ITEM 1B.
UNRESOLVED STAFF COMMENTS
None.
Our principal properties are fiber optic networks and their component assets. We own a majority of the communications equipment required for operating the network and our business. As of June 30, 2013, we own or lease approximately 75,800 fiber route miles or 5,443,000 fiber miles. We provide colocation and connectivity services utilizing our own data centers located within major carrier hotels and other strategic buildings in 25 locations throughout the United States. We do not own the buildings where we provide our colocation and connectivity services; however, as of August 31, 2013, the zColo group managed approximately 175,000 square feet of billable colocation space. See “Item 1. Business - Our Telecom and Internet Infrastructure Assets,” for additional discussion related to our network and colocation properties.
We lease our corporate headquarters in Boulder, Colorado as well as regional offices and sales, administrative and other support offices. Our corporate headquarters located at 1805 29th Street, Suite 2050, Boulder, Colorado is approximately 29,951 square feet. We lease properties to locate the POPs necessary to operate our networks. Office and POP space is leased in the markets where we maintain our network and generally ranges from 100 to 5,000 square feet. Each of the Company’s business units utilize these facilities.
The majority of our leases have renewal provisions at either fair market value or a stated escalation above the last year of the current term.
ITEM 3.
ITEM 3.
LEGAL PROCEEDINGS
In the ordinary course of business, we are from time to time party to various litigation matters that we believe are incidental to the operation of our business. We record an appropriate provision when the occurrence of loss is probable and can be reasonably estimated. We cannot estimate with certainty our ultimate legal and financial liability with respect to any such pending litigation matters, and it is possible one or more of them could have a material adverse effect on us. However, we believe that the outcome of any such pending litigation matters will not have a material adverse effect upon our results of operations our consolidated financial condition or our liquidity.
ITEM 4.
ITEM 4.
MINE SAFETY DISCLOSURES
Not Applicable
PART II
ITEM 5.
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Holders of Our Common Stock
We are a privately held company, and there is no public or private trading market for our equity. We are a wholly-owned subsidiary of Zayo Group Holdings, Inc. See “Item 12: Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters” for information regarding the beneficial ownership of our indirect parent company.
Dividend Policy
We have never declared or paid any cash dividends to our preferred equity holders and no cash dividends are contemplated on our preferred units in the foreseeable future. In addition, our Credit Agreement and the Indentures governing our Notes contain restrictions on our ability to pay dividends or make other distributions with respect to any equity interests.
Issuer Purchases of Equity Securities
None.
ITEM 6.
ITEM 6.
SELECTED FINANCIAL DATA
The following tables present selected historical consolidated financial information for Zayo Group, LLC for the periods and as of the dates indicated. The selected historical consolidated financial information for Zayo Group, LLC as of and for the years ended June 30, 2013, 2012, 2011, 2010, and 2009 is derived from, and qualified by reference to, our audited consolidated financial statements and should be read in conjunction with such audited consolidated financial statements and related notes and “Item 7:
ITEM 7
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Information contained in this Annual Report on Form 10-K (this “Report”), in other filings by Zayo Group, LLC (“we” or “us”), with the Securities and Exchange Commission (the “SEC”) in press releases and in presentations by us or our management that are not historical by nature constitute “forward-looking statements,” which can be identified by the use of forward-looking terminology such as “believes,” “expects,” “plans,” “intends,” “estimates,” “projects,” “could,” “may,” “will,” “should,” or “anticipates,” or the negatives thereof, other variations thereon or comparable terminology, or by discussions of strategy. No assurance can be given that future results expressed or implied by the forward-looking statements will be achieved and actual results may differ materially from those contemplated by the forward-looking statements. Such statements are based on management’s current expectations and beliefs, and are subject to a number of risks and uncertainties that could cause actual results to differ materially from those expressed or implied by the forward-looking statements. These risks and uncertainties include, but are not limited to, those relating to our financial and operating prospects, current economic trends, future opportunities, ability to retain existing customers and attract new ones, our acquisition strategy and ability to integrate acquired companies and assets, outlook of customers, reception of new products and technologies, and strength of competition and pricing. Other factors and risks that may affect our business and future financial results are detailed in our SEC filings, including, but not limited to, those described under “Item 1A: Risk Factors” and in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” We caution you not to place undue reliance on these forward-looking statements, which speak only as of their respective dates. We undertake no obligation to publicly update or revise forward-looking statements to reflect events or circumstances after the date of this Report or to reflect the occurrence of unanticipated events, except as may be required by law.
The following discussion and analysis should be read together with our audited consolidated financial statements and the related notes appearing elsewhere in this Report.
Amounts presented in this Item 7 are rounded. As such, rounding differences could occur in period-over-period changes and percentages reported throughout this Item 7.
Overview
Introduction
We are a provider of bandwidth infrastructure and network-neutral colocation and connectivity services, which are key components of telecommunications and Internet infrastructure services. These services enable our customers to manage, operate, and scale their telecommunications and data networks and data center related operations. We provide our bandwidth infrastructure services over our dense metropolitan, regional, national and international fiber networks, enabling our customers to transport data, voice, video, and Internet traffic, as well as to interconnect their networks. Our bandwidth infrastructure services are primarily used by wireless service providers, carriers and other communications service providers, financial services companies, social networking companies, web-centric companies, law firms, education and healthcare institutions, and other companies that require fiber based bandwidth services.We typically provide our lit bandwidth infrastructure services for a fixed-rate monthly recurring fee under contracts, which usually vary between one and twenty years in length. Our network-neutral colocation and connectivity services facilitate the exchange of voice, video, data, and Internet traffic between multiple third-party networks.
As of June 30, 2013, our fiber networks spanned approximately 75,800 route miles and 5,443,000 fiber miles, served 285 geographic markets in the United States and Europe, and connected to 12,222 buildings, including 3,303 cellular towers, allowing us to provide our bandwidth infrastructure services to our customers over redundant fiber facilities between key customer locations. We use undersea capacity on the Trans-Atlantic undersea telecommunications network (“TAT-14”) and other trans-Atlantic cables to provide connectivity from the U.S. to Europe and from London to continental Europe. We operate a Tier 1 IP network over our metro and long haul networks with connectivity to the U.S. and Europe. The majority of the markets that we serve, and buildings to which we connect, have few other networks capable of providing similar bandwidth infrastructure services, which we believe provides us with a sustainable competitive advantage in these markets. As a result, we believe that the services we provide to our customers would be difficult to replicate in a cost- and time-efficient manner. We provide our network-neutral colocation and connectivity services utilizing our own data centers located within major carrier hotels and other strategic buildings in 25 locations throughout the United States.
We are a wholly-owned subsidiary of Zayo Group Holdings, Inc., a Delaware corporation (“Holdings”), which is in turn wholly owned by Communications Infrastructure Investments, LLC, a Delaware limited liability company (“CII”).
Our fiscal year ends June 30 each year, and we refer to the fiscal year ended June 30, 2011 as "Fiscal 2011," the fiscal year ended June 30, 2012 as “Fiscal 2012,” and the fiscal year ended June 30, 2013 as “Fiscal 2013.”
Our Strategic Product Groups
The Company's segments, which we internally refer to as Strategic Product Groups, are our primary decision-making and governance organizations. Strategic Product Groups are structured around the services that we provide and operate with a high degree of autonomy and financial responsibility. Each Strategic Product Group is responsible for the revenue, costs and associated capital expenditures of their respective services. The Strategic Product Groups enable sales, make pricing and product decisions, engineer networks and deliver services to customers, and support customers for their specific telecom and Internet infrastructure services. Strategic Product Groups operate across all of the Company's geographies.
The Company had historically operated as three Strategic Product Groups: Zayo Bandwidth ("ZB"), Zayo Colocation ("zColo") and Zayo Fiber Solutions ("ZFS"). The ZB group provided primarily lit bandwidth infrastructure services, the zColo group provided colocation and connectivity services and the ZFS group provided dark fiber related services.
Effective January 1, 2013, the Company implemented certain changes to its Strategic Product Group structure that had the impact of disaggregating the lit bandwidth services group (ZB) into its constituent lit bandwidth services and changed the name of our legacy ZFS group to Zayo Dark Fiber. As of June 30, 2013, the Company has seven Strategic Product Groups as described below.
Zayo Dark Fiber ("Dark Fiber"). Through our Dark Fiber Strategic Product Group, we provide dark fiber and related services on portions of our fiber network and on newly constructed network. We provide dark fiber pairs to our customers, who then light the fiber using their own optronic equipment, allowing the customer to manage bandwidth on their own metropolitan and long haul networks according to their specific business needs. As part of our service offering, we manage and maintain the underlying fiber network for the customer. Other related services may include the installation and maintenance of building entrance fiber or riser fiber for distribution within a building. Customers include carriers and other communication service providers, Internet service providers, wireless service providers, major media and content companies, large enterprises, and other companies that have the expertise to run their own fiber optic networks. We market and sell dark fiber-related services under long-term contracts (averaging approximately fifteen years in length); customers either pay upfront for the fiber (generally referred to as an IRU or Indefeasible Right to Use) or on a monthly basis for the fiber. Fiber maintenance (or O&M) is generally paid on a annual or monthly recurring basis regardless of the form of the payment for the provision of the fiber. Recurring payments are fixed but many times include automatic annual price escalators intended to compensate us for inflation.
Zayo Wavelength Services ("Waves"). Through our Waves Strategic Product Group, we provide lit bandwidth infrastructure services to customers utilizing optical wavelength technology. From a technological standpoint, the service is provided by multiplexing a number of optical customer signals onto different wavelengths (i.e., colors) of laser light. The Waves segment provides wavelength services in speeds of 1G, 2.5G, 10G, 40G, and 100G. The Waves Strategic Product Group also provides a dedicated wavelength service; that is, wavelengths on fibers that are not shared between customers. Customers include carriers, financial services companies, healthcare, government institutions, education institutions and other enterprises. Services are typically provided for terms between one and five years for a fixed recurring monthly fee and in some cases an additional upfront, non-recurring fee.
Zayo SONET Services ("SONET"). The Company's Synchronous Optical Network Strategic Product Group provides lit bandwidth infrastructure services to its customers utilizing SONET technology. SONET is a standardized protocol that transfers multiple digital bit streams over optical fiber using lasers or highly coherent light from light-emitting diodes. SONET technology is often used to support private line services. This protocol enables transmission of voice, data and video at high speeds. SONET networks are protected, which provides for virtually instantaneous restoration of service in the event of a fiber cut or equipment failure. Services are provided in speeds ranging from DS-1 (1.54 Mb) to OC-192 (10G) of capacity. Customers in this Group are largely carriers. Services are typically provided for terms between one and five years for a fixed recurring monthly fee and in some cases an additional upfront, non-recurring fee.
Zayo Ethernet Services ("Ethernet"). The Company's Ethernet Strategic Product Group provides lit bandwidth infrastructure services to its customers utilizing Ethernet technology. Ethernet services are offered in metropolitan markets as well as between metropolitan areas (intercity) in point to point and multi-point configurations. Unlike data transmission over a Waves network, information transmitted over Ethernet is transferred in a packet or frame across the network. The frame enables the data to navigate across a shared infrastructure in order to reach the intended destination. Services are provided in speeds ranging from 10 Mb to 10 GigE. Customers include carriers, financial services companies, healthcare, government institutions, education institutions and other enterprises. Services are typically provided for terms between one and ten years for a fixed recurring monthly fee and in some cases an additional upfront, non-recurring fee.
Zayo Internet Protocol Services ("IP"). The Company's Internet Protocol Strategic Product Group provides lit bandwidth infrastructure services to its customers utilizing Internet Protocol technology. IP technology transports data across multiple circuits from the source to the destination. Information leaving the source is divided into several packets and each
packet traverses the network utilizing the most efficient path and means. Packets of information may travel across different physical circuits or paths in order to reach the destination, at which point the packets are reassembled to form the complete communication. Services are generally used to exchange or access traffic on the public Internet. Services are provided in speeds ranging from 10 Mb to 100 G on a single port interface. Customers include regional telecommunications and cable carriers, enterprises, educational institutions and content companies. Services are typically provided for terms between one and ten years for a fixed recurring monthly fee and in some cases an additional upfront, non-recurring fee. Pricing is generally a function of bandwidth capacity and transport required to carry traffic from customer location to an Internet gateway.
Zayo Mobile Infrastructure ("MIG"). The Company's Mobile Infrastructure Strategic Product Group provides two key services: Fiber-to-the-Tower ("FTT") and Small Cell Infrastructure. The Company's FTT products consist of fiber based backhaul from cellular towers to mobile switching centers. This service is generally provided in speeds of 50 Mpbs and above and is used by wireless service providers to enable 3G and 4G cellular services. The segment's Small Cell Infrastructure services provide two separate sub-services. The first sub-service is neutral space and power, similar to a provider of mobile and broadcast tower space. Wireless services providers purchase this service to have a physical location to mount their small cell antennas. The second sub-service is dark fiber backhaul from the antenna to a mobile switching center. The MIG customers are wireless carriers. Services are typically provided for terms between five and 20 years for a fixed recurring monthly fee and, in most cases, an additional upfront, non-recurring fee. Pricing is a function of the quantity of dark fiber consumed and the number of neutral space and power locations provided.
Zayo Colocation ("zColo"). Through our zColo Strategic Product Group, we provide network-neutral colocation and connectivity services in 25 data center and interconnection facilities across 19 markets throughout the United States.The zColo Group manages approximately 175,000 square feet of billable colocation space as of August 31, 2013 within these 25 facilities. All of our facilities provide 24 hour per day, 365 days per year management and monitoring with physical security, fire suppression, power distribution, backup power, cooling and multiple redundant fiber connections to many major networks. The components of our network neutral colocation offering are: space, power, interconnection and remote technical services. We sell space in half-racks, racks, cabinets, cages, and private suites. We provide alternating current (“AC”) and direct current (“DC”) power at various levels. Our power product is backed up by batteries and generators. As a network-neutral provider of colocation services, we provide our customers with interconnection services allowing customers to connect and deliver capacity services between separate networks using fiber, Ethernet, SONET, DS3 and DS1 service levels. We believe our interconnection offering is differentiated by our intra-building dark fiber infrastructure connecting multiple suites in major US carrier hotel locations and our Metro Interconnect product that allows customers to interconnect to other important traffic exchange buildings within a metro market. We also offer data center customers outsourced technical resources through our “remote hands” product. Customers can purchase packages of time or use our technical staff on an as-needed basis. Customers vary somewhat by facility with a significant portion of the Group's revenue coming from customers requiring a high degree of connectivity and who choose to colocate in our key carrier hotel and regional aggregation hub facilities. These customers include: domestic and foreign carriers, Internet service providers, cloud services providers, on-line gaming companies, content providers and CDN, media companies and other connectivity focused enterprise customers. Services are typically provided for terms between one and ten years for a recurring monthly fee and, in many cases, an additional upfront, non-recurring fee. zColo is the exclusive operator of the Meet-Me Room at 60 Hudson Street in New York City, New York, which is one of the most important carrier hotels in the United States with 300 domestic and international networks interconnecting within this facility.
Demand for our services does not materially fluctuate based on seasonality.
Recent Developments
Pending and Recently Closed Acquisitions
Access Communications, Inc. ("Access")
On August 13, 2013, we entered into a Stock Purchase Agreement (the "Agreement") with Access Communications, Inc. ("Access"), a Minnesota corporation, and shareholders of Access. Upon the closing of the transaction contemplated by the Agreement, Zayo will acquire 100 percent of the equity interest in Access. The purchase price, subject to certain adjustments at close and post-closing, is $40.0 million and will be paid with cash on hand.
Access is a provider of metro bandwidth infrastructure services that owns and operates a 1,200 mile fiber network that covers the greater Minneapolis-St. Paul metropolitan area, connecting more than 500 on-net buildings, including the area's major datacenters and carrier hotel facilities. Access is primarily focused on providing dark fiber services to a concentrated set of Minneapolis area carrier, enterprise and governmental customers, particularly within the education segment.
Broadband Stimulus Awards
We are an active participant in federal broadband stimulus projects created through the American Recovery and Reinvestment Act of 2009. To date, we have been awarded, as a direct recipient, federal stimulus funds for two projects and as a
sub-recipient federal stimulus funds for one project by the National Telecommunication and Information Administration. The projects involve the construction, ownership, and operation of fiber networks for the purpose of providing broadband services to governmental and educational institutions, as well as underserved, and usually rural, communities. As part of the award, the federal government funds a large portion of the construction and development costs. On the three projects awarded to us to date, as either a direct or sub-recipient, the stimulus funding will cover, on average, approximately 75% of the total expected cost of the projects. All of these projects allow for our ownership or use of the network for other commercial purposes, including the sale of our bandwidth infrastructure services to new and existing customers. The details of the three awards are as follows:
•
In February 2010, we, as the direct recipient, were awarded $25.1 million in funding to construct 626 miles of fiber network connecting 21 community colleges in Indiana. The total project involved approximately $31.4 million of capital expenditures, of which $6.3 million was funded by us. The Company completed this project on July 31, 2013.
•
In July 2010, we, as the direct recipient, were awarded a $13.4 million grant to construct 286 miles of fiber network in Anoka County, Minnesota, outside of Minneapolis. The total project involves approximately $19.2 million of capital expenditures of which $5.7 million is anticipated to be funded by us. The Company completed this project on June 18, 2013.
•
In September 2011, we signed, as a sub-recipient, an agreement relating to an award granted to Com Net, Inc. (“Com Net”) from the NTIA Broadband Technology Opportunities Program. Our portion of the project involves the construction of nearly 366 fiber miles in the Western Ohio region. Per the terms of our sub-recipient agreement, we will match up to 30% of total costs of constructing the 366 fiber miles up to a maximum contribution of $3.1 million. We estimate the total costs (before reimbursements) of constructing these 366 fiber miles to be approximately $10.4 million. The Company anticipates this project will be completed by November 2013.
Factors Affecting Our Results of Operations
Business Acquisitions
We were founded in 2007 in order to take advantage of the favorable Internet, data and wireless growth trends driving the demand for bandwidth infrastructure services. These trends have continued in the years since our founding, despite volatile economic conditions, and we believe that we are well-positioned to continue to capitalize on those trends. We have built our network and services primarily through 26 acquisitions accounted for as business combinations (through August 31, 2013).
Fiscal 2013 Acquisitions
Core NAP, L.P. (“Core NAP”)
On May 31, 2013, zColo entered into an Asset Purchase Agreement with Core NAP, L.P. (“Core NAP”). The agreement was consummated on the same date, at which time zColo acquired substantially all of the net assets of Core NAP for a purchase price of approximately $7.0 million, subject to customary post-closing adjustments. $1.1 million of the purchase price is currently held in escrow pending the expiration of the indemnification period. The purchase price was paid with cash on hand.
The acquired Core NAP business operated a 15,000 sq. ft. data center facility in northwest Austin, Texas, which offered carrier-neutral colocation consisting of a dense enterprise footprint with over 220 existing customers and four major carriers providing services to cloud, enterprise, financial, carrier, media and other connectivity focused customers. With this acquisition, the Company's zColo business unit now operates 21 interconnect-focused colocation facilities nationwide.
The results of the acquired Core NAP business are included in our operating results beginning May 31, 2013.
Litecast/Balticore, LLC (“Litecast”)
On December 31, 2012, we acquired 100% of the equity interest in Litecast, a provider of metro bandwidth infrastructure services in Baltimore, Maryland, for a price of $22.2 million. $3.3 million of the purchase price is currently held in escrow pending the expiration of the indemnification adjustment period. The acquisition was funded with cash on hand.
Litecast owned and operated a Baltimore metropolitan fiber network, connecting over 110 on-net buildings, including the city's major datacenters and carrier hotel facilities. Litecast focused on providing dark fiber and Ethernet-based services to a concentrated set of Baltimore enterprise and governmental customers, particularly within the healthcare and education industries.
The results of the acquired Litecast business are included in our operating results beginning January 1, 2013.
First Telecom Services, LLC (“First Telecom”)
On December 14, 2012, we acquired 100% of the equity interest in First Telecom, a privately held limited liability company, for total consideration of $109.7 million, subject to certain adjustments at closing and post-closing. $11.0 million of the purchase price is currently held in escrow pending the expiration of the indemnification adjustment period. The acquisition was funded with cash on hand.
First Telecom was a provider of bandwidth infrastructure services throughout the Northeastern and Midwestern United States. First Telecom managed a network of over 8,000 route miles and 350,000 fiber miles and approximately 500 on-net buildings. It focused on providing dark fiber and wavelength services across an 11 state footprint, with its highest concentration of network and revenue in Pennsylvania and Ohio.
The results of the acquired First Telecom business are included in our operating results beginning December 15, 2012.
USCarrier Telecom, LLC (“USCarrier”)
In connection with the American Fiber Systems Holding Corporation acquisition, we acquired an ownership interest in USCarrier. USCarrier was a provider of transport services such as Ethernet and Wavelength primarily to other telecommunications providers. As of June 30, 2012, we owned 55% of the outstanding Class A membership units and 34% of the outstanding Class B membership units of USCarrier. On October 1, 2012, we acquired the remaining equity interest in USCarrier not previously owned for total consideration of $16.1 million, subject to certain post-closing adjustments. The acquisition was funded with cash on hand.
Prior to our acquisition of the remaining interest, our interest in USCarrier was recorded using the cost basis of accounting and as such, the operating results of the acquired USCarrier business were not included in the operating results of the Company until October 1, 2012. The results of the acquired USCarrier business are included in our operating results beginning October 1, 2012. The Company recognized an impairment on its prior investment in USCarrier of $2.2 million during the quarter ended June 30, 2012 due to a decline in the fair value of the Company's ownership interest based on the agreed upon purchase price.
FiberGate Holdings, Inc. (“FiberGate”)
On August 31, 2012, we acquired 100% of the outstanding equity interest in FiberGate for total consideration of $118.3 million, subject to certain post-closing adjustments. The acquisition was funded with cash on hand. $17.5 million of the purchase price is currently held in escrow pending the expiration of the indemnification adjustment period.
Headquartered in Alexandria, Virginia, FiberGate was a provider of dark fiber services throughout the Washington, D.C., Northern Virginia, and Baltimore, Maryland corridor. The FiberGate acquisition added 399 route miles and 183,000 fiber miles to our metro fiber network in and around the U.S. capital region. FiberGate also added 317 on-net buildings, including federal government sites, carrier hotels, data centers, cell towers, and enterprise buildings. FiberGate provided dark fiber services to the federal government since its inception in 1995 and expanded its clientele to include large enterprise and telecommunications customers.
The results of the acquired FiberGate business are included in our operating results beginning August 31, 2012.
AboveNet Inc. (“AboveNet”)
On July 2, 2012, we acquired 100% of the outstanding capital stock of AboveNet, a public company listed on the New York Stock Exchange, for total consideration of approximately $2,212.5 million in cash, net of cash acquired. At the closing, each outstanding share of AboveNet common stock was converted into the right to receive $84 in cash.
AboveNet was a provider of bandwidth infrastructure and network-neutral colocation and interconnection services, primarily to large corporate enterprise clients and communication carriers, including Fortune 1000 and FTSE 500 companies in the United States and Europe. AboveNet's commercial strategy was consistent with ours, which is to focus on leveraging its infrastructure assets to provide bandwidth infrastructure services to a select set of customers with high bandwidth demands. AboveNet provided lit and dark fiber bandwidth infrastructure services over its dense metropolitan, regional, national, and international fiber networks. It also operated a Tier 1 IP network with direct and indirect (through peering arrangements) connectivity in many of the most important bandwidth centers and peering exchanges in the U.S., Europe, and Japan. Its product set was highly aligned with our own, consisting primarily of dark fiber, waves, Ethernet, IP and colocation services. AboveNet had also grown a very strong base of business with enterprise clients, particularly within the financial services sector.
The acquisition of AboveNet added 20,590 new route miles and approximately 2,500,000 fiber miles to our network and added connections to approximately 4,000 on-net buildings, including more than 2,600 enterprise locations, many of which housed some of the largest corporate users of network services in the world. AboveNet's metropolitan networks typically contained 432, and in some cases 864, fiber strands in each cable. This high fiber count allowed AboveNet to add new
customers in a timely and cost-effective manner by focusing incremental construction and capital expenditures on the laterals that connect to the customer premises. AboveNet's metropolitan networks served 17 markets in the U.S., with strong network footprints in a number of the largest metropolitan markets including Boston, Massachusetts; Chicago, Illinois; Los Angeles, California; New York, New York; Philadelphia, Pennsylvania; San Francisco, California; Seattle, Washington; and Washington, D.C. It also serves four metropolitan markets in Europe: London, United Kingdom; Amsterdam, Netherlands; Frankfurt, Germany; and Paris, France. These locations also included many private data centers and hub locations that were important for AboveNet's customers. AboveNet used under-sea capacity on the Japan-U.S. Cable Network to provide connectivity between the U.S and Japan, and capacity on the Trans-Atlantic undersea telecommunications network and other trans-Atlantic cables to provide connectivity from the U.S. to Europe.
Included in the AboveNet purchase price was a business which provided network management and professional services to certain users of bandwidth capacity. As the professional services business (“Zayo Professional Services” or “ZPS”) did not align with our primary focus of providing bandwidth infrastructure services, ZPS was spun-off to Holdings on September 30, 2012. On the spin-off date, we estimated the net fair value of the ZPS assets and liabilities that were contributed to Holdings to be $26.3 million.
The results of the acquired AboveNet business, excluding ZPS, are included in our operating results beginning July 2, 2012.
Fiscal 2012 Acquisitions
Acquisition of Arialink
On May 1, 2012, we acquired 100% of the equity interest in Control Room Technologies, LLC, Allegan Fiber Communications, LLC, and Lansing Fiber Communications (collectively, “Arialink”) for net cash consideration of $17.1 million. Included in the $17.1 million purchase price were certain assets and liabilities which supported Arialink's managed service product offerings. Concurrently with the closing of the Arialink acquisition, we spun-off a portion of Arialink's business supporting those managed service product offerings to Holdings. Our estimate of the fair value of the net assets spun-off to Holdings was approximately $1.8 million. The remaining assets were contributed to the ZB and Dark Fiber Strategic Product Groups.
The results of the acquired business are included in our operating results beginning May 1, 2012.
Acquisition of Mercury Marquis Holdings, LLC (“MarquisNet”)
On December 31, 2011, we entered into an Asset Purchase Agreement with MarquisNet. The transactions contemplated by the agreement closed on the same date, at which time our zColo Strategic Product Group acquired substantially all of the net assets of MarquisNet for total consideration of $13.6 million. The acquisition was funded with a draw on the Company's revolving line-of-credit.
The acquired MarquisNet business operated a single 28,000 square foot data center which provides colocation services in Las Vegas, Nevada.
The operating results of the acquired business are included in our operating results beginning January 1, 2012.
Acquisition of 360networks Holdings (USA) Inc. (“360networks”)
On December 1, 2011, we acquired 100% of the equity of 360networks. We paid the purchase price of approximately $317.9 million, net of approximately $1.0 million in cash acquired and net of an assumed working capital deficiency of approximately $26.0 million. Included in the $318.1 million purchase price was VoIP 360, Inc. (“VoIP360”), a legal subsidiary of 360networks. The VoIP360 entity held substantially all of 360networks' Voice over Internet Protocol (“VoIP”) and other voice product offerings. Effective January 1, 2011, we spun-off our voice operations to Holdings in order to maintain focus on our bandwidth infrastructure business. Concurrently with the closing of the 360networks acquisition, we spun-off 360networks VoIP operations to Holdings. On the spin-off date, we estimated the net fair value of the VoIP assets and liabilities that were contributed to Holdings to be $11.7 million.
The acquired 360networks business operated approximately 19,879 route miles of intercity and metropolitan fiber network across 22 states and British Columbia. 360networks' intercity network interconnected over 70 markets across the central and western United States, including 23 of our fiber markets and a number of new markets such as Albuquerque, New Mexico; Bismarck, North Dakota; Des Moines, Iowa; San Francisco, California; San Diego, California; and Tucson, Arizona. In addition to its intercity network, 360networks operated over 800 route miles of metropolitan fiber networks across 26 markets, including Seattle, Washington; Denver, Colorado; Colorado Springs, Colorado; Omaha, Nebraska; Sacramento, California; and Salt Lake City, Utah.
The results of the legacy 360networks business are included in our operating results beginning December 1, 2011.
Summary of Business Acquisitions
The table below summarizes the dates and purchase prices (which are net of cash acquired and includes assumption of debt and capital leases) of all acquisitions and asset purchases since our inception.
We completed each of the acquisitions described above, with the exception of Voicepipe, with cash raised through combinations of equity and debt capital. We acquired Voicepipe from certain existing CII equity holders in exchange for CII preferred units.
Spin-Off of Business Units
During Fiscal 2013, we determined that the services provided by one of our business units, Zayo Professional Services ("ZPS"), did not fit within our current business model of providing bandwidth infrastructure, colocation and interconnection services. Accordingly, the Company spun-off ZPS to Holdings, the parent of the Company, effective September 30, 2012.
Effective January 1, 2011, we finalized a restructuring of our units which resulted in the units more closely aligning with their product offerings rather than a combination of product offerings and customer demographics. Prior to the restructuring, the Zayo Enterprise Networks ("ZEN") unit held a mix of bandwidth infrastructure, colocation, interconnection, and managed service product offerings. Subsequent to the restructuring, the remaining ZEN unit consisted of only managed service product offerings. As the product offerings provided by the restructured ZEN unit fell outside of our business model, the business unit, was spun-off to Holdings on April 1, 2011.
During Fiscal 2013 and Fiscal 2011, the results of the operations of ZPS and ZEN are presented in a single caption entitled, “Earnings from discontinued operations, net of income taxes” on our consolidated statements of operations. All
discussions contained in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” relate only to our results of operations from our continuing operations.
Debt and Equity Financing
In connection with the AboveNet acquisition, on July 2, 2012, we issued $750.0 million aggregate principal amount of 8.125% senior secured first-priority notes due 2020 (“Senior Secured Notes”) and $500.0 million aggregate principal amount of 10.125% senior unsecured notes due 2020 (“Senior Unsecured Notes”, and collectively with the Senior Secured Notes, the “Notes”). We also entered into a $250.0 million senior secured revolving credit facility (the “Revolver”) and a $1.62 billion senior secured term loan facility, issued at a $30.0 million discount, which accrues interest at floating rates (the “Term Loan Facility”). The effective interest rate on the Term Loan Facility as of July 2, 2012 was 7.125%.
In addition, CII concluded the sale of 98,916,060 Class C Preferred Units of CII pursuant to certain securities purchase agreements with new private investment funds, as well as certain existing owners of CII and other investors. The total value of the Class C Preferred Units of CII issued pursuant to the securities purchase agreements was approximately $470.3 million, net of $2.0 million in costs associated with raising the additional capital. $133.2 million of the net proceeds from the equity raised were contributed to us in June 2012, and the remaining $337.1 million was contributed during the year ended June 30, 2013.
A portion of the proceeds from the equity contribution, together with (i) the net proceeds from the Notes and the Term Loan Facility and (ii) cash on hand, were used to pay the outstanding portion of our previously existing credit facilities, to finance the cash tender offer for, and subsequent redemption of, our $350.0 million outstanding aggregate principal amount of previously existing notes, and to pay the cash consideration for the AboveNet acquisition and associated fees and expenses.
In connection with the debt extinguishment activities discussed above, we recognized an expense in July 2012 of $65.0 million associated with debt extinguishment costs, including a non-cash expense of $17.0 million associated with the write-off of our unamortized debt issuance costs, a cash expense of $39.8 million associated with the payment of early redemption fees on our previous indebtedness, and a non-cash expense of $8.1 million associated with the write-off of the net unamortized discount on the extinguished debt balances. In connection with the Notes offering and the Term Loan Facility, we recorded an original issue discount of $30.0 million and incurred debt issuance costs of $85.2 million. These costs and the original issue discount are being amortized to interest expense over the respective terms of the underlying debt instruments using the effective interest method.
On October 5, 2012, we entered into a second amendment (the "Second Amendment") to our credit agreement governing our Revolver and Term Loan Facility (the “Credit Agreement"). Under the terms of the Second Amendment, effective October 5, 2012, the interest rate on our Term Loan Facility was adjusted to bear an interest rate at LIBOR plus 4.0%, which represented a decrease of 187.5 basis points from the original Credit Agreement. The Second Amendment set a floor on the Term Loan Facility’s interest rate at 5.25%. The Second Amendment also reduced the interest rate on the Revolver by 187.5 basis points.
On February 27, 2013, we entered into a Fourth Amendment to our credit agreement (the “Fourth Amendment”). Under the terms of the Fourth Amendment, effective February 27, 2013, the interest rate on our Term Loan Facility was further adjusted to bear interest at LIBOR plus 3.5% (the “Term Loan LIBOR Spread”) with a minimum LIBOR rate of 1.0%. The amended terms represent a downward adjustment of 50 basis points on the Term Loan LIBOR Spread and a 25 basis point reduction in the minimum LIBOR rate from the Second Amendment. Under the terms of the Fourth Amendment, our Revolver, which was undrawn as of June 30, 2013, will bear interest at LIBOR plus 3.00% (based on the Company’s current leverage ratio) (the “Revolving Loan LIBOR Spread”), which represents a downward adjustment of 50 basis points on the Revolving Loan LIBOR Spread from the Second Amendment. The Fourth Amendment also amended certain terms and provisions of the Company's credit agreement, including removing the senior secured and total leverage maintenance covenants and increasing the total leverage ratio required to be met in order to incur certain additional indebtedness from 5.00:1.00 to 5.25:1.00 as a multiple of EBITDA (as defined in the Credit Agreement).
In connection with the aforementioned amendments, we incurred early redemption call premiums of $16.2 million and $16.1 million for the Second Amendment and Fourth Amendment, respectively. The early redemption call premiums were paid with cash on hand to a syndicate of lenders under the Credit Agreement.
In connection with the debt refinancing transactions discussed above, we recognized an expense of $77.3 million during the year ended June 30, 2013, associated with debt extinguishment costs. The loss on extinguishment of debt associated with these transactions includes a portion of the aforementioned early call premiums paid to non-consenting creditors, non-cash expense associated with the write-off of unamortized debt issuance costs and issuance discounts on the debt balances accounted for as an extinguishment and certain fees paid to third parties involved in the debt refinancing transactions.
In August 2012, we entered into forward-starting interest rate swap agreements with an aggregate notional value of $750.0 million, a maturity date of June 30, 2017, and a start date of June 30, 2013. The contracts state that we shall pay a 1.67%
fixed rate of interest for the term of the agreement beginning on the start date. The counterparties will pay to us the greater of actual LIBOR or 1.25%. We entered into the forward-starting swap arrangements to reduce the risk of increased interest costs associated with potential future increases in LIBOR rates.
Substantial Indebtedness
We had total indebtedness (excluding capital lease obligations) of $2,830.7 million and $689.7 million as of June 30, 2013 and 2012, respectively. Our indebtedness as of June 30, 2013 principally included our $750.0 million of 8.125% Senior Secured Notes, our $500.0 million of 10.125% Senior Unsecured Notes, and an outstanding balance of $1,603.8 million on our $1.620 billion Term Loan Facility. The interest rate on the Term Loan Facility is floating and was 4.50% as of June 30, 2013.
As a result of the growth of our business from the acquisitions, discussed above, and capital expenditures and the increased debt used to fund those investing activities, our results of operations for the respective periods presented and discussed herein are not comparable.
Substantial Capital Expenditures
During Fiscal 2013, 2012 and 2011, we invested $323.2 million (net of stimulus grant reimbursements), $124.1 million (net of stimulus grant reimbursements) and $112.5 million (net of stimulus grant reimbursements), respectively, in capital expenditures related to property and equipment primarily to expand our fiber network and largely in connection with new customer contracts. We expect to continue to make significant capital expenditures in future periods.
As a result of the growth of our business from the acquisitions discussed above and capital expenditures and the increased debt used to fund those investing activities, our results of operations for the respective periods presented and discussed herein are not comparable.
Change in Operating Segments
As a result of our organic and acquisition-related growth, the Zayo Bandwidth segment had grown considerably in scale and complexity. Therefore, effective January 1, 2013, we changed our reporting segments by disaggregating the legacy Zayo Bandwidth segment into the following five separate segments: Waves; SONET; Ethernet; IP; and MIG, see "Item 7 - Overview". Separating the lit services segment into its component products allows for better management accountability and decision making while providing greater visibility to our Chief Operating Decision Maker. Concurrent with these changes we also changed the name of our Zayo Fiber Solutions segment to Zayo Dark Fiber.
We began recording revenue and expense transactions in these new segments on July 1, 2012, but we did not begin reporting the disaggregate information to our Chief Operating Decision Maker (as defined in Accounting Standards Codification 280 - Segment Reporting) until January 1, 2013. We have determined that it is not practicable to restate financial information prior to July 1, 2012 to correspond to the new product group view. Current year segment information throughout this Annual Report on Form 10-K reflects the operating results of both our new business segments and the legacy ZB segment. The change to the Company's ZB segment did not impact the comparability of the zColo or Dark Fiber segments between periods.
Critical Accounting Policies and Estimates
This discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue, expenses and related disclosures. We base our estimates on historical results which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We evaluate these estimates on an ongoing basis. Actual results may differ from these estimates under different assumptions or conditions.
We have accounting policies that involve estimates such as the allowance for doubtful accounts, revenue reserves, useful lives of long-lived assets, fair value of our common and preferred units issued as compensation, accruals for estimated tax and legal liabilities, accruals for exit activities associated with real estate leases, accruals for customer disputes and valuation allowance for deferred tax assets. We have identified the policies below, which require the most significant judgments and estimates to be made in the preparation of our consolidated financial statements, as critical to our business operations and an understanding of our results of operations.
Revenue and Trade Receivables
We recognize revenue derived from leasing fiber optic telecommunications infrastructure and the provision of telecommunications and colocation services when the service has been provided and when there is persuasive evidence of an arrangement, the fee is fixed or determinable and collection of the receivable is reasonably assured. Taxes collected from customers and remitted to government authorities are excluded from revenue.
Most revenue is billed in advance on a fixed-rate basis. The remainder of revenue is billed in arrears on a transactional basis determined by customer usage. The Company often bills customers for upfront charges, which are non-refundable. These charges relate to down payments or prepayments for future services and are influenced by various business factors including how the Company and customer agree to structure the payment terms. If the upfront payment made by a customer provides no benefit to the customer beyond the contract term, the upfront charge is deferred and recognized as revenue ratably over the contract term. If the upfront payment provides benefit to the customer beyond the contract term, the charge is recognized as revenue over the estimated life of the customer relationship.
Revenue attributable to leases of dark fiber pursuant to indefeasible rights-of-use agreements (“IRUs”) are accounted for in the same manner as the accounting treatment for sales of real estate with property improvements or integral equipment. This accounting treatment typically results in the deferral of revenue for the cash that has been received and the recognition of revenue ratably over the term of the agreement (generally up to 20 years). However, ASC 360-20 Property Plant and Equipment: Real Estate Sales, allows for full profit recognition on IRU contracts when the following conditions have been met: 1) the sale has been consummated, 2) the buyer’s initial and continuing investments are adequate to demonstrate a commitment to pay for the property, 3) the seller’s receivable is not subject to future subordination, and 4) the seller has transferred to the buyer the usual risks and rewards of ownership in a transaction that is in substance a sale and does not have a substantial continuing involvement with the property.
Revenue is recognized at the amount expected to be realized, which includes billing and service adjustments. During each reporting period, we make estimates for potential future sales credits to be issued in respect of current revenue, related to service interruptions and customer disputes, which are recorded as a reduction in revenue. We analyze historical credit activity when evaluating our credit reserve requirements. We reserve for known service interruptions as incurred. We review customer disputes and reserve against those we believe to be valid claims. The determination of the customer dispute credit reserve involves significant judgment, estimations and assumptions.
We defer recognition of revenue until cash is collected on certain components of revenue, principally contract termination charges and late fees.
We estimate the ability to collect our receivables by performing ongoing credit evaluations of our customers’ financial condition, and provide an allowance for doubtful accounts based on expected collection of our receivables. Our estimates are based on assumptions and other considerations, including payment history, credit ratings, customer financial performance, industry financial performance and aging analysis.
Stock-Based Compensation
We account for our stock-based compensation in accordance with the provisions of ASC 718-Compensation: Stock Compensation, which requires stock compensation to be recorded as either liability or equity awards based on the terms of the grant agreement. The common units granted to employees are considered to be stock-based compensation with terms that require the awards to be classified as liabilities due to cash settlement features. As such, we account for these awards as a liability and re-measure the liability at each reporting date until the date of settlement. Each reporting period we adjust the value
of the vested portion of our liability awards to their fair value. The preferred units granted to certain employees and directors are considered to be stock-based compensation with terms that require the awards to be classified as equity. As such, we account for these awards as equity, which requires us to determine the fair value of the award on the grant date and amortize the related expense over the vesting period of the award.
We use a third party valuation firm to assist in the valuation of our common units each reporting period and preferred units when granted. In developing a value for these units, we utilize a two-step valuation approach. In the first step we estimate the value of our equity instruments through an analysis of valuations associated with various future potential liquidity scenarios for our shareholders. The second step involves allocating this value across our capital structure. The valuation is conducted in consideration of the guidance provided in the American Institute of Certified Public Accountant (“AICPA”) Practice Aid “Valuation of Privately-Held Company Equity Securities Issued as Compensation” and with adherence to the Uniform Standards of Professional Appraisal Practice (“USPAP”) set forth by the Appraisal Foundation.
We employ a probability-weighted estimated return method to value our common units. The method estimates the value of the units based on an analysis of values of the enterprise assuming various future outcomes. The unit value was based on a probability-weighted present value of expected future proceeds to our shareholders, considering each potential liquidity scenario available to us as well as preferential rights of each security. This approach utilizes a variety of assumptions regarding the likelihood of a certain scenario occurring, if the event involves a transaction, the potential timing of such an event, and the potential valuation that each scenario might yield. The potential future outcomes that we considered were remaining a private company with the same ownership, a sale or merger, and an initial public offering (“IPO”).
We equally weighted the valuation estimate associated with remaining a private entity with the same ownership and the valuation estimate associated with an IPO, with the least weight applied to the company sale assumption. In the private entity, or status quo, assumption, we assessed our value using a discounted cash flow approach, which involves developing a projected free cash flow, estimating an appropriate risk adjusted present value discount rate, calculating the present value of our projected free cash flows, and calculating a terminal value. There are several inputs that are required to develop an estimate of the enterprise value when utilizing these income approaches including forecasted earnings, discount rate, and the terminal multiple and/or the capitalization factor. We have developed a forecast of our revenues and EBITDA through June 30, 2018. Our forecasted revenues and EBITDA are based on our business operations as of the balance sheet date. If a material acquisition has occurred or is probable of occurring subsequent to the balance sheet date, the forecast utilized in the valuation reflects the pro forma results of operations of the combined entities. The next step in the income approach is to estimate a discount rate which most appropriately reflects our cost of capital, which we estimated to be 9.95%. In determining this discount rate, we utilized a weighted average cost of capital (“WACC”) utilizing the Capital Asset Pricing Model (“CAPM”) build-up method. This method derives the cost of equity in part from the volatility (risk) statistics suggested by the Guideline Public Companies in the form of their five year historical betas. We included certain incremental risk premiums specific to us to account for the fact that we have historically depended on outside investment to operate and have a history of substantial volatility in earnings and cash flows. Based on our projections and discount rate, we estimate the present value of our future cash flows. In order to estimate the enterprise value, we add to the estimated discounted cash flows an estimated terminal value. The terminal value is estimated utilizing the “Observed Market Multiple” method and the "H-Model" method. The Observed Market Multiple method assumes the Company will be sold at the end of the forecast period. To develop a terminal multiple, we observe prevailing valuations associated with the Guideline Public Companies and the acquisitions of guideline Companies. A terminal EBITDA multiple was selected to calculate the terminal value under this methodology. Next, the H-Model reflects the Company as a going concern after the projection period by assuming that free cash flows grow at a supernormal rate starting in July 2018 and linearly taper to a long-term growth rate over a period of five years. These assumptions are used to construct a capitalization factor which is applied directly to the terminal year free cash flow, producing a terminal value specific to the H-Model Method. Both terminal values are converted into a present value through the use of an appropriate present value factor. After adding the present value of free cash flows and terminal value for each scenario, we weighted the Observed Market Multiple method at 25% and the H-Model method at 75% to calculate a final enterprise value under the status quo scenario.
For purposes of the probability-weighted expected return method valuation, management also considered various liquidation possibilities including an IPO and a sale or merger. In each of these scenarios a distribution is established around the estimated dates and valuations of each scenario. Future valuation figures are based upon corresponding market data for comparable companies in comparable scenarios. These include publicly-traded valuation statistics and acquisition valuation statistics for comparable companies in the IPO scenario and sale/merger scenario, respectively. Valuation statistics are combined with expectations regarding our future economic performance to produce future valuation estimates. Estimates are then translated to present value figures through the use of appropriate discount rates.
Based on these scenarios, management calculated the probability-weighted expected return to all of the equity holders. The resulting enterprise valuation was then allocated across our capital structure. Upon a liquidation of CII, or upon a non-liquidating distribution, the holders of common units would share in the proceeds after the CII preferred unit holders received their unreturned capital contributions and their priority return (6% per annum). After the preferred unreturned capital
contributions and the priority return are satisfied, the remaining proceeds are allocated on a scale ranging from 85% to the Class A preferred unit holders and 15% to the common unit holders to 80% to the preferred unit holders and 20% to the common unit holders depending upon the return multiple to the preferred unit holders.
The value attributable to each class of shares is then discounted in order to account for the lack of marketability of the units. In determining the appropriate lack of marketability discount, we evaluated both empirical and theoretical approaches to arrive at a composite range which we believe indicates a reasonable spectrum of discounts for each of the valuation techniques utilized. The empirical methods we utilized rely on datasets procured from observed transactions in interests in the public domain that are perceived to incorporate pricing information related to the marketability (or lack thereof) of the interest itself. These empirical methods include IPO Studies and Restricted Stock Studies. The primary theoretical models utilized in our analysis were the option pricing approach, discounted cash flow and Quantitative Marketability Discount Model.
The following table reflects the estimated value of the Class A, B, C D, E, F, G and H common units as of June 30, 2013, 2012 and 2011:
Determining the fair value of share-based awards at the grant date and subsequent reporting dates requires judgment. If actual results differ significantly from these estimates, stock-based compensation expense and the Company’s results of operations could be materially impacted.
Property and Equipment
We record property and equipment acquired in connection with a business combination at their estimated fair values on the acquisition date. See “-Critical Accounting Policies and Estimates: Acquisitions-Purchase Price Allocation.” Purchases of property and equipment are stated at cost, net of depreciation. Major improvements are capitalized, while expenditures for repairs and maintenance are expensed when incurred. Costs incurred prior to a capital project’s completion are reflected as construction-in-progress and are part of network infrastructure assets. Depreciation begins once the property and equipment is available and ready for use. Certain internal direct labor costs of constructing or installing property and equipment are capitalized. Capitalized direct labor reflects a portion of the salary and benefits of certain field engineers and other employees that are directly related to the construction and installation of network infrastructure assets. We have contracted with third party contractors for the construction and installation of the majority of our fiber optic network. Depreciation and amortization is provided on a straight-line basis over the estimated useful lives of the assets, with the exception of leasehold improvements, which are amortized over the lesser of the estimated useful lives or the term of the lease.
Estimated useful lives of our property and equipment are as follows:
We perform periodic internal reviews to estimate useful lives of our property and equipment. Due to rapid changes in technology and the competitive environment, selecting the estimated economic life of telecommunications property, and equipment requires a significant amount of judgment. Our internal reviews take into account input from our network services personnel regarding actual usage, physical wear and tear, replacement history, and assumptions regarding the benefits and costs of implementing new technology that factor in the need to meet our financial objectives.
When property and equipment is retired or otherwise disposed of, the cost and accumulated depreciation is removed from the accounts, and resulting gains or losses are reflected in operating income.
From time to time, we are required to replace or re-route existing fiber due to structural changes such as construction and highway expansions, which is defined as a “relocation.” In such instances, we fully depreciate the remaining carrying value of network infrastructure removed or rendered unusable, and capitalize the new fiber and associated construction costs of the relocation placed into service, which is reduced by any reimbursements received for such costs. To the extent that the relocation does not require the replacement of components of our network, and only involves the act of moving our existing network infrastructure, as-is, to another location, the related costs are expensed as incurred.
Interest costs are capitalized for all assets that require a period of time to get them ready for their intended use. This policy is based on the premise that the historical cost of acquiring an asset should include all costs necessarily incurred to bring it to the condition and location necessary for its intended use. In principle, the cost incurred in financing expenditures for an asset during a required construction or development period is itself a part of the asset’s historical acquisition cost. The amount of interest costs capitalized for qualifying assets is determined based on the portion of the interest cost incurred during the assets’ acquisition periods that theoretically could have been avoided if expenditures for the assets had not been made. The amount of interest capitalized in an accounting period is calculated by applying the capitalization rate to the average amount of accumulated expenditures for the asset during the period. The capitalization rates used to determine the value of interest capitalized in an accounting period is based on our weighted average effective interest rate for outstanding debt obligations during the respective accounting period. During Fiscal 2013 and Fiscal 2012, the Company capitalized interest in the amount of $13.0 million and $5.5 million, respectively.
We periodically evaluate the recoverability of our long-lived assets and evaluate such assets for impairment whenever events or circumstances indicate that the carrying amount of such assets may not be recoverable. Impairment is determined to exist if the estimated future undiscounted cash flows are less than the carrying value of such assets. We consider various factors to determine if an impairment test is necessary. The factors include: consideration of the overall economic climate, technological advances with respect to equipment, our strategy, and capital planning. Since our inception, no event has occurred nor has there been a change in the business environment that would trigger an impairment test for our property and equipment assets.
Deferred Tax Accounting
Deferred tax assets arise from a variety of sources, the most significant being: a) tax losses that can be carried forward to be utilized against taxable income in future years; and b) expenses recognized in our income statement but disallowed in our tax return until the associated cash flow occurs.
We record a valuation allowance to reduce our deferred tax assets to the amount that is expected to be recognized. The level of deferred tax asset recognition is influenced by management’s assessment of our future profitability with regard to relevant business plan forecasts. At each balance sheet date, existing assessments are reviewed and, if necessary, revised to
reflect changed circumstances. In a situation where recent losses have been incurred, the relevant accounting standards require convincing evidence that there will be sufficient future profitability.
In connection with several of our acquisitions, we have acquired significant net operating loss carryforwards (“NOLs”). The Tax Reform Act of 1986 contains provisions that limit the utilization of NOLs if there has been an “ownership change” as described in Section 382 of the Internal Revenue Code.
Upon acquiring a company that has NOLs, we prepare an assessment to determine if we have a legal right to use the acquired NOLs. In performing this assessment we follow the regulations within the Internal Revenue Code Section 382: Net Operating Loss Carryovers Following Changes in Ownership. Any disallowed NOLs acquired are written-off in purchase accounting.
A valuation allowance is required for deferred tax assets if, based on available evidence, it is more-likely-than-not that all or some portion of the asset will not be realized due to the inability to generate sufficient taxable income in the period and/or of the character necessary to utilize the benefit of the deferred tax asset. When evaluating whether it is more-likely-than-not that all or some portion of the deferred tax asset will not be realized, all available evidence, both positive and negative, that may affect the realizability of deferred tax assets is identified and considered in determining the appropriate amount of the valuation allowance. We continue to monitor our financial performance and other evidence each quarter to determine the appropriateness of our valuation allowance. If we are unable to meet our taxable income forecasts in future periods we may change our conclusion about the appropriateness of the valuation allowance which could create a substantial income tax expense in our consolidated statement of operations in the period such change occurs.
As of June 30, 2013, we have a cumulative NOL carryforward balance of $1,375.9 million. During the year ending June 30, 2013, we generated $90.6 million of NOL carryforwards that are available to offset future taxable income and we added $1,008.8 million to our NOL carryforward balance as a result of NOL carryforwards acquired from the AboveNet acquisition. Our NOL carryforwards, if not utilized to reduce taxable income in future periods, will expire in various amounts beginning in 2020 and ending in 2032. We utilized NOL carryforwards to offset income tax obligations during the year ended June 30, 2012. As a result of Internal Revenue Service regulations, we are currently limited to utilizing a maximum of $590.9 million of acquired NOL carryforwards during Fiscal 2014; however, to the extent that we do not utilize $590.9 million of our acquired NOL carryforwards during a fiscal year, the difference between the $590.9 million maximum usage and the actual NOLs usage is carried over to the next calendar year. Of our $1,375.9 million NOL carryforwards balance, $1,187.9 million of these NOL carryforwards were acquired in acquisitions. The deferred tax assets recognized at June 30, 2013 have been based on future profitability assumptions over a five-year horizon.
The analysis of our ability to utilize our NOL balance is based on our forecasted taxable income. The forecasted assumptions approximate our best estimates, including market growth rates, future pricing, market acceptance of our products and services, future expected capital investments, and discount rates. Although our forecasted income includes increased taxable earnings in future periods, flat earnings over the period in which our NOL carryfowards are available would result in full utilization of our current unreserved NOL carryforwards.
Goodwill and Purchased Intangibles
We perform an assessment of goodwill for impairment annually in April or more frequently if we determine that indicators of impairment exist. Our impairment review process compares the fair value of each reporting unit to its carrying value. Our reporting units are consistent with the reportable business units identified in Note 17-Segment Reporting, to our consolidated financial statements.
Our impairment assessment begins with a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. The initial qualitative assessment includes comparing the overall financial performance of the reporting units against the planned results. Additionally, each reporting unit’s fair value is assessed under certain events and circumstances, including macroeconomic conditions, industry and market considerations, cost factors, and other relevant entity-specific events. If it is determined in the qualitative assessment that it is more likely than not that the fair value of a reporting unit is less than its carrying value, then a two-step quantitative impairment test is performed. During Fiscal 2013, the Company performed a two-step goodwill impairment evaluation in connection with our change in segments effective January 1, 2013 and updated our assessment based on a qualitative analysis as of April 2013. During Fiscal 2012, the Company performed a qualitative assessment and determined it was not necessary to complete the quantitative two-step goodwill impairment evaluation.
In connection with our January 1, 2013 goodwill impairment assessment, the Company performed a quantitative goodwill impairment evaluation for each of our reporting units. In performing the two-step quantitative impairment test, if the fair value of the reporting unit exceeds its carrying value, goodwill is not impaired and no further testing is performed. If the carrying value of the reporting unit exceeds its estimated fair value, then a second step must be performed, and the implied fair value of the reporting unit’s goodwill must be determined and compared to the carrying value of the reporting unit’s goodwill.
If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, then an impairment loss equal to the difference will be recorded.
In our January 1, 2013 impairment test, we considered the use of multiple valuation techniques in accordance with fair value measurements and disclosures guidance to estimate the fair value of our reporting units and have consistently applied an income and market-based approach to measure fair value.
Under the income approach, we estimated the reportable segment’s fair value using the discounted cash flow method. The discounted cash flow method involves the following key steps:
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the development of projected free cash flows;
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the estimation of an appropriate risk adjusted present value discount rate;
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the calculation of the present value of projected free cash flow; and
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the calculation of a terminal value.
In developing the projected free cash flows, we utilized expected growth rates implied by the financial projections that have been developed and are used by management. The cash flow forecasts are based upon the Company's internally developed forecast. In developing the discount rate, we use a rate that reflects the cost of capital for the Company. This cost of capital reflects the relative risk of an investment in the Company, and the time value of money. We calculate this discount rate using the weighted-average cost of capital formula. For the January 1, 2013 impairment test, management estimated the weighted-average cost of capital for the strategic product groups to be: 10% for SONET, 10.3% for FTT, 9.9% for Waves, 15.7% for ZIP, 14.9% for Ethernet, 8.6% for ZFS, and 14.9% for zColo. Using the projected cash flow and discount rate inputs, we calculate the present value of our projected cash flows. In calculating the terminal value, we estimate a long-term growth rate that we believe appropriately reflects the expected long-term growth in nominal U.S. gross domestic product. The terminal value is converted to a present value through the use of the appropriate present value factor. This figure is then summed with the present value of projected free cash flow for the projection period to render a valuation estimate for each reporting segment.
Under the market approach, we estimate the reportable segment’s fair value using the Analysis of Guideline Public Companies method. The use of this method involves the following:
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identification and selection of a group of acceptable and relevant guideline companies;
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selection of financial ratios and time period most appropriate for the analysis;
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financial adjustments made to both or either of the guideline and/or subject companies to make the underlying financial figures comparable;
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subjective discounts or premiums to implied ratios to account for observations relating to substantial differences that would be perceived as having an impact on value between the collective guideline companies and us; and
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selection of a statistical midpoint or range within the dataset most appropriate for the analysis.
In identifying and selecting the guideline companies that could be deemed appropriate for our reporting units, we screened potential companies using a research tool with parameters including constraints regarding geographic location, primary industry classification, and market capitalization. We selected the Enterprise Value to EBITDA ratio as the most appropriate market-based valuation technique for us. We estimated the 2013 EBITDA trading multiples based on Guideline Public Companies for each of our product groups and adjusted the multiples selected for each product group based on customer contractual term and historical churn rates. In addition, we compared the weighted average EBITDA multiple for all product groups to the Company's peer multiples to assess whether overall enterprise valuation results were appropriate.
In estimating the fair value of each of our reportable segments as of January 1, 2013, we averaged the valuations from each of the approaches above. The resulting valuations were significantly higher than the carrying value of our reporting segments. Although we estimate the fair value of our segments utilizing the average of various valuation techniques, none of the valuation techniques on a stand-alone basis indicated an impairment of any of our segments as of January 1, 2013.
Acquisitions - Purchase Price Allocation
We apply the acquisition method of accounting to account for business combinations. The cost of an acquisition is measured as the aggregate of the fair values at the date of exchange of the assets given, liabilities incurred, and equity instruments issued. Identifiable assets, liabilities, and contingent liabilities acquired or assumed are measured separately at their fair value as of the acquisition date. The excess of the cost of the acquisition over our interest in the fair value of the identifiable net assets acquired is recorded as goodwill. If our interest in the fair value of the identifiable net assets acquired in a business combination exceeds the cost of the acquisition, a gain is recognized in earnings on the acquisition date only after we have reassessed whether we have correctly identified all of the assets acquired and all of the liabilities assumed.
For most acquisitions, we engage outside appraisal firms to assist in the fair value determination of identifiable intangible assets such as customer relationships, tradenames, property and equipment and any other significant assets or liabilities. We adjust the preliminary purchase price allocation, as necessary, after the acquisition closing date through the end of the measurement period (up to one year) as we finalize valuations for the assets acquired and liabilities assumed.
The determination and allocation of fair values to the identifiable assets acquired and liabilities assumed is based on various assumptions and valuation methodologies requiring considerable management judgment. The most significant variables in these valuations are discount rates, terminal values, the number of years on which to base the cash flow projections, as well as the assumptions and estimates used to determine cash inflows and outflows or other valuation techniques (such as replacement cost). We determine which discount rates to use based on the risk inherent in the related activity’s current business model and industry comparisons. Terminal values are based on the expected life of products, forecasted life cycle and forecasted cash flows over that period. Although we believe that the assumptions applied in the determination are reasonable based on information available at the date of acquisition, actual results may differ from the estimated or forecasted amounts and the difference could be material.
Background for Review of Our Results of Operations
Operating Costs
Our operating costs consist primarily of colocation facility costs, colocation facility utilities costs and third-party network service costs. Our colocation facility costs include rent and license fees paid to the landlords of the buildings in which our zColo business operates along with the utility costs to power those facilities. Third-party network service costs result from our leasing of certain network facilities, primarily leases of circuits and dark fiber, from other local exchange carriers to augment our owned infrastructure for which we are generally billed a fixed monthly fee. While increases in demand will drive additional operating costs in our business, as per our strategy of leveraging our infrastructure assets, we expect to primarily utilize our existing network infrastructure and augment, when necessary, with additional circuits or services from third-party providers. Transport costs include the upfront cost of the initial installation of such circuits. We have excluded depreciation and amortization expense from our operating costs.
Selling, General and Administrative Expenses
Our selling, general and administrative (“SG&A”) expenses include personnel costs (including compensation and benefits and stock-based compensation), costs associated with the operation of our network (network operations), and other related expenses, including sales commissions, marketing programs, office rent, professional fees, travel, software maintenance costs, costs incurred related to potential and closed acquisitions (i.e., transaction costs) and other expenses.
We compensate certain members of our management and independent directors through grants of common units of CII, which vest over varying periods of time, depending on the terms of employment of each such member of management or director. In addition, certain of our senior executives and independent directors have been granted preferred units of CII.
For the common units granted to members of management and directors, we recognize an expense equal to the fair value of all of those common units vested during the period, and record a liability in respect of that amount. Subsequently, we recognize changes in the fair value of those common units through increases or decreases in stock-based compensation expense and adjustments to the related stock-based compensation liability.
When the preferred units are initially granted, we recognize no expense. We use the straight line method, over the vesting period, to amortize the fair value of those units, as determined on the date of grant. Subsequent changes in the fair value of the preferred units granted to those executive officers and directors are not taken into consideration as we recognize that expense.
After compensation and benefits and stock-based compensation, network operations expenses are the largest component of our SG&A expenses. Network operations expenses include all of the non-personnel related expenses of maintaining our network infrastructure, including contracted maintenance fees, right-of-way costs, rent for locations where fiber is located (including cellular towers), pole attachment fees, and relocation expenses.
Refer to Item 6. Selected Financial Data for financial information discussed herein.
Year Ended June 30, 2013 Compared to the Year Ended June 30, 2012
Revenue
Our total revenue increased by $606.1 million, or 159%, from $382.0 million to $988.1 million for the years ended June 30, 2012 and 2013, respectively. The increase in revenue was primarily a result of our Fiscal 2012 and Fiscal 2013 acquisitions and organic growth. The table below reflects the revenue recognized by each entity acquired during Fiscal 2012 and Fiscal 2013 during the quarterly period immediately preceding the respective acquisition date multiplied by four ("LQA revenue"). The table also reflects the Company's estimates of the allocation of those revenues, based upon the nature of the service, to each of our strategic product groups. The amounts below include adjustments to the historical amounts recognized by the acquired company resulting from estimated purchase accounting adjustments.
In addition to the acquisition-related revenue growth during the period resulting from the aforementioned acquisitions, we experienced organic growth. Organic growth is based on several factors, including gross new sales, gross installed revenue, and churn processed. We define these terms below:
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Gross New Sales: The dollar amount of orders recorded as monthly recurring revenue ("MRR") or monthly amortized revenue ("MAR") in a period that have been signed by the customer and accepted by service activation. The dollar value of a gross new sale is equal to the monthly recurring price that the customer will pay for the service or the monthly amortized amount of the revenue that the Company recognizes for that service. Gross new sales do not include intercompany sales.
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Gross Installed Revenue: Gross Installed Revenue is the amount of MRR and MAR for services that have been installed, tested, accepted by the customer, and entered into the billing system in a given period. Gross Installed Revenue is further divided into new service, price increases, and upgrades. Gross installed revenue does not include intercompany installation activity.
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Churn Processed: Any negative change to monthly recurring revenue or monthly amortized revenue. Churn processed is further divided into disconnects, negative price changes, and disconnects associated with upgrades. Churn processed does not include intercompany churn.
As a result of internal sales efforts since June 30, 2012, we have entered into $1,032.1 million in gross new sales contracts, which will represent an additional $18.4 million in monthly revenue once installation on those contracts is accepted. Since June 30, 2012, we have received acceptance on gross installations that have resulted in incremental monthly revenue of $18.3 million as of June 30, 2013 as compared to June 30, 2012. This increase in revenue related to our organic growth is partially offset by total customer churn of $13.4 million in monthly revenue since June 30, 2012.
The following table reflects the stratification of our revenues during the years ended June 30, 2013 and 2012:
Zayo Bandwidth. Our revenues from our legacy ZB operating segment increased by $387.1 million, or 142%, from $272.1 million to $659.2 million for the years ended June 30, 2012 and 2013, respectively. The increase is a result of both the acquisition related growth, discussed above, and organic growth. Since June 30, 2012, ZB has entered into new sales contracts with an aggregate contract value of $492.9 million. During the same period, ZB has received acceptance on gross installations that have resulted in incremental monthly revenue of $13.7 million as of June 30, 2013 as compared to June 30, 2012. This increase in revenue related to organic growth is partially offset by total customer churn at ZB of $10.0 million in monthly revenue since June 30, 2012.
Beginning July 1, 2012, the Company began tracking gross new sales contracts, monthly revenue increases resulting from installations and monthly revenue decreases resulting from churn at the new product group level. The following table depicts these statistics for each of the new ZB product groups and the legacy ZB group since July 1, 2012:
Dark Fiber. Our revenues from our Dark Fiber operating segment increased by $223.9 million, or 316%, from $70.9 million to $294.8 million for the years ended June 30, 2012 and 2013, respectively. The increase is a result of both the acquisition related growth, discussed above, and organic growth. Since June 30, 2012, Dark Fiber has entered into sales contracts with an aggregate contract value of $487.2 million. During the same period, Dark Fiber received acceptance on gross installations that have resulted in additional monthly revenue of $3.6 million as of June 30, 2013 as compared to June 30, 2012. This increase in revenue related to organic growth is partially offset by total customer churn at Dark Fiber of $2.6 million in monthly revenue since June 30, 2012.
zColo. Our revenues from our zColo segment increased by $20.1 million, or 46%, from $43.3 million to $63.4 million for the years ended June 30, 2012 and 2013, respectively. The increase is a result of both the acquisition related growth, discussed above, and organic growth. Since June 30, 2012, zColo has entered into sales contracts with an aggregate contract value of $52.0 million. During the same period, zColo received acceptance on gross installations that have resulted in additional monthly revenue of $0.9 million as of June 30, 2013, as compared to June 30, 2012. This increase in revenue related to organic growth is partially offset by total customer churn at zColo of $0.9 million in monthly revenue since June 30, 2012.
Operating Costs, Excluding Depreciation and Amortization
Our operating costs, excluding depreciation and amortization, increased by $54.0 million, or 65%, from $82.6 million to $136.6 million for the years ended June 30, 2012 and 2013, respectively. The increase in operating costs primarily relates to additional network costs incurred in order to support new customer contracts entered into subsequent to June 30, 2012 and additional costs associated with our Fiscal 2012 and Fiscal 2013 acquisitions. The 65% increase in operating costs occurred
during the same period in which our revenues increased by 159%. The lower ratio of operating costs as compared to revenues is primarily a result of gross installed revenues having a lower component of associated operating costs than the prior period's installed revenue base since a higher percentage of our newly installed revenue are supported by our owned infrastructure assets (i.e., on-net). The ratio also benefited from a higher percentage of acquired revenue being on-net and from network related synergies realized related to our Fiscal 2012 and Fiscal 2013 acquisitions.
Selling, General and Administrative Expenses
The table below sets forth the components of our selling, general and administrative (“SG&A”) expenses during the years ended June 30, 2013 and 2012:
Compensation and Benefits Expenses. Compensation and benefits expenses increased by $71.2 million, or 151%, from $47.1 million to $118.3 million for the year ended June 30, 2013. The increase reflects the increased number of employees hired during the year to support our growing business, including certain employees retained from acquired businesses. At June 30, 2013, we had 1,130 full time employees compared to 500 full time employees at June 30, 2012. A majority of the increase to our headcount occurred on July 2, 2012 as a result of hiring certain former employees of AboveNet.
Network Operations Expenses. Network operations expenses increased by $83.2 million, or 224%, from $37.1 million to $120.3 million for the years ended June 30, 2012 and 2013, respectively. The increase in such expenses principally reflects the growth of our network assets and the related expenses of operating that expanded network. The ratio of network operating expenses as a percentage of revenues increased during the year ended June 30, 2013 to 12% compared to 10% in the year ended June 30, 2012. The increase is principally a result of additional expenses due to our Fiscal 2013 and Fiscal 2012 acquisitions. In addition, during the fourth quarter of 2013, we recognized a one-time charge of $6.6 million related to lease termination costs associated with exit activities initiated for unutilized office and technical facilities space.
Other SG&A. Other SG&A expenses, which includes expenses such as property tax, franchise fees, travel, office expense, and maintenance expense on colocation facilities, increased by $39.4 million, or 189%, from $20.9 million to $60.2 million for the years ended June 30, 2013. The increase is principally a result of additional expenses attributable to our Fiscal 2013 and Fiscal 2012 acquisitions. In addition, during the fourth quarter of 2013, we recognized a one-time charge of $3.6 million related to lease termination costs associated with exit activities initiated for unutilized office and technical facilities space.
Transaction Costs. Transaction costs include expenses associated with professional services (i.e., legal, accounting, regulatory, etc.) rendered in connection with acquisitions and travel expense, severance and other expenses incurred that are directly associated with potential and closed acquisitions. Transaction costs increased during the year ended June 30, 2013, as compared to the year ended June 30, 2012 by $7.6 million from $6.6 million to $14.2 million for the years ended June 30, 2012 and 2013, respectively, primarily due to the relative number and size of acquisitions that occurred in Fiscal 2013 as compared to Fiscal 2012.
Stock-Based Compensation. Stock-based compensation expenses increased by $78.7 million, or 299%, from $26.3 million to $105.0 million during the years ended June 30, 2012 and 2013, respectively.
The stock-based compensation expense associated with the common units is impacted by both the estimated value of the common units and the number of common units vesting during the period. The following table reflects the estimated fair value of the common units during the relevant periods impacting the stock-based compensation expense for the years ended June 30, 2013 and 2012.
The increase in the value of the common units is primarily a result of our organic growth since June 30, 2012, synergies realized and expected to be realized from our Fiscal 2012 and Fiscal 2013 acquisitions and a reduction to the discount rate utilized in the Company's valuation of the common units resulting from the Company's reduced financing costs.
We recognize changes in the fair value of the common units through increases or decreases in stock-based compensation expense and adjustments to the related stock-based compensation liability. The stock-based compensation liability associated with the common units was $158.5 million and $54.4 million as of June 30, 2013 and June 30, 2012, respectively. The liability is impacted by changes in the estimated value of the common units, number of vested common units, and distributions made to holders of the common units.
In December 2011, CII and the preferred unit holders of CII authorized a non-liquidating distribution to common unit holders of up to $10.0 million. The eligibility for receiving proceeds from the distribution was determined by the liquidation preference of the unit holder. Receiving proceeds from the authorized distribution was at the election of the common unit holder. As a condition of the early distribution, common unit holders electing to receive an early distribution received 85% of the amount that they would otherwise be entitled to receive if the distribution were in connection with a liquidating distribution. The common unit holders electing to receive the early distribution retained all of their common units and are entitled to receive future distributions only to the extent such future distributions are in excess of the non-liquidating distribution, excluding the 15% discount. During the year ended June 30, 2012, $9.1 million was distributed to the Company's common unit holders. Common unit holders electing to receive the early distribution forfeited $1.6 million in previously recognized stock-based compensation, which was recorded as a reduction to stock-based compensation during the year ended June 30, 2012.
Depreciation and Amortization
Depreciation and amortization expense increased by $240.1 million, or 282%, from $85.0 million to $325.1 million for the years ended June 30, 2012 and 2013, respectively. The increase is a result of the substantial increase to our property and equipment and intangible assets since June 30, 2012, principally a result of our Fiscal 2012 and Fiscal 2013 acquisitions and our $332.5 million in capital expenditures since June 30, 2012.
Total Other Expense, Net
The table below sets forth the components of our total other expense, net for the years ended June 30, 2013 and 2012, respectively.
Interest expense. Interest expense increased by $151.8 million, or 299%, from $50.7 million to $202.5 million for the years ended June 30, 2012 and 2013, respectively. The increase is a result of our increased indebtedness during Fiscal 2013 as compared to Fiscal 2012, partially offset by a decrease in our weighted-average interest rate from Fiscal 2012 to Fiscal 2013.
Loss on extinguishment of debt. In connection with the repayment of the Company's previously existing term loan and revolver and redemption of the Company's $350.0 million outstanding aggregate principal amount of previously issued notes in July 2012 (the "July 2, 2012 debt refinancing activities") and the subsequent re-pricing transactions completed during the second and third quarters of Fiscal 2013 related to the Company's Term Loan Facility and Revolver (the "Second and Fourth Amendments to our Credit Agreement"), the Company recorded a loss on extinguishment of debt totaling $77.3 million during the year ended June 30, 2013. In connection with the July 2, 2012 debt refinancing activities, discussed above, we recognized an expense of $65.0 million associated with debt extinguishment costs, including a cash expense of $39.8 million associated with the payment of early redemption fees on our previous indebtedness and non-cash expenses of $17.0 million associated with the write-off of our unamortized debt issuance costs and $8.1 million associated with the write-off of the net unamortized discount on the extinguished debt balances. In connection with the Second and Fourth Amendments to our Credit Agreement, we recognized a loss on extinguishment of debt of $12.3 million. The loss consisted of a cash expense of $3.3 million associated with the payment of an early call premium paid to certain creditors and other third party expenses and $9.0 million associated with the write-off of unamortized debt issuance costs and discounts.
Impairment of cost method investment. In connection with the October 1, 2010 acquisition of American Fiber Systems Holdings Corporation ("AFS"), the Company acquired an ownership interest in USCarrier. As of June 30, 2012, the Company’s ownership in USCarrier was comprised of 55% of the outstanding Class A membership units and 34% of the outstanding Class B membership units. On August 15, 2012, the Company entered into an agreement to acquire the remaining equity interest in USCarrier. Although the Company had a significant ownership position in USCarrier at June 30, 2012, as a result of certain disputes with the board of managers of USCarrier, the Company was unable to exercise control or significant influence over USCarrier’s operating and financial policies and was denied regular access to the financial records of USCarrier and as such the Company accounted for this investment utilizing the cost method of accounting. At the time of the AFS merger, management estimated the fair value of its interest in USCarrier to be $15.1 million. Based upon the agreed upon purchase price of the remaining outstanding equity interests, the fair value of the Company’s ownership interest in USCarrier as of June 30, 2012 was determined to be $12.8 million and as such the Company recognized an impairment of $2.2 million during the quarter ended June 30, 2012.
Provision for Income Taxes
The Company recorded a benefit from income taxes of $24.0 million during the year ended June 30, 2013 as compared to a provision for income taxes of $29.6 million during the year ended June 30, 2012. Our provision for income taxes includes both the current provision and a provision for deferred income tax expense resulting from timing differences between tax and financial reporting accounting bases. We are unable to combine our net operating losses (“NOLs”) for application to the income of our subsidiaries in some states and thus our state income tax expense is higher than the expected blended rate. In addition, as a result of our stock-based compensation and transaction costs not being deductible for income tax purposes, our effective tax rate is higher than the statutory rate. During the year ended June 30, 2013, the Company dissolved certain acquired legal entities which resulted in the loss of state NOLs that were generated by the dissolved legal entities. The loss of these NOLs resulted in an increase to the provision for income taxes of $2.8 million during the year ended June 30, 2013. The following table reconciles an expected tax provision based on the statutory federal tax rate applied to our earnings before income taxes.
Year Ended June 30, 2012 Compared to the Year Ended June 30, 2011
Revenue
Our total revenue increased by $94.8 million, or 33%, from $287.3 million to $382.0 million for the years ended June 30, 2011 and 2012, respectively. The increase in revenue was impacted by the October 1, 2010 AFS merger, the December 1, 2011 acquisition of 360networks and December 31, 2011 acquisition of MarquisNet. The monthly recurring revenue on the acquisition date of the acquired AFS, 360networks, and MarquisNet businesses was approximately $2.3 million, $7.0 million and $0.6 million, respectively. The remaining increase in revenue recognized during the year ended June 30, 2012 as compared to the year ended June 30, 2011 was a result of organic growth. As a result of internal sales efforts since June 30, 2011, we have entered into $663.0 million of gross new sales contracts, which will represent an additional $8.9 million in monthly revenue once installation on those contracts is accepted. Since June 30, 2011, we have received acceptance on gross installations that have resulted in additional monthly revenue of $7.7 million as of June 30, 2012, as compared to June 30, 2011. This increase in revenue related to our organic growth is partially offset by total customer churn of $4.9 million in monthly revenue since June 30, 2011.
The following table reflects the stratification of our revenues during these periods.
Zayo Bandwidth. Our revenues from our ZB operating segment increased by $58.0 million, or 27%, from $214.1 million to $272.1 million during the years ended June 30, 2011 and 2012, respectively. The increase is a result of both acquisitions and organic growth. Of the approximately $2.3 million in acquired monthly recurring revenue from AFS, approximately $1.5 million was assigned to the ZB operating segment. Additionally, $5.4 million of the acquired monthly recurring revenue from 360networks was assigned to the ZB operating segment. Since June 30, 2011, ZB received acceptance on gross installations that have resulted in additional monthly revenue of $5.4 million as of June 30, 2012, as compared to June 30, 2011. This increase in revenue related to organic growth is partially offset by total customer churn at ZB of $3.9 million in monthly revenue since June 30, 2011. Also offsetting the increase in revenue is a decrease resulting from ZB transferring certain intra-building and colocation assets and related customer revenues to the zColo segment on January 1, 2011 and on July 1, 2011.
Zayo Fiber Solutions. Our revenues from our ZFS operating segment increased by $26.3 million, or 59%, from $44.5 million to $70.9 million during the years ended June 30, 2011 and 2012, respectively. The increase is a result of both acquisitions and organic growth. Of the approximately $2.3 million in acquired monthly recurring revenue from AFS, approximately $0.8 million was assigned to the ZFS operating segment. Additionally, $1.6 million of the acquired monthly recurring revenue from 360networks was assigned to the ZFS operating segment. Since June 30, 2011, ZFS received acceptance on gross installations that have resulted in additional monthly revenue of $1.5 million as of June 30, 2012, as compared to June 30, 2011. This increase in revenue related to organic growth is partially offset by total customer churn at ZFS of $0.3 million in monthly revenue since June 30, 2011.
zColo. Our revenues from our zColo segment increased by $9.4 million, or 28% from $33.9 million to $43.3 million during the years ended June 30, 2011 and 2012, respectively. The increase is a result of acquisition and organic growth and as a result of certain intra-building and colocation services, which were migrated from ZB to zColo subsequent to June 30, 2011. The Company acquired MarquisNet on December 31, 2011 and the entire MarquisNet business was allocated to the zColo segment. The monthly recurring revenue on the acquisition date of the acquired MarquisNet business was approximately $0.6 million. Since June 30, 2011, zColo received acceptance on gross installations that have resulted in additional monthly revenue of $0.8 million as of June 30, 2012, as compared to June 30, 2011. This increase in revenue related to organic growth is partially offset by total customer churn at zColo of $0.7 million in monthly revenue since June 30, 2011. Effective January 1, 2011, the ZB segment transferred contracts amounting to approximately $0.3 million in monthly recurring revenue to the zColo Strategic Product Group and effective July 1, 2011, ZB transferred a colocation facility in Pittsburgh, Pennsylvania and the associated quarterly recurring revenue of approximately $0.1 million to the zColo segment.
Operating Costs, Excluding Depreciation and Amortization
Our operating costs, excluding depreciation and amortization, increased by $11.1 million, or 15% from $71.5 million to $82.6 million for the years ended June 30, 2011 and 2012, respectively. The increase in operating costs, excluding depreciation and amortization, primarily relates to additional network costs incurred in order to support new customer contracts entered into subsequent to June 30, 2011 and additional costs associated with the acquired 360networks, MarquisNet and Arialink businesses. The 15% increase in operating costs, excluding depreciation and amortization, occurred during the same period in which our revenues increased by 33%. The lower ratio of operating costs as compared to revenues is primarily a result of gross installed revenues having a lower component of associated operating costs than the prior period’s installed revenue base due to a higher percentage of our newly installed revenue being supported by our owned infrastructure assets (i.e., on-net). The ratio also benefited from synergies realized related to our previous acquisitions.
Selling, General and Administrative Expenses
The table below sets forth the components of our SG&A expenses during the years ended June 30, 2012 and 2011, respectively.
Compensation and Benefits Expenses. Compensation and benefits expenses increased by $7.4 million, or 19%, from $39.7 million to $47.1 million for the years ended June 30, 2011 and 2012, respectively. The increase reflects the increased number of employees hired during the year to support our growing business. At June 30, 2012, we had 500 full time employees compared to 396 at June 30, 2011. A majority of the increase to our headcount occurred on December 1, 2011 as a result of hiring certain former employees of 360networks.
Network Operations Expenses. Network operations expenses increased by $9.5 million, or 35%, from $27.6 million to $37.1 million for the years ended June 30, 2011 and 2012, respectively. The increase in such expenses principally reflects the growth of our network assets and the related expenses of operating that expanded network. The ratio of network operating expenses as a percentage of revenues was consistent during the years ended June 30, 2012 and 2011 at 10%.
Other SG&A. Other SG&A expenses, which includes expenses such as property tax, franchise fees, travel, office expense, and maintenance expense on colocation facilities, decreased by $0.9 million, or 4%, from $21.8 million to $20.9 million for the years ended June 30, 2011 and 2012, respectively. The decrease is principally a result of reduced franchise fees resulting from favorable renegotiations on existing franchise agreements. These savings were partially offset by increases in other SG&A expenses associated with our acquisitions of 360networks and MarquisNet.
Transaction Costs. Transaction costs include expenses associated with professional services (i.e., legal, accounting, regulatory, etc.) rendered in connection with acquisitions, travel expense, severance expense incurred on the date of acquisition and other direct expenses incurred that are associated with potential and closed acquisitions. Transaction costs increased during Fiscal 2012 by $5.8 million as a result of costs associated with our acquisitions of 360networks, MarquisNet, Arialink, AboveNet, FiberGate and USCarrier.
Stock-Based Compensation. Stock-based compensation expense increased by $1.9 million, or 8%, from $24.3 million to $26.3 million for the years ended June 30, 2011 and 2012, respectively.
The stock-based compensation expense associated with the common units is impacted by both the estimated value of the common units and the number of common units vesting during the period. During the year ended June 30, 2012, an additional 9.4 million units vested as compared to the year ended June 30, 2011. The following table reflects the estimated fair value of the common units during the relevant periods impacting the stock-based compensation expense for the years ended June 30, 2012, 2011and 2010.
Depreciation and Amortization
Depreciation and amortization expense increased by $24.5 million, or 41%, from $60.5 million to $85.0 million for the years ended June 30, 2011 and 2012, respectively. The increase is a result of the substantial increase to our property and equipment and intangible assets since June 30, 2011, principally a result of $124.1 million in capital expenditures since June 30, 2011 and the increase to our property and equipment and intangible asset balance due to the AFS acquisition on October 1, 2010, the 360networks acquisition on December 1, 2011, the MarquisNet acquisition on December 31, 2011 and the Arialink acquisition on May 1, 2012.
Total Other Expense, Net
The table below sets forth the components of our total other expense, net for the years ended June 30, 2012 and 2011, respectively.
Interest Expense. Interest expense increased by $17.3 million, or 52%, from $33.4 million to $50.7 million for the years ended June 30, 2011 and 2012, respectively. The increase is a result of our increased indebtedness during the year ended June 30, 2012 as compared to the year ended June 30, 2011. In connection with the 360networks acquisition, we entered into a $315.0 million Term Loan agreement on December 1, 2011, which accrued interest during the period at 7.0%. During the quarter ended March 31, 2012, we borrowed an additional $30.0 million against our Prior Revolving Credit Facility, which accrued interest at a floating rate ranging from 4.0% to 4.75% during the period.
Impairment of cost method investment. In connection with the AFS merger, the Company acquired an ownership interest in USCarrier. As of June 30, 2012, the Company’s ownership in USCarrier was comprised of 55% of the outstanding Class A membership units and 34% of the outstanding Class B membership units. On August 15, 2012, the Company entered into an agreement to acquire the remaining equity interest in USCarrier. Although the Company had a significant ownership position in USCarrier at June 30, 2012, as a result of certain disputes with the board of managers of USCarrier, the Company was unable to exercise control or significant influence over USCarrier’s operating and financial policies and was denied regular access to the financial records of USCarrier and as such the Company accounted for this investment utilizing the cost method of accounting. At the time of the AFS merger, management estimated the fair value of its interest in USCarrier to be $15.1 million. Based upon the agreed upon purchase price of the remaining outstanding equity interests, the fair value of the Company’s ownership interest in USCarrier as of June 30, 2012 was determined to be $12.8 million and as such the Company recognized an impairment of $2.2 million during the quarter ended June 30, 2012.
Provision for Income Taxes
Income tax expense increased over the prior year by $16.7 million, from $12.5 million to $29.2 million, for the years ended June 30, 2011 and 2012, respectively. Our provision for income taxes includes both the current provision and a provision for deferred income tax expense resulting from timing differences between tax and financial reporting accounting bases. We are
unable to combine our net operating losses (“NOLs”) for application to the income of our subsidiaries in some states and thus our state income tax expense is higher than the expected blended rate. In addition, as a result of our stock based compensation and transaction costs not being deductible for income tax purposes, our effective tax rate is higher than the statutory rate.
The following table reconciles an expected tax provision based on a statutory federal tax rate applied to our book net income.
Adjusted EBITDA
We define Adjusted EBITDA as earnings from continuing operations before interest, income taxes, depreciation and amortization (“EBITDA”) adjusted to exclude transaction costs, stock-based compensation, and certain non-cash items. We use Adjusted EBITDA to evaluate operating performance, and this financial measure is among the primary measures used by management for planning and forecasting for future periods. We believe that the presentation of Adjusted EBITDA is relevant and useful for investors because it allows investors to view results in a manner similar to the method used by management and facilitates comparison of our results with the results of other companies that have different financing and capital structures.
We also monitor Adjusted EBITDA because we have debt covenants that restrict our borrowing capacity that are based on a leverage ratio, which utilizes a modified EBITDA, as defined in our Credit Agreement. The modified EBITDA is consistent with our definition of Adjusted EBITDA; however, it includes the pro forma Adjusted EBITDA of and expected synergies from the companies acquired by us during the quarter in which the debt compliance certification is due. The indentures governing our Notes limit any increase in our secured indebtedness (other than certain forms of secured indebtedness expressly permitted under the indentures) to a pro forma secured debt ratio of 4.5 times our previous quarter's annualized modified EBITDA and limit our incurrence of additional indebtedness to a total indebtedness ratio of 5.25 times our previous quarter's annualized modified EBITDA, which is consistent with the incurrence restrictions in the Credit Agreement governing our Term Loan Facility.
Adjusted EBITDA results, along with other quantitative and qualitative information, are also utilized by management and our compensation committee for purposes of determining bonus payouts to employees.
Adjusted EBITDA has limitations as an analytical tool and should not be considered in isolation from, or as a substitute for, analysis of our results as reported under GAAP. For example, Adjusted EBITDA:
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does not reflect capital expenditures, or future requirements for capital and major maintenance expenditures or contractual commitments;
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does not reflect changes in, or cash requirements for, our working capital needs;
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does not reflect the significant interest expense, or the cash requirements necessary to service the interest payments, on our debt; and
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does not reflect cash required to pay income taxes.
Our computation of Adjusted EBITDA may not be comparable to other similarly titled measures computed by other companies because all companies do not calculate Adjusted EBITDA in the same fashion. Reconciliations from net earnings/(loss) from continuing operations to Adjusted EBITDA and net cash provided by operating activities to Adjusted EBITDA are as follows:
Reconciliation from net earnings/(loss) to Adjusted EBITDA
Liquidity and Capital Resources
Our primary sources of liquidity have been cash provided by operations, equity contributions, and borrowings. Our principal uses of cash have been for acquisitions, capital expenditures, and debt service requirements. See Item 7 - “Management's Discussion and Analysis of Financial Condition and Results of Operations - Cash Flows,” below. We anticipate that our principal uses of cash in the future will be for acquisitions, capital expenditures, working capital, and debt service.
We have financial covenants under the Indentures governing our Notes and our Credit Agreement that, under certain circumstances, restrict our ability to incur additional indebtedness. The Indentures governing our Notes limit any increase in our secured indebtedness (other than certain forms of secured indebtedness expressly permitted under the Indentures) to a pro forma secured debt ratio of 4.5 times our previous quarter's annualized modified EBITDA and limit our incurrence of additional indebtedness to a total indebtedness ratio of 5.25 times our previous quarter's annualized modified EBITDA. The Credit Agreement similarly limits our incurrence of additional indebtedness. See Note 9- Long Term Debt - Debt Covenants for more information on our financial covenants.
As of June 30, 2013, we had $88.1 million in cash and cash equivalents and a working capital deficit of $54.0 million. Cash and cash equivalents consist of amounts held in bank accounts and highly-liquid U.S. treasury money market funds. Although we have a working capital deficit as of June 30, 2013, a substantial portion of the deficit is a result of a current deferred revenue balance of $36.0 million that we will be recognizing as revenue over the next twelve months. The actual cash outflows associated with fulfilling this deferred revenue obligation during the next twelve months will be significantly less than the June 30, 2013 current deferred revenue balance. Additionally, as of June 30, 2013, we had $243.4 million available under our Revolver, which includes a reduction for outstanding letters of credit. No amounts have been drawn against the $250.0 million Revolver.
Our capital expenditures, net of stimulus grants, increased by $199.1 million, or 160.4%, during the year ended June 30, 2013 as compared to the year ended June 30, 2012 from $124.1 million to $323.2 million, respectively. Our capital expenditures primarily relate to success-based contracts. The increase in capital expenditures is a result of meeting the needs of our larger customer base resulting from our acquisitions and organic growth. We expect to continue to invest in our network for the foreseeable future. These capital expenditures, however, are expected to primarily be success-based; that is, in most situations, we will not invest the capital until we have an executed customer contract that supports the investment.
As part of our corporate strategy, we continue to be regularly involved in discussions regarding potential acquisitions of companies and assets, some of which may be quite large. We expect to fund such acquisitions with cash from operations, debt (including available borrowings under our $250.0 million Revolver), equity contributions, and available cash on hand.
Cash Flows
We believe that our cash flow from operating activities, in addition to cash and cash equivalents currently on-hand, will be sufficient to fund our operating activities for the foreseeable future, and in any event for at least the next 12 to 18 months. Given the generally volatile global economic climate, no assurance can be given that this will be the case.
We regularly review acquisitions and additional strategic opportunities, including large acquisitions, which may require additional debt or equity financing.
The following table sets forth components of our cash flow for the years ended June 30, 2013, 2012, and 2011.
Net Cash Flows from Operating Activities
Net cash flows from operating activities increased by $225.7 million, or 135%, from $167.6 million to $393.3 million during the years ended June 30, 2012 and 2013, respectively. Net cash flows from operating activities during the year ended June 30, 2013 represents the loss from continuing operations of $144.6 million, plus the add backs of non-cash items deducted in the determination of net loss, principally depreciation and amortization of $322.7 million, stock-based compensation expense of $105.0 million, losses on extinguishment of debt of $77.3 million, additions to deferred revenue of $61.5 million and non-cash interest expense of $12.3 million, less amortization of deferred revenue of $42.3 million and changes in the deferred tax provision of $25.7 million, plus or minus the net change in working capital components.
Net cash flows from operating activities during the year ended June 30, 2012 represents our net loss from continuing
operations of $5.8 million, plus the add back to our net loss of non-cash items deducted in the determination of net loss, principally depreciation and amortization of $85.0 million, the deferred tax provision of $31.1 million and non-cash stock-based compensation expense of $26.3 million, plus the change in working capital components.
The increase in net cash flows from operating activities during the year ended June 30, 2013 as compared to the year ended June 30, 2012 is primarily a result of additional earnings from synergies realized from our Fiscal 2012 and Fiscal 2013 acquisitions and organic growth.
Cash Flows Used for Investing Activities
We used cash in investing activities of $2,795.9 million and $475.4 million during the years ended June 30, 2013 and 2012, respectively. During the year ended June 30, 2013, our principal uses of cash for investing activities were $2,212.5 million for the acquisition of AboveNet, $118.3 million for the acquisition of FiberGate, $16.1 million for the acquisition of USCarrier, $109.7 million for the acquisition of First Telecom, $22.2 million for the acquisition of Litecast, $7.0 million for the acquisition of Core NAP and $323.2 million in additions to property and equipment, net of stimulus grant reimbursements. Partially offsetting the net cash used in investing activities during the year ended June 30, 2013 was purchase consideration of $1.9 million and $0.8 million returned from our acquisitions of MarquisNet and Arialink, respectively and $10.4 million in principal payments received during the period against a related party loan.
During the year ended June 30, 2012, our principal uses of cash for investing activities were $317.9 million for the acquisition of 360networks, $15.5 million for our acquisition of MarquisNet, $17.9 million for the acquisition of Arialink and $124.1 million in additions to property and equipment, net of stimulus grant reimbursements.
Cash Flows from Financing Activities
Our net cash provided by financing activities was $2,334.0 million and $433.1 million during the years ended June 30, 2013 and 2012, respectively. Our cash flows from financing activities during the year ended June 30, 2013 primarily comprise $3,189.3 million from the proceeds from long-term debt, $345.0 million in equity contributions from Holdings and $22.7 million in net transfers of cash out of restricted cash accounts. These cash inflows were partially offset by $83.1 million in debt issuance costs, $1,058.6 million in principal repayments on long-term debt obligations, $72.1 million in early redemption fees on debt extinguishments, $7.2 million in cash contributed to ZPS, and $1.9 million in principal payments on capital leases during the year ended June 30, 2013.
Our cash flows from financing activities during the year ended June 30, 2012 comprise $335.6 million from the proceeds from long-term borrowings, and $134.8 million in equity contributions from Holdings. This cash inflow was partially offset by $11.7 million in debt issuance costs, $1.6 million in principal repayments on long-term debt obligations, $22.8 million in net transfers of cash to restricted cash accounts and $1.6 million in principal payments on capital leases during the period.
Contractual Cash Obligations
The following table represents a summary of our estimated future payments under contractual cash obligations as of June 30, 2013. Changes in our business needs, cancellation provisions, changing interest rates and other factors may result in actual payments differing from these estimates. We cannot provide certainty regarding the timing and amounts of these future payments.
Our purchase commitments are primarily success-based; that is, we have executed customer contracts that support the future capital expenditures. The contractual long-term debt payments, above, include an estimate of future interest expense based on the interest rates in effect on our floating rate debt obligations as of the most recent balance sheet date.
Off-Balance Sheet Arrangements
We do not have any special purpose or limited purpose entities that provide off-balance sheet financing, liquidity, or market or credit risk support and we do not engage in leasing, hedging, or other similar activities that expose us to any significant liabilities that are not (i) reflected on the face of the consolidated financial statements, (ii) disclosed in Note 15 - Commitments and Contingencies to the consolidated financial statements, or in the Future Contractual Obligations table included in this Item 7 above or (iii) discussed under "Item 7A:
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our exposure to market risk consists of changes in interest rates from time to time and market risk arising from changes in foreign currency exchange rates that could impact our cash flows and earnings.
As of June 30, 2013, we had outstanding approximately $750.0 million Senior Secured Notes, $500.0 million Senior Unsecured Notes, a balance of $1,580.7 million on our Term Loan Facility and $13.2 million of capital lease obligations. As of September 23, 2013, our Revolver was undrawn, and we had $243.4 million available for borrowing capacity.
Based on current market interest rates for debt of similar terms and average maturities and based on recent transactions, we estimate the fair value of our Notes to be $1,364.4 million as of June 30, 2013. Our Senior Secured Notes and Senior Unsecured Notes accrue interest at fixed rates of 8.125% and 10.125%, respectively.
Both our Revolver and our Term Loan Facility accrue interest at floating rates subject to certain conditions. As of June 30, 2013, the applicable interest rate on our Revolver was 3.3% and the rate on our Term Loan Facility was 4.5%. A hypothetical increase in the applicable interest rate on our Term Loan Facility of one percentage point would increase our annual interest expense by 0.2% or $3.2 million because the applicable interest rate as of June 30, 2013 was below the Credit Agreement's 1.0% LIBOR floor. A hypothetical increase of one percentage point above the LIBOR floor would increase the Company's annual interest expense by approximately $16.0 million. These interest rate sensitivities do not give consideration to any potential offset related to our forward-starting interest rate swaps, which are discussed below.
In August 2012, we entered into forward-starting interest rate swap agreements with an aggregate notional value of $750.0 million, a maturity date of June 30, 2017, and a start date of June 30, 2013. There was no up-front cost for this agreement. The contract states that we shall pay a 1.67% fixed rate of interest for the term of the agreement beginning on the start date. The counterparty will pay to us the greater of actual LIBOR or 1.25%. We entered in to the forward-starting swap arrangements to reduce the risk of increased interest costs associated with potential future increases in LIBOR rates. We recognized changes in the fair value of the interest rate swaps of $2.6 million was reflected as a decrease in interest expense for the year ended June 30, 2013. A hypothetical increase in LIBOR rates of 100 basis points would increase the fair value of our interest rate swaps by approximately $26.6 million.
We are exposed to the risk of changes in interest rates if it is necessary to seek additional funding to support the expansion of our business and to support acquisitions. The interest rate that we may be able to obtain on future debt financings will be dependent on market conditions.
We have exposure to market risk arising from foreign currency exchange rates, primarily as it relates to the British pound. During the year ended June 30, 2013, our foreign activities accounted for 5.9% of our consolidated revenue. Due to the strengthening of the British pound compared to the U.S. dollar, the average translation rate for the year ended December 31, 2013 increased 1.0% compared to the average translation rate used for the year ended December 31, 2012.
We monitor foreign markets and our commitments in such markets to manage currency and other risks. To date, we have not entered into any hedging arrangement designed to limit exposure to foreign currencies. Because of our European expansion, our level of foreign activities is expected to increase and if it does, we may determine that such hedging arrangements would be appropriate and will consider such arrangements to minimize risk.
We do not have any material commodity price risk.
ITEM 8.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Reference is made to the information set forth beginning on page.
ITEM 9.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A.
CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
We carried out an evaluation as of the last day of the period covered by this Annual Report on Form 10-K, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (the “Exchange Act”). Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in reports filed or submitted under the Exchange Act is accumulated and communicated to our management, including our Chief Executive
Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Based on our evaluation under the framework in Internal Control-Integrated Framework, our management concluded that our disclosure controls and procedures were effective as of June 30, 2013.
Management’s Annual Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
Based on our evaluation under the framework in Internal Control-Integrated Framework, our management concluded that our internal control over financial reporting was effective as of June 30, 2013.
Changes in Internal Controls over Financial Reporting
There were no changes in our internal control over financial reporting that occurred during the most recently completed fiscal quarter that have materially affected, or are reasonably likely to material affect, our internal control over financial reporting.
ITEM 9B.
ITEM 9B.
OTHER INFORMATION
Not applicable.
PART III
ITEM 10.
ITEM 10.
DIRECTOR, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The following table sets forth the names, ages and positions of our directors and executive officers as of June 30, 2013. Additional biographical information for each individual is provided in the text following the table.
Management Team
Daniel Caruso, one of our cofounders, has served as our Chief Executive Officer since our inception in 2007. Between 2004 and 2006, Mr. Caruso was President and CEO of ICG Communications, Inc. (“ICG”). In 2004, he led a buyout of ICG and took it private. In 2006, ICG was sold to Level 3 Communications, Inc. (“Level 3”). Prior to ICG, Mr. Caruso was one of the founding executives of Level 3, and served as their Group Vice President from 1997 through 2003 where he was responsible for Level 3’s engineering, construction, and operations organization and most of its lines of business and marketing functions. Prior to Level 3, Mr. Caruso was a member of the MFS Communications Company, Inc. (“MFS Communications”) senior management team. He began his career at Illinois Bell Telephone Company, a former subsidiary of Ameritech Corporation. He holds an MBA from the University of Chicago and a B.S. in Mechanical Engineering from the University of Illinois.
Kenneth desGarennes has served as our Chief Financial Officer and Vice President since October 2007. From November 2003 to October 2007, Mr. desGarennes served as Chief Financial Officer for Wire One Communications, Inc. (“Wire One”). Prior to joining Wire One, Mr. desGarennes was a Senior Director at The Gores Group, LLC, a technology-focused private equity firm. Mr. desGarennes started his career as a commercial banking officer with First Union Bank before moving to Accenture plc, where he worked for six years in a corporate development role. Mr. desGarennes received his B.S. in finance from the University of Maryland in College Park.
Scott Beer has served as our Vice President, General Counsel and Secretary since May 2007. From August 2006 to May 2007, Mr. Beer worked for Level 3 as VP of Carrier Relations. Prior to Level 3’s acquisition of ICG, Mr. Beer was VP and General Counsel of ICG, overseeing all legal and regulatory matters for the company from September 2004 to August 2006. Before starting with ICG, Mr. Beer was in-house counsel at MCI WorldCom Network Services Inc., supporting the Mass Markets Finance Department for three years. He began his legal career as an associate attorney for McGloin, Davenport, Severson & Snow, PC, where he was a commercial litigator and represented several large communication companies. Mr. Beer holds a Juris Doctorate from Detroit College of Law at Michigan State University. He earned his B.A. from Michigan State in Communications and Pre-law.
David Howson has served as President of Sales and Customer Management since May 2012. Mr. Howson joined the Company in June 2010 as President of the zColo business unit. From April 1998 to May 2010, Mr. Howson served as part of the management team at Level 3 where he was responsible for various operations roles, including serving as Senior Vice President from 2004 to 2010. Before joining Level 3, Mr. Howson worked for a subsidiary of MFS Communications responsible for the design and construction of fiber networks and colocation facilities in Europe, Asia, and Australia. Mr. Howson earned his Engineering degree from Oxford Brookes University in England.
Glenn Russo has served as Executive Vice President of Corporate Strategy and Development since April 2011. Mr. Russo joined the Company in September 2008 as President of Zayo Enterprise Networks. Mr. Russo’s responsibilities include the evaluation and execution of acquisition opportunities, business development, Zayo Professional Services, Europe and marketing. From September 2000 to August 2008, Mr. Russo served as part of the management team at Level 3. He acted as Senior Vice President from 2003 to 2008, where he was responsible for transport and infrastructure services across North America and Europe. Before joining Level 3, Mr. Russo was a senior executive at Bridgeworks Inc., a regional network services company in Texas, and spent 16 years with ExxonMobil’s global chemical product division in a range of IT, sales and finance leadership positions. Mr. Russo earned his Engineering degree from Cornell University.
Chris Morley has served as President of IP, Colocation and Ethernet since May 2012 and the Network Control Center since June 2013. Mr. Morley joined the Company in 2009 and served as Chief Financial Officer and Head of Product Management for the Zayo Bandwidth business unit until December 2010. From December 2010 through May 2012, Mr. Morley served as the President of zColo. From 2008 until joining the Company in 2009, Mr. Morley acted as an independent consultant advising operating companies and private equity investors on strategy, merger and acquisition due diligence, execution, and operational improvements. During 2006 and 2007, Mr. Morley served as part of the management team for One Communications Corporation, serving as Chief Integration Officer and the Executive Vice President of Operations and Networks. From 1999 to 2006, Mr. Morley served as part of the management team for Conversent Communications, LLC, serving as Executive Vice President of Operations and Engineering. Mr. Morley received his B.S. in Finance from the University of Denver.
Matthew Erickson has served as the President of Zayo Fiber and Transport Services since May 2012. Mr. Erickson's responsibilities include full business responsibility for Zayo's Dark Fiber, Wavelength, Sonet and Mobile Infrastructure Business Units. In addition, Mr. Erickson oversees Zayo's operations and outside plant organizations. Mr. Erickson joined the Company in 2006. From 2006 through May of 2012, Mr. Erickson has held various roles at the company including President of Zayo Fiber Solutions, Senior Vice President of Corporate Development & Strategy and Vice President of Marketing & Product Management. Before joining the Company, Mr. Erickson was at ICG, where he was Vice President of Marketing & Product Management from 2004 to 2006. Prior to ICG, Mr. Erickson was at Level 3, where he held various roles including Internet, transport and infrastructure product management and corporate strategy/development. Mr. Erickson began his career at PricewaterhouseCoopers in the audit and financial advisory services groups. Mr. Erickson received his B.S. in Accounting from Colorado State University.
Martin Snella has served as the Chief Technology Officer and Chief Information Officer since January 2010. Mr. Snella joined the Company in January 2008 and served as the Senior Vice President of Operations, Information Technology, Engineering, and OSP from 2008 to 2009. Prior to Zayo, Mr. Snella was the Executive Vice President of Operations at ICG Communications, leading engineering, field operations and information technology. Mr. Snella has served at the executive level in construction, engineering, operations and IT for a number of telecom and technology companies, including Expanets, Qwest Cyber Solutions, Level 3 Communications and AT&T Broadband (TCI). Mr. Snella began his career in 1981, as a Telecommunications Specialist in the United States Air Force.
Directors
Rick Connor has served as a Director and Chairman of the audit committee since June 2010. Mr. Connor is currently retired. Prior to his retirement in 2009, he was an audit partner with KPMG LLP (“KPMG”) where he served clients in the telecommunications, media, and energy industries for 38 years. From 1996 to 2008, he served as the Managing Partner of KPMG’s Denver office. Mr. Connor earned his B.S. degree in accounting from the University of Colorado. Mr. Connor was appointed Director and the Chairman of the Audit Committee as a result of his extensive technical accounting and auditing background, knowledge of SEC filing requirements and experience with telecommunications clients. Mr. Connor is a member of the Board of Directors and Chairman of the Audit Committee of Antero Resources Corporation, an independent oil and natural gas corporation. Mr. Connor is also a member of the Board of Directors and Chairman of the Audit Committee of Centerra Gold, Inc., a Toronto based gold mining company listed on the Toronto Stock Exchange.
Michael Choe has served as a Director since March 2009 and is currently the Chairman of the Compensation Committee. Mr. Choe is currently a Managing Director at Charlesbank Capital Partners LLC (“Charlesbank”), where he is responsible for executing and monitoring investments in companies. He joined Harvard Private Capital Group, the predecessor to Charlesbank, in 1997, and was appointed as Managing Director in 2006. Prior to that he was with McKinsey & Company,
where he focused on corporate strategy work in energy, health care, and media. Mr. Choe graduated from Harvard University with a B.A. in Biology. Mr. Choe is a member of the Board of Directors of DEI Holdings, Inc., Horn Industrial Services, LLC, OnCore Manufacturing, LLC, and United Road Services. Mr. Choe was appointed Director as a result of his extensive experience with mergers and acquisitions of middle-market companies.
John Siegel has served as a Director since May 2007. Mr. Siegel has been a Partner of Columbia Capital since April 2000, where he focuses on communication services investments. Mr. Siegel is a member of the Board of Directors of euNetworks, Cologix, GTS Central Europe, Virtustream, and Teliris, Inc. Prior to Columbia, Mr. Siegel held positions with Morgan Stanley Capital Partners, Fidelity Ventures, and the Investment Banking Division of Alex. Brown & Sons, Incorporated. Mr. Siegel received his B.A. from Princeton University and his M.B.A. from Harvard Business School. Mr. Siegel was appointed Director as a result of his vast knowledge of the telecommunications industry obtained over his career of investing primarily in the telecommunications/data services arena.
Gillis Cashman has served as a Director since May 2007. Mr. Cashman currently serves as a Managing Partner of M/C Partners, where he focuses on telecom and media infrastructure. He joined M/C Partners as an associate in 1999 and was promoted to partner in 2006 before his appointment to his current position in 2007. From 1997 to 1999, he was with Salomon Smith Barney in the Global Telecommunications Corporate Finance Group, where he focused on mergers and acquisitions in the wireline and wireless segments of the telecommunications industry. Mr. Cashman currently serves as the Chairman of Baja Broadband Holding Company, LLC and serves on the Board of Directors of Corelink Data Centers, CSDVRS, GTS Central Europe and Plum Choice, Inc. Mr. Cashman received an AB in economics from Duke University. Mr. Cashman was appointed Director as a result of his merger and acquisition experience and portfolio company management evidenced by his current position at M/C Partners, where he leads the Broadband Infrastructure and Services portion of the M/C Partners portfolio.
John Downer has served as a Director since May 2007. Mr. Downer joined the Oak Investment Partners team as Director-Private Equity in 2003 following a 14-year career as a Managing Director at Cornerstone Equity Investors, LLC, a middle-market private equity firm with over $1.2 billion under management. At Cornerstone, Mr. Downer led the management buyout of a number of technology and tech-related companies and acted as the lead investor for numerous later-stage expansion financings. Prior to Cornerstone, Mr. Downer worked at the private equity groups at T. Rowe Price and the Harvard Management Company. Mr. Downer currently serves as a director of Geotrace Technologies, Inc., LumaSense Technologies, Inc., Plastic Logic Russia, and Enterprise Sourcing Services and is a Trustee of Phillips Exeter Academy. Mr. Downer earned his B.A., J.D., and M.B.A. from Harvard University. Mr. Downer was appointed Director as a result of his knowledge of mergers and acquisitions, legal, financing and operations gathered over his private equity career.
Philip Canfield has served as a Director since July 2012. Mr. Canfield is currently co-head of the Information Services & Technology Group at the private equity firm GTCR. Mr. Canfield joined GTCR in 1992 and became a Principal in 1997. From 1990 until 1992, he was with Kidder, Peabody and Company, where he worked in the corporate finance department. Mr. Canfield is a member of the Board of Directors of Sorenson Communications, Inc., IQNavigator, Inc., Global Traffic Network, Inc., OneSource and Rural Broadband Investments. He holds an M.B.A. from the University of Chicago and a B.B.A. in Finance with high honors from the Honors Business Program at the University of Texas. Mr. Canfield was appointed Director as a result of his experience in corporate finance and in the telecommunications industry, evidenced by his key role in GTCR’s successful investments in AppNet, Transaction Network Services, DigitalNet, CellNet, and Solera.
Lawrence Fey has served as a Director since July 2012. Mr. Fey is currently a Principal at GTCR where he focuses on investments in the Information Services and Technology sector. He joined GTCR in 2005, became a Vice President in 2008 and a Principal in 2012. From 2003 until 2005, he was with Morgan Stanley, where he worked in the Mergers, Acquisition and Restructuring / Corporate Finance group. He currently is a member of the Board of Directors of Six3 Systems, Inc., CAMP Systems International, Inc., Global Traffic Network, Inc., and Mondee, Inc. Mr. Fey holds a B.A. in Economics cum laude from Dartmouth College. Mr. Fey was appointed Director as a result of his experience in corporate finance and in the telecommunications industry, evidenced by his key role in past successful GTCR investments such as Solera and CellNet.
Stephanie Comfort has served as a Director since July 2013. Ms. Comfort is an advisory partner with Genesis, Inc., a Denver-based consultancy where she provides strategy and investor relations consulting to companies in a broad range of industries. Prior to Genesis, Stephanie was Executive Vice President, Corporate Strategy and Development at CenturyLink. Serving in the same role at Qwest Communications International, she was one of four senior executives selected to join the CenturyLink Leadership Team, post-merger. During her ten years at both companies, Stephanie’s responsibilities included corporate strategy, product innovation, brand strategy, investor relations and mergers and acquisitions. Before joining Qwest, Ms. Comfort held various management and analyst positions including 18 years covering the Telecommunications Services sector as a top-ranked sell-side analyst on Wall Street. Stephanie joined Qwest in 2002 from Morgan Stanley where she served as senior telecommunications services analyst, and was recognized as an “All-Star Analyst” by Institutional Investor Magazine and a “Top Stock Picker” by the Wall Street Journal. Stephanie holds an MBA from The Wharton School and a BA in
Economics from Wellesley College. Ms. Comfort was appointed Director as a result of her experience in the telecommunications industry, specifically as it relates to operating companies and her Wall Street investment experience.
Don Gips has served as a Director since July 2013. Mr. Gips served as the United States Ambassador to South Africa from July 2009 until January 2013 and is currently a senior director at the Albright Stonebridge Group, a global strategy firm headquartered in Washington, DC. He is also the chairman of the U.S. Chamber of Commerce’s U.S.-South Africa Business Council. Mr. Gips served as assistant to President Obama on the Presidential Transition Team and then served in the White House, where he ran the office of Presidential Personnel. Mr. Gips previously served in the White House during the Clinton administration, working as Chief Domestic Policy Advisor to Vice President Al Gore. From 1998-2008, Mr. Gips was Group Vice President of Global Corporate Development for Level 3 Communications. Mr. Gips also served as Chief of the International Bureau at the Federal Communications Commission where he was responsible for WTO negotiations and spectrum policy. Before entering government, he was a management consultant to Fortune 500 companies at McKinsey & Company. Mr. Gips received an MBA from the Yale School of Management where he was recently honored as a Donaldson Fellow and received his undergraduate degree from Harvard University. Mr. Gips was appointed Director as a result of his extensive experience in the telecommunications industry.
Committees of the Board
Audit Committee
Our Audit Committee is currently composed of Mr. Connor, Ms. Comfort, Mr. Cashman, and Mr. Fey. Ms. Comfort and Mr. Fey were added to the committee on July 1, 2013. Each of the Audit Committee Members are non-employee members of the board.
Compensation Committee
Our Compensation Committee is currently composed of Mr. Choe, Mr. Gips, Mr. Downer, and Ms. Comfort. Mr. Gips and Ms. Comfort were added to the committee on July 1, 2013. Each of the Compensation Committee Members are non-employee members of the board.
Nominating and Governance Committee
Our Nominating and Governance Committee is currently composed of Mr. Canfield, Mr. Choe, Mr. Siegel, and Mr. Gips. Each of the Nominating and Governance Committee Members are non-employee members of the board.
Code of Ethics
We have adopted a written code of conduct that serves as the code of ethics applicable to our directors, officers and employees, including our principal executive officer and senior financial officers, in accordance with Section 406 of the Sarbanes-Oxley Act of 2002 and the rules of the SEC. In the event that we make any changes to, or provide any waivers from, the provisions of our code of conduct applicable to our principal executive officer and senior financial officers, we intend to disclose such events on our website or in a report on Form 8-K within four business days of such event. This code of conduct is available in the “Corporate Governance” section of our website at http://www.zayo.com/investors.
Compensation Discussion and Analysis
The following Compensation Discussion and Analysis describes the material elements of compensation for our named executive officers. When we refer to “named executive” in this section, we mean the five executives listed in the Summary Compensation Table, below.
Compensation Objectives
The objective of our compensation practices is to attract, retain, and motivate the highest quality employees and executives who share our core value of enhancing equity-holder value. We believe that the primary goal of management is to create value for our stakeholders, and we have designed our compensation program around this philosophy. Substantially all of our employees have a material portion of their compensation tied to the Company’s performance, and a large portion of the overall compensation of our executives is comprised of long-term compensation.
Elements of Executive Compensation
The components of compensation for our executives are base salary, quarterly non-equity incentive compensation, equity participation, and benefits. In addition, in limited circumstances, the Compensation Committee may exercise its discretion to pay other cash bonuses. Total compensation is targeted at or above the median for the industry, depending on the executive’s experience, historical performance and demands of the position. Total compensation increases with position and responsibility. Pursuant to our objective of aligning our executives’ interests with the interests of our equity holders, we create compensation packages that meet or exceed general industry levels by combining base salaries that are at or below industry levels with bonuses and equity incentives that are at or above industry levels. The percentage of compensation that is “at risk” also increases with position and responsibility. “At risk” compensation includes potential quarterly payouts under our non-equity incentive compensation plan and long-term incentive awards. Executives with greater roles in, and responsibility for, achieving our performance goals bear a greater proportion of the risk that those goals are not achieved and receive a greater proportion of the rewards if goals are met or surpassed.
Base Salary. We provide our executives with a base salary to provide them with an immediate financial incentive. Base salaries are determined based on (1) a review of salary ranges for similar positions at companies of similar size based on annual revenues, (2) the specific experience level of the executive, and (3) expected contributions by the executive. Base salaries are generally at or below our peer companies. Base salaries are approved by the Board’s Compensation Committee and are based on the recommendation of our CEO, Mr. Caruso. Base salaries are reviewed and adjusted from time to time based on individual merit, promotions or other changes in job responsibilities. There are no automatic increases in base salary.
Our co-founder and CEO, Mr. Caruso, currently receives a minimal base salary. In lieu of receiving a market-based salary, Mr. Caruso and the Compensation Committee agreed to structure substantially all of his compensation in the form of equity awards.
Non-Equity Incentive Compensation Plan. Consistent with our compensation objectives described above, we also have a quarterly non-equity incentive compensation plan in which most of our full-time, non-commissioned employees, including our executives, participate. Similar to base salaries, this plan provides our executives with potential cash payments which act as an incentive for current performance, while also encouraging behavior that is consistent with our long-term goals.
We make non-equity incentive compensation plan payments to participating executives if quarterly financial targets and certain business unit objectives are met. The financial targets and business unit objectives are proposed by the CEO (who does not participate in the non-equity incentive compensation plan) and are approved by the Compensation Committee. Our CEO recommends to the Compensation Committee the quarterly payouts under this plan, from 0% to 200% of an individual or a group’s target payout, based on the relative achievement of the financial targets and business unit objectives. The actual financial results may be adjusted up or down to account for certain non-recurring or unusual events, if approved by the Compensation Committee.
The Company and business unit objectives that were set in Fiscal 2013 consisted of financial performance objectives (either adjusted EBITDA or equity internal rate of return ("IRR"), strategy initiatives, executive initiatives and financial management goals, at the business unit level. The business unit objectives established for the Company reflect a mix of near-term projects and longer-term improvement initiatives. Actual payouts under the plan are determined based on our CEO’s quantitative and qualitative evaluation of performance against the objectives and are approved by our Compensation Committee. During Fiscal 2013, payouts for all participants without non-equity incentive compensation guarantees were
approved at 150% of the target. Individual payouts ranged from 0% to 200% of an employee's target and were determined based upon individual performance as determined by the respective department manager and President of the business unit. Payouts for these quarters were recommended by the CEO and approved by our Compensation Committee based on the significant effort on, and progress towards integrating the acquisition of Abovenet, Inc.
The table below shows the total target payouts and actual payouts under the non-equity incentive compensation plan for Fiscal 2013 for our Chief Executive Officer, Chief Financial Officer, and three most highly compensated other executive officers. We refer to these five people as our named executives.
Upon reevaluating the current ratio of base salary, bonus and equity of our named executives, we may increase their bonus targets in connection with any increase in their base salaries with the approval of the Compensation Committee.
Our CEO, Mr. Caruso, does not earn a quarterly payment under the non-equity incentive compensation plan.
Equity. A significant percentage of total compensation for our executives consists of equity compensation. We believe equity ownership encourages executives to behave like owners and provides a clear link between the interest of executives and those of equity holders. In support of our compensation objectives, equity values are generally above what management estimates to be the industry median, so that when combined with below or at median salaries and non-equity incentive compensation, they create total compensation at or above the median of our industry generally.
Certain employees, including our executives, are granted common units in CII, our indirect parent company. Upon a distribution at CII, the holders of common units are entitled to share in the proceeds of a distribution after certain obligations to the preferred unit holders are met. See “Note 12: Equity,” of our Fiscal 2013 Consolidated Financial Statements for additional information on member’s equity of CII, including the common units.
Certain executives also received preferred units in CII. The preferred unit holders are not entitled to receive dividends or distributions (although CII may elect to include holders of preferred units in distributions at its discretion). Upon a distribution at CII the holders of preferred units are entitled to receive their unreturned capital contributions and a priority return of 6% prior to any distributions being made to common unit holders. After the unreturned capital contributions and priority returns are satisfied, preferred unit holders receive 80 to 85% of the proceeds of a distribution while the common unit holders receive the remaining 15 to 20%, depending on the aggregate of the preferred holders' return on their investments.
Common units are awarded to executives upon hiring, and thereafter, at the discretion of the Compensation Committee based on the executives’ past or expected role in increasing our equity value. All of the granted common units are subject to the terms of employee equity agreements covering vesting and transfer, among other terms.
In Fiscal 2013, each of the named executive officers received incremental grants based on the Compensation Committee’s subjective evaluation of their overall performance and expected contribution to the future increase in CII’s overall equity value.
Bonus. Under the terms of his offer letter, Mr. Howson was entitled to a signing bonus equal to $60,000, which was paid during Fiscal 2011.
Benefits. We offer our executives the same health and welfare benefit and disability plans that we offer to all of our employees.
Determination of Executive Compensation
Our CEO, Mr. Caruso, makes recommendations to the Compensation Committee regarding the total compensation of each executive (excluding himself), including base salary, non-equity incentive compensation, and equity participation as well as the financial targets and business unit objectives which determine bonus payouts. The Compensation Committee considers the CEO’s recommendations in consultation with the full Board, and makes all final decisions for the total amount of compensation and each element of compensation for our executives, including Mr. Caruso.
Mr. Caruso and the Compensation Committee use their general knowledge of the compensation practices of other similar telecommunications companies and other private equity-owned companies in the formulation of their recommendations and decisions. The day-to-day design and administration of savings, health, welfare and paid time-off plans and policies applicable to our employees in general, including our executives, are handled by company management and our professional employee organization, ADP.
Employment and Equity Arrangements
During Fiscal 2013, our named executives have been granted the following preferred and common units in CII as equity compensation for services rendered.
(1)
Class G and H common units vest 33.33% on the first vesting date and the remaining units vest pro-rata on a monthly basis over a period of two years after the first vesting date.
Accelerated Vesting. Under the respective Employee Equity Agreements for Messrs. desGarennes, Russo, Snella and Howson, each of their unvested Units will immediately vest five months after the consummation of a sale of CII, provided that the relevant employee has remained continuously employed from the date of the relevant Employee Equity Agreement through the date of such sale and does not voluntarily terminate his employment prior to the expiration of such five months, if (i) all of the consideration paid in respect of such sale consists of cash or certain marketable securities or (ii) in the event that the consideration consists of other than cash or such securities, the board of directors of CII determines that such sale constituted a management control acquisition. For purposes of such Employee Equity Agreement, a “sale” of CII means any of (a) a merger or consolidation of CII or its subsidiaries into or with any other person or persons, or a transfer of units in a single transaction or a series of transactions, in which in any case the members of CII or the members of its subsidiaries immediately prior to such merger, consolidation, sale, exchange, conveyance or other disposition or first of such series of transactions possess less than a majority of the voting power of CII’s or its subsidiaries’ or any successor entity’s issued and outstanding capital securities immediately after such transaction or series of such transactions; or (b) a single transaction or series of transactions, pursuant to which a person or persons who are not direct or indirect wholly-owned subsidiaries of CII acquire all, or substantially all, of CII’s or its subsidiaries’ assets determined on a consolidated basis, in each case, other than (i) the issuance of additional capital securities in a public offering or private offering for the account of CII or (ii) a foreclosure or similar transfer of equity occurring in connection with a creditor exercising remedies upon the default of any indebtedness of CII. Further, for purposes of such Employee Equity Agreement, “management control acquisition” is defined as a sale of CII with respect to which (i) immediately prior to such sale of CII, Dan Caruso is serving CII as chief executive officer and (ii) after giving effect to the consummation of the sale of CII, Dan Caruso is not offered the opportunity to serve as the chief executive officer of the combined company resulting from such sale of CII.
Under the Vesting Agreements for Mr. Caruso, the unvested Preferred Units and Common Units will, upon a sale of CII, immediately vest, provided that the executive remains employed by CII or one of its subsidiaries. For purposes of the Vesting Agreements, “sale” of CII means any of the following: (a) a merger or consolidation of CII or its subsidiaries into or
with any other person or persons, or a transfer of units in a single transaction or a series of transactions, in which in any case the members of CII or the members of its subsidiaries immediately prior to such merger, consolidation, sale, exchange, conveyance or other disposition or first of such series of transactions possess less than a majority of the voting power of CII’s or its subsidiaries’ or any successor entity’s issued and outstanding capital securities immediately after such transaction or series of such transactions; (b) a single transaction or series of transactions, pursuant to which a person or persons who are not direct or indirect wholly-owned subsidiaries of CII acquire all, or substantially all, of CII’s or its subsidiaries’ assets determined on a consolidated basis, in each case whether pursuant to a sale, lease, transfer, exclusive license or other disposition outside of the ordinary course of business.
Summary Compensation Table
The following summary compensation table sets forth information concerning the annual and long-term compensation earned by our named executive officers.
(1)
Amounts shown reflect the grant date fair value calculated in accordance with Financial Accounting Standards Board Accounting Standards Codification 718-10-10, for the fiscal years ended June 30, 2013, June 30, 2012 and June 30, 2011. Assumptions used to determine these values can be found in Note 14 - Fair Value Measurements of our Consolidated Financial Statements.
(2)
Comprises compensation which we describe under “Item 11:
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
One hundred percent of our equity is owned, indirectly, by CII. The following table sets forth the beneficial ownership of our indirect parent company, CII, by each person or entity that is known to us to own more than 5% of CII’s outstanding membership interests and each of our named executive officers and directors who owns an interest in CII as of September 23, 2013. CII’s membership interests are comprised of Preferred Class C Units and Common Units. The ownership rights of the members of CII are governed by the Fourth Amended and Restated Limited Liability Company Agreement, dated December 13, 2012 as further amended by the First Amendment to the Fourth Amended and Restated Limited Liability Company Agreement, dated July 1, 2013.
On July 2, 2012, in connection with the Company's acquisition of AboveNet, the Company completed a third round of equity financing in which 98,916,060.11 Class C Preferred Units were sold to new and existing investors for aggregate proceeds of $472.3 million. At the same time, all existing Preferred Units were converted into 257,632,089 Class C Preferred Units.
The Common Units do not carry voting rights. Upon a liquidation of the Company, the holders of the preferred units are entitled to receive their unreturned capital contributions and a priority return of 6% prior to any distributions being made to common unit holders. After the unreturned capital contributions and priority returns are satisfied, preferred unit holders receive 80% to 85% of the proceeds of a distribution while the common unit holders receive the remaining 15% to 20%, depending on the aggregate preferred investor return on investment. As of September 23, 2013, CII had 356,932,491 Preferred Class C Units outstanding and 461,803,801 common units outstanding. Beneficial ownership is determined in accordance with the rules of the SEC. Except as otherwise indicated, to our knowledge, the persons named in the table below have sole voting and investment power with respect to all units shown as owned by them except as otherwise set forth in the notes to the table and subject to community property laws, where applicable.
*
Less than 1%
**
Calculated based on each beneficial owner's respective holding as a percentage of total common units issued. No voting rights are associated with this ownership class.
(1)
Aggregate holdings of Battery Ventures VII, L.P., Battery Investment Partners VII, LLC, and Battery Ventures VIII, L.P. The address for all three entities is 930 Winter Street, Suite 2500, Waltham, MA 02451.
(2)
Aggregate holdings of Charlesbank Equity Fund VI, LP, CB Offshore Equity Fund VI, LP, Charlesbank Equity Coinvestment Fund VI, LP, and Charlesbank Equity Coinvestment Partners, LP. The address for all four entities is 200 Clarendon, 5th Floor, Boston, MA 02116.
(3)
Aggregate holdings of Columbia Capital Equity Partners IV (QP), L.P., Columbia Capital Equity Partners IV (QPCO), L.P., Columbia Capital Employee Investors IV, L.P., Columbia Capital Equity Partners III (QP), L.P., Columbia Capital Equity Partners III (Caymen) L.P., Columbia Capital Equity Partners III (AI), L.P., Columbia Capital Investors III, L.L.C., and Columbia Capital Employee Investors III, L.L.C. The address for all eight entities is 201 N. Union Street, Suite 300, Alexandria, VA, 22314.
(4)
Aggregate holdings of GTCR Fund X/A, LP, GTCR Fund X/C, LP, GTCR Co-Invest X, LP. The address for all three entities is 300 North LaSalle Street, Suite 5600, Chicago, IL, 60654.
(5)
Aggregate holdings of M/C Venture Partners VI, L.P., M/C Venture Investors, L.L.C., M/C Venture Partners V, L.P., and Chestnut Venture Partners, L.P. The address for all four entities is 75 State Street, Suite 2500, Boston, MA, 02109.
(6)
Address is 525 University Avenue, Suite 1300, Palo Alto, CA 94301.
(7)
Michael Choe is the Managing Director of Charlesbank Capital Partners.
(8)
John Siegel is a Partner of Columbia Capital.
(9)
Gillis Cashman is a General Partner of M/C Partners.
(10)
John Downer is the Director-Private Equity of Oak Investment Partners.
(11)
Philip Canfield is a Principal of GTCR LLC.
(12)
Lawrence Fey is a Principal of GTCR LLC.
ITEM 13.
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
On April 1, 2011, after completing a restructuring of our operating segments, we determined that the Zayo Enterprise Networks ("ZEN") unit no longer fit within our current business model and we spun the ZEN business unit to our ultimate parent, CII. CII subsequently contributed the assets and liabilities of ZEN to its Onvoy subsidiary, which consolidates under Holdings, the parent of the Company.
During Fiscal 2013, we determined that the services provided by one of our business units, Zayo Professional Services ("ZPS"), did not fit within our current business model of providing bandwidth infrastructure, colocation and interconnection services. Accordingly, the Company spun-off ZPS to Holdings, the parent of the Company, effective September 30, 2012.
We have certain ongoing contractual relationships with Onvoy and ZPS, which are based on agreements entered into at rates between Onvoy, ZPS and us that we believe approximate market rates.
The contractual relationships between us, Onvoy and ZPS cover the following services:
Services Provided to Onvoy and ZPS
We have entered into a Master Services Agreement with Onvoy which requires us to provide the following services to Onvoy:
•
Transport services for circuits.
•
Leases of colocation racks in various markets.
•
Fiber and optronics management.
•
Leases of colocation racks at the colocation facility at 60 Hudson Street, New York, New York.
We have entered into a Master Services Agreement with ZPS which requires us to provide the following services to ZPS:
•
Transport services for circuits.
•
Fiber and optronics management.
Services Provided by Onvoy and ZPS
We have entered into a Master Services Agreement with Onvoy which requires Onvoy to provide the following services to us:
•
Agent services for customer referrals.
•
Fiber IRU and services related to fiber in Minnesota.
•
Transport services covering lit services.
•
Sublease for space in Minneapolis and Plymouth, Minnesota.
•
Lease of colocation racks.
•
Agreements covering VoIP and switching services.
We have entered into a Master Services Agreement with ZPS which requires ZPS to provide the following services to us:
•
Agent services for customer referrals.
In addition to the services and contracts described above, we have entered into transition services agreements with Onvoy and ZPS that outline each party’s responsibility with regards to payment to, and separation of services associated with, shared vendors. Furthermore, we have entered into a management agreement with Onvoy and ZPS which relates to certain services provided for Onvoy by our management, such as compensation and benefits, insurance, tax, financial services and other corporate support.
Subsequent to the September 30, 2012 spin-off of ZPS, April 1, 2011 spin-off of ZEN, and the March 12, 2010 spin-off of Onvoy, the revenue and expenses associated with transactions with ZPS, ZEN and Onvoy have been recorded in the results from continuing operations. The following table represents the revenue and expense transactions recognized with these related parties subsequent to their spin-off dates (in thousands):
We, or Onvoy or ZPS, may terminate existing contracts in the future or we may enter into additional or other contractual arrangements with Onvoy or ZPS as a result of which our contractual relationship with Onvoy or ZPS and the payments among us and Onvoy or ZPS pursuant to such contracts may substantially change.
As of June 30, 2013, the Company had a receivable balance due from Onvoy, in the amount of $0.6 million related to services the Company provided to OVS and/or ZEN. As of June 30, 2013, the Company did not have a receivable balance due from ZPS related to services the Company had provided to ZPS.
Purchase of Previously Outstanding Notes
On September 14, 2010, Dan Caruso, our President, Chief Executive Officer and Director, purchased $0.5 million (face amount) of our previously outstanding notes in connection with our September 20, 2010 $100.0 million notes offering. The purchase price of the notes purchased by Mr. Caruso was $0.5 million, including the premium on the notes and accrued interest. On July 2, 2012, in connection with our refinancing activities (see "Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations - New Indebtedness and Equity Invested"), we repaid our previously outstanding notes. Mr. Caruso’s notes were repurchased for $0.5 million.
Purchase of Unsecured Notes
On June 28, 2012, Matthew Erickson, the President of ZFS, purchased $0.6 million in aggregate principal amount of our 10.125% senior unsecured notes due 2020 at the offering price for such notes in the Notes offering. Mr. Erickson qualifies as an “accredited investor” (as defined in Rule 501 under the Securities Act), and this purchase was on terms available to other investors. As of June 30, 2013, the principal amount outstanding was $0.6 million.
Transactions with CII
As of July 1, 2011, the Company had a due to related-party balance with CII of $4.6 million. The liability with CII related to an interest payment made by CII on the Company’s Notes. During the year ended June 30, 2012, CII made an additional interest payment of $11.0 million on behalf of the Company. During the quarter ended June 30, 2012, the Company and CII agreed to settle the then outstanding payable to CII in the amount of $15.5 million through an increase in CII’s equity interest in the Company. There were no transactions with CII during the year ended June 30, 2013.
Director Independence
Our board of directors consists of ten directors and has an audit committee, a compensation committee, and a nominating and governance committee. The nominating and governance committee is charged with board composition issues including evaluating independence of existing and prospective directors. Each member of the compensation committee is a non-employee director as defined in Rule 16b-3 of the Exchange Act and is an outside director as defined in Section 162(m) of the Internal Revenue Code. The Company's equity is not publicly traded, and the nominating and governance committee has not undertaken a formal evaluation of our outside directors' independence.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
We first engaged Grant Thornton LLP (“Grant Thornton”) to be our independent registered public accounting firm in March 2008. Our Audit Committee of the Board of Directors (the “Audit Committee”) completed a process in accordance with the Audit Committee’s charter to review the appointment of the Company’s independent registered public accounting firm. As a result of this process, on April 27, 2012, the Audit Committee determined to dismiss Grant Thornton effective upon the issuance of the Company’s Quarterly Report for the quarter ended March 31, 2012. On May 3, 2012, the Audit Committee engaged KPMG LLP (“KPMG”) to be the Company’s independent registered public accounting firm for the fiscal year ending June 30, 2012.
The aggregate fees billed to us for each of the years ended June 30, 2013 and 2012 for professional accounting services, including Grant Thornton’s review of our interim consolidated financial statements in the Company's Quarterly Report for the quarter ended March 31, 2012 and KPMG’s audit of our annual consolidated financial statements for Fiscal 2012 and 2013, are set forth in the table below:
For purposes of the preceding table, the professional fees are classified as follows:
•
Audit fees - These are fees billed for the fiscal years shown for professional services performed for the audit of the Company’s consolidated financial statements for that year, comfort letters, consents and reviews of interim/quarterly financial information. Audit fees for each year shown include amounts that have been billed to us through September 23, 2013 and any additional amounts that are expected to be billed to us thereafter. For the year ended June 30, 2013, audit fees for services provided by Grant Thornton, LLP include the re-issuance of its audit opinion for the June 30, 2011 Annual Report filed on Form 10-K/A in connection with the June 30, 2013 Annual Report. For the year ended June 30, 2012, audit fees for services provided by Grant Thornton, LLP include its review of the Company’s interim consolidated financial statements for the quarter ended March 31, 2012 and the re-issuance of its audit opinion for the June 30, 2011 Annual Report filed on Form 10-K/A and June 30, 2012 Annual Report. For the year ended June 30, 2012, audit fees also include fees associated with the restatement of our June 30, 2011 Annual Report filed on Form 10-K/A and the related restatements of our Quarterly Reports on Form 10-Q/A for the quarters ended September 30, 2011 and December 31, 2011 as filed with the SEC on May 15, 2012.
•
Audit-related fees - These are fees billed for assurance and related services that are traditionally performed by our independent certified public accounting firm.
•
Tax fees - These are fees billed for all professional services by professional staff of our independent registered public accounting firm’s tax division except those services related to the audit of our financial statements. These include fees for tax compliance, tax planning and tax advice. Tax compliance involves preparation of original and amended tax returns, refund claims and tax payment services. Tax planning and tax advice encompass a diverse range of subjects, including assistance with tax audits and appeals, tax advice related to mergers, acquisitions and dispositions, and requests for rulings or technical advice from taxing authorities.
Audit Committee Pre-Approval Policy and Procedures. The Audit Committee must review and pre-approve all audit and non-audit services provided by KPMG, LLP, our independent registered public accounting firm greater than $100,000 and our Audit Committee Chairman must approve all such services greater than $50,000. In conducting reviews of audit and non-audit services, the Audit Committee will determine whether the provision of such services would impair our principal accounting firm’s independence. The Audit Committee will only pre-approve services that it believes will not impair our independent accounting firm’s independence.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
Documents Filed as Part of this Report
1. Financial Statements
2. Exhibits
The Exhibits required by this item are listed in the Exhibit Index. Each management contract and compensatory plan or arrangement is denoted with a “+” in the Exhibit Index.
Financial statements and financial statement schedules required to be filed for the registrant under Items 8 or 15 are set forth following the index page at page F-l. Exhibits filed as a part of this report are listed below. Exhibits incorporated by reference are indicated in parentheses.
EXHIBIT INDEX
(1)
The XBRL related information in Exhibit 101 shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to liability of that section and shall not be incorporated by reference into any filing or other document pursuant to the Securities Act of 1933, as amended, except as shall be expressly set forth by specific reference in such filing or document.
*
Filed/furnished herewith.
Report of Independent Registered Public Accounting Firm
The Board of Directors and Member
Zayo Group, LLC:
We have audited the accompanying consolidated balance sheets of Zayo Group, LLC and subsidiaries (the Company) as of June 30, 2013 and 2012, and the related consolidated statements of operations, comprehensive loss, member’s equity, and cash flows for each of the years in the two-year period ended June 30, 2013. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Zayo Group, LLC and subsidiaries as of June 30, 2013 and 2012, and the results of their operations and their cash flows for each of the years in the two-year period ended June 30, 2013, in conformity with U.S. generally accepted accounting principles.
/s/ KPMG LLP
Boulder, Colorado
September 23, 2013
Report of Independent Registered Public Accounting Firm
Board of Directors and Member
Zayo Group, LLC
We have audited the accompanying consolidated statements of operations, comprehensive loss, member’s equity, and cash flows of Zayo Group, LLC (a Delaware limited liability company) and subsidiaries (collectively, the “Company”) for the year ended June 30, 2011. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the results of operations and cash flows of Zayo Group, LLC and subsidiaries for the year ended June 30, 2011 in conformity with accounting principles generally accepted in the United States of America.
/s/ GRANT THORNTON LLP
Denver, Colorado
September 9, 2011 (except as to Note 2 in the previously filed 2011 financial statements, which is not presented herein and is as of May 15, 2012)
ZAYO GROUP, LLC AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
ZAYO GROUP, LLC AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
ZAYO GROUP, LLC AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
ZAYO GROUP, LLC AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF MEMBER’S EQUITY
(in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
ZAYO GROUP, LLC AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
ZAYO GROUP, LLC AND SUBSIDIARIES
Refer to Note 3 - Acquisitions for details regarding the Company’s recent acquisitions and Note 4 - Spin-off of Business for details regarding the Company’s discontinued operations.
Refer to Note 12 - Equity to the Company's consolidated financial statements for details of the non-cash capital transactions.
The accompanying notes are an integral part of these consolidated financial statements.
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
(1) ORGANIZATION AND DESCRIPTION OF BUSINESS
Zayo Group, LLC, a Delaware limited liability company, was formed on May 4, 2007, and is the operating parent company of a number of subsidiaries engaged in telecommunication and Internet infrastructure services. Zayo Group, LLC and its subsidiaries are collectively referred to as “Zayo Group” or the “Company.” Headquartered in Boulder, Colorado, the Company operates an integrated metropolitan and nationwide fiber optic infrastructure in the United States and Europe to offer:
•
Dark and lit bandwidth infrastructure services on metro, regional and national fiber networks.
•
Colocation and connectivity services.
•
Mobile infrastructure.
Zayo Group, LLC is wholly owned by Zayo Group Holdings, Inc. (“Holdings”), which in turn is wholly-owned by Communications Infrastructure Investments, LLC (“CII”).
(2)
BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES
a. Basis of Presentation
The accompanying consolidated financial statements include all the accounts of the Company and its wholly-owned subsidiaries. All inter-company accounts and transactions have been eliminated in consolidation. The accompanying consolidated financial statements and related notes have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”).
Unless otherwise noted, dollar amounts and disclosures throughout the Notes to the consolidated financial statements relate to the Company's continuing operations and are presented in thousands of dollars.
b. Foreign Currency Translation
Local currencies of foreign subsidiaries are the functional currencies for financial reporting purposes. For operations outside the U.S. that have functional currencies other than the U.S. dollar, assets and liabilities are translated to U.S. dollars at period-end exchange rates, and revenue, expenses and cash flows are translated using monthly average exchange rates during the year. Gains or losses resulting from currency translation are recorded as a component of accumulated other comprehensive loss in member's equity and in the consolidated statements of comprehensive loss. A significant portion of the Company's foreign subsidiaries have the British Pound as the functional currency, which experienced significant fluctuations against the U.S. dollar during 2013. The Company recognizes foreign currency translation adjustments as a component of accumulated other comprehensive loss in member's equity and in the consolidated statement of comprehensive loss in accordance with accounting guidance for foreign currency translation. The Company considers the majority of its investments in its foreign subsidiaries to be long-term in nature. The Company's foreign exchange transaction gains and losses, including where its investments in its foreign subsidiaries are not considered to be long-term in nature, are included within "Other income/(expense), net" on the consolidated statement of operations.
c. Spin-off of Business
On September 30, 2012, the Company completed a spin-off of its Zayo Professional Services ("ZPS") business. On April 1, 2011, the Company completed a spin-off of its Zayo Enterprise Networks (“ZEN”) business. The Company distributed all of the assets and liabilities of ZPS and ZEN to Holdings on the respective spin-off dates and accounted for the spin-offs as equity transactions at carryover basis, as the transactions were considered to be between entities under common control.
Management determined that it had discontinued all significant cash flows and continuing involvement with respect to ZPS and ZEN’s operations and therefore considers these to be discontinued operations. The results of operations of ZPS and ZEN prior to their respective spin-off dates have been presented in a single caption entitled, "Earnings from discontinued operations, net of income taxes" on the accompanying consolidated statements of operations. Management has not allocated any general corporate overhead to amounts presented in discontinued operations, nor has it elected to allocate interest costs.
In connection with certain business combinations, the Company may acquire assets or liabilities that support products outside of the Company’s primary focus of providing bandwidth infrastructure and network neutral colocation services. In some cases, the net assets acquired which support product offerings outside of the scope of the Company’s primary focus were spun-
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
off to Holdings on the acquisition date and accounted for as equity transactions at carryover basis. As the spin-off of certain of these acquired non-core assets occurred on the acquisition date, the consolidated financial statements do not reflect the operating results or net assets of these spun-off businesses.
d. Use of Estimates
The preparation of the Company's consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expense during the reporting period. Significant estimates are used when establishing allowances for doubtful accounts, reserves for disputed line cost billings, determining customer lives used to recognize certain revenues, determining useful lives for depreciation and amortization, determining accruals for exit activities associated with real estate leases, assessing the need for impairment charges (including those related to investments, intangible assets and goodwill), determining the fair values of assets acquired and liabilities assumed in business combinations, accounting for income taxes and related valuation allowances against deferred tax assets and estimating the common unit fair values used to compute stock-based compensation liability. Management evaluates these estimates and judgments on an ongoing basis and makes estimates based on historical experience, current conditions, and various other assumptions that are believed to be reasonable at the time under the circumstances. The results of these estimates form the basis for making judgments about the carrying values of assets and liabilities as well as identifying and assessing the accounting treatment with respect to commitments and contingencies. Actual results may differ from these estimates under different assumptions or conditions.
e. Reclassifications
Certain immaterial reclassifications have been made to prior years to conform to the current period's presentation.
f. Cash and Cash Equivalents and Restricted Cash
The Company considers all highly liquid investments with original maturities of three months or less to be cash and cash equivalents. Cash equivalents are stated at cost, which approximates fair value. Restricted cash consists of cash balances held by various financial institutions as collateral for letters of credit and surety bonds. These balances are reclassified to cash and cash equivalents when the underlying obligation is satisfied, or in accordance with the governing agreement. Restricted cash balances expected to become unrestricted during the next twelve months are recorded as current assets. As of June 30, 2013 and 2012, the Company had a current restricted cash balance of zero and $22,417, respectively. The current restricted cash balance as of June 30, 2012 related to cash held in escrow associated with the Company’s July 2, 2012 debt refinancing - see Note 9 - Long Term Debt. Restricted cash balances that are not expected to become unrestricted during the next twelve months are recorded as other non-current assets. As of June 30, 2013 and 2012, the Company had a non-current restricted cash balance of $5,533 and $958, respectively.
g. Investments
Investments in equity securities for which the Company does not have significant influence over the investee and does not have a readily determinable fair value are recorded using the cost method of accounting. Under this method, the investment is recorded in the balance sheet at historical cost. Subsequently, the Company recognizes as income any dividends received that are distributed from earnings since the date of initial investment. Dividends received that are distributed from earnings prior to the date of acquisition are recorded as a reduction of the cost of the investment. Cost method investments are reviewed for impairment if factors indicate that a decrease in value of the investment has occurred. If an impairment is considered other than temporary, an impairment loss is recognized as the difference between the investment’s cost and its estimated fair value as of the end of the reporting period.
h. Trade Receivables
Trade receivables are recorded at the invoiced amount and do not bear interest. The Company maintains an allowance for doubtful accounts for estimated losses inherent in its trade receivable portfolio. In establishing the required allowance, management considers historical losses adjusted to take into account current market conditions and the customer’s financial condition, the amount of receivables in dispute, and the age of receivables and current payment patterns. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote.
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
i. Property and Equipment
The Company’s property and equipment includes assets in service and under construction or development.
Property and equipment is recorded at historical cost or acquisition date fair value. Costs associated directly with network construction, service installations, and development of business support systems, including employee-related costs, are capitalized. Depreciation is calculated on a straight-line basis over the asset’s estimated useful life from the date placed into service or acquired. Management periodically evaluates the estimates of the useful life of property and equipment by reviewing historical usage, with consideration given to technological changes, trends in the industry, and other economic factors that could impact the network architecture and asset utilization.
Equipment acquired under capital leases is recorded at the lower of the fair value of the asset or the net present value of the minimum lease payments at the inception of the lease. Depreciation of equipment held under capital leases is included in depreciation and amortization expense, and is calculated on a straight-line basis over the estimated useful lives of the assets, or the related lease term, whichever is shorter.
Management reviews property and equipment for impairment whenever events or changes in circumstances indicate that the carrying value of its property and equipment may not be recoverable. An impairment loss is recognized when the assets’ carrying value exceeds both the assets’ estimated undiscounted future cash flows and the assets’ estimated fair value. Measurement of the impairment loss is then based on the estimated fair value of the assets. Considerable judgment is required to project such future cash flows and, if required, to estimate the fair value of the property and equipment and the resulting amount of the impairment. No impairment charges were recorded for property and equipment during the years ended June 30, 2013, 2012 or 2011.
The Company capitalizes interest for assets that require a period of time to get them ready for their intended use. The amount of interest capitalized is based on the Company’s weighted average effective interest rate for outstanding debt obligations during the respective accounting period.
j. Goodwill and Purchased Intangibles
Intangible assets arising from business combinations, such as acquired customer contracts and relationships (collectively “customer relationships”), are initially recorded at fair value. The Company amortizes customer relationships primarily over an estimated life of 10 to 20 years, using the straight-line method as this method approximates the timing in which the Company expects to receive the benefit from the acquired customer relationship assets. Goodwill represents the excess of the purchase price over the fair value of the net identifiable assets acquired in a business combination.
Goodwill and indefinite-lived intangible assets are reviewed for impairment at least annually in April, or more frequently if a triggering event occurs between impairment testing dates. The Company’s impairment assessment begins with a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. The qualitative assessment includes comparing the overall financial performance of the reporting units against the planned results used in the last quantitative goodwill impairment test, which was conducted in January 2013 in connection with our change in segments. Additionally, each reporting unit’s fair value is assessed in light of certain events and circumstances, including macroeconomic conditions, industry and market considerations, cost factors, and other relevant entity- and reporting unit-specific events. If it is determined under the qualitative assessment that it is more likely than not that the fair value of a reporting unit is less than its carrying value, then a two-step quantitative impairment test is performed. Under the first step, the estimated fair value of the reporting unit is compared with its carrying value (including goodwill). If the fair value of the reporting unit exceeds its carrying value, step two does not need to be performed. If the estimated fair value of the reporting unit is less than its carrying value, an indication of goodwill impairment exists for the reporting unit and the enterprise must perform step two of the impairment test (measurement). Under step two, an impairment loss is recognized for any excess of the carrying amount of the reporting unit’s goodwill over the implied fair value of that goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit in a manner similar to a purchase price allocation in acquisition accounting. The residual fair value after this allocation is the implied fair value of the reporting unit goodwill. Fair value of the reporting unit under the two-step assessment is determined using a discounted cash flow analysis. The selection and assessment of qualitative factors used to determine whether it is more likely than not that the fair value of a reporting unit exceeds the carrying value involves significant judgments and estimates.
Intangible assets with finite useful lives are amortized over their respective estimated useful lives and reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. No impairment charges were recorded for goodwill or intangibles during the years ended June 30, 2013, 2012 or 2011.
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
k. Derivative Financial Instruments
The Company from time-to-time utilizes interest rate swaps to mitigate its cash exposure to interest rate risk. Derivative instruments are recorded in the balance sheet as either assets or liabilities, measured at fair value. The Company has historically entered into interest rate swaps to convert a portion of its floating-rate debt to fixed-rate debt and has not applied hedge accounting; therefore, the changes in the fair value of the interest rate swaps are recognized in earnings as adjustments to interest expense. The principal objectives of the derivative instruments are to minimize the cash interest rate risks associated with financing activities. The Company does not use financial instruments for trading purposes. The Company utilizes interest rate swap contracts in connection with the Term Loan Facility entered into during the July 2012 financing transactions. See Note 9 - Long-term Debt, for further discussion of the Company’s debt obligations and Note 14 - Fair Value Measurements, for a discussion of the fair value of the interest rate swaps.
l. Revenue Recognition
The Company recognizes revenues derived from leasing fiber optic telecommunications infrastructure and the provision of telecommunications and colocation services when the service has been provided and when there is persuasive evidence of an arrangement, the fee is fixed or determinable, and collection of the receivable is reasonably assured. Taxes collected from customers and remitted to a governmental authority are reported on a net basis and are excluded from revenue.
Most revenue is billed in advance on a fixed-rate basis. The remainder of revenue is billed in arrears on a transactional basis determined by customer usage. The Company often bills customers for upfront charges, which are non-refundable. These charges relate to activation fees, installation charges or prepayments for future services and are influenced by various business factors including how the Company and customer agree to structure the payment terms. If the upfront payment made by a customer provides no benefit to the customer beyond the contract term, the upfront charge is deferred and recognized as revenue ratably over the contract term. If the upfront payment provides benefit to the customer beyond the contract term, the charge is recognized as revenue over the estimated life of the customer relationship. The Company also defers costs associated with customer activation and installation to the extent of upfront amounts received from customers, which are recognized as expense over the same period for which the associated revenue is recognized.
The Company typically records revenues from leases of dark fiber, including indefeasible rights-of-use (“IRU”) agreements, over the term that the customer is given exclusive access to the assets. Dark fiber IRU agreements generally require the customer to make a down payment upon the execution of the agreement with monthly IRU fees paid over the contract term, however in some cases the Company receives up to the entire lease payment at the inception of the lease and recognizes the revenue ratably over the lease term.
m. Operating Costs and Accrued Liabilities
The Company's operating costs consist primarily of colocation facility costs, colocation facility utilities costs and third-party network service costs. Colocation facility costs include rent and license fees paid to the landlords of the buildings in which our zColo business operates along with the utility costs to power those facilities. Third-party network service costs result from our leasing of certain network facilities, primarily leases of circuits and dark fiber, from other local exchange carriers to augment our owned infrastructure for which the Company is generally billed a fixed monthly fee. The caption in the consolidated statements of operations “operating costs, excluding depreciation and amortization” solely includes costs associated with the aforementioned use of other carriers’ networks.
The Company recognizes the cost of these facilities or services when it is incurred in accordance with contractual requirements. The Company routinely disputes incorrect billings. The most prevalent types of disputes include disputes for circuits that are not disconnected on a timely basis and usage bills with incorrect or inadequate call detail records. Depending on the type and complexity of the issues involved, it may take several quarters to resolve disputes.
In determining the amount of such operating expenses and related accrued liabilities to reflect in its consolidated financial statements, management considers the adequacy of documentation of disconnect notices, compliance with prevailing contractual requirements for submitting such disconnect notices and disputes to the provider of the facilities, and compliance with its interconnection agreements with these carriers. Significant judgment is required in estimating the ultimate outcome of the dispute resolution process, as well as any other amounts that may be incurred to conclude the negotiations or settle any litigation.
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
n. Stock-Based Compensation
The common units granted by the Company’s ultimate parent company, CII, to the employees and independent directors of Zayo Group are considered stock-based compensation with terms that require the awards to be classified as liabilities due to cash settlement features. As such, the Company accounts for these awards as a liability and re-measures the liability at each reporting date. These awards typically vest over a period of three or four years with the first vesting date occurring one year after the grant date and the remaining unvested shares vesting pro-rata over the remaining term. The common units may fully vest subsequent to a liquidity event. The stock compensation expense associated with the common unit liability is recognized on a straight-line basis over the requisite service period and is adjusted each reporting period to fair value. Subsequent to the vesting period end date, changes to the fair value of the liability classified awards are recognized as incurred until the awards are settled.
The preferred units granted by the Company’s ultimate parent company, CII, to the employees and independent directors of Zayo Group are considered stock-based compensation with terms that require the awards to be classified as equity. As such, the Company accounts for these awards as equity, which requires the cost to be measured at the grant date based on the fair value of the award. The cost is recognized as expense over the requisite service period. Preferred unit awards typically vest over a period of three or four years with the first vesting date occurring one year after the grant date and the remaining unvested shares vesting pro-rata over the remaining term and may fully vest subsequent to a liquidity event.
Determining the fair value of share-based awards at the grant date and subsequent reporting dates requires judgment. If actual results differ significantly from these estimates, stock-based compensation expense and the Company’s results of operations could be materially impacted.
o. Legal Costs
Costs incurred to hire and retain external legal counsel to advise us on regulatory, litigation and other matters is expensed as the related services are received.
p. Government Grants
The Company receives grant money from the National Telecommunications and Information Administration (“NTIA”) Broadband Technology Opportunity Program. The Company recognizes government grants when it is probable that the Company will comply with the conditions attached to the grant arrangement and the grant will be received. The Company accounts for grant money received for reimbursement of capital expenditures as a reduction of the cost of the asset in arriving at its carrying value. The grant is thus recognized in earnings over the useful life of a depreciable asset by way of a reduced depreciation charge.
q. Income Taxes
The Company recognizes income taxes under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in earnings in the period that includes the enactment date.
Estimating the future tax benefit associated with deferred tax assets requires significant judgment. Deferred tax assets arise from a variety of sources, the most significant being: a) tax losses that can be carried forward to be utilized against taxable income in future years; and b) expenses recognized in the Company’s income statement but disallowed in the Company’s tax return until the associated cash flow occurs.
The Company records a valuation allowance to reduce its deferred tax assets to the amount that is expected to be recognized. The valuation allowance is established if, based on available evidence, it is more-likely-than-not that all or some portion of the asset will not be realized due to the inability to generate sufficient taxable income in the period and/or of the character necessary to utilize the benefit of the deferred tax asset. When evaluating whether it is more-likely-than-not that all or some portion of the deferred tax asset will not be realized, all available evidence, both positive and negative, that may affect the realizability of deferred tax assets is identified and considered in determining the appropriate amount of the valuation allowance. The Company continues to monitor its financial performance and other evidence each quarter to determine the
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
appropriateness of the Company’s valuation allowance. At each balance sheet date, existing assessments are reviewed and, if necessary, revised to reflect changed circumstances.
The analysis of the Company’s ability to utilize its NOL balance is based on the Company’s forecasted taxable income. The forecasted assumptions approximate the Company’s best estimates, including market growth rates, future pricing, market acceptance of the Company’s products and services, future expected capital investments, and discount rates. If the Company is unable to meet its taxable income forecasts in future periods the Company may change its conclusion about the appropriateness of the valuation allowance which could create a substantial income tax expense in the Company’s consolidated statement of operations in the period such change occurs.
The Company records interest related to unrecognized tax benefits and penalties in provision for income taxes.
r. Fair Value of Financial Instruments
ASC 820-10 Fair Value Measurements defines fair value, establishes a framework for measuring fair value, and requires expanded disclosures about fair value measurements. ASC 820-10 emphasizes that fair value is a market-based measurement, not an entity-specific measurement, and defines fair value as the price that would be received to sell an asset or transfer a liability in an orderly transaction between market participants at the measurement date. ASC 820-10 discusses valuation techniques, such as the market approach (comparable market prices), the income approach (present value of future income or cash flow) and the cost approach (cost to replace the service capacity of an asset or replacement cost), which are each based upon observable and unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions.
Fair Value Hierarchy
ASC 820-10 establishes a fair value hierarchy that requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. A financial instrument’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the fair value measurement. GAAP establishes three levels of inputs that may be used to measure fair value:
Level 1
Inputs to the valuation methodology are unadjusted quoted prices for identical assets or liabilities in active markets that the Company has the ability to access.
Level 2
Inputs to the valuation methodology include:
•
quoted prices for similar assets or liabilities in active markets;
•
quoted prices for identical or similar assets or liabilities in inactive markets;
•
inputs other than quoted prices that are observable for the asset or liability; and
•
inputs that are derived principally from or corroborated by observable market data by correlation or other means.
If the asset or liability has a specified (contractual) term, the Level 2 input must be observable for substantially the full term of the asset or liability.
Level 3
Inputs to the valuation methodology are unobservable and significant to the fair value measurement.
The Company views fair value as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining the fair value measurements for assets and liabilities required to be recorded at fair value, management considers the principal or most advantageous market in which it would transact and considers assumptions that market participants would use when pricing the asset or liability, such as inherent risk, transfer restrictions, and risk of nonperformance.
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
s. Concentration of Credit Risk
Financial instruments that potentially subject the Company to concentration of credit risk consist principally of cash investments and accounts receivable. The Company’s cash and cash equivalents are primarily held in commercial bank accounts in the United States of America. The Company limits its cash investments to high-quality financial institutions in order to minimize its credit risk.
The Company’s trade receivables, which are unsecured, are geographically dispersed. During the year ended June 30, 2013, the Company had no single customer that exceeded 10% of total revenue. During the years ended June 30, 2012 and 2011, the Company had one customer that accounted for 12% of the total revenue recognized during each period. As of June 30, 2012, the Company had one customer with a trade receivable balance of 14% of total receivables. No other customers’ trade receivable balance as of June 30, 2013 or 2012 exceeded 10% of the Company’s consolidated net trade receivable balance.
(3)
ACQUISITIONS
As of June 30, 2013 and since the formation of Zayo Group, LLC in May, 2007, the Company has consummated 25 transactions accounted for as business combinations. The acquisitions were executed as part of the Company’s business strategy of expanding through acquisitions. The acquisitions of these businesses have allowed the Company to increase the scale at which it operates, which in turn affords the Company the ability to increase its operating leverage, extend its network reach, and broaden its customer base.
The accompanying consolidated financial statements include the operations of the acquired entities from their respective acquisition dates.
Acquisitions During the Year Ended June 30, 2013
AboveNet Inc. (“AboveNet”)
On July 2, 2012, the Company acquired 100% of the outstanding capital stock of AboveNet, previously a publicly traded company listed on the New York Stock Exchange, in exchange for cash of approximately $2,212,492, net of cash acquired. The purchase price was based upon the price of $84 per share agreed to in the Agreement and Plan of Merger and the number of AboveNet shares outstanding on July 2, 2012.
AboveNet's legacy service offering included a business that provided professional services to certain users of bandwidth capacity. As the professional services business (“Zayo Professional Services” or “ZPS”) did not align with the Company's primary focus of providing bandwidth infrastructure services, ZPS was spun off to Holdings on September 30, 2012. The Company estimated the fair value on the acquisition date of the assets and liabilities of ZPS to be $26,342 (including $2,424 in cash) and is netted within the caption "Net assets of Zayo Professional Services (excluding cash)" presented in the purchase price allocation table below.
FiberGate Holdings, Inc. (“FiberGate”)
On August 31, 2012, the Company acquired 100% of the equity interest in FiberGate, a privately held corporation, for total consideration of $118,335. The acquisition was funded with cash on hand. $17,550 of the purchase price is currently held in escrow pending the expiration of the working capital and indemnification adjustment period.
USCarrier Telecom, LLC (“USCarrier”)
In connection with the October 1, 2010 acquisition of AFS, the Company acquired an ownership interest in USCarrier. USCarrier is a provider of transport services such as Ethernet and Wavelength primarily to other telecommunications providers. As of June 30, 2012, the Company owned 55% of the outstanding Class A membership units and 34% of the outstanding Class B membership units of USCarrier. On October 1, 2012, the Company acquired the remaining equity interests in USCarrier not previously owned for total consideration of $16,092, subject to certain post-closing adjustments. The acquisition cost was paid with cash on hand.
First Telecom Services, LLC (“First Telecom”)
On December 14, 2012, the Company acquired 100% of the equity interest in First Telecom, for total consideration of $109,700, subject to certain post-closing adjustments. $11,000 of the purchase price is currently held in escrow pending the expiration of the indemnification adjustment period. The acquisition cost was paid with cash on hand.
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
Litecast/Balticore, LLC (“Litecast”)
On December 31, 2012, the Company acquired 100% of the equity interest in Litecast, a provider of metro bandwidth infrastructure services in Baltimore, Maryland, for total consideration of $22,160, subject to certain post-closing adjustments. $3,338 of the purchase price is currently held in escrow pending the expiration of the indemnification adjustment period. The acquisition cost was paid with cash on hand.
Core NAP, L.P. (“Core NAP")
On May 31, 2013, zColo entered into an Asset Purchase Agreement with Core NAP, L.P. (“Core NAP”). The agreement was consummated on the same date, at which time zColo acquired substantially all of the net assets of Core NAP for a purchase price of approximately $7,030, subject to customary post-closing adjustments. $1,095 of the purchase price is currently held in escrow pending the expiration of the indemnification adjustment period. The purchase price was paid with cash on hand.
Acquisitions During the Year Ended June 30, 2012
Control Room Technologies, LLC, Allegan Fiber Communications, LLC and Lansing Fiber Communications (collectively “Arialink”)
On May 1, 2012, the Company acquired 100% of the equity interest in Arialink. The purchase price, which was funded with cash on hand, was $17,926, net of cash acquired.
Included in the Arialink acquisition were certain assets and liabilities which supported Arialink’s managed service product offerings. Concurrently with the close of the Arialink acquisition, the Company spun-off the portion of Arialink’s business that supported those managed service product offerings to Holdings. The Company’s estimate of the fair value of the net assets spun-off to Holdings is approximately $1,752, which has been reflected as a non-cash contribution to parent in the consolidated statement of member’s equity for the year ending June 30, 2012 and is netted within the caption "Net assets distributed to Parent" presented in the purchase price allocation table below.
360networks Holdings (USA) Inc. (“360networks”)
On December 1, 2011, the Company acquired all of the outstanding equity interest in 360networks for a contractual purchase price of $345,000. In connection with the agreement, the Company agreed to assume a net working capital deficit of approximately $26,400 and acquired $709 in cash balances. In March 2012, the Company received $400 in cash from an escrow account as a final working capital adjustment. As a result, the net consideration paid for the transaction was $317,891. The acquisition was funded with proceeds from a $315,000 Senior Secured Term Loan Facility (“Original Term Loan Facility”) which was entered into on December 1, 2011 (see Note 9 - Long-Term Debt) and cash on hand.
Included in the $345,000 contractual purchase price was VoIP360, Inc., a legal subsidiary of 360networks. The VoIP360, Inc. entity held substantially all of 360networks’ Voice over Internet Protocol (“VoIP”) and other voice product offerings. Effective April 1, 2011, Zayo spun-off its voice operations to Holdings in order to maintain focus on its Bandwidth Infrastructure business (see Note 4 - Spin-off of Business). To further this objective, concurrently with the close of the 360networks acquisition, the Company spun-off 360networks’ VoIP operations to Holdings. On the spin-off date, the Company estimated the fair value of the VoIP assets and liabilities which were distributed to Holdings to be $11,700 and is netted within the caption "Net assets distributed to parent" presented in the purchase price allocation table below.
Mercury Marquis Holdings, LLC (“MarquisNet”)
On December 31, 2011, the Company entered into an Asset Purchase Agreement with MarquisNet. The agreement was consummated on the same date, at which time zColo acquired substantially all of the net assets of MarquisNet for a purchase price of $15,875, subject to post-closing adjustments. In connection with the agreement, the parties estimated the Company would assume a net working capital deficit of approximately $419. As such, the consideration paid for the transaction was reduced to $15,456. The acquisition was funded with a draw on the Company’s revolving line-of-credit, which was subsequently repaid.
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
Acquisitions During the Year Ended June 30, 2011
AGL Networks, LLC (“AGL Networks”)
On July 1, 2010, the Company acquired all of the equity interest in AGL Networks. AGL Networks is a communication service provider focused on providing dark fiber services to its customers who are primarily located in the Atlanta, Georgia; Phoenix, Arizona; and Charlotte, North Carolina markets. The purchase price of this acquisition, after post-close adjustments, was $73,666. The acquisition was financed with cash on hand. There was no contingent consideration associated with the purchase.
American Fiber Systems Holding Corporation (“AFS”)
On October 1, 2010, the Company completed a merger with American Fiber Systems Holding Corporation, the parent company of American Fiber Systems, Inc. The AFS merger was consummated with the exchange of $110,000 in cash and a $4,500 non-interest bearing promissory note due in 2012 for all of the interest in AFS. The Company calculated the fair market value of the promissory note to be $4,141 resulting in an aggregate purchase price of $114,141 . The purchase price was based upon the valuation of both the business and assets directly owned by AFS and its ownership interest in USCarrier Telecom Holdings, LLC (“USCarrier”). There was no contingent consideration associated with the purchase.
Acquisition Method Accounting Estimates
The Company initially recognizes the assets and liabilities acquired from the aforementioned acquisitions based on its preliminary estimates of their acquisition date fair values. As additional information becomes known concerning the acquired net assets, management may make adjustments to the opening balance sheet of the acquired company up to the end of the measurement period, which is no longer than a one year period following the acquisition date. The determination of the fair values of the acquired assets and liabilities assumed (and the related determination of estimated lives of depreciable tangible and identifiable intangible assets) require significant judgment. As of June 30, 2013, the Company finalized its fair value analysis and resulting purchase accounting for the 360networks, Marquisnet and Arialink acquisitions consummated in Fiscal 2012 and for the AboveNet, FiberGate, USCarrier, and Litecast acquisitions. The Company has not completed its fair value analysis and calculations in sufficient detail necessary to arrive at the final estimates of the fair value of the acquired assets and liabilities assumed, specifically property and equipment, intangible assets, and deferred revenue, along with the related allocations to goodwill and intangible assets as it relates to its acquisitions of First Telecom and Core NAP. As such, all information presented as it relates to these acquisitions is preliminary and subject to revision pending the final fair value analysis.
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
The table below reflects the Company's estimates of the acquisition date fair values of the assets and liabilities assumed from its Fiscal 2013 acquisitions:
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
The table below reflects the Company's estimates of the acquisition date fair values of the acquired assets and liabilities assumed from its Fiscal 2012 acquisitions:
The table below reflects the Company's estimates of the acquisition date fair values of the assets and liabilities assumed from its Fiscal 2011 acquisitions:
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
The goodwill arising from the Company's acquisitions results from the synergies, anticipated incremental sales to the acquired company customer base and economies-of-scale expected from the acquisitions. The Company has allocated the goodwill to the reporting units (in existence on the respective acquisition dates) that were expected to benefit from the acquired goodwill. The allocation was determined based on the excess of the fair value of the acquired business over the fair value of the individual assets acquired and liabilities assumed that were assigned to the reporting units. Note 7 - Goodwill, displays the allocation of the Company's acquired goodwill to each of its reporting units. The goodwill associated with the acquisitions of USCarrier, First Telecom, Litecast, and Core NAP is deductible for tax purposes. The goodwill associated with the acquisitions of AboveNet and Fibergate is not deductible for tax purposes.
In each of the Company's Fiscal 2013, 2012, and 2011 acquisitions, the Company acquired certain customer relationships. These relationships represent a valuable intangible asset, as the Company anticipates continued business from the acquired customer bases. The Company's estimate of the fair value of the acquired customer relationships is based on a multi-period excess earnings valuation technique. The fair value of the acquired customer relationships for each acquisition was determined as follows: 2013 acquisitions -- AboveNet, $457,907; FiberGate, $35,963; USCarrier, $6,820; First Telecom, $35,516; LiteCast, $12,510; 2012 acquisitions -- 360networks, $19,923; MarquisNet, $7,874; Arialink, $6,807; 2011 acquisitions -- AGL Networks, $3,433; AFS, $57,082. For Fiscal 2013 acquisitions, the Company estimates the useful life of the acquired customer relationships to be approximately 20 years as it relates to AboveNet, FiberGate, Litecast and USCarrier and 14 years for First Telecom. For Fiscal 2012 acquisitions, the Company estimated the useful life of the acquired customer relationships to be approximately 20 years as it relates to Arialink and 360networks and 11 years for MarquisNet. For Fiscal 2011 acquisitions, the Company estimated the useful life of the acquired customer relationships to be approximately 19 and 14 years, respectively, as it relates to the AGL Networks and AFS acquisitions.
The previous owners of AboveNet and 360networks had entered into various agreements, including IRU agreements with other telecommunication service providers to lease fiber and other bandwidth infrastructure in exchange for upfront cash payments. The Company accounted for acquired deferred revenue at its acquisition date fair value, which was determined utilizing both the income and market approaches. The income approach was based upon management’s assessment of the cost of the network encumbered by the IRU contracts in place, as well as the future costs to be incurred in connection with the Company’s continuing legal obligation associated with the acquired IRU contracts plus a reasonable profit margin. The market approach incorporated the actual up-front payments received by AboveNet and 360networks under contracts entered in to within close proximity to the acquisition date, as those were recent market transactions between unrelated parties, and comparable transactions that the Company had entered in to with third-party customers within 18 months of the acquisition. A fair value of $146,016 and $45,455 was assigned to the acquired deferred revenue balance of AboveNet and 360networks, respectively. The $143,373 represented in our purchase price allocation table above for AboveNet is shown net of amounts allocated to ZPS. The acquired deferred revenue is being recognized over a weighted average contract term of 9.1 years and 12.5 years for the AboveNet and 360networks acquisitions, respectively.
Purchase Accounting Estimates Associated with Deferred Taxes
Based on the Company’s fair value assessment related to deferred tax assets acquired in the 360networks and AboveNet acquisitions, a value of $85,076 and $42,126 was assigned to the acquired deferred tax assets and deferred tax liabilities, respectively. Refer to "Adjustments to Purchase Accounting Estimates Associated with Prior Year Acquisitions" below for discussion of adjustments made to acquired deferred tax assets for 360networks related to limitation of acquired net operating loss carryforwards.
During the quarter ended June 30, 2013, the Company finalized its acquisition accounting for AboveNet. In conjunction therewith, it completed a “change in ownership” analysis, within the meaning of Section 382 of the Internal Revenue Code (“IRC”). Section 382 of the IRC limits an acquiring company's ability to utilize net operating loss carryforwards (“NOLs”) previously generated by an acquired company in order to reduce future taxable income. As a result of the Company's acquisition of AboveNet, the Company is subject to annual limitations on usage of the acquired $1,008,755 of NOLs generated by AboveNet prior to the acquisition date.
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
The tax effect of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities are as follows:
Adjustments to Purchase Accounting Estimates Associated with Current Year Acquisitions
AboveNet Inc. (“AboveNet”)
During the year ended June 30, 2013, the Company finalized its acquisition accounting for AboveNet. In connection therewith, it completed its fair value analysis and calculations in sufficient detail necessary to arrive at the final estimates of the fair value of the acquired assets and liabilities assumed, along with the related allocations to goodwill and intangible assets. As a result of completing its fair value analysis, the Company increased its original estimate of the fair value of property, plant and equipment, deferred revenue, and intangible assets acquired from the AboveNet acquisition in the amount of $732,800, $56,173 and $48,278, respectively. The Company has retrospectively recorded a corresponding net decrease to the goodwill acquired from the AboveNet acquisition in the amount of $723,347 related to these adjustments and other immaterial adjustments recorded in connection with finalization of purchase accounting for AboveNet totaling $304, which has been reflected in the accompanying consolidated balance sheets as of June 30, 2013. In addition, the revision in the fair value estimates previously discussed resulted in a decrease to the net deferred tax assets acquired by $48,089, with a corresponding increase in goodwill. The fair value adjustments to the Company's provisional acquisition accounting for AboveNet impacted the Company's historical results of operations during interim periods of Fiscal 2013, which have been retrospectively adjusted. The table below summarizes the impact of these adjustments to interim periods in Fiscal 2013 and these adjustments are reflected in the unaudited quarterly financial data for Fiscal 2013 included in Note 19 - Quarterly Financial Data, for the quarters ended September 30, 2012, December 31, 2012, and March 31, 2013, and June 30, 2013.
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
Adjustments to Purchase Accounting Estimates Associated with Prior Year Acquisitions
MarquisNet and Arialink
During the year ended June 30, 2013, the Company finalized its acquisition accounting for MarquisNet and Arialink and adjusted its previously reported allocation of the purchase consideration associated with these acquisitions as a result of changes to the original fair value estimates of certain items acquired from these acquisitions. These changes are the result of additional information obtained since the filing of the Company's Annual Report on Form 10-K for the year ended June 30, 2012 that related to the facts and circumstances in existence at the respective acquisition dates. Other current assets increased $2,672 due to refunds of $1,875 and $797 from escrow accounts related to the resolution of contingent purchase price adjustments associated with the Company’s acquisitions of MarquisNet and Arialink, respectively. Accrued liabilities increased by $450 as a result of finalizing an estimate for a pre-acquisition legal contingency associated with the Arialink acquisition. Goodwill decreased by $2,327 as an offset to the aforementioned and other immaterial adjustments.
360networks Holdings (USA) Inc. (“360networks”)
During the year ended June 30, 2013, the Company finalized its acquisition accounting for 360networks. In conjunction therewith, it completed a “change in ownership” analysis, within the meaning of Section 382 of the Internal Revenue Code (“IRC”). Section 382 of the IRC limits an acquiring company's ability to utilize net operating loss carryforwards (“NOLs”) previously generated by an acquired company in order to reduce future taxable income. As a result of the Company's acquisition of 360networks and due to changes in the ownership of 360networks prior to the Company's acquisition, the Company is limited to utilizing $84,500 of the NOLs generated by 360networks prior to the acquisition date. As a result of completing the Section 382 analysis, the Company has reduced its original estimate of the fair value of the deferred tax asset acquired from 360networks by $58,691. The Company has retrospectively recorded a corresponding increase to the goodwill acquired from the 360networks acquisition in the amount of $58,691, which has been reflected in the accompanying consolidated balance sheets as of June 30, 2012. This adjustment to the Company's provisional acquisition accounting had no effect on the Company's historical results from operations.
Transaction Costs
Transaction costs include expenses incurred which are directly related to potential and closed acquisitions. The Company incurred transaction costs of $14,204, $6,630, and $865 during the years ended June 30, 2013, 2012 and 2011. Transaction costs have been included in selling, general and administrative expenses during these periods.
Pending Acquisition
Access Communications, Inc. ("Access")
As discussed in Note 20 - Subsequent Events, on August 13, 2013, the Company entered into a stock purchase agreement with Access, a Minnesota corporation, and shareholders of Access. Upon the close of the transaction contemplated by the stock purchase agreement, Zayo will acquire 100% of the equity interest in Access. The purchase price, subject to certain
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
adjustments at close and a period of time after closing, is $40,000 and is expected to be paid with cash on hand. The acquisition is subject to customary closing conditions and approvals.
Access is a provider of metro bandwidth infrastructure services that owns and operates a 1,200 mile fiber network that covers the greater Minneapolis-St. Paul metropolitan area, connecting more than 500 on-net buildings, including the area's major datacenters and carrier hotel facilities. Access is primarily focused on providing dark fiber services to a concentrated set of Minneapolis area carriers, enterprise and governmental customers, particularly within the education segment.
Pro-forma Financial Information (Unaudited)
The unaudited pro forma results presented below include the effects of the Company’s Fiscal 2012 acquisitions of 360networks, Arialink and MarquisNet and the Company’s Fiscal 2013 acquisitions of AboveNet, Fibergate, USCarrier, First Telecom, Litecast, and Core NAP as if each acquisition occurred on July 1, 2011. The pro-forma results of the acquired AboveNet business exclude the operating results of the professional service business acquired in the AboveNet acquisition which was spun-off to Holdings on September 30, 2012 (see Note 4 - Spin-off of Business). The pro forma loss for the years ended June 30, 2013 and 2012 includes the additional depreciation and amortization resulting from the adjustments to the value of property and equipment and intangible assets resulting from purchase accounting and a net increase to revenue during 2013 and a net decrease to revenue during 2012 as a result of the acquisition date valuation of acquired deferred revenue. The pro forma results also include interest expense associated with debt used to fund the acquisitions. The pro forma results do not include any anticipated synergies or other expected benefits of the acquisitions. The unaudited pro forma financial information below is not necessarily indicative of either future results of operations or results that might have been achieved had the acquisitions been consummated as of July 1, 2011.
The Company is unable to determine the amount of revenue associated with each acquisition recognized in the post-acquisition period due to accelerated timing of integration activities.
(4)
SPIN-OFF OF BUSINESS
In connection with certain business combinations, the Company may acquire assets or liabilities that support products outside of the Company’s primary focus of providing bandwidth infrastructure services.
On September 30, 2012, the Company completed a spin-off of Zayo Professional Services LLC ("ZPS"), a professional service business unit acquired in the acquisition of AboveNet. The Company distributed all of the assets and liabilities of ZPS on the spin-off date to Holdings.
The Company continues to have ongoing contractual relationships with ZPS to provide ZPS with bandwidth capacity. The contractual relationships are based on agreements that were entered into at estimated market rates. During the quarter ended September 30, 2012, transactions with ZPS were eliminated upon consolidation. Subsequent to the spin-off date, transactions with ZPS have been included in the Company’s results of operations. See Note 16 - Related-Party Transactions, for a discussion of transactions with ZPS during year ended June 30, 2013.
In conjunction with the acquisitions of 360networks and Arialink during the year ending June 30, 2012, the Company spun-off certain of the operations acquired to Holdings as described in Note 3 - Acquisitions. Holdings subsequently contributed the spun-off net assets to Onvoy Voice Services, Inc. ("OVS") and Zayo Enterprise Networks LLC ("ZEN"). Since the net assets and related operations were spun-off concurrent with the closing of the acquisitions, there were no historical results reported by the Company requiring discontinued operations presentation.
On April 1, 2011, the Company completed a spin-off of ZEN, a business unit that provides managed services. The Company distributed all of the assets and liabilities of ZEN on the spin-off date to Holdings.
Consistent with discontinued operations reporting provisions of ASC 205-20, Discontinued Operations, management discontinued all significant cash flows and continuing involvement with respect to the ZPS operations effective September 30,
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
2012 and ZEN operations effective April 1, 2011. Therefore, for the year ended June 30, 2013 and June 30, 2011, the results of the operations of ZPS and ZEN have been aggregated in a single caption entitled, “Earnings from discontinued operations, net of income taxes” in the accompanying consolidated statements of operations.
Earnings from discontinued operations, net of income taxes in the accompanying consolidated statements of operations are comprised of the following:
The earnings from discontinued operations, net of income taxes, is net of $1,544 of intercompany expenses which ZPS recognized during Fiscal 2013 from transactions with other Zayo Group subsidiaries.
(5) INVESTMENT
In connection with the AFS acquisition, the Company acquired an ownership interest in USCarrier. USCarrier is a provider of transport services such as Ethernet and Wavelength primarily to other telecommunications providers. As of June 30, 2012, the Company’s ownership in USCarrier was comprised of 55% of the outstanding Class A membership units and 34% of the outstanding Class B membership units. As discussed in Note 3 - Acquisitions, on August 15, 2012, the Company entered into an agreement with the other equity holders of USCarrier to acquire the remaining equity interest in USCarrier. On October 1, 2012, the transaction was consummated and the Company acquired the remaining outstanding equity interest in USCarrier.
Although the Company had a significant ownership position in USCarrier prior to the October 1, 2012 acquisition, as a result of certain historical disputes with the board of managers of USCarrier, the Company was unable to exercise control or significant influence over USCarrier’s operating and financial policies and was denied access to the financial records of USCarrier, and as such, the Company accounted for this investment utilizing the cost method of accounting.
Based on the agreed upon purchase price of the remaining outstanding equity interests included in the August 15, 2012 purchase agreement, the fair value of the Company’s ownership interest in USCarrier was determined to be $12,827, and as such, the Company wrote-down the carrying value of its investment in USCarrier of $15,075 to its fair value and recognized an impairment of $2,248 during the year ended June 30, 2012.
At the time of the AFS merger, management estimated the fair value of its interest in USCarrier to be $15,075. In valuing the Company’s interest in USCarrier, management used both an income- and market- based approach to estimate the acquisition date fair value. Subsequent to the AFS merger and prior to purchasing the remaining equity interest in US Carrier, the Company did not received any dividend payments from USCarrier nor did the Company invest any additional capital in USCarrier.
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
(6) PROPERTY AND EQUIPMENT
Property and equipment, including assets held under capital leases, was comprised of the following:
Total depreciation expense, including depreciation of assets held under capital leases, for the years ended June 30, 2013, 2012 and 2011 was $280,113, $70,357 and $47,905, respectively.
Included within the Company’s property and equipment balance are assets under capital leases with a cost of $13,219 and $17,751 with associated accumulated depreciation of $3,722 and $4,988 as of June 30, 2013 and 2012, respectively. The Company recognized depreciation expense associated with assets under capital leases of $1,781, $1,377 and $1,272 for the years ended June 30, 2013, 2012 and 2011, respectively. During Fiscal 2013, the Company wrote off $12,121 of capital lease assets (with associated accumulated depreciation of $3,047) in connection with the AboveNet and First Telecom acquisitions.
During the years ended June 30, 2013 and 2012, the Company received a total of $9,319 and $22,826, respectively, in grant money from the NTIA’s Broadband Technology Opportunities Program (“the Program”) for reimbursement of property and equipment expenditures. The Company has accounted for these funds as a reduction of the cost of its fiber optic network. As of June 30, 2013, the Company anticipates the receipt of $25 in grant money related to grant agreements entered into under the Program, which will offset capital expenditures in future periods. See Note 15 - Commitments and Contingencies-Other Commitments.
During the years ended June 30, 2013, 2012 and 2011, the Company capitalized interest in the amounts of $12,970, $5,472, and $3,691, respectively. The Company capitalized $28,613, $9,373, and $6,230 of direct labor costs to property and equipment accounts during the years ended June 30, 2013, 2012 and 2011, respectively.
(7)
GOODWILL
The Company’s goodwill balance was $682,775 and $193,803 as of June 30, 2013 and 2012, respectively. Additions to goodwill during the year ended June 30, 2013 relate to the acquisitions of AboveNet, FiberGate, USCarrier, First Telecom, Litecast, and Core NAP (See Note 3 - Acquisitions).
The Company’s reportable segments are comprised of its reporting units. Historically, the Company operated as three strategic product groups: Zayo Bandwidth ("ZB"), Zayo Colocation ("zColo") and Zayo Fiber Solutions ("ZFS"). Effective January 1, 2013, the Company implemented certain changes to its organizational structure that resulted in the disaggregation of the legacy ZB strategic product group into five separate reportable segments: Zayo Wavelength Services ("Waves"), Zayo SONET Services ("SONET"), Zayo Ethernet Services ("Ethernet"), Zayo IP Services ("IP") and Zayo Mobile Infrastructure Group ("MIG") (See Note 17 - Segment Reporting). Upon the January 1, 2013 disaggregation of the legacy ZB segment, the goodwill balance of the ZB segment was re-allocated to the newly formed segments based upon a relative fair value allocation method. Effective January 1, 2013, the Company also changed the name of its legacy ZFS segment to Zayo Dark Fiber ("Dark Fiber"). The following table reflects the allocation of goodwill acquired in the Company's Fiscal 2013 acquisitions to the
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
Company's legacy reporting units and the allocation of the legacy ZB goodwill balance to each of the Company's newly formed reportable segments:
Refer to Note 3 - Acquisitions for discussion of adjustments recorded to the previously reported allocation of purchase consideration associated with prior year and current year acquisitions. These changes are the result of additional information obtained since the filing of the Company's Annual Report on Form 10-K for the year ended June 30, 2012 and the Company's Quarterly Reports of Form 10-Q for the quarters ended September 30, 2012, December 31, 2012, and March 31, 2013 that related to facts and circumstances in existence at the respective acquisition dates.
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
(8) INTANGIBLE ASSETS
Identifiable acquisition-related intangible assets as of June 30, 2013 and 2012 were as follows:
The weighted average amortization period for the Company’s customer relationships and trade name assets is 17.84 years and 2.7 years, respectively. The Company has determined that the certifications have indefinite lives. The amortization period for underlying rights is 20.0 years. The amortization of intangible assets for the years ended June 30, 2013, 2012 and 2011 was $42,567, $14,604 and $12,558, respectively.
During the years ended June 30, 2013 and 2012, the Company wrote off $548 and $9,335 in fully amortized intangible assets, respectively. Estimated future amortization of finite-lived intangible assets is as follows:
(9)
LONG-TERM DEBT
On December 1, 2011 the Company and Zayo Capital, Inc. (“Zayo Capital”), a 100% owned finance subsidiary of the Company that does not have independent assets or operations, entered into a $315,000 senior secured term loan facility (the “Original Term Loan Facility”). The net proceeds from the Original Term Loan were approximately $296,523 after deducting the discount on the Original Term Loan Facility of $9,450 and debt issuance costs of approximately $9,027. The Original Term Loan Facility was being accreted to its par value over the term of the loan as additional interest expense using the effective interest rate method. The proceeds of the Original Term Loan Facility were used to partially fund the acquisition of 360networks (See Note 3 - Acquisitions). The Original Term Loan Facility had a maturity date of September 15, 2016 and the borrowings thereunder bore interest at varying levels based on the London Interbank Offered Rate (“LIBOR”) plus a spread of 5.5% (subject to a minimum LIBOR rate of 1.5%) or a specified base rate plus a spread of 4.5%. As of June 30, 2012, the
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
applicable interest rate on the Term Loan was 7.0%. The balance on the Original Term Loan Facility was $305,159, net of the unamortized discount of $8,265, as of June 30, 2012. The Original Term Loan Facility was refinanced in July 2012.
In March 2010, the Company co-issued, with Zayo Capital (at an issue price of 98.779%), $250,000 of Senior Secured Notes. These Notes bore interest at 10.25% annually and were due on March 15, 2017. The net proceeds from the Original Notes were approximately $239,050 after deducting the discount on the Notes of $3,052 and debt issuance costs of approximately $7,898. In September 2010, the Company completed an offering of an additional $100,000 in Notes (at an issue price of 103%). These Notes were part of the same series as the $250,000 Senior Secured Notes (collectively, the "Original Notes") and also bore interest at a rate of 10.25% and were due on March 15, 2017. The net proceeds from this debt issuance were approximately $98,954 after adding the premium on the Notes of $3,000 and deducting debt issuance costs of approximately $4,046. The Company used a portion of the proceeds from this issuance of the Notes to fund the merger with AFS (see Note 3 - Acquisitions). The Original Notes were being accreted to their par value over the term of the Original Notes as an increase or decrease to interest expense using the effective interest method until they were redeemed in July 2012.
In March 2010, the Company also entered into a revolving line-of-credit (the “Original Revolver”). Concurrent with offering the $100,000 of Notes in September 2010, the Company amended the terms of its Original Revolver to increase the borrowing capacity from $75,000 to $100,000 (adjusted for letter of credit usage). The Company capitalized $2,248 in debt issuance costs associated with the amended Original Revolver.
As of June 30, 2012, $30,000 was outstanding under the Original Revolver. Standby letters of credit were outstanding in the amount of $6,166. Outstanding letters of credit backed by the Original Revolver accrued interest at a rate ranging from 3.5% to 4.5% per annum based upon the Company’s leverage ratio. As of June 30, 2012, the interest rate on the outstanding Original Revolver balance was 4.2%. The Original Revolver was paid off in July 2012.
As of June 30, 2012, the Company’s debt obligations included the Original Notes with a balance of $350,122 (net of unamortized premiums and discounts of $122), the Original Term Loan Facility with a balance of $305,159 (net of unamortized discount of $8,266) and $30,000 outstanding under the Company’s Original Revolver.
On July 2, 2012, the Company and Zayo Capital issued $750,000 aggregate principal amount of 8.125% senior secured first-priority notes due 2020 (the "Senior Secured Notes") and $500,000 aggregate principal amount of 10.125% senior unsecured notes due 2020 (the "Senior Unsecured Notes", and together with the Senior Secured Notes, the “Notes”). On July 2, 2012, the Company also entered into a $250,000 senior secured revolving credit facility (the "Revolver") and a $1,620,000 senior secured term loan facility, issued at a $30,000 discount, which accrues interest at floating rates (the “Term Loan Facility”); the rate on the Term Loan Facility was initially subject to a floor of 7.125%. A portion of the net proceeds from the Notes and the Term Loan Facility, together with cash on hand and equity contributions (See Note 8 - Equity), were used to extinguish the Company’s previously existing term loan and revolver, to finance the cash tender offer for and subsequent redemption of the Company’s $350,000 outstanding aggregate principal amount of previously issued notes, to pay the cash consideration for the AboveNet acquisition, and to pay associated fees and expenses.
In connection with the debt extinguishment activities discussed above, the Company recognized an expense in July 2012 of $64,975 associated with debt extinguishment costs, including a cash expense of $39,798 associated with the payment of early redemption fees on the Company’s previous indebtedness and non-cash expenses of $17,032 associated with the write-off of the Company’s unamortized debt issuance costs and $8,145 associated with writing-off the net unamortized discount on the debt balances extinguished.
On October 5, 2012, the Company and Zayo Capital entered into a second amendment (the “Second Amendment”) to the agreement governing its Term Loan Facility (the "Credit Agreement"). Under the terms of the Second Amendment, effective October 5, 2012, the interest rate on the Company’s Term Loan Facility was adjusted to bear an interest rate at LIBOR plus 4.0%, which represented a decrease of 187.5 basis points from the original Credit Agreement. The Second Amendment set a floor on the Term Loan Facility’s interest rate at 5.25%. The Second Amendment also reduced the interest rate on the Revolver by 187.5 basis points.
On February 27, 2013, the Company and Zayo Capital entered into a Fourth Amendment (the “Fourth Amendment”) to the Company's Credit Agreement. Under the terms of the Fourth Amendment, effective February 27, 2013, the interest rate on the Company’s Term Loan Facility was further adjusted to bear interest at LIBOR plus 3.5% (the “Term Loan LIBOR Spread”) with a minimum LIBOR rate of 1.0%. The amended terms represent a downward adjustment of 50 basis points on the Term Loan LIBOR Spread and a 25 basis point reduction in the minimum LIBOR rate from the Second Amendment. Under the terms of the Fourth Amendment, the Company’s Revolver, which was undrawn as of June 30, 2013, will bear interest at LIBOR plus 3.00%, based on the Company’s current leverage ratio (the “Revolving Loan LIBOR Spread”), which represents a downward
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
adjustment of 50 basis points on the Revolving Loan LIBOR Spread from the Second Amendment. The Fourth Amendment also amended certain terms and provisions of the Company's Credit Agreement, including removing the senior secured and total leverage maintenance covenants and increasing the total leverage ratio required to be met in order to incur certain additional indebtedness from 5.00:1.00 to 5.25:1.00 as a multiple of EBITDA (as defined in the Credit Agreement).
In connection with the aforementioned amendments, the Company incurred early redemption call premiums of $16,200 and $16,119 for the Second Amendment and Fourth Amendment, respectively. The early redemption call premium was paid with cash on hand to a syndicate of creditors in the Company’s Term Loan Facility. Prior to the consummation of the amendments, the Company requested the consent of all creditors holding balances in the Company’s Term Loan Facility to the amended terms. $15,261 and $15,040 of the early call premium paid to consenting creditors in the Second and Fourth Amendments, respectively, have been accounted for as additional debt issuance costs during the year ended June 30, 2013, which are being amortized over the term of the Term Loan Facility using the effective interest method. The remaining call premium of $939 and $1,079 associated with the Second and Fourth Amendments, respectively, that was paid to non-consenting creditors has been recorded as a loss on extinguishment of debt on the consolidated statements of operations for the year ended June 30, 2013. Existing and/or new creditors replaced the non-consented commitments such that the full amount of the Company's term loan commitments were replaced in both the Second and Fourth Amendments. The principal payment of $344,452 to the non-consenting creditors is reflected on the consolidated statement of cash flows as a principal payment on long-term debt, and the corresponding $344,452 received from new creditors is reflected as proceeds from issuance of long-term debt.
In connection with the amendments, the Company recognized an expense of $12,278 during the year ended June 30, 2013 associated with debt extinguishment costs. The loss on extinguishment of debt associated with the amendments includes the aforementioned early call premiums paid to non-consenting creditors, non-cash expense associated with the write off of unamortized debt issuance costs and issuance discounts on the debt balances accounted for as an extinguishment, and certain fees paid to third parties involved in the amendments.
The interest rates in effect on the Term Loan Facility and Revolver as of June 30, 2013 were 4.50% and 3.27%, respectively. The Revolver is subject to a commitment fee of 0.5% of the weighted-average unused capacity and outstanding letters of credit backed by the Revolver are subject to a 0.25% fee per annum. The Revolver has a maturity date of July 2017.
The Term Loan Facility was issued at a discount of $30,000 and has a maturity date of July 2019. The issue discount is being amortized to interest expense over the term of the loan. The terms of the Term Loan Facility require the Company to make quarterly principal payments of $4,050 plus an annual payment of up to 50% of excess cash flow, as determined in accordance with the Credit Agreement, and no such payment was required during the year ending June 30, 2013.
As of June 30, 2013, the balances of the Notes and Term Loan Facility were $1,250,000 and $1,580,705 (net of an unamortized discount of $23,343).
In October 2010, in connection with the AFS merger, the Company provided the former owners of AFS with a promissory note in the amount of $4,500. The Company recorded this note at its fair value on the acquisition date, which was determined to be $4,141. Management estimated the imputed interest associated with this note on the acquisition date to be $359, which was recognized over the term of the promissory note. During the years ended June 30, 2013, 2012, and 2011, the Company recognized interest expense and a corresponding increase to the promissory note obligation of $59, $174, and $126, respectively. The promissory note was non-interest bearing and was paid in full in October 2012.
As of June 30, 2013, no amounts were outstanding on the Company’s Revolver. Standby letters of credit were outstanding in the amount of $6,561 as of June 30, 2013, leaving $243,439 available under the Revolver as of June 30, 2013. Outstanding letters of credit backed by the Revolver accrue interest at a rate ranging from LIBOR plus 2.0% to LIBOR plus 3.0% per annum based upon the Company’s leverage ratio.
Debt covenants
The Credit Agreement, as amended, contains a covenant that requires the Company to maintain a minimum fixed-charge coverage ratio. Pursuant to the Credit Agreement, the Company shall not permit its Fixed Charge Coverage Ratio, which is defined in the Credit Agreement as the ratio of the Company's annualized modified EBITDA (as defined in the Credit Agreement) during the most recent quarter minus Capital Expenditures (as defined in the Credit Agreement) for the twelve month period ended as of the end of each applicable fiscal quarter to interest expense for that same period to be less than the minimum ratio for the applicable period set forth below:
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
The Credit Agreement also requires the Company and its subsidiaries to comply with customary affirmative and negative covenants, including covenants restricting the ability of the Company and its subsidiaries, subject to specified exceptions, to incur additional indebtedness, make additional guaranties, incur additional liens on assets, or dispose of assets, pay dividends, or make other distributions, voluntarily prepay certain other indebtedness, enter into transactions with affiliated persons, make investments and amend the terms of certain other indebtedness.
The Credit Agreement does not contain any restrictions on the ability of the Company's subsidiaries' to pay dividends to Zayo Group, LLC.
The Credit Agreement contains customary events of default, including among others, non-payment of principal, interest, or other amounts when due, inaccuracy of representations and warranties, breach of covenants, cross default to certain other indebtedness, insolvency or inability to pay debts, bankruptcy, or a change of control.
The indentures governing the Company's Notes limit any increase in the Company's secured indebtedness (other than certain forms of secured indebtedness expressly permitted under the indentures) to a pro forma secured debt ratio of 4.5 times the Company's previous quarter's annualized modified EBITDA, as defined in the indentures, and limit the Company's incurrence of additional indebtedness to a total indebtedness ratio of 5.25 times the previous quarter's annualized modified EBITDA.
The Company was in compliance with all covenants associated with its debt agreements as of June 30, 2013 and 2012.
Redemption rights
At any time prior to July 1, 2015 (for the Senior Secured Notes) and July 1, 2016 (for the Senior Unsecured Notes), the Company may redeem all or part of the Notes at a redemption price equal to the sum of (i) 100% of the principal amount thereof, plus (ii) accrued interest and a "make-whole" premium, which is a lump sum payment derived from a formula based on the net present value of future coupon payments that will not be paid because of the early redemption.
On or after July 1, 2015 (for the Senior Secured Notes) or July 1, 2016 (for the Senior Unsecured Notes) the Company may redeem all or part of the Notes, at the redemption prices (expressed as percentages of principal amount and set forth below), plus accrued and unpaid interest and additional interest, if any, thereon, to the applicable redemption date, subject to the rights of the holders of the Notes on the relevant record date to receive interest due on the relevant interest payment date, if redeemed during the 12-month period beginning on July 1 of the years indicated below:
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
In the event of an equity offering to the public, at any time prior to July 1, 2015, the Company may redeem up to 35% of the aggregate principal amount of the Notes issued under the Company's indenture at a redemption price of 108.125% (for the Senior Secured Notes) and 110.25% (for the Senior Unsecured Notes) of the principal amount thereof, plus accrued and unpaid interest and additional interest, if any, thereon to the redemption date, subject to the rights of the holders of the Notes on the relevant record date to receive interest due on the relevant interest payment date, with the net cash proceeds of one or more equity offerings, provided that (i) at least 65% of the aggregate principal amount of the Notes issued under the indenture remains outstanding immediately after the occurrence of such redemption and (ii) the redemption occurs within 90 days of the date of the closing of such equity offering.
The Company may purchase the Notes in open-market transactions, tender offers, or otherwise. The Company is not required to make any mandatory redemption or sinking fund payments with respect to the Notes.
The Company, at any time prior to August 28, 2013, may voluntarily make prepayments against the principal balance of the Term Loan Facility. If the source of such prepayments is from proceeds of Funded Debt (as defined in the Credit Agreement), having a lower interest rate than the applicable Term Loan Facility rate, such prepayments will be accompanied by a premium payment of 1.0% of the aggregate prepayment amount. The Company may make prepayments on the Term Loan Facility at any time without incurring a 1.0% premium charge if the prepayment is from a source other than Funded Debt having a lower interest rate than the applicable Term Loan Facility rate, and at any time after August 28, 2013, regardless of the source.
Aggregate future contractual maturities of long-term debt (excluding issue discounts and premiums) were as follows as of June 30, 2013:
Guarantees
The Notes are fully and unconditionally guaranteed, jointly and severally, on a senior secured basis by all of the Company’s current and future domestic restricted subsidiaries. The Notes were co-issued with Zayo Capital which does not have independent assets or operations.
Debt issuance costs
In connection with the Notes offering, Revolver and the amended Term Loan Facility and subsequent Fiscal 2013 amendments, the Company incurred debt issuance costs of $130,148. These costs are being amortized to interest expense over the respective terms of the underlying debt instruments using the effective interest method, unless extinguished earlier, at which time the related unamortized costs are immediately expensed.
Unamortized debt issuance costs of $19,706 and $22,561 associated with the Company’s previous indebtedness were recorded as part of the loss on extinguishment of debt during the year ended June 30, 2013 upon the settlement of the Company’s previous debt obligations in July 2012 and material amendment to the Company's existing debt obligations in October 2012 and February 2013, respectively. The balance of debt issuance costs as of June 30, 2013 and 2012 was $98,960 and $19,706, net of accumulated amortization of $11,482 and $6,187, respectively. Interest expense associated with the amortization of debt issuance costs was $11,482, $3,441, and $2,220 for the years ended June 30, 2013, 2012 and 2011, respectively. The amortization of debt issuance costs is included on the consolidated statements of cash flows within the caption “non-cash interest expense” along with the amortization or accretion of the premium and discount on the Company’s indebtedness and changes in the fair value of the Company's interest rate derivatives.
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
Interest rate derivatives
On August 13, 2012, the Company entered into forward-starting interest rate swap agreements with an aggregate notional value of $750,000, a maturity date of June 30, 2017, and a start date of June 30, 2013. There were no up-front fees for these agreements. The contract states that the Company shall pay a 1.67% fixed rate of interest for the term of the agreement beginning on the start date. The counter-party will pay to the Company the greater of actual LIBOR or 1.25%. The Company entered in to the forward-starting swap arrangements to reduce the risk of increased interest costs associated with potential changes in LIBOR rates.
Changes in the fair value of interest rate swaps are recorded as an increase or decrease in interest expense in the consolidated statements of operations for the applicable period. During the year ended June 30, 2013, $2,642 was recorded as a decrease in interest expense for the change in the fair value of the interest rate swaps. The fair value of the interest rate swaps of $2,642 is included in “Other long term assets” in the Company’s consolidated balance sheet as of June 30, 2013.
(10)INCOME TAXES
The Company, a limited liability company, is taxed at the Holdings level. All income tax balances resulting from the operations of Zayo Group, on a separate return basis, are reflected in these consolidated financial statements.
The Company’s (benefit)/provision for income taxes is summarized as follows:
The Company’s effective income tax rate differs from what would be expected if the federal statutory rate were applied to earnings before income taxes primarily because of certain expenses that represent permanent differences between book and tax expenses and deductions, such as stock-based compensation expense that is recorded as an expense for financial reporting purposes but is not deductible for tax purposes.
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
A reconciliation of the actual income tax provision and the tax computed by applying the U.S. federal rate to the earnings before income taxes during the years ended June 30, 2013, 2012 and 2011 are as follows:
Deferred income taxes reflect the tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes.
The tax effect of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities are as follows:
As of June 30, 2013, the Company had $1,375,906 of net operating loss ("NOL") carry forwards. During the year ending June 30, 2012, the Company utilized $19,520 of NOLs. After completing a Section 382 NOL limitation study for the 360networks acquisition, it was determined that $157,618 of NOL carryforwards would never be realized due to limitation and were therefore recorded as an adjustment to the net deferred tax assets recognized in the purchase price allocation for 360networks (see Note 3 - Acquisitions). The Company acquired $1,008,755 of NOL carryforwards in the AboveNet acquisition. The acquisition, however, was considered a “change in ownership” within the meaning of Section 382 of the
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
Internal Revenue Code and, as a result, such NOL carryforwards are subject to an annual limitation, reducing the amount available to offset income tax liabilities absent the limitation. Currently available NOL carryforwards as of June 30, 2013 are approximately $400,578. In acquisition accounting, the aforementioned acquired NOL carryforwards and associated deferred tax assets were initially recorded net of amounts that would expire unused as a result of the estimated Section 382 annual limitations. The Company's NOL carryforwards, if not utilized to reduce taxable income in future periods, will expire in various amounts beginning in 2020 and ending in 2032.
As of June 30, 2013, the Company had approximately of $1,162 foreign jurisdiction net operating loss carry forwards. The majority of these foreign jurisdiction net operating loss carry forwards do not expire.
As of June 30, 2013, the Company had tax-effected state net operating loss carry forwards of approximately $58,189, which are subject to limitations on their utilization and have various expiration periods through 2032.
Management believes it is more likely than not that it will utilize its net deferred tax assets to reduce or eliminate tax payments in future periods. The Company’s evaluation encompassed (i) a review of its recent history of profitability for the past three years (excluding permanent book versus tax differences) and (ii) a review of internal financial forecasts demonstrating its expected capacity to utilize its deferred tax assets.
Uncertain Tax Positions
The Company is subject to audit by various taxing authorities, and these audits may result in proposed assessments where the ultimate resolution results in the Company owing additional income taxes. The statute of limitations is open with respect to tax years 2008 to 2012; however, to the extent that the Company has an NOL balance which was generated in a tax year outside of this statute of limitations period, such tax years will remain open until such NOLs are utilized by the Company. The Company establishes reserves when management believes there is uncertainty with respect to certain positions and the Company may not succeed in realizing the tax benefits. The Company recognizes the effect of income tax positions only if those positions are more likely than not of being sustained. Recognized income tax positions are measured at the largest amount that is greater than 50% likely of being sustained. Changes in recognition or measurement are reflected in the period in which the change in judgment occurs. The application of income tax law is inherently complex and as such, it requires many subjective assumptions and judgments regarding income tax exposures. Interpretations of and guidance surrounding income tax laws and regulations change over time; as such, changes in these subjective assumptions and judgments can materially affect amounts recognized in the balance sheets and statements of operations. As of June 30, 2013 and 2012, there was no accrued interest or penalties related to uncertain tax positions since the Company’s NOL carryforwards are sufficient to absorb any tax deficiencies that may ultimately be due if the Company’s uncertain tax positions are settled with the taxing authorities.
The Company has reduced its NOL carryforward for known tax exposures, which is referred to herein as "reserves". As of June 30, 2013, the total amount of the reserves for uncertain tax positions was $5,808. The Company’s tax reserves reflect management’s estimate of the maximum amount of tax benefit that is more likely than not of being realized. While the Company believes its reserves are adequate to cover its known uncertain tax positions, there can be no assurance that in all instances, tax positions challenged by a taxing authority will be resolved for an amount that does not exceed its related reserve. With respect to these reserves, the Company’s income tax expense includes (i) any changes in tax reserves arising from material changes during the period in the facts and circumstances (i.e., new information) surrounding a tax position, and (ii) any difference from the Company’s tax position as recorded in the financial statements and the final resolution of a tax position during the period. Such resolution could materially increase or decrease income tax expense in the Company’s consolidated financial statements in future periods and could impact operating cash flows.
Unrecognized tax benefits represent the aggregate tax effect of differences between tax return positions and the amounts otherwise recognized in the Company’s financial statements, and as a result of the substantial NOL carryforwards, are netted against the Company’s deferred tax asset balance in the consolidated balance sheets. A reconciliation of the beginning
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
and ending amount of unrecognized tax benefits, excluding interest and penalties, is as follows:
(11) ACCRUED LIABILITIES
Accrued liabilities included in current liabilities consisted of the following:
(12)
EQUITY
Zayo Group was initially formed on May 4, 2007, and is a wholly-owned subsidiary of Holdings, which in turn is wholly owned by CII. CII was organized on November 6, 2006, and subsequently capitalized on May 7, 2007, with capital contributions from various institutional and founder investors. Cash, property, and service proceeds from the capitalization of CII were contributed to the Company, and the contributions are reflected in the Company’s member’s equity. The Company is controlled by the CII Board of Directors, which is in turn controlled by the members of CII in accordance with the rights specified in the CII operating agreement.
During the years ended June 30, 2013, 2012 and 2011, CII contributed $345,013, $134,796, and $36,450, respectively, in cash to the Company through Holdings. CII funded these amounts primarily from equity contributions from its investors.
In connection with and prior to the acquisition of AboveNet, CII concluded the sale of 98,916,060.11 Class C Preferred Units of CII pursuant to certain securities purchase agreements with new private investment funds, as well as certain existing owners of CII and other investors. The total value of the Class C Preferred Units of CII sold pursuant to the securities purchase agreements was approximately $470,274, net of $1,976 in costs associated with raising the additional equity. In June 2012, $133,150 of the proceeds (net of fees) from the equity raised were contributed to the Company, and the remaining $337,124 was contributed during the year ended June 30, 2013. As of July 2, 2012, the equity commitments from CII’s investors had been fulfilled. During the year ended June 30, 2013, CII contributed an additional $7,968 in cash to the Company. The source of the additional cash contribution was dividend payments received from CII's other subsidiaries.
As discussed in Note 13 - Stock-Based Compensation, during the year ended June 30, 2012, the Board of CII authorized a non-liquidating distribution to certain common unit holders. The total amount of the aggregate distributions to
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
employees of the Company was $9,080. The distribution was funded by CII, which resulted in a non-cash capital contribution to the Company and is reflected as such in the consolidated statement of member’s equity during the year ended June 30, 2012.
During the year ended June 30, 2012, CII and the Company agreed to settle a related party payable due to CII in the amount of $15,541 via a non-cash equity contribution. This contribution is reflected in the consolidated statement of member’s equity in the caption “Non-cash contributions/distributions to Parent, net.”
ZEN was spun-off from the Company on April 1, 2011 to Holdings, the Company’s parent (see Note 4 - Spin-off of Business). As a result of the spin-off the Company’s member’s interest account was reduced by the carrying value of ZEN on the spin-off date of $6,368 during the year ended June 30, 2011.
As discussed in Note 4 - Spin-off of Business, the Company completed a spin-off of ZPS to Holdings on September 30, 2012. As a result of the spin-off, member’s interest was reduced by $26,659, the carrying value of the net assets of ZPS on the spin-off date, as reflected in the consolidated statements of member’s equity for the period ended June 30, 2013.
Holdings is the taxable parent of the Company and Onvoy Voice Services, Inc. (“Onvoy”). Subsequent to spinning the ZEN operations to Holdings, Holdings contributed the assets and liabilities of the historical ZEN segment to Onvoy. Holdings allows for the sharing of Holdings’ NOL carry forwards between the Company and Onvoy. To the extent that any entity utilizes NOLs or other tax assets that were generated or acquired by the other entity, the entities will settle the related-party transfer of deferred tax asset associated with such NOLs and other deferred-tax transfers between the companies via an increase or decrease to the respective entity’s member’s equity. During the years ended June 30, 2013, 2012 and 2011, the Company’s member’s equity balance decreased by $4,127, $3,402 and $2,598, respectively, as a result of transferring net deferred tax assets or liabilities to Onvoy.
As discussed in Note 3 - Acquisitions, the net assets supporting 360networks legacy VoIP business and the net assets supporting Arialink’s managed service product offerings were spun-off to Holdings on December 1, 2011 and May 1, 2012, respectively. Management estimates that the fair value of the net assets of 360networks’ legacy VoIP business which were spun-off to Holdings was $11,700, including $46 in cash and the fair value of the net assets supporting Arialink’s managed service product offerings was $1,752 on the respective spin-off dates. The fair value of the net assets, excluding cash, distributed to Holdings is reported as a non-cash reduction to the Company’s member’s investment account on the consolidated statement of member’s equity.
(13)
STOCK-BASED COMPENSATION
Liability Classified Awards
The Company has been given authorization by CII to award 525,000,000 of CII's common units as profits interests to employees and directors of the Company.
As of June 30, 2012, CII had six classes of common units with different liquidation preferences - Class A through Class F units. During the year ended June 30, 2013, CII issued two additional classes of common units: Class G and Class H. Common units are issued to employees and to independent directors of the Company and are allocated by the Chief Executive Officer and the board of managers on the terms and conditions specified in the employee equity agreement. The common units do not have voting rights. At June 30, 2013, 461,204,980 common units of CII were issued and outstanding to employees and directors of the Company and 63,795,020 common units of CII were available to be issued. At June 30, 2012, 169,083,792 common units were issued and outstanding to employees and directors of the Company and 355,916,208 common units were available to be issued.
The common units are considered to be stock-based compensation with terms that require the awards to be classified as liabilities due to cash settlement features. As such, the Company accounts for the vested awards as a liability and re-measures the liability to fair value at each reporting date until the date of settlement.
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
As of June 30, 2013 and 2012, the estimated fair value of the common units was as follows:
The liability associated with the common units was $158,520 and $54,367 as of June 30, 2013 and 2012, respectively. The stock-based compensation expense associated with the common units was $104,195, $25,382, and $23,490 during the years ended June 30, 2013, 2012 and 2011, respectively.
The Company's stock-based compensation relates to employees functioning in the selling, general and administrative capacity. The Company presents stock-based compensation as a separate component of selling, general and administrative expenses on the consolidated statement of operations due to the size and volatility of the non-cash expense.
The holders of common units of CII are not entitled to transfer their units or receive dividends or distributions, except at the discretion of CII's Board of Directors. Upon a liquidation of CII, or upon a non-liquidating distribution, the holders of common units share in the proceeds after the capital contributions of the CII preferred unit holders plus their priority return of 6% per annum has been reimbursed. The remaining proceeds from a liquidation event are distributed between the preferred and common unit holders on a scale ranging from 85% to the preferred unit holders and 15% to the common unit holders to 80% to the preferred unit holders and 20% to the common unit holders. The percentage allocated to the common unit holders is dependent upon the return multiple realized by the preferred unit holders as defined in the CII operating agreement. The maximum incremental allocation of proceeds from a liquidation event to common unit holders, of 20%, occurs if the return multiple realized by a preferred unit holder reaches 3.5 times each respective preferred holder's combined capital contributions.
Each class of common units has a liquidation threshold. Holders of a respective class of common units begin to receive a portion of the proceeds from a liquidity event once the aggregate distributions previously made with respect to issued common units of earlier classes are equal to or greater than the respective common unit classes liquidation threshold. Common unit holders of each of the following classes begin sharing in the proceeds of a liquidation event once the total amount distributed to early classes reaches the following liquidation thresholds:
In December 2011, CII and the preferred unit holders of CII authorized a non-liquidating cash distribution to common unit holders of up to $10,000. The eligibility for receiving proceeds from this distribution was determined by the liquidation preference of the unit holder. Receiving proceeds from the authorized distribution was at the election of the common unit holder. As a condition of the early distribution, common unit holders electing to receive an early distribution received 85% of the amount that they would otherwise be entitled to receive if the distribution were in connection with a liquidating distribution.
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
The common unit holders electing to receive the early distribution will retain all of their common units and be entitled to receive future distributions only to the extent such future distributions are in excess of the non-liquidating distribution, before applying the 15% discount. During the year ended June 30, 2012, $9,080 was distributed to the Company’s common unit holders as a result of the December 2011 non-liquidating distributions. The distribution was paid by CII and is reflected in the Company’s Consolidated Statement of Member’s Equity as a capital contribution (non-cash). Common unit holders electing to receive the early distribution forfeited $1,615 in previously recognized stock-based compensation which had the effect of reducing stock-based compensation expense during the year ended June 30, 2012.
In June 2012, CII and the preferred unit holders of CII authorized an additional non-liquidating cash distribution in the amount of $7,000 to the Company’s Chief Executive Officer. The officer will retain all of his common units and be entitled to receive future distributions only to the extent such future distributions are in excess of the $7,000 non-liquidating distribution.
The following table represents the activity as it relates to common unit issuances and forfeitures during the years ended June 30, 2013, 2012 and 2011.
The following table represents the activity as it relates to common units vested since the Company’s inception:
As of June 30, 2013 and 2012, respectively, the Company had 271,035,055 and 78,585,454 common units that were unvested and outstanding. As of June 30, 2013, the fair value of unvested common units issued to employees and independent directors was $131,973. The unvested shares at June 30, 2013 will become fully vested over the next three years.
The Company utilizes a probability-weighted estimated return method to value the common units. The method estimates the value of the units based on an analysis of values of the enterprise assuming various future outcomes. The estimated fair value of the common units is based on a probability-weighted present value of expected future proceeds to CII’s shareholders, considering certain potential liquidity scenarios available to CII’s investors as well as preferential rights of each security. This approach utilizes a variety of assumptions regarding the probability of a certain scenario occurring, if the event involves a transaction, the potential timing of such an event, and the potential valuation that each scenario might yield. The potential future outcomes that were considered by management were remaining a private company with the same ownership, a
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
sale or merger, and an initial public offering (“IPO”). The income approach utilized under the remaining private scenario was based on management's projected future cash flows and was discounted at a market participant weighted-average cost of capital. The market-based approach, utilized under the IPO and sale scenarios, estimates the fair value of CII’s equity based on observable multiples of revenue and EBITDA paid by investors and acquirers of interests of comparable companies in the public and private markets. These observable revenue and EBITDA multiples are applied to projected twelve-month revenue and EBITDA amounts at the dates of the potential exit events and discounted back using CII’s estimated cost of equity. The value attributable to each class of shares is then discounted in order to account for the lack of marketability of the units.
Equity Classified Awards
CII has issued preferred units to certain Zayo Group executives and directors as compensation. The terms of these preferred unit awards require the Company to record the award as an equity award. The Company estimates the fair value of these equity awards on the grant date and recognizes the related expense over the vesting period of the awards. As these awards have been issued by CII to employees and Directors of the Company as compensation, the related expense has been recorded by the Company in the accompanying consolidated statements of operations. The Company recognized stock-based compensation expense and a related increase to the Company's member interest account of $853, $871, and $820 for the years ended June 30, 2013, 2012 and 2011, respectively.
During fiscal year 2008, CII issued 6,400,000 preferred units in CII to the two founders of the Company, one of whom is the Company’s current CEO. The vesting for these units was completed in September 2010. Management estimated the fair value of the equity awards on the grant date to be $6,400. Stock-based compensation expense recognized in connection with these Class A units issued for the year ended June 30, 2011 was $240. These preferred units were in lieu of any significant cash compensation to the founders during the period beginning on May 1, 2007 and ending October 31, 2010.
In June 2010, CII issued 136,985 preferred units to two of the Company’s Board members. The preferred units issued vested over a period of three years. Management estimated the fair value of the equity awards on the grant date to be $312. In March 2011, one of these Board members resigned from his position resulting in a forfeiture of the 63,926 preferred units issued to the Board member. The grant date fair market value of the 73,059 preferred units issued to the remaining Board member was determined to be $167. Stock-based compensation expense recognized for this grant during the years ended June 30, 2013, 2012 and 2011 was $51, $69 and $42, respectively.
In December 2010, CII issued 390,000 preferred units to the Company’s CEO. Management estimated the fair value of the equity awards on the grant date to be $967 based on a weighted average of various market and income based valuation approaches. The Company recognizes the related expense over the vesting period of three years which began October 31, 2010. In January 2011, CII issued an additional 580,000 preferred units to the CEO. The Company estimated the fair value of these equity awards on the grant date to be $1,438 and the Company recognizes the related expense over a vesting period of three years which began October 31, 2010. The preferred units issued to the Company’s CEO are in lieu of any significant cash compensation for the executive during the three year vesting period ending October 31, 2013. Stock-based compensation expense recognized for these preferred units during the years ended June 30, 2013, 2012 and 2011 was $802, $802 and $535, respectively.
(14) FAIR VALUE MEASUREMENTS
The Company’s financial instruments consist of cash and cash equivalents, restricted cash, trade receivables, accounts payable, interest rate swaps, long-term debt and stock-based compensation liability. The carrying values of cash and cash equivalents, restricted cash, trade receivables, and accounts payable approximated their fair values at June 30, 2013 and 2012 due to the short maturity of these instruments.
The carrying value of the Company’s note obligations reflects the original amounts borrowed, net of unamortized discounts or premiums and was $1,250,000 and $350,122 as of June 30, 2013 and 2012, respectively. Based on market interest rates for debt of similar terms and average maturities, the fair value of the Company's notes as of June 30, 2013 and 2012 was estimated to be $1,364,375 and $392,600, respectively. The Company’s fair value estimates associated with its note obligations were derived utilizing Level 2 inputs - quoted prices for similar instruments in active markets.
The carrying value of the Company’s term loan obligations reflects the original amounts borrowed, net of the unamortized discount and was $1,580,705 and $305,159 as of June 30, 2013 and 2012, respectively. The Company’s term loan accrues interest at variable rates based upon the one month, three month or six month LIBOR (with a LIBOR floor of 1.00%) plus a spread of 3.50%. Since management does not believe that the Company’s credit quality has changed significantly since
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
the date when the amended Term Loan Facility was entered into and subsequently repriced, its carrying amount approximates fair value. Without giving effect to the Company's interest rate swap which goes into effect July 1, 2013, a hypothetical increase in the applicable interest rate on the Company’s term loan of one percentage point above the 1.0% LIBOR floor would increase the Company’s annual interest expense by approximately $16,079.
The Company’s interest rate swaps are valued using discounted cash flow techniques that use observable market inputs, such as LIBOR-based yield curves, forward rates, and credit ratings. A change in the fair value of the interest rate swaps of $2,642 was recorded as a decrease to interest expense during the year ended June 30, 2013. A hypothetical increase in LIBOR rates of 100 basis points would increase the fair value of the interest rate swaps by approximately $26.6 million.
The carrying value of the Company’s Revolver as of June 30, 2012 reflected the balance outstanding, which was $30,000. Based on current market interest rates for debt of similar terms, the carrying value of the Revolver as of June 30, 2012 approximated fair value as the interest rate for the Revolver was variable based upon either a base rate or a Eurodollar rate plus an applicable margin and management did not believe that the Company’s credit quality has changed significantly since the date at which the Revolver was entered into. As of June 30, 2013, there is no balance currently outstanding under the Company's current Revolver.
The Company recorded its promissory note with the previous owners of AFS at its fair value on the acquisition date, which was determined to be $4,141. As of June 30, 2012, management estimated the imputed interest associated with this note to be $359, which was amortized to interest expense through October 2012 the due date of the note. The fair value of this promissory note was not re-measured each reporting period; however, based on current interest rates for debt instruments with similar maturity dates, the June 30, 2012 book value of the AFS promissory note approximated fair value.
The Company records its interest rate swaps and stock-based compensation liability at their estimated fair value. Financial instruments measured at fair value on a recurring basis are summarized below:
(15)
COMMITMENTS AND CONTINGENCIES
Capital Leases
Future contractual payments under the terms of the Company’s capital lease obligations were as follows:
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
Operating Leases
The Company leases office space, warehouse space, network assets, switching and transport sites, points of presence and equipment under non-cancelable operating leases. Lease expense was $87,090, $45,885 and $38,375 for the years ended June 30, 2013, 2012 and 2011, respectively.
For scheduled rent escalation clauses during the lease terms or for rental payments commencing at a date other than the date of initial occupancy, the Company records minimum rental expenses on a straight-line basis over the terms of the leases. When the straight-line expense recorded exceeds the cash outflows during the respective period, the Company records a deferred rent liability on the consolidated balance sheets and amortizes the deferred rent over the terms of the respective leases.
Minimum contractual lease payments due under the Company’s long-term operating leases are as follows:
Lease Termination Costs
During the fourth quarter of 2013, the Company recorded a charge for lease termination costs totaling $10,360 related to exit activities initiated for unutilized space associated with leased office and technical facilities, which was partially offset by a benefit related to the release of associated rent escalation accrual in the amount of $163. The net lease termination charge recorded during the year ended June 30, 2013 was $10,197. In connection with integration activities associated with acquisitions completed during fiscal years 2012 and 2013, the Company completed an analysis of existing and acquired facilities leases and determined that certain facilities under lease would not be used by the Company in the future. The charge has been included in operating costs and selling, general and administrative expenses. As of June 30, 2013, the remaining lease termination obligation associated with these facilities was $10,073, which is recorded net of expected sublease income of $2,952. The Company will periodically re-evaluate its assumptions used to estimate this obligation and may record adjustments prospectively as facts or circumstances change related to the impaired leased facilities.
A summary of the lease termination charges and related activity follows:
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
Purchase Commitments
At June 30, 2013, the Company was contractually committed for $85,835 of capital expenditures for construction materials and purchases of property and equipment. A majority of these purchase commitments are expected to be satisfied in the next twelve months. These purchase commitments are primarily success based; that is, the Company has executed customer contracts that support the future capital expenditures.
Outstanding Letters of Credit
As of June 30, 2013, the Company had $6,561 in outstanding letters of credit, which were primarily entered into in connection with various lease agreements.
Other Commitments
In February 2010, the Company was awarded an NTIA Broadband Technology Opportunities Program grant for a fiber network project in Indiana (the “Indiana Stimulus Project”). The Indiana Stimulus Project involves approximately $31,425 of capital expenditures, of which $25,100 is to be funded by a government grant and approximately $6,285 is to be funded by the Company. In connection with this project, 626 route miles of fiber are to be constructed and lit. The Company began capitalizing certain pre-construction costs associated with this project in April 2010 and began receiving grant funds in May 2010. As of June 30, 2013, the Company has been reimbursed for $96 of expenses and $23,786 of capital expenditures related to the Indiana Stimulus Project. The Company also contributed $4,400 of pre-existing network assets to the project as of June 30, 2013. The Company completed this project on July 31, 2013.
In July 2010, the Company was awarded from the NTIA Broadband Technology Opportunities Program a $13,383 grant to construct 286 miles of fiber network in Anoka County, Minnesota, outside of Minneapolis (the “Anoka Stimulus Project”). The Anoka Stimulus Project involves approximately $19,117 of capital expenditures, of which $13,383 is to be funded by a government grant and approximately $5,735 is to be funded by the Company. As of June 30, 2013, The Company has been reimbursed for $121 of expenses and $11,646 of capital expenditures related to the Anoka Stimulus Project. The Company anticipates this project will be completed by December 2013.
In September 2011, the Company signed a sub-recipient agreement on an award granted to Com Net, Inc. (“Com Net”) from the NTIA Broadband Technology Opportunities Program. The award of approximately $30,032 to Com Net will expand broadband services to rural and underserved communities in Western Ohio. In order to effectively implement the project, Com Net established the GigE Plus Availability Coalition consisting of Zayo Group, OARnet and an initial group of 33 Broadband Service Providers to deploy broadband to 28 western Ohio counties. Upon completion, the project will add nearly 366 new miles of fiber to Zayo Group’s existing Ohio network. As a sub recipient, the Company is required to contribute to the federal match. The Company’s maximum contribution is $3,111 which represents a 30% match on the assets to which the Company will take ownership. The Company anticipates the project will be completed by November 2013. As of June 30, 2013, the Company has incurred $476 in capital expenditures associated with this project.
Contingencies
In the normal course of business, the Company is party to various outstanding legal proceedings, asserted and unasserted claims, and carrier disputes. In the opinion of management, the ultimate disposition of these matters, both asserted and unasserted, will not have a material adverse effect on the Company’s financial condition, results of operations, or cash flows.
(16)
RELATED-PARTY TRANSACTIONS
As of July 1, 2011, the Company had a due to related-party balance with CII of $4,590. The liability with CII relates to an interest payment made by CII on the Company’s Notes. During the year ended June 30, 2012, CII made an additional interest payment of $10,951 on behalf of the Company. During the year ended June 30, 2012, the Company and CII agreed to settle the then outstanding payable to CII in the amount of $15,541 through an increase in CII’s equity in the Company. The Company has not included these non-cash payments of interest in its statements of cash flows.
As of June 30, 2013 and 2012, the Company had a net receivable balance with Onvoy, Inc. ("Onvoy") in the amount of $622 and $103, respectively, related to services the Company provided to Onvoy.
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
As discussed in Note 4 - Spin-off of Business, the Company spun-off the ZPS business, which was acquired in the AboveNet acquisition, to Holdings on September 30, 2012. As of June 30, 2013, the Company did not have a receivable balance due from ZPS related to services the Company had provided to ZPS. The receivable from ZPS relates to the net working capital surplus of $10,447 on the spin-off date that was transferred to ZPS. During the year ended June 30, 2013, the Company received $10,447 in payments from ZPS against a receivable related to the net working capital surplus of $10,447 on the spin-off date that was transferred to ZPS that was reimbursed to the Company during Fiscal 2013. Related payments from ZPS are reflected in cash flows from investing activities on the consolidated statement of cash flows during the year ended June 30, 2013.
Revenue and expenses associated with transactions with Onvoy and ZPS (subsequent to its September 30, 2012 spin-off date) have been recorded in the Company’s results from continuing operations. The following table represents the revenue and expense transactions recognized with Onvoy and ZPS subsequent to their spin-off dates:
Dan Caruso, the Company’s President, Chief Executive Officer and Director purchased $500 of the Company’s notes in connection with the Company’s $100,000 notes offering in September 2010. The purchase price of the notes acquired by Mr. Caruso was $516 after considering the premium on the notes and accrued interest. On July 2, 2012, the Company repurchased Mr. Caruso’s Notes for $541 pursuant to its offer to repurchase all of the outstanding notes of that series.
On July 2, 2012, Matthew Erickson, the President of Dark Fiber, purchased $600 in aggregate principal amount of the Company’s 10.125% senior unsecured notes due 2020 at the offering price for such notes stated in the Company’s private notes offering. Mr. Erickson qualifies as an “accredited investor” (as defined in Rule 501 under the Securities Act) and purchased the notes on terms available to other investors.
(17) SEGMENT REPORTING
An operating segment is a component of an entity that has all of the following characteristics:
•
It engages in business activities from which it may earn revenues and incur expenses.
•
Its operating results are regularly reviewed by the entity’s chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance.
•
Its discrete financial information is available.
The Company’s chief operating decision maker is its Chief Executive Officer.
The Company uses the management approach to determine the segment financial information that should be disaggregated and presented separately within the Company's footnotes to its financial statements presented in its filings on Form 10-K with the SEC. The management approach is based on the manner by which management has organized the segments within the Company for making operating decisions, allocating resources, and assessing performance.
Upon a change in the Company's reporting structure that results in changes to the composition of one or more of its reporting units, the Company is required to reassign assets and liabilities to the reporting units affected. The re-allocation of assets and liabilities (excluding goodwill) is determined based on which reporting unit the asset will be employed in or to which reporting unit the liability relates. The re-allocation of goodwill is determined based on a relative fair value method that utilizes the fair values of the new reporting units. The relative fair values of the reporting units are estimated using both income and market based valuation techniques. Upon a change in the Company's reportable segments, the Company performs a goodwill impairment test immediately prior to a change in reporting units at the legacy reporting unit level and immediately after a change in reporting units at the new reporting unit level.
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
The Company's segments, which are internally referred to as Strategic Product Groups, are the primary decision-making and governance organizations. Strategic Product Groups are structured around the services provided and operated with a high degree of autonomy and financial responsibility. Each Strategic Product Group is responsible for the revenue, costs and associated capital expenditures of their respective services. The Strategic Product Groups enable sales, make pricing and product decisions, engineer networks and deliver services to customers, and support customers for their specific telecom and Internet infrastructure services. Strategic Product Groups operate across all of the Company's geographies.
The Company has historically operated as three segments: Zayo Bandwidth ("ZB"), Zayo Colocation ("zColo") and Zayo Fiber Solutions ("ZFS"). The ZB group provided primarily lit bandwidth infrastructure services, the zColo group provided colocation and connectivity services and the ZFS group provided dark fiber related services.
Effective January 1, 2013, the Company implemented certain changes to its Strategic Product Group structure that had the impact of disaggregating the lit bandwidth services group (ZB) into its constituent lit bandwidth services and changed the name of our legacy ZFS group to Zayo Dark Fiber. As of June 30, 2013, the Company has seven Strategic Product Groups as described below:
•Zayo Dark Fiber ("Dark Fiber"). Through the Dark Fiber Strategic Product Group, the Company provides dark fiber and related services on portions of the fiber network and on newly constructed network. The Company provides dark fiber pairs to customers, who then light the fiber using their own optronic equipment, allowing the customer to manage bandwidth on their own metropolitan and long haul networks according to their specific business needs. As part of this service offering, the Company manages and maintains the underlying fiber network for the customer. Other related services may include the installation and maintenance of building entrance fiber or riser fiber for distribution within a building. Customers include carriers and other communication service providers, Internet service providers, wireless service providers, major media and content companies, large enterprises, and other companies that have the expertise to run their own fiber optic networks. The Company markets and sells dark fiber-related services under long-term contracts (averaging approximately fifteen years in length); customers either pay upfront for the fiber (generally referred to as an IRU or Indefeasible Right to Use) or on a monthly basis for the fiber. Fiber maintenance (or O&M) is generally paid on an annual or monthly recurring basis regardless of the form of the payment for the provision of the fiber. Recurring payments are fixed but many times include automatic annual price escalators intended to compensate for inflation.
•Zayo Wavelength Services ("Waves"). Through the Waves Strategic Product Group, the Company provides lit bandwidth infrastructure services to customers utilizing optical wavelength technology. From a technological standpoint, the service is provided by multiplexing a number of optical customer signals onto different wavelengths (i.e., colors) of laser light. The Waves segment provides wavelength services in speeds of 1G, 2.5G, 10G, 40G, and 100G. The Waves Strategic Product Group also provides a dedicated wavelength service; that is, wavelengths on fibers that are not shared by between customers. Customers include carriers, financial services companies, healthcare, government institutions, education institutions and other enterprises. Services are typically provided for terms between one and five years for a fixed recurring monthly fee and in some cases an additional upfront, non-recurring fee.
•Zayo SONET Services ("SONET"). The Company's Synchronous Optical Network Strategic Product Group provides lit bandwidth infrastructure services to its customers utilizing SONET technology. SONET is a standardized protocol that transfers multiple digital bit streams over optical fiber using lasers or highly coherent light from light-emitting diodes. SONET technology is often used to support private line services. This protocol enables transmission of voice, data and video at high speeds. SONET networks are protected, which provides for virtually instantaneous restoration of service in the event of a fiber cut or equipment failure. Services are provided in speeds ranging from DS-1 (1.54 Mb) to OC-192 (10 Gbps) of capacity. Customers are largely carriers. Services are typically provided for terms between one and five years for a fixed recurring monthly fee and in some cases an additional upfront, non-recurring fee.
•Zayo Ethernet Services ("Ethernet"). The Company's Ethernet Strategic Product Group provides lit bandwidth infrastructure services to its customers utilizing Ethernet technology. Ethernet services are offered in metropolitan markets as well as between metropolitan areas (intercity) in point to point and multi-point configurations. Unlike data transmission over a Waves network, information transmitted over Ethernet is transferred in a packet or frame across the network. The frame enables the data to navigate across a shared infrastructure in order to reach the intended destination. Services are provided in speeds ranging from 10 Mb to 10 GigE. Customers include carriers, financial services companies, healthcare, government institutions, education institutions and other enterprises. Services are
ZAYO GROUP, LLC AND SUBSIDIARIES
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(in thousands, except for preferred and common units and per unit values)
typically provided for terms between one and ten years for a fixed recurring monthly fee and in some cases an additional upfront, non-recurring fee.
•Zayo Internet Protocol Services ("IP"). The Company's Internet Protocol Strategic Product Group provides lit bandwidth infrastructure services to its customers utilizing Internet Protocol technology. IP technology transports data across multiple circuits from the source to the destination. Information leaving the source is divided into several packets and each packet traverses the network utilizing the most efficient path and means. Packets of information may travel across different physical circuits or paths in order to reach the destination, at which point the packets are reassembled to form the complete communication. Services are generally used to exchange or access traffic on the public Internet. Services are provided in speeds ranging from 10 Mb to 100G on a single port interface. Customers include regional telecommunications and cable carriers, enterprises, educational institutions and content companies. Services are typically provided for terms between one and ten years for a fixed recurring monthly fee and in some cases an additional upfront, non-recurring fee. Pricing is generally a function of bandwidth capacity and transport required to carry traffic from customer location to an Internet gateway.
•Zayo Mobile Infrastructure ("MIG"). The Company's Mobile Infrastructure Strategic Product Group provides two key services: Fiber-to-the-Tower ("FTT") and Small Cell Infrastructure. The Company's FTT products consist of fiber based backhaul from cellular towers to mobile switching centers. This service is generally provided in speeds of 50 Mb and above and is used by wireless service providers to enable 3G and 4G cellular services. The segment's Small Cell Infrastructure services provide two separate sub-services. The first sub-service is neutral space and power, similar to a provider of mobile and broadcast tower space. Wireless services providers purchase this service to provide them with a physical location to mount their small cell antennas. The second sub-service is dark fiber backhaul from the antenna to a mobile switching center. The MIG customers are wireless carriers. Services are typically provided for terms between five and 20 years for a fixed recurring monthly fee and, in most cases, an additional upfront, non-recurring fee. Pricing is a function of the quantity of dark fiber consumed and the number of neutral space and power locations provided.
•Zayo Colocation ("zColo"). Through the zColo Strategic Product Group, the Company provides network-neutral colocation and connectivity services in 25 data center and interconnection facilities across 19 markets throughout the United States.The zColo group manages approximately 175,000 square feet of billable colocation space as of August 31, 2013 within these 25 facilities. All facilities provide 24 hour per day, 365 days per year management and monitoring with physical security, fire suppression, power distribution, backup power, cooling and multiple redundant fiber connections to many major networks. The components of the Company's network neutral colocation offering are: space, power, interconnection and remote technical services. The Company sells space in half-racks, racks, cabinets, cages, and private suites and provides alternating current (“AC”) and direct current (“DC”) power at various levels. The power product is backed up by batteries and generators. As a network-neutral provider of colocation services, the Company provides customers with interconnection services, allowing customers to connect and deliver capacity services between separate networks using fiber, Ethernet, SONET, DS3 and DS1 service levels. The Company believes the interconnection offering is differentiated by intra-building dark fiber infrastructure connecting multiple suites in major U.S. carrier hotel locations and the Metro Interconnect product that allows customers to interconnect to other important traffic exchange buildings within a metro market leveraging the metro fiber network. The Company also offers data center customers outsourced technical resources through our “remote hands” product. Customers can purchase packages of time or use technical staff on an as-needed basis. Customers vary somewhat by facility with a significant portion of the Group's revenue coming from customers requiring a high degree of connectivity and who choose to colocate in our key carrier hotel and regional aggregation hub facilities. These customers include: domestic and foreign carriers; Internet service providers, cloud services providers, on-line gaming companies, content providers and CDN, media companies and other connectivity focused enterprise customers. Services are typically provided for terms between one and ten years for a recurring monthly fee and, in many cases, an additional upfront, non-recurring fee.
Effective January 1, 2013, revenues for all of the Company’s products are included in one of the Company's seven business units. The results of operations for each business unit include an allocation of certain corporate related overhead costs. The allocation is based on a percentage that represents management’s estimate of the relative burden each segment bears of corporate overhead costs. Identifiable assets for each business unit are reconciled to total consolidated assets including unallocated corporate assets and intercompany eliminations. Unallocated corporate assets consist primarily of cash, deferred tax assets, and debt issuance costs.
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(in thousands, except for preferred and common units and per unit values)
The segment information for the year ended June 30, 2013 reflects the operating results of both the Company's new business segments and the legacy ZB segment. Segment information prior to July 1, 2012 has not been restated to reflect the Company's new business segments, as the Company began recording revenue and expense transactions at the new segment level effective July 1, 2012 and management has determined that it is impracticable to restate financial information prior to July 1, 2012 under the new business segments. The change to the Company's business units did not impact the comparability of the zColo or Dark Fiber segments. The following tables summarize significant financial information of each of the segments:
(1) During the fourth quarter, the Company recognized a charge of $10,197 for lease termination costs related to exit activities initiated for unutilized space associated with leased office and technical facilities, which was allocated by segment as follows: $2,831 for Waves, $159 for SONET, $1,912 for Ethernet, $1,002 for IP, $505 for MIG, $194 for zColo, and $3,594 for ZFS.
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(in thousands, except for preferred and common units and per unit values)
Adjusted EBITDA
The Company defines Adjusted EBITDA as earnings from continuing operations before interest, income taxes, depreciation and amortization (“EBITDA”) adjusted to exclude acquisition-related transaction costs, stock-based compensation, and certain non-cash or non-recurring items. The Company uses Adjusted EBITDA to evaluate operating performance, and this financial measure is among the primary measures used by management for planning and forecasting of future periods. The Company believes that the presentation of Adjusted EBITDA is relevant and useful for investors because it allows investors to view results in a manner similar to the method used by management and facilitates comparison of the Company’s results with the results of other companies that have different financing and capital structures.
The Company also monitors Adjusted EBITDA because it has debt covenants that restrict its borrowing capacity that are based on a leverage ratio, which utilizes a modified EBITDA, as defined in the Company’s credit agreements. The modified EBITDA is consistent with the Company’s definition of Adjusted EBITDA; however, it includes the pro forma Adjusted EBITDA of and expected synergies from the companies acquired by the Company during the quarter in which the debt compliance certification is due. The indentures governing the Company's Notes limit any increase in the Company's secured indebtedness (other than certain forms of secured indebtedness expressly permitted under the indentures) to a pro forma secured debt ratio of 4.5 times the previous quarter's annualized modified EBITDA and limit the Company's incurrence of additional indebtedness to a total indebtedness ratio of 5.25 times the previous quarter's annualized modified EBITDA, which is consistent with the incurrence restrictions in the Company's Credit Agreement governing its Term Loan Facility.
Adjusted EBITDA results, along with other quantitative and qualitative information, are also utilized by the Company and its compensation committee for purposes of determining bonus payouts to employees.
Adjusted EBITDA has limitations as an analytical tool and should not be considered in isolation from, or as a substitute for, analysis of the Company's results from operations and operating cash flows as reported under GAAP. For example, Adjusted EBITDA:
•
does not reflect capital expenditures, or future requirements for capital and major maintenance expenditures or contractual commitments;
•
does not reflect changes in, or cash requirements for, working capital needs;
•
does not reflect the significant interest expense, or the cash requirements necessary to service the interest payments, on the Company's debt; and
•
does not reflect cash required to pay income taxes.
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(in thousands, except for preferred and common units and per unit values)
The Company’s computation of Adjusted EBITDA may not be comparable to other similarly titled measures computed by other companies because all companies do not calculate Adjusted EBITDA in the same fashion. Reconciliations from net earnings/(loss) to Adjusted EBITDA by segment and on a consolidated basis are as follows:
Reconciliation from net earnings/(loss) to Adjusted EBITDA
ZAYO GROUP, LLC AND SUBSIDIARIES
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(in thousands, except for preferred and common units and per unit values)
The following is a summary of geographical information (dollars in thousands):
The Company includes all non-current assets, except for goodwill, in its long-lived assets.
(18) CONDENSED CONSOLIDATING FINANCIAL INFORMATION
As discussed in Note 9 - Long-Term Debt, on July 2, 2012, the Company co-issued, with its 100% owned finance subsidiary, Zayo Capital, Inc., $750,000 Senior Secured Notes and $500,000 Senior Unsecured Notes. The Notes are fully and unconditionally guaranteed, jointly and severally, on a senior secured basis by all of the Company’s current and future domestic restricted subsidiaries. Zayo Capital does not have independent assets or operations. The non-guarantor subsidiaries consist of the foreign subsidiaries that were acquired in conjunction with the Company's acquisition of AboveNet.
The accompanying consolidating financial information has been prepared and is presented to display the components of the Company’s balance sheets, statements of operations and statements of cash flows in a manner that allows an existing or future holder of the Company’s Notes to review and analyze the current financial position and recent operating results of the legal subsidiaries that guarantee the Company’s debt obligations.
The operating activities of the separate legal entities included in the Company’s consolidated financial statements are interdependent. The accompanying consolidating financial information presents the results of operations, financial position and cash flows of each legal entity. Zayo Group and its guarantors provide services to each other during the normal course of business. These transactions are eliminated in the consolidated results of operations of the Company.
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
Condensed Consolidating Balance Sheet
June 30, 2013
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
Condensed Consolidating Balance Sheet
June 30, 2012
ZAYO GROUP, LLC AND SUBSIDIARIES
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(in thousands, except for preferred and common units and per unit values)
Condensed Consolidating Statement of Operations
For the Year Ended June 30, 2013
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
Condensed Consolidating Statement of Operations
For the Year Ended June 30, 2012
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
Condensed Consolidating Statement of Operations
For the Year Ended June 30, 2011
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NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
Condensed Consolidating Statement of Cash Flows
June 30, 2013
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
Condensed Consolidating Statement of Cash Flows
June 30, 2012
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
Condensed Consolidating Statement of Cash Flows
June 30, 2011
ZAYO GROUP, LLC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
(19) QUARTERLY FINANCIAL DATA
The following table presents the unaudited quarterly results for the year ended June 30, 2013:
(1)
Revenue and depreciation and amortization expense recognized during interim periods of Fiscal 2013 have been retrospectively stated for material adjustments in the valuation of deferred revenue, property, plant and equipment, and intangible assets recorded in connection with the finalization of AboveNet purchase accounting during the quarter ended June 30, 2013. See Note 3 - Acquisitions - Adjustments to Purchase Accounting Estimates Associated with Current Year Acquisitions.
(2)
The Company realized an increase in revenue and operating expenses beginning August 31, 2012 as a result of the acquisition of FiberGate.
(3)
The Company realized an increase in revenue and operating expenses beginning October 1, 2012 as a result of the acquisition of USCarrier.
(4) The Company realized an increase in revenue and operating expenses beginning December 14, 2012 as a result of the acquisition of First Telecom.
(5) The Company realized an increase in revenue and operating expenses beginning December 31, 2012 as a result of the acquisition of Litecast.
(6) The Company realized an increase in revenue and operating expenses beginning June 1, 2013 as a result of the acquisition of Core NAP.
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NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
(7)
During the quarter ended June 30, 2013, the Company recognized a charge of $10,197 for lease termination costs related to exit activities initiated for unutilized space associated with leased office and technical facilities - see Note 15 - Commitments and Contingencies.
(8) The Company realized a decrease in interest expense during the second and third quarters of 2013 due to financing transactions completed to lower its interest rates on its variable rate debt. During the fourth quarter of 2013, favorable movements in interest rates increased the fair value of the Company's interest rate swaps, resulting in a decrease in the Company's interest expense - see Note 9 - Long-Term Debt.
(9)
The Company completed debt refinancing transactions during the first, second and third quarters of Fiscal 2013, resulting in a loss on debt extinguishment in each respective period. See Note 9 - Long-Term Debt.
(10)
The Company spun-off its ZPS operating unit on September 30, 2012 - see Note 4 - Spin-Off of Business.
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NOTES TO THE CONSOLIDATED STATEMENTS
(in thousands, except for preferred and common units and per unit values)
The following table presents the unaudited quarterly results for the year ended June 30, 2012:
(1)
The Company realized an increase in revenue and operating expenses beginning December 1, 2011 as a result of the acquisition of 360networks. The Company also recognized an increase in interest expense associated with the debt issued to fund the acquisition - see Note 9 - Long-Term Debt.
(2)
The Company realized an increase in revenue and operating expenses beginning December 31, 2011 as a result of the acquisition of MarquisNet.
(3)
The Company realized an increase in revenue and operating expenses beginning May 1, 2012 as a result of the acquisition of Arialink.
(4)
During the quarter ended June 30, 2012, the Company recognized an impairment on its investment in USCarrier of $2,248 - see Note 5 - Investments.
(20) SUBSEQUENT EVENTS
See Note 3 - Acquisitions, for a discussion of acquisitions that have closed subsequent to year end or are pending as of September 23, 2013.
On September 12, 2013, the Board of CII authorized a $10 million non-liquidating distribution to certain common unit holders. The total amount of the aggregate distributions to employees of the Company is estimated to be $10 million and will be
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(in thousands, except for preferred and common units and per unit values)
recognized as a non-cash capital contribution to the Company once the distributions are made, which is expected to occur during the second quarter of Fiscal 2014.
Signatures
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, this 23rdday of September, 2013.
ZAYO GROUP, LLC
By:
/s/ Ken desGarennes
Ken desGarennes
Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.