewhat offset by efficiency gains as described below, favorable equipment pricing and the timing of projects.
In each of the years ended 2005 through 2013, over 75% of our total annual capital expenditures, excluding capital expenditures for integration of a 2006 acquisition and branding and a capital lease commitment for our strategic market expansion, were for what we deem success-based opportunities. This includes costs to connect to new customer locations with our fiber network and increase capacity in our network, IP backbone enhancements, collocation facility expansion and central office infrastructure to serve growing customer demands. These types of expenditures can fluctuate as our volume of sales and service installations increases or decreases or as a result of economies of scale as described below.
For the full year
2014
, we expect capital expenditures to be in the range of $420 million to $440 million (see “Future Sources of Cash” below for discussion of anticipated funding sources), which is lower than our previously disclosed expectations of $440 million to $460 million, as a result of lower equipment pricing and more efficient deployment of network assets to integrate and connect our strategic market expansion into our national network and operating infrastructure. Additionally, success-based investments are expected to be lower than originally anticipated due to our ability to deliver
enhancements more economically than previously expected, as well as effective equipment redeployment as we continue to gain economies of scale and advance our capabilities on equipment logistics. We expect the majority of our 2014 capital expenditures to be related to success-based opportunities. The amount of our expected 2014 capital expenditures is within the forecast amount permitted under the interim operating covenants. Our anticipated capital expenditures include approximately $35 million of capital expenditures to integrate and connect the strategic market expansion fiber into our national network and operating infrastructure. Also, included in expected capital expenditures are amounts we must spend to replace older network components, especially electronics, which are expenditures that we expect will continue to grow over time. We expect quarterly fluctuations in our capital spending due to the timing of large projects and other external factors such as customer readiness, permitting and weather.
Future Sources of Cash
Based on current assumptions, we expect to generate sufficient cash from operations along with available cash on hand (including cash equivalents and investments) and borrowing capacity under our undrawn Revolver to provide sufficient funds to meet our expected capital expenditure and liquidity needs to operate our business and service our debt for the foreseeable future. However, if our assumptions prove incorrect or if there are other factors that negatively affect our cash position such as material unanticipated losses, a significant reduction in demand for our services, an acceleration of customer disconnections, or other adverse factors, or if we make acquisitions, enter into joint ventures or repurchase additional shares of our common stock, we may need to seek additional sources of funds through financing or other means. There is no assurance that other sources of financing on acceptable terms will be available in the future. Other risks, such as a rating downgrade on our debt or adverse debt market conditions, could further impact our potential access to or the cost of financing sources. Our ability to draw upon the available commitments under our Revolver is subject to compliance with all of the covenants contained in the credit agreement and our continued ability to make certain representations and warranties. In the case of the Revolver, the covenants include financial maintenance covenants, such as leverage and interest coverage ratios and limitations on capital expenditures that are primarily derived from Modified EBITDA and debt levels. We are required to comply with these ratios as a condition to any borrowing under the Revolver and for as long as any loans are outstanding under the Revolver. The representations and warranties include the absence of liens on our properties other than certain permitted liens, the absence of litigation or other developments that have or could reasonably be expected to have a material adverse effect on us and our subsidiaries as a whole and continued effectiveness of the documents granting security for the loans.
A lack of revenue growth or an inability to control costs could negatively impact Modified EBITDA and cause our failure to meet the required minimum ratios under the Revolver if we have loans outstanding under the Revolver or wish to draw on it. Although we currently believe that we will continue to be in compliance with the covenants, various factors, including deterioration of the economy, increased competition and pricing pressure and loss of revenue from significant customers, an acceleration of customer disconnections, a significant reduction in demand for our products without adequate reductions in capital expenditures and operating expenses or an uninsured catastrophic loss of physical assets or other risk factors could cause us to fail to meet our covenants. If our revenue growth is not sufficient to sustain the Modified EBITDA performance required to meet the debt covenants described above, and we have loans outstanding under the Revolver or wish to draw on it, we would have to consider cost cutting or other measures to maintain required Modified EBITDA levels or to enhance liquidity.
The Revolver, Term Loan and Senior Notes (the "Revolver and Long-Term Debt Obligations"), as well as the interim operating covenants, limit our ability to declare cash dividends, repurchase shares, incur indebtedness, incur liens on property and undertake acquisitions, among other things. The agreements governing the Revolver and Long-Term Debt Obligations also include cross-default provisions under which we are deemed to be in default if we default under any of the other material outstanding obligations. If we are in default under any of the covenants under the Term Loan and Revolver, we also could potentially be subject to an acceleration of the repayment date of the Term Loan and the Revolver if we have borrowed any amounts under that facility. If we do not comply with the covenants under the Revolver, we would not be able to draw additional funds under the Revolver and the lenders could cancel the Revolver unless the respective lenders agree to further modify the covenants. Covenant defaults under the credit agreement for the Revolver and Term Loan also may constitute an event of default under the indentures for the Senior Notes. In addition, the lenders under the Revolver may require prepayment of outstanding revolving loans if a change of control and ratings decline occurs as defined in the credit agreement. We are required to offer to prepay the Senior Notes and the Term Loan on an individual basis if a change of control and a debt rating decline occur, as defined in the indentures for the Senior Notes and the Term Loan covenants under our credit agreement. As of
June 30, 2014
, we were in compliance with all of our debt covenants.
Possible Future Uses of Cash
In order to mitigate potential variability in interest rates, reduce future cash interest payments, reduce principal amounts outstanding or reduce our leverage, we or our affiliates may, from time to time, enter into interest rate derivatives, purchase or redeem our outstanding Senior Notes for cash in the open market or privately negotiated transactions, or engage in other
transactions to reduce the principal amount of outstanding Senior Notes. As of
June 30, 2014
, we had not entered into any interest rate derivative transactions. Under the terms of our Revolver, which is more restrictive than our Term Loan and the indentures for the Senior Notes, we currently may repurchase a portion of our outstanding Senior Notes if the sum of our cash and cash equivalents and borrowing availability under our Revolver is a minimum of $200 million after giving effect to the repurchase, provided that we do not use the Revolver proceeds for this purpose and we meet certain other conditions. However, the interim operating covenants prohibit us from repurchasing or retiring indebtedness.
In August, 2013, our Board of Directors authorized a $500 million multi-year common stock repurchase program, of which approximately
$112.6 million
was repurchased during the six months ended June 30, 2014. As of June 30, 2014, we had repurchased $250.1 million of our common stock and a total of $249.9 million remains available under the Board's stock repurchase authorization. The repurchase authorization does not have an expiration date, but can be withdrawn by the Board at any time. We suspended our stock repurchase program indefinitely in June 2014 in compliance with our interim operating covenants, which prohibit additional share repurchases. Our Revolver, as amended in August 2013, permits repurchases of our common stock, or restricted payments, up to $500 million from August 9, 2013 to December 31, 2014, and thereafter $250 million annually in the aggregate if after the transaction the sum of our cash and cash equivalents and availability under our Revolver is a minimum of $200 million, we have not used that basket for other permissible purposes, including dividend payments, and we meet certain other conditions. Up to $200 million of the restricted payments capacity not used through December 31, 2014 may be carried over to the fiscal year ending December 31, 2015. For the fiscal years ending December 31, 2015 and thereafter, up to $100 million of unused restricted payments capacity may be carried over to the next subsequent fiscal year. At
June 30, 2014
, we had repurchased
$250.1 million
of our common stock of the maximum $500 million permissible under our Revolver covenants through December 31, 2014.
We generally expect to maintain approximately $300 million in cash, cash equivalents and short-term investments in order to provide ongoing liquidity and flexibility for other operating and strategic initiatives. The actual balance of cash, cash equivalents and short-term investments will depend on the timing of collections, payments, our business operations in general and any financing activities we may undertake and is likely to fluctuate from quarter to quarter.
Risk Management
As of
June 30, 2014
, our cash, cash equivalents and short-term investments were held in financial institutions, U.S. Treasury money market mutual funds, commercial paper and debt securities issued by the U.S. Treasury and other U.S. government agencies. Although we actively monitor the depository institutions, credit quality of the U.S. government and its entities and the performance and quality of our investments and the mutual funds that hold our cash and cash equivalents, we are exposed to risks resulting from deterioration in the financial condition of the U.S. government and its entities, deterioration in the financial condition or failure of financial institutions holding our cash deposits, decisions of our investment advisors and the investment managers of the money market funds and defaults in securities underlying the funds and investments. We prioritize safety over investment return in choosing the investment vehicles for cash, cash equivalents and investments and have diversified these investments to the extent practical in an effort to minimize our exposure to any one investment vehicle or financial institution. We may change the nature of our cash, cash equivalent and short-term investments as market conditions change.
Off-Balance Sheet Arrangements
As of
June 30, 2014
, we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.
Commitments
Our long-term commitments have not materially changed from those disclosed in our Annual Report on Form 10-K for the year ended
December 31, 2013
, except for the redemption of the remaining $23.5 million principal amount of our 2018 Notes during the first quarter of 2014. See "Management's Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources."
Item 3. Quantitative and Qualitative Disclosures About Market Risk
For quantitative and qualitative disclosures about market risk, see Item 7A, “Quantitative and Qualitative Disclosures About Market Risk” in our Annual Report on Form 10-K for the year ended
December 31, 2013
. Our exposures to market risk have not changed materially since
December 31, 2013
.