Item 2. Management’s Discussion and Analysis
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
You should read the following discussion and analysis together with our condensed consolidated financial statements and related notes included in this report. The discussion in this report contains forward-looking statements that involve risks and uncertainties, such as statements of our plans, objectives, expectations and intentions. The cautionary statements made in this report should be read as applying to all related forward-looking statements wherever they appear in this report. Our actual results could differ materially from those discussed here. Factors that could cause or contribute to these differences include, but are not limited to:
Our acquisition of Sprint Communications (as defined below), including difficulties integrating our business with the Sprint Business, which may result in the combined company not operating as effectively and efficiently as expected; transition services required to support the Sprint Business and the related costs continuing for a period longer than expected, the COVID-19 pandemic and accompanying government policies worldwide; vaccination and in-office requirements, delays in the delivery of network equipment or optical fiber, loss of key right-of-way agreements, future economic instability in the global economy, including the risk of economic recession and recent bank failures and liquidity concerns at certain other banks, which could affect spending on Internet services; the impact of changing foreign exchange rates (in particular the Euro to US dollar and Canadian dollar to US dollar exchange rates) on the translation of our non-US dollar denominated revenues, expenses, assets and liabilities into US dollars; legal and operational difficulties in new markets; the imposition of a requirement that we contribute to the US Universal Service Fund on the basis of our Internet revenue; changes in government policy and/or regulation, including rules regarding data protection, cyber security and net neutrality; increasing competition leading to lower prices for our services; our ability to attract new customers and to increase and maintain the volume of traffic on our network; the ability to maintain our Internet peering and right-of-way arrangements on favorable terms; our ability to renew our long-term leases of optical fiber and right-of-way agreements that comprise our network; our reliance on a limited number of equipment vendors, and the potential for hardware or software problems associated with such equipment; the dependence of our network on the quality and dependability of third-party fiber and right-of-way providers; our ability to retain certain customers that comprise a significant portion of our revenue base; the management of network failures and/or disruptions; our ability to make payments on our indebtedness as they become due and outcomes in litigation, risks associated with variable interest rates under our Swap Agreement as well as other risks discussed from time to time in our filings with the Securities and Exchange Commission, including, without limitation, this report and our quarterly reports on Form 10-Q for the quarterly periods ended March 31, 2023 and June 30, 2023 and our annual report on Form 10-K for the year ended December 31, 2022.
General Overview
We are a facilities-based provider of low-cost, high-speed Internet access, private network services, and data center colocation space and power. Our network is specifically designed and optimized to transmit packet switched data. We deliver our services primarily to small and medium-sized businesses, communications service providers and other bandwidth-intensive organizations in 54 countries across North America, Europe, South America, Oceania and Africa. We are a Delaware corporation, and we are headquartered in Washington, DC.
We offer on-net Internet access services exclusively through our own facilities, which run from our network to our customers’ premises. We offer our on-net services to customers located in buildings that are physically connected to our network. As a result, we are not dependent on local telephone companies or cable TV companies to serve our customers for our on-net Internet access and private network service. Our on-net service consists of high-speed Internet access and private network services offered at speeds ranging from 100 megabits per second (“Mbps”) to 400 gigabits per second (“Gbps”).
Our on-net revenues represented 47.2% of our revenues for the three months ended September 30, 2023, 75.5% of our revenues for the three months ended September 30, 2022, 55.9% of our revenues for the nine months ended September 30, 2023 and 75.5% of our revenues for the nine months ended September 30, 2022. We provide our on-net Internet access and private network services to our corporate, net-centric and enterprise customers. Our corporate customers are located in multi-tenant office buildings (“MTOB’s”) which typically include law firms, financial services firms, advertising and marketing firms, as well as health care providers, educational institutions and other professional services businesses. Our net-centric customers include bandwidth-intensive users that leverage our network either to deliver content to end users or to provide access to residential or commercial internet users. Content delivery customers include over the top (“OTT”) media service providers, content delivery networks, web hosting companies, and commercial content and application software providers. Our net-centric customers include 7,971 access networks comprised of other Internet service providers (“ISPs”), telephone companies, mobile phone operators and cable television companies that
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collectively provide internet access to a substantial number of broadband subscribers and mobile phone subscribers across the world. These net-centric customers generally receive our services in carrier neutral colocation facilities and in our data centers. We expanded selling our services to enterprise customers in connection with our acquisition of the Sprint Business. We define “enterprise” customers as large corporations (typically, Fortune 500 companies with greater than $5 billion in annual revenue) running Wide Area Networks (“WAN”) with several dozen to several hundred sites. Our enterprise customers generally purchase our services on a price per location basis. We operate data centers throughout North America and Europe that allow our customers to collocate their equipment and access our network.
In addition to providing our on-net services, we provide Internet access and private network services to customers that are not located in buildings directly connected to our network. We provide these off-net services primarily to corporate customers using other carriers’ circuits to provide the “last mile” portion of the link from the customers’ premises to our network. Our off-net revenues represented 47.6% of our revenues for the three months ended September 30, 2023, 24.4% of our revenues for the three months ended September 30, 2022, 40.4% of our revenues for the nine months ended September 30, 2023 and 24.4% of our revenues for the nine months ended September 30, 2022.
Wavelength and Optical Transport Services
In connection with our acquisition of the Sprint Business, we expanded our offerings of optical wavelength services and optical transport services over our fiber network. We are selling these wavelength services to our existing customers, customers of Sprint Communications and to new customers who require dedicated optical transport connectivity without the capital and ongoing expenses associated with owning and operating network infrastructure. We are increasing the number of locations where we can sell wavelength services to meet customer demand. Revenues related to our optical wavelength services were $3.0 million and $4.6 million for the three and nine months ended September 30, 2023, respectively.
We also provide certain non-core services because of certain acquisitions, including our acquisition of the Sprint Business. We continue to support but do not actively sell these non-core services. We expect that our revenues from non-core services will decline. Our non-core revenues represented 4.2% of our revenues for the three months ended September 30, 2023, 0.1% of our revenues for the three months ended September 30, 2022, 3.0% of our revenues for the nine months ended September 30, 2023 and 0.1% of our revenues for the nine months ended September 30, 2022.
Acquisition of Sprint Communications
On May 1, 2023 (the “Closing Date”), Cogent Infrastructure, Inc., a Delaware corporation and our direct wholly owned subsidiary, closed on its acquisition of the U.S. long-haul fiber network (including the non-U.S. extensions thereof) of Sprint Communications and its subsidiaries (the “Sprint Business”) in accordance with the terms and conditions of the Membership Interest Purchase Agreement (the “Purchase Agreement”), dated September 6, 2022, by and among us, Sprint Communications LLC, a Kansas limited liability company (“Sprint Communications”) and an indirect wholly owned subsidiary of T-Mobile US, Inc., a Delaware corporation (“T-Mobile”), and Sprint LLC, a Delaware limited liability company and an indirect wholly owned subsidiary of T-Mobile (the “Seller”). On the Closing Date, we purchased from the Seller all of the issued and outstanding membership interests (the “Purchased Interests”) of Wireline Network Holdings LLC, a Delaware limited liability company that, following an internal restructuring and divisive merger, holds Sprint Communications’ assets and liabilities relating to the Sprint Business (such transactions contemplated by the Purchase Agreement, collectively, the “Transaction”).
Purchase Price
The Transaction closed on May 1, 2023 (the “Closing Date”). On the Closing Date, we consummated the Transaction pursuant to the terms of the Purchase Agreement, providing a purchase price of $1 payable to the Seller for the Purchased Interests, subject to customary adjustments, including working capital (the “Working Capital Adjustment”), as set forth in the Purchase Agreement. As consideration for the Purchased Interests, the Working Capital Adjustment (primarily related to acquired cash and cash equivalents of an estimated $43.4 million at the Closing Date in order to fund the international operations of the Sprint Business) was $66.1 million, of which $61.1 million was paid to the Seller on the Closing Date.
The Purchase Agreement also includes an estimated payment of $52.3 million from Seller to Buyer related to acquired short-term lease obligations (the “Short-term Lease Payment”). After further analysis, the Short-term Lease Payment was reduced by $4.8 million from $57.1 million at June 30, 2023 to $52.3 million at September 30, 2023. The Short-term Lease Payment will be paid from
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the Seller to us in four equal payments in months 55 to 58 after the Closing Date. The Short-term Lease Payment was recorded at its present value resulting in a discount of $15.6 million. The interest rate used in determining the present value was derived considering rates on similar issued debt instruments with comparable durations, amongst other market factors. The determination of the discount rate requires some judgment. The amortization of the discount resulted in interest income of $0.7 million and $1.2 million for the three and nine months ended September 30, 2023, respectively. A final determination of the Working Capital Adjustment and the Short-term Lease Payment is expected by the end of 2023.
IP Transit Services Agreement
On the Closing Date, Cogent Communications, Inc. and T-Mobile USA, Inc., a Delaware corporation and direct subsidiary of T-Mobile (“TMUSA”), entered into an agreement for IP transit services (“IP Transit Services Agreement”), pursuant to which TMUSA will pay us an aggregate of $700.0 million, consisting of (i) $350.0 million in equal monthly installments of $29.2 million per month during the first year after the Closing Date and (ii) $350.0 million in equal monthly installments of $8.3 million per month over the subsequent 42 months. We concluded that the $700.0 million cash consideration was not separately identifiable from the business combination. As a result, the IP Transit Services Agreement was recorded in connection with the Transaction. During the three and nine months ended TMUSA paid us $87.5 million and $116.7 million, respectively, under the IP Transit Agreement. On October 3, 2023 an additional $29.2 million payment was received. On November 2, 2023, an additional $29.2 million payment was received.
Transition Services Agreement
On the Closing Date, we entered into a transition services agreement (the “TSA”) with the Seller, pursuant to which the Seller will provide to us, and we will provide to the Seller on an interim basis following the Closing Date, certain specified services (the “Transition Services”) to ensure an orderly transition following the separation of the Sprint Business from Sprint Communications. The services to be provided by the Seller to us include, among others, information technology support, back office and finance, real estate and facilities, vendor and supply chain management including payments to vendors of the Sprint Business for us reimbursed at cost and human resources. The services to be provided by us to the Seller include, among others, information technology and network support, finance and back office and other wireless business support.
The Transition Services are generally intended to be provided for a period of up to two years following the Closing Date, although such period may be extended for an additional one-year term by either party upon 30 days’ prior written notice. The fees for the Transition Services are calculated using either a per service monthly fee or an hourly rate for the employees allocated to provide such services. Any third-party costs incurred in providing the Transition Services are passed on to the party receiving such services at cost for the two-year period and at cost plus 20 percent, if the TSA is extended.
Either party to the TSA may terminate the agreement (i) with respect to any individual service in full for convenience upon 30 days’ prior written notice for certain services and reduced for other services after a 90-day period. The TSA may be terminated in its entirety if the other party has failed to perform any of its material obligations and such failure is not cured within 30 days. The TSA provides for customary indemnification and limits on liability. During the three and nine months ended September 30, 2023 we were billed $101.2 million and $218.0 million as due to the Seller under the TSA, respectively, primarily for reimbursement at cost of payment to vendors of the Sprint Business. During the three and nine months ended September 30, 2023 we paid $153.1 million to the Seller under the TSA. Amounts billed under the TSA are due 30 days from receipt of the related invoice. As of September 30, 2023, we owed $69.6 million to the Seller and the Seller owed $16.8 million to us under the TSA. The amounts due from the Seller are primarily reimbursements for severance costs related to Sprint Business employees and services provided by the Company for the Seller.
Other Services Provided to Seller
In addition, on the Closing Date, we entered into a commercial agreement with TMUSA (“Commercial Agreement”) for colocation and connectivity services, pursuant to which we will provide such services to TMUSA for a per service monthly fee plus certain third-party costs incurred in providing the services. During the three and nine months ended September 30, 2023 we recorded $8.0 million and $15.3 million, respectively, from TMUSA under the Commercial Agreement. As of September 30, 2023, TMUSA owed $3.2 million to us under the Commercial Agreement.
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Competitive Advantages
We believe we address many of the data communications needs of small and medium-sized businesses, communications service providers and other bandwidth-intensive organizations by offering them high-quality, high-speed Internet access and private network services at attractive prices. With our acquisition of the Sprint Business, we began offering services to larger enterprise customers. We believe that our organization has the following competitive advantages:
Low Cost of Operation: We believe that the wireline telecom industry is undergoing, and will continue to face, significant price deflation for its applications and services. This price deflation is a result of a variety of factors including increased competition, enhanced substitutability of certain products and services and the continued impact of Moore’s Law, which has driven down the cost of technology, particularly for fiber optic Wavelength Division Multiplexing (“WDM”) equipment and optically interfaced routers. Faced with the backdrop of continued price deflation in our industry, we have made a series of discreet choices around our network design, operating strategy and product offerings that are consistent with our objective of becoming the low cost operator in our industry. Since our initiation of operations, this strategy has resulted in a rapid decline in our cost to transmit bits, which has increased our margins and decreased our capital intensity as measured by our capital expenditures per total revenues. Over the last five fiscal years, our cost of goods sold per bit delivered for our customers has declined at a compounded annual rate of 21.0%. Important components of our low cost operating strategy include:
● One Network Protocol . Upon our founding, we selected to operate our network solely using Ethernet protocol. We made this selection in order to take advantage of the significantly greater installed base and lower cost of Ethernet network equipment versus other protocols, the substantially lower costs associated with operating and maintaining one network protocol and the continued benefits of the rapid price performance ratio improvements of Ethernet-related equipment. Our single network design allows us to avoid many of the costs that our competitors who operate circuit-switched, time-division multiplexing (“TDM”) and hybrid fiber coaxial networks incur related to provisioning, monitoring and maintaining multiple transport protocols. Selecting one operating protocol has also had positive effects in terms of our operating overhead and the simplicity of our organization. We believe the vast majority of our competition currently operates their networks with multiple protocols and we believe that attempts to upgrade their networks to one protocol would be operationally challenging and costly.
● Widespread Access to Fiber on a Cost Effective, Long-Term Basis . We have acquired a large portfolio of dark fiber leases from around the world sourced from the excess inventory of existing networks. This choice to lease rather than build reduces our capital intensity and the operating costs of our intercity and metro networks. The nature of this portfolio and the individual leases provide us long-term access to dark fiber at attractive rates and, in many cases the opportunity to extend these leases for multiple terms. On average, a modest number of our dark fiber leases come up for renewal each year. We have relationships with over 320 dark fiber vendors across the globe, enabling us to lease dark fiber on a long-term, cost-effective basis to virtually any geographic route or facility we require. The acquisition of the Sprint fiber network provides us significant additional fiber assets
● Narrow and Focused Product Set . Since our founding, we have strategically focused on delivering a very narrow product set to our customers. The vast majority of our revenue is driven by or related to our high-capacity, bi-directional, symmetric internet access services which can be accessed on-net in MTOBs and carrier neutral data centers (“CNDCs”) or off-net through other carriers’ “last mile” connections to customer facilities. There are significant cost advantages as a result of this narrow product set. We believe that the relative size of our salesforce training, support and overhead is lower than comparable telecom providers that tend to offer a broader, one-stop shop product set to their client base.
● Scalable Network Equipment and Hub Configurations . Due to our single network protocol and narrow product set, our transmission and network operations rely mainly on two sets of equipment for operation. In order to further scale our operating leverage, we have systematically reused older equipment in less dense portions of our network. Due to interoperability between the generations of products, we are able to transfer older equipment from our core, high-traffic areas to newer, less congested routes. The result of this dynamic grooming process is that we are able to utilize our equipment for materially longer periods than the expected life of this equipment, thereby reducing our capital investment in our network. We design and build all of our network hubs to the same standards and configurations. This replication strategy provides us scale benefits in equipment purchases, training, and maintenance.
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● Low cost right-of-way agreements . In connection with our acquisition of the Sprint Business, we acquired numerous right-of-way agreements. Many of these right-of-way agreements are at favorable rates and these agreements would be difficult to obtain.
Greater Control and Superior Delivery . Our on-net service does not rely on circuits that must be provisioned by a third-party carrier. In our on-net MTOBs we provide our customers the entire network, including the “last mile” and the in-building wiring connecting to our customer’s suite. In our CNDCs we are collocated with our customers. As a result, only a cross-connection within the data center is required to provide our services to our customers. The structure of our on-net service provides us with more control over our service, quality and pricing. It also allows us to provision services more quickly and efficiently than provisioning services on a third-party carrier network. The vast majority of our on-net services can be installed in less than two weeks, which is materially faster than the installation times for some of our incumbent competitors.
High-Quality, Reliable Service. We are able to offer high-quality Internet service due to our network design and composition. We believe that we deliver a high level of technical performance because our network is optimized for packet switched traffic. Its design increases the speed and throughput of our network and reduces the number of data packets dropped during transmission compared to traditional circuit-switched networks. We believe that our network is more reliable and carries traffic at lower cost than networks built as overlays to traditional circuit-switched, or TDM networks.
Large Addressable Market. We have systematically evaluated and chosen our network extensions to buildings, data centers and markets based upon a rigorous set of criteria to evaluate the economic opportunity of network locations. Additional factors relevant to our pursuit of new buildings include the willingness of building owners to grant us access rights, the availability of optical fiber networks to serve those buildings, the costs to connect buildings to our network and equipment availability. We have also begun to evaluate the sustainability of new locations by evaluating the LEED Green Rating of Buildings, the potential to source renewable energy at potential locations and the potential impact of climate change on a location including access to water and the risk of flooding. Our network is connected to 3,257 total buildings located in 227 metropolitan markets. These buildings include 1,860 large MTOBs (totaling 1.0 billion square feet of office space) in major North American cities where we offer our services to a diverse set of high-quality corporate customers within close physical proximity of each other. These buildings also include 1,528 CNDCs located in 1,337 buildings in North America, Europe, South America, Oceania and Africa where our net-centric customers directly interconnect with our network. We also operate 60 of our own data centers (four of which converted from facilities acquired with the Sprint Business) across the United States and in Europe, which comprise over 808,000 square feet of floor space and are directly connected to our network. We believe that these network points of presence strategically position our network to attract high levels of Internet traffic and maximize our revenue opportunities and profitability.
Balanced, High-Traffic Network. Since its inception, our network has grown significantly in terms of its geographic reach, customer connections, and traffic. We currently serve 7,971 access networks as well as numerous large and small content providers and 55,045 corporate customer connections. Because of these growing bases of customers who distribute (content providers) and receive (access networks) content on our network, we believe that the majority of all the traffic remains “on-net” by both originating and terminating on our network. This control of traffic is an important differentiator as it increases our service reliability and speed of traffic delivery. The increasing share of traffic delivered from content providers to access networks also enhances our margins as we are compensated by both the originating customer and terminating customer. The breadth of our network, extensive size of our customer base, and the volume of our traffic enables us to be one of a handful of Tier 1 networks that are interconnected on a settlement-free basis. This Tier 1 network peering status broadens our geographic delivery capability and materially reduces our network costs.
Proven and Experienced Management Team . Our senior management team is composed of seasoned executives with extensive expertise in the telecommunications industry as well as knowledge of the markets in which we operate. The members of our senior management team have an average of over 20 years of experience in the telecommunications industry and many have been working together at the Company for several years. Several members of the senior management team have been working together at the Company since 2000. Our senior management team has designed and built our network and, during our formative years, led the integration of network assets we acquired through 13 significant previous acquisitions and managed the expansion and growth of our business. We anticipate that our management team will successfully manage the integration of the Sprint Business into our current operations.
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Our Strategy
We intend to become the leading provider of high quality, high-speed Internet access and private network services and to continue to improve our profitability and cash flow. The principal elements of our strategy include:
Grow our Corporate Customer Base. Our on-net corporate customers are typically small to medium-sized businesses connected to our network through MTOBs or connected to our network through one of our CNDCs. We generally sell two types of services to our corporate customers: dedicated internet access and private network services. We typically sell dedicated internet access at the same price per connection as our competitors, but our customers benefit from our significantly faster speeds and rapid installation times. These customers are increasingly integrating off-site data centers and cloud services into their IT infrastructure in order to take advantage of the safety, security and redundancy that is offered by locating company processing power, storage and software at a data center. An important part of this new infrastructure is a high-speed, dedicated internet connection from the corporate premises to the data center and the Internet and from one corporate premises to other corporate premises. We believe that the importance of data centers will increasingly lead tenants to reconfigure their communications infrastructure to include dedicated internet access across their locations. With our acquisition of Sprint Business, we began offering services to larger enterprise customers.
Increase our Share of the Net-Centric Market . We are currently one of the leading providers of high-speed internet access to a variety of content providers and access networks across the world. We intend to further load our high-capacity network as a result of the growing demand for high-speed internet access generated by these types of bandwidth-intensive applications such as over-the-top (“OTT”) media services, online gaming, video, Internet of Things (“IoT”), voice over IP (“VOIP”), remote data storage, and other services. We expect that we will continue to grow our shares of these segments by offering our customers a series of attractive features including:
● Geographic breadth – We have the broadest CNDC footprint in the industry and currently offer network services in 54 countries – as net-centric customers seek a more international audience this footprint is a significant advantage;
● High capacity and reliability – We offer 100 Mbps to 100 Gbps ports in all of the CNDCs and 400 Gbps in selected locations on our network, which differentiates the capacity choices we provide our net-centric clients;
● Balanced customer base – Our leading share of content providers and access networks increases the amount of traffic that originates and terminates on our network thereby reducing latency and enhancing reliability;
● Large and dedicated salesforce – Our team of net-centric sales professionals is one of the largest salesforces in this industry segment and enables us to better serve this customer segment while also identifying new sales opportunities and gaining new business and customers; and
● The customers of the Sprint Business will include a number of large enterprise customers, a type of customer that we have not traditionally served.
Pursue On-net Customer Growth. Our high-capacity network provides us with the ability to add a significant number of customers to our network with minimal direct incremental costs. We intend to increase usage of our network and operational infrastructure by adding customers in our existing on-net buildings, as well as developing additional markets and connecting more MTOBs and CNDCs to our network. We emphasize our on-net services because they generate greater profit margins and we have more control over service levels, quality and pricing, and our on-net services are provisioned in considerably less time than our off-net services. Our fiber network connects directly to our on-net customers’ premises and we pay no local access (“last mile”) charges to other carriers to provide our on-net services.
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Continue to Improve our Sales Efforts and Productivity. A critical factor in our success has been our investment and focus on our sales and marketing efforts. We seek to maintain a consistent level of sales productivity as measured by the number of connections sold per salesperson per month, taking into account adjustments to the changing mix of products sold and installed. In order to gain market share in our targeted businesses, we expect to continue our sales efforts including introducing strategies and tools to optimize and improve our sales productivity. We have developed several training programs that are directed toward increasing our sales representative tenure and increasing our sales representative productivity. In addition, we have required all of our employees to work in the office on a full-time basis, thereby providing additional opportunities for management coaching and oversight in order to increase productivity.
Expand our Off-net Corporate Internet Access Business. We have agreements with over 580 national and international carriers providing us last mile network access to over 6 million commercial buildings that are lit by fiber optic cable across North America and that are not currently served by our network. We believe these agreements broaden our addressable market for corporate dedicated internet access and enhances our competitive position through the ability to provide enterprise-wide connectivity for corporate customers. In order to take advantage of this large set of commercial buildings we have developed an automated process to enable our salesforce to identify opportunities in the off-net market for dedicated internet access and to quickly offer pricing proposals to potential customers. We continue to negotiate reduced pricing under our numerous carrier agreements that enable us to reduce our cost of off-net services, which enhances our competitive position in the marketplace.
Expand our Product Offerings to Include Wavelength and Optical Transport Services . In connection with the Transaction, we expanded our offerings of optical wavelength and optical transport services over our fiber network. We are selling these services to our existing customers, customers of Sprint Communications and to new customers who require dedicated optical transport connectivity without the capital and ongoing expenses associated with owning and operating network infrastructure. We operate data centers throughout North America and Europe that allow our customers to collocate their equipment and access our network. In connection with the Transaction, we will also expand our colocation offerings.
Results of Operations
Three Months Ended September 30, 2023 Compared to the Three Months Ended September 30, 2022
Our management reviews and analyzes several key financial measures in order to manage our business and assess the quality and variability of our service revenue, operating results and cash flows. The following summary tables present a comparison of our results of operations with respect to certain key financial measures. The comparisons illustrated in the tables are discussed in greater detail below.
Three Months Ended
September 30,
Percent
2023
2022
Change
(in thousands)
Service revenue
$
275,429
$
150,000
83.6
%
On-net revenue
130,049
113,219
14.9
%
Off-net revenue
130,970
36,611
257.7
%
Wavelength revenue
2,992
—
NM
Non-core revenue
11,417
170
NM
Network operations expenses (1)
173,594
57,220
203.4
%
Selling, general, and administrative (“SG&A) expenses (2)
65,308
39,114
67.0
%
Acquisition costs – Sprint Business
351
2,004
(82.5)
%
Depreciation and amortization expenses
86,734
22,897
278.8
%
Change in valuation - interest rate swap agreement
4,825
16,923
NM
Loss on bargain purchase – Sprint Business
3,332
—
NM
Interest income – IP Transit Services Agreement
10,299
—
NM
Interest expense
24,198
17,948
34.8
%
Income tax (benefit) expense
(13,623)
969
NM
(1) Includes non-cash equity-based compensation expenses of $370 and $176 in the three months ended September 30, 2023 and 2022, respectively.
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(2) Includes non-cash equity-based compensation expenses of $7,041 and $6,035 in the three months ended September 30, 2023 and 2022, respectively.
NM – not meaningful
September 30,
Percent
2023
2022
Change
Other Operating Data
Average Revenue Per Unit (ARPU)
ARPU - on-net
$
475
$
458
3.8
%
ARPU - off-net
$
1,156
$
920
25.6
%
ARPU - wavelengths
$
2,312
$
—
NM
Average Price per Megabit — installed base
$
0.30
$
0.27
9.6
%
Customer Connections—end of period
On-net
89,623
82,614
8.5
%
Off-net
36,766
13,359
175.2
%
Wavelengths
449
—
NM
Non-core
11,187
348
NM
Service Revenue. We continually work to grow our total service revenue by increasing the number of potential customers that we can reach on our network. We do this by investing capital to expand the geographic footprint of our network, increasing the number of buildings that we are connected to, including CNDC’s and MTOB’s, and increasing our penetration rate into our existing buildings. These efforts broaden the global reach of our network and increase the size of our potential addressable market. We also seek to grow our service revenue by investing in our sales and marketing team. We typically sell corporate connections at similar pricing to our competitors, but our clients benefit from our significantly faster speeds, greater aggregate throughput, enhanced service level agreements and rapid installation times. In the net-centric market, we offer comparable services in terms of capacity but typically at significantly lower prices.
Our service revenue increased by 83.6% from the three months ended September 30, 2022 to the three months ended September 30, 2023. Exchange rates positively affected our increase in service revenue by $1.8 million. All foreign currency comparisons herein reflect results for the three months ended September 30, 2023 translated at the average foreign currency exchange rates for the three months ended September 30, 2022. We increased our total service revenue by expanding our network, adding additional buildings to our network, increasing our penetration into the buildings connected to our network and gaining market share by offering our services at lower prices than our competitors. Revenue from the Sprint Business for the three months ended September 30, 2023 was $113.0 million.
Revenue recognition standards include guidance relating to any tax assessed by a governmental authority that is directly imposed on a revenue-producing transaction between a seller and a customer and may include, but is not limited to, gross receipts taxes, Universal Service Fund fees and certain state regulatory fees. We record these taxes billed to our customers on a gross basis (as service revenue and network operations expense) in our consolidated statements of comprehensive income. The impact of these taxes including the Universal Service Fund resulted in an increase to our revenues of $10.4 million from the three months ended September 30, 2022 to the three months ended September 30, 2023. Excise taxes from the Sprint Business for the three months ended September 30, 2023 were $10.8 million.
Revenue and customer connections by customer type
Our corporate customers generally purchase their services on a price per connection basis. Our net-centric customers generally purchase their services on a price per megabit-metered basis. We began to serve enterprise customers in connection with our acquisition of the Wireless Business. We define “enterprise” customers as large corporations (typically, Fortune 500 companies with greater than $5 billion in annual revenue) running Wide Area Networks (“WAN”) with several dozen to several hundred sites. Our enterprise customers generally purchase our services on a price per location basis. Revenues from our corporate, net-centric customers and enterprise customers represented 43.7%, 34.5% and 21.8% of total service revenue, respectively, for the three months ended September 30, 2023. Revenues from our corporate and net-centric customers represented 57.0% and 43.0% of total service revenue, respectively, for the three months ended September 30, 2022. Revenues from corporate customers increased by 40.9% to $120.5 million for the three months ended September 30, 2023 compared to the three months ended September 30, 2022. Revenues from our
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net-centric customers increased by 47.2% to $94.9 million for the three months ended September 30, 2023 compared to the three months ended September 30, 2022. Revenues from our enterprise customers were $60.0 million for the three months ended September 30, 2023. Certain of our historical corporate and net-centric customers (in total approximately 400 customers representing approximately $0.3 million in monthly recurring revenue) have been reclassified from our legacy net-centric and corporate revenue and customer connections to enterprise revenue and customer connections. Certain of the customer connections we acquired in the Sprint Business were classified as corporate and net-centric revenue and customer connections. We acquired 17,823 corporate customer connections, 5,711 net-centric customer connections and 23,209 enterprise customer connections with the Sprint Business. In connection with our acquisition of the Sprint business, we classified the Sprint Business revenue as $20.1 million of monthly recurring revenue as enterprise revenue, $12.9 million of monthly recurring revenue as corporate revenue and $6.5 million of monthly recurring revenue as net-centric revenue.
Our revenue from our corporate customers increased primarily due to corporate customer connections acquired with the Sprint Business. Our corporate customers take advantage of our superior speeds, greater aggregate throughput, service levels and installation times versus our competitors. The growing trend of customers installing second lines for redundancy in order to construct virtual private networks (“VPNs”) has also led to our ability to increase our corporate revenues. Beginning with and throughout the COVID-19 pandemic, we witnessed a deteriorating real estate market in and around the buildings we service in central business districts in North America. Because of the rising vacancy levels and falling lease initiations or renewals, we experienced a slowdown in new sales to our corporate customers, which negatively affected our legacy corporate revenue results. During the three months ended September 30, 2023, we slowly began to see declining vacancy rates and rising office occupancy rates. In addition, we began to see positive trends in our corporate business. As the option to fully or partially work from home becomes permanently established at many companies, our corporate customers are integrating some of the new applications that became part of the remote work environment, which benefits our corporate business as these customers upgrade their Internet access infrastructure to higher capacity connections. Further, if and when companies eventually return to the buildings in which we operate, we believe it will present an opportunity for increased sales. However, the exact timing and path of these positive trends remains uncertain, and as the after effects of the COVID-19 pandemic linger, we may continue to see increased corporate customer turnover, fewer upgrades of existing corporate customer configurations and fewer new tenant opportunities, which would negatively affect our corporate revenue growth.
Our revenue from our net-centric customers increased primarily due to an increase in our number of net-centric customers, growth in network traffic from these customers and from net-centric customer connections acquired with the Sprint Business partly offset by a decline in our average price per megabit. Our net-centric customers purchase our services on a price per megabit basis. The net-centric market exhibits significant pricing pressure due to the continued introduction of new technology, which lowers the marginal cost of transmission and routing, and the commodity nature of the service where price is typically the only differentiating factor for these customers. Our average price per megabit of our installed base of customers increased by 9.6% from the three months ended September 30, 2022 to the three months ended September 30, 2023 from the impact of the price per megabit customers acquired in the Sprint Business. The impact of foreign exchange rates has a more significant impact on our net-centric revenues.
Revenue and customer connections by network connection type
Our on-net revenues increased by 14.9% from the three months ended September 30, 2022 to the three months ended September 30, 2023. Our on-net revenues increased as we increased the number of our on-net customer connections by 8.5% at September 30, 2023 from September 30, 2022. On-net revenue increased at a greater rate than on-net customer connections primarily due to an increase in our on-net ARPU from the three months ended September 30, 2022 to the three months ended September 30, 2023. ARPU is determined by dividing revenue for the period by the average customer connections for that period. On-net revenues from customers acquired in the Sprint Business were $6.3 million for the three months ended September 30, 2023.
Our off-net revenues increased by 257.7% from the three months ended September 30, 2022 to the three months ended September 30, 2023. Our off-net revenues increased primarily from the 175.2% increase in the number of our off-net customer connections from September 30, 2022 to September 30, 2023. Off-net revenues from customers acquired in the Sprint Business were $92.4 million for the three months ended September 30, 2023.
In connection with our acquisition of the Sprint Business, we expanded our offering of optical wavelength and optical transport services over our fiber network. Wavelength revenues from customers acquired in the Sprint Business were $3.0 million for the three months ended September 30, 2023.
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Our non-core revenues increased from the three months ended September 30, 2022 to the three months ended September 30, 2023 primarily from the acquisition of non-core revenues from customers acquired in the Sprint Business. Non-core revenues from customers acquired in the Sprint Business were $11.3 million for the three months ended September 30, 2023.
Network Operations Expenses. Network operations expenses include the costs of personnel associated with service delivery, network management and customer support, network facilities costs, fiber and equipment maintenance fees, leased circuit costs, access and facilities fees paid to building owners and excise taxes billed to our customers and recorded on a gross basis. Our network operations expenses, including non-cash equity-based compensation expense, increased by 203.4% from the three months ended September 30, 2022 to the three months ended September 30, 2023. Non-cash equity-based compensation expense is included in network operations expenses consistent with the classification of the employee’s salary and other compensation. The increase in network operations expense is primarily attributable to an increase in costs related to our network and facilities expansion activities, an increase in power costs and $101.6 million of network operations expense from our acquisition of the Sprint Business for the three months ended September 30, 2023.
Selling, General, and Administrative (“SG&A”) Expenses. Our SG&A expenses, including non-cash equity-based compensation expense, increased by 67.0% from the three months ended September 30, 2022 to the three months ended September 30, 2023. Non-cash equity-based compensation expense is included in SG&A expenses consistent with the classification of the employee’s salary and other compensation. SG&A expenses increased primarily from an increase in salaries and benefits from an 91.2% increase in our total headcount, including 942 employees added to our headcount from our acquisition of the Sprint Business. Our sales force headcount, inclusive of sales management, was 833 at September 30, 2023 and 669 at September 30, 2022, and our total headcount was 1,990 at September 30, 2023 and 1,041 at September 30, 2022. The Sprint Business added 114 employees to our sales force headcount. SG&A expense from our acquisition of the Sprint Business was $29.9 million for the three months ended September 30, 2023.
Depreciation and Amortization Expenses. Our depreciation and amortization expense increased by 278.8% from the three months ended September 30, 2022 to the three months ended September 30, 2023. The increase is primarily due to the depreciation expense associated with the increase in deployed fixed assets and $59.0 of depreciation and amortization expense from assets, including a finance lease totaling $160.9 million being amortized over forty-four months, acquired with the Sprint Business.
Gain on Bargain Purchase
We accounted for our acquisition of the Sprint Business as a business combination. The identifiable assets acquired and liabilities assumed were recorded at their fair values as of the acquisition date. Assigning fair market values to the assets acquired and liabilities assumed at the date of an acquisition requires the use of significant judgment regarding estimates and assumptions. The fair value of the identifiable assets acquired was $1.5 billion (including amounts due under the IP Transit Services Agreement) and was in excess of the $1.0 billion liabilities assumed and the $0.6 billion net consideration to be received from the Seller resulting in a gain on bargain purchase of $1.2 billion. During the three months ended September 30, 2023, certain adjustments were made to the purchase price resulting in a reduction to the total gain on bargain purchase of $3.3 million.
Interest Income - IP Transit Services Agreement
On the Closing Date, we entered into the IP Transit Services Agreement with T-Mobile USA, Inc., (“TMUSA”), pursuant to which TMUSA will pay us an aggregate of $700.0 million, consisting of (i) $350.0 million in equal monthly installments during the first year after the Closing Date and (ii) $350.0 million in equal monthly installments over the subsequent 42 months.
We accounted for the Transaction as a business combination under ASC Topic 805 Business Combinations (“ASC 805”). Under ASC 805, we concluded that the $700.0 million of payments to be made represent consideration received to complete the acquisition of a distressed business. We also evaluated whether the IP Transit Services Agreement was in the scope of ASU No. 2014-09 Revenue from Contracts with Customers (“ASC 606”). We concluded that TMUSA did not represent a “customer” as defined by ASC 606, the stated contract price did not represent consideration for services to be delivered, and the transaction did not satisfy the definition of revenue, which excluded this arrangement from the scope of ASC 606. As a result, the IP Transit Services Agreement was recorded in connection with the Transaction at its discounted present value resulting in a discount of $79.6 million. The amortization of the discount resulted in interest income of $10.3 million for the three months ended September 30, 2023.
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Interest Expense. Our interest expense resulted from interest incurred on our $500.0 million aggregate principal amount of 3.50% Senior Secured Notes due 2026 that we issued in May 2021 (the “2026 Notes”), interest incurred on our $450.0 million aggregate principal amount of 7.00% Senior Unsecured Notes due 2027 that we issued in June 2022 (the “2027 Notes”) and interest incurred on our finance lease obligations. Our finance leases include a lease totaling $160.9 million being amortized over forty-four months, acquired with the Sprint Business. Our interest expense increased by 34.8% from the three months ended September 30, 2022 to the three months ended September 30, 2023. The increase was primarily due to the impact of the finance lease acquired with the Sprint Business and an increase in interest rates on our 2027 Notes as compared to the 2024 Notes.
Change in Valuation - Interest Rate Swap Agreement. As of September 30, 2023, the fair value of our Swap Agreement was a net liability of $56.4 million. We recorded unrealized losses for the non-cash change in the valuation of the Swap Agreement of $4.8 million in the three months ended September 30, 2023 and $16.9 million in the three months ended September 30, 2022 from an increase in interest rates.
Under the Swap Agreement settlement payment made in November 2021, we received $0.6 million from the counterparty for a net cash savings of $0.6 million for the period from August 9, 2021 (the Swap Agreement inception date) to October 31, 2021, in May 2022, we received $1.2 million from the counterparty for a net cash savings of $1.2 million for the period from November 1, 2021 to April 30, 2022. Under the Swap Agreement settlement payment made in November 2022, we paid $3.4 million to the counterparty for a net cash interest cost of $3.4 million for the period from May 1, 2022 to October 31, 2022. Under the Swap Agreement settlement payment made in May 2023, we paid $9.5 million to the counterparty for a net cash interest cost of $9.5 million for the period from November 1, 2022 to April 30, 2023. Under the Swap Agreement settlement payment made in November 2023, we paid $12.0 million to the counterparty for a net cash interest cost of $12.0 million for the period from May 1, 2023 to October 31, 2023.
Income Tax (Benefit) Expense. Our income tax benefit was $13.6 million for the three months ended September 30, 2023 and our income tax expense was $1.0 million for the three months ended September 30, 2022. The decrease in our income tax expense is primarily related to projected operating results related to the Sprint Business acquisition, the reversal of deferred tax liabilities acquired with the Sprint Business and the reversal of a valuation allowance on our business interest expense deferred tax asset.
Buildings On-net. As of September 30, 2023 and 2022, we had a total of 3,257 and 3,126 on-net buildings connected to our network, respectively. The increase in our on-net buildings was a result of our disciplined network expansion program. We anticipate adding a similar number of buildings to our network for the next several years.
Nine Months Ended September 30, 2023 Compared to the Nine Months Ended September 30, 2022
Our management reviews and analyzes several key financial measures in order to manage our business and assess the quality and variability of our service revenue, operating results and cash flows. The following summary tables present a comparison of our
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results of operations with respect to certain key financial measures. The comparisons illustrated in the tables are discussed in greater detail below.
Nine Months Ended
September 30,
Percent
2023
2022
Change
(in thousands)
Service revenue
$
668,822
$
447,625
49.4
%
On-net revenue
373,856
337,829
10.7
%
Off-net revenue
270,234
109,279
147.3
%
Wavelength revenue
4,578
—
NM
Non-core revenue
20,154
517
NM
Network operations expenses (1)
369,734
171,183
116.0
%
Selling, general, and administrative (“SG&A) expenses (2)
194,046
119,129
62.9
%
Acquisition costs – Sprint Business
1,490
2,004
(25.6)
%
Depreciation and amortization expenses
164,403
68,659
139.4
%
Foreign exchange gain on 2024 Notes
—
31,561
NM
Loss on debt extinguishment and redemption – 2024 Notes
—
11,885
Change in valuation – interest rate swap agreement
4,283
45,703
NM
Interest income – IP Transit Services Agreement
17,968
—
NM
Gain on bargain purchase – Sprint Business
1,152,386
—
NM
Interest expense
71,855
45,594
57.6
%
Income tax (benefit) expense
(33,599)
10,063
NM
(1) Includes non-cash equity-based compensation expenses of $750 and $465 in the nine months ended September 30, 2023 and 2022, respectively.
(2) Includes non-cash equity-based compensation expenses of $19,491 and $17,709 in the nine months ended September 30, 2023 and 2022, respectively.
NM – not meaningful
Nine Months Ended
September 30,
Percent
2023
2022
Change
Other Operating Data
Average Revenue Per Unit (ARPU)
ARPU—on-net
$
482
$
460
4.9
%
ARPU—off-net
$
1,194
$
933
28.0
%
ARPU – Wavelengths
$
2,266
$
—
NM
Average Price per Megabit — installed base
$
0.27
$
0.29
(5.8)
%
Customer Connections—end of period
On-net
89,623
82,614
8.5
%
Off-net
36,766
13,359
175.2
%
Wavelengths
449
—
NM
Non-core
11,187
348
NM
Service Revenue. We continually work to grow our total service revenue by increasing the number of potential customers that we can reach on our network. We do this by investing capital to expand the geographic footprint of our network, increasing the number of buildings that we are connected to, including CNDC’s and MTOB’s, and increasing our penetration rate into our existing buildings. These efforts broaden the global reach of our network and increase the size of our potential addressable market. We also seek to grow our service revenue by investing in our sales and marketing team. We typically sell corporate connections at similar pricing to our competitors, but our clients benefit from our significantly faster speeds, greater aggregate throughput, enhanced service level agreements and rapid installation times. In the net-centric market, we offer comparable services in terms of capacity but typically at significantly lower prices.
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Our service revenue increased by 49.4% from the nine months ended September 30, 2022 to the nine months ended September 30, 2023. Exchange rates negatively affected our increase in service revenue by $1.8 million. All foreign currency comparisons herein reflect results for the nine months ended September 30, 2023 translated at the average foreign currency exchange rates for the nine months ended September 30, 2022. We increased our total service revenue by expanding our network, adding additional buildings to our network, increasing our penetration into the buildings connected to our network and gaining market share by offering our services at lower prices than our competitors. Revenue from the Sprint Business was $191.0 million from May 1, 2023 (the closing date) to September 30, 2023.
Revenue recognition standards include guidance relating to any tax assessed by a governmental authority that is directly imposed on a revenue-producing transaction between a seller and a customer and may include, but is not limited to, gross receipts taxes, Universal Service Fund fees and certain state regulatory fees. We record these taxes billed to our customers on a gross basis (as service revenue and network operations expense) in our consolidated statements of comprehensive income. The impact of these taxes including the Universal Service Fund resulted in an increase to our revenues of $18.5 million from the nine months ended September 30, 2022 to the nine months ended September 30, 2023. Excise taxes from the Sprint Business were $17.8 million from May 1, 2023 (the closing date) to September 30, 2023.
Revenue and customer connections by customer type
Our corporate customers generally purchase their services on a price per connection basis. Our net-centric customers generally purchase their services on a price per megabit-metered basis. We began to serve enterprise customers in connection with our acquisition of the Sprint Business. We define “enterprise” customers as large corporations (typically, Fortune 500 companies with greater than $5 billion in annual revenue) running Wide Area Networks (“WAN”) with several dozen to several hundred sites. Our enterprise customers generally purchase our services on a price per location basis. Revenues from our corporate, net-centric customers and enterprise customers represented 45.0%, 41.1% and 13.9% of total service revenue, respectively, for the nine months ended September 30, 2023. Revenues from our corporate and net-centric customers represented 57.4% and 42.6% of total service revenue, respectively, for the nine months ended September 30, 2022. Revenues from corporate customers increased by 17.1% to $300.7 million for the nine months ended September 30, 2023 compared to the nine months ended September 30, 2022. Revenues from our net-centric customers increased by 44.0% to $274.9 million for the nine months ended September 30, 2023 compared to the nine months ended September 30, 2022. Revenues from our enterprise customers were $93.3 million, from May 1, 2023 (the closing date) to September 30, 2023. Certain of our historical corporate and net-centric customers (in total approximately 400 customers representing approximately $0.3 million in monthly recurring revenue) have been reclassified from our legacy net-centric and corporate revenue and customer connections to enterprise revenue and customer connections. Certain of the customer connections we acquired in the Sprint Business were classified as corporate and net-centric revenue and customer connections. We acquired 17,823 corporate customer connections, 5,711 net-centric customer connections and 23,209 enterprise customer connections with the Sprint Business. In connection with our acquisition of the Sprint Business, we classified the Sprint Business revenue as $20.1 million of monthly recurring revenue as enterprise revenue, $12.9 million of monthly recurring revenue as corporate revenue and $6.5 million of monthly recurring revenue as net-centric revenue.
Our revenue from our corporate customers increased primarily due to an increase in our number of corporate customers and from corporate customer connections acquired with the Sprint Business. Our corporate customers take advantage of our superior speeds, greater aggregate throughput, service levels and installation times versus our competitors. The growing trend of customers installing second lines for redundancy in order to construct virtual private networks (“VPNs”) has also led to our ability to increase our corporate revenues. Beginning with and throughout the COVID-19 pandemic, we witnessed a deteriorating real estate market in and around the buildings we service in central business districts in North America. Because of the rising vacancy levels and falling lease initiations or renewals, we experienced a slowdown in new sales to our corporate customers, which negatively affected our corporate revenue results. During the nine months ended September 30, 2023, we slowly began to see declining vacancy rates and rising office occupancy rates. In addition, we began to see positive trends in our corporate business. As the option to fully or partially work from home becomes permanently established at many companies, our corporate customers are integrating some of the new applications that became part of the remote work environment, which benefits our corporate business as these customers upgrade their Internet access infrastructure to higher capacity connections. Further, if and when companies eventually return to the buildings in which we operate, we believe it will present an opportunity for increased sales. However, the exact timing and path of these positive trends remains uncertain, and as the after effects of the COVID-19 pandemic linger, we may continue to see increased corporate customer turnover, fewer upgrades of existing corporate customer configurations and fewer new tenant opportunities, which would negatively affect our corporate revenue growth.
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Our revenue from our net-centric customers increased primarily due to an increase in our number of net-centric customers and growth in network traffic from these customers and from net-centric customer connections acquired with the Sprint Business. Our net-centric customers purchase our services on a price per megabit basis. The net-centric market exhibits significant pricing pressure due to the continued introduction of new technology, which lowers the marginal cost of transmission and routing, and the commodity nature of the service where price is typically the only differentiating factor for these customers. Our average price per megabit of our installed base of customers decreased by 5.8% from the nine months ended September 30, 2022 to the nine months ended September 30, 2023. The impact of foreign exchange rates has a more significant impact on our net-centric revenues.
Revenue and customer connections by network connection type
Our on-net revenues increased by 10.7% from the nine months ended September 30, 2022 to the nine months ended September 30, 2023. Our on-net revenues increased as we increased the number of our on-net customer connections by 8.5% at September 30, 2023 from September 30, 2022. On-net customer revenues increased at a greater rate than on-net customer connections primarily due to an increase in our on-net ARPU from the nine months ended September 30, 2022 to the nine months ended September 30, 2023. ARPU is determined by dividing revenue for the period by the average customer connections for that period. On-net revenues from customers acquired in the Sprint Business was $10.4 million from May 1, 2023 (the closing date) to September 30, 2023.
Our off-net revenues increased by 147.3% from the nine months ended September 30, 2022 to the nine months ended September 30, 2023. Our off-net revenues increased primarily from the increase in the number of our off-net customer connections from September 30, 2022 to September 30, 2023. Off-net revenues from customers acquired in the Sprint Business were $156.4 million from May 1, 2023 (the closing date) to September 30, 2023.
In connection with our acquisition of the Sprint Business, we expanded our offering of optical wavelength and optical transport services over our fiber network. Wavelength revenues from customers acquired in the Sprint Business were $4.6 million from May 1, 2023 (the closing date) to September 30, 2023.
Our non-core revenues increased from the nine months ended September 30, 2022 to the nine months ended September 30, 2023 primarily from the acquisition of non-core revenues from customers acquired in the Sprint Business. Non-core revenues from customers acquired in the Sprint Business were $19.7 million from May 1, 2023 (the closing date) to September 30, 2023.
Network Operations Expenses. Network operations expenses include the costs of personnel associated with service delivery, network management and customer support, network facilities costs, fiber and equipment maintenance fees, leased circuit costs, access and facilities fees paid to building owners and excise taxes billed to our customers and recorded on a gross basis. Our network operations expenses, including non-cash equity-based compensation expense, increased by 116.0% from the nine months ended September 30, 2022 to the nine months ended September 30, 2023. Non-cash equity-based compensation expense is included in network operations expenses consistent with the classification of the employee’s salary and other compensation. The increase in network operations expense is primarily attributable to an increase in costs related to our network and facilities expansion activities, an increase in power costs and $174.0 million of network operations expense from our acquisition of the Sprint Business from May 1, 2023 (the closing date) to September 30, 2023.
Selling, General, and Administrative (“SG&A”) Expenses. Our SG&A expenses, including non-cash equity-based compensation expense, increased by 62.9% from the nine months ended September 30, 2022 to the nine months ended September 30, 2023. Non-cash equity-based compensation expense is included in SG&A expenses consistent with the classification of the employee’s salary and other compensation. SG&A expenses increased primarily from an increase in salaries and benefits from an 91.2% increase in our total headcount, including 942 employees added to our headcount from our acquisition of the Sprint Business. Our sales force headcount, inclusive of sales management, was 833 at September 30, 2023 and 669 at September 30, 2022, and our total headcount was 1,990 at September 30, 2023 and 1,041 at September 30, 2022. The Sprint Business added 114 employees to our sales force headcount. SG&A expense from our acquisition of the Sprint Business was $73.1 million from May 1, 2023 (the Closing date) to September 30, 2023.
Depreciation and Amortization Expenses. Our depreciation and amortization expense increased by 139.4% from the nine months ended September 30, 2022 to the nine months ended September 30, 2023. The increase is primarily due to the depreciation expense associated with the increase in deployed fixed assets and $86.1 of depreciation and amortization expense from assets, including a finance lease totaling $160.9 million being amortized over forty-four months, acquired with the Sprint Business.
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Gain on Bargain Purchase
We accounted for our acquisition of the Sprint Business as a business combination. The identifiable assets acquired and liabilities assumed were recorded at their fair values as of the acquisition date. Assigning fair market values to the assets acquired and liabilities assumed at the date of an acquisition requires the use of significant judgment regarding estimates and assumptions. The fair value of the identifiable assets acquired was $1.5 billion (including amounts due under the IP Transit Services Agreement) and was in excess of the $1.0 billion liabilities assumed and the $0.6 billion net consideration to be received from the Seller resulting in a gain on bargain purchase of $1.2 billion.
Interest Income - IP Transit Services Agreement
On the Closing Date, we entered into the IP Transit Services Agreement with TMUSA, pursuant to which TMUSA will pay us an aggregate of $700.0 million, consisting of (i) $350.0 million in equal monthly installments during the first year after the Closing Date and (ii) $350.0 million in equal monthly installments over the subsequent 42 months.
We accounted for the Transaction as a business combination under ASC Topic 805 Business Combinations (“ASC 805”). Under ASC 805, we concluded that the $700.0 million of payments to be made represent consideration received to complete the acquisition of a distressed business. We also evaluated whether the IP Transit Services Agreement was in the scope of ASU No. 2014-09 Revenue from Contracts with Customers (“ASC 606”). We concluded that TMUSA did not represent a “customer” as defined by ASC 606, the stated contract price did not represent consideration for services to be delivered, and the transaction did not satisfy the definition of revenue, which excluded this arrangement from the scope of ASC 606. As a result, the IP Transit Services Agreement was recorded in connection with the Transaction at its discounted present value resulting in a discount of $79.6 million. The amortization of the discount resulted in interest income of $18.0 million from May 1, 2023 (the closing date) to September 30, 2023.
Foreign Exchange Gain 2024 Notes . Our 2024 Notes were issued in Euros and were reported in our reporting currency – US Dollars until they were fully extinguished in June 2022. The gain on foreign exchange on our 2024 Notes from converting our 2024 Notes into USD was $31.6 million for the nine months ended September 30, 2022.
Interest Expense and Loss on Debt Extinguishment and Redemption. Our interest expense resulted from interest incurred on our 2024 Notes until these notes were fully extinguished in June 2022, interest incurred on our $500.0 million aggregate principal amount of our 2026 Notes, interest incurred on our $450.0 million aggregate principal amount of our 2027 Notes and interest incurred on our finance lease obligations. Our interest expense increased by 57.6% from the nine months ended September 30, 2022 to the nine months ended September 30, 2023. The increase was primarily due to the increase in interest rates on our 2027 Notes as compared to the 2024 Notes, $9.5 million of interest expense paid in May 2023 associated with our Swap Agreement and the impact of the finance lease acquired with the Sprint Business. Our finance leases include a lease totaling $160.9 million being amortized over forty-four months, acquired with the Sprint Business. In June 2022, we extinguished our 2024 Notes at 101.094% of par value resulting in a loss on debt extinguishment and redemption of $11.9 million.
Change in Valuation - Interest Rate Swap Agreement. As of September 30, 2023, the fair value of our Swap Agreement was a net liability of $56.4 million, and we recorded an unrealized loss for the non-cash change in the valuation of the Swap Agreement of $4.3 million in the nine months ended September 30, 2023 and $45.7 million in the nine months ended September 30, 2022 from an increase in interest rates.
Under the Swap Agreement settlement payment made in November 2021, we received $0.6 million from the counterparty for a net cash savings of $0.6 million for the period from August 9, 2021 (the Swap Agreement inception date) to October 31, 2021, in May 2022, we received $1.2 million from the counterparty for a net cash savings of $1.2 million for the period from November 1, 2021 to April 30, 2022. Under the Swap Agreement settlement payment made in November 2022, we paid $3.4 million to the counterparty for a net cash interest cost of $3.4 million for the period from May 1, 2022 to October 31, 2022. Under the Swap Agreement settlement payment made in May 2023, we paid $9.5 million to the counterparty for a net cash interest cost of $9.5 million for the period from November 1, 2022 to April 30, 2023. Under the Swap Agreement settlement payment made in November 2023, we paid $12.0 million to the counterparty for a net cash interest cost of $12.0 million for the period from May 1, 2023 to October 31, 2023.
Income Tax (Benefit) Expense. Our income tax benefit was $33.6 million for the nine months ended September 30, 2023 and our income tax expense was $10.1 million for the nine months ended September 30, 2022. The decrease in our income tax expense is
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primarily related to projected operating results related to the Sprint Business acquisition, the reversal of deferred tax liabilities acquired with the Sprint Business and the reversal of a valuation allowance on our business interest expense deferred tax asset.
Buildings On-net. As of September 30, 2023 and 2022, we had a total of 3,257 and 3,126 on-net buildings connected to our network, respectively. The increase in our on-net buildings was a result of our disciplined network expansion program. We anticipate adding a similar number of buildings to our network for the next several years.
Liquidity and Capital Resources
In assessing our liquidity, management reviews and analyzes our current cash balances, accounts receivable, accounts payable, accrued liabilities, capital expenditure commitments, and required finance lease and debt payments and other obligations. As our business has grown as a result of an increasing customer base, the Transaction, broader geographic coverage and increased traffic on our network, we have produced a growing level of cash provided by operating activities. Because of the operating leverage of our network, our annual capital expenditures measured as a percentage of revenues has fallen over the last decade. Increasing our cash provided by operating activities is, in part, dependent upon expanding our geographic footprint and increasing our network capacity. Supply chain issues may adversely affect our ability to grow our network and revenue.
We have also had increasing success in raising capital by issuing notes and arranging financing and leases that have had a lower cost and more flexible terms. The combination of this improved operating performance and access to capital has enhanced our financial flexibility and increased our ability to make distributions to stockholders in the form of cash dividends or through share repurchases. Since our initial public offering, we have returned over $1.4 billion to our stockholders through share repurchases and dividends. We will continue to assess our capital and liquidity needs and, where appropriate, return capital to stockholders.
Over the next several years, we have significant contractual and anticipated cash outlays including our indicative dividend payments on our common stock, our maturing debt obligations, interest payments on our debt obligations and our projected capital expenditure requirements in order to help execute our business plan including the acquisition of the Sprint Business. Based upon the historical growth rate of our dividend, we expect that we would have to provide approximately $375 million in order to meet our expected quarterly dividend payments over the next two years, inclusive of payments under the IP Transit Services Agreement. Our $500.0 million of 2026 Notes accrue interest at 3.50%, mature in May 2026 and include annual interest payments of $17.5 million until maturity. In June 2022, we redeemed our 2024 Notes with the proceeds from our issuance of $450.0 million of our 2027 Notes. Our 2024 Notes accrued interest at 4.375% and our 2027 Notes accrue interest at 7.00%. Our $450.0 million of 2027 Notes mature in June 2027 and include annual interest payments of $31.5 million until maturity.
Under our Swap Agreement, we pay the counterparty a semi-annual payment based upon overnight SOFR plus a contractual interest rate spread, and the counterparty pays us a semi-annual fixed 3.50% interest payment. These settlement payments are made in November and May of each year until the Swap Agreement expires in February 2026. As of September 30, 2023, $56.4 million of our cash and cash equivalents are restricted for use under our Swap Agreement. We have made a $57.6 million deposit with the counterparty to the Swap Agreement. If the fair value of the Swap Agreement exceeds a net liability of $57.6 million, we will be required to deposit additional funds with the counterparty equal to the net liability fair value. As of September 30, 2023, $56.4 million of the deposit was restricted and $1.2 million was unrestricted. The valuation of the Swap Agreement reduced to $43.8 million as of November 6, 2023.
We may need to, or elect to, refinance all or a portion of our indebtedness at or before maturity and we cannot provide assurances that we will be able to refinance any such indebtedness on commercially reasonable terms or at all. In addition, we may elect to secure additional capital in the future, at acceptable terms, to improve our liquidity or fund acquisitions or for general corporate purposes. In addition, in an effort to reduce future cash interest payments as well as future amounts due at maturity or to extend debt maturities, we may, from time to time, issue new debt, enter into interest rate swap agreements, enter into debt for debt, or cash transactions to purchase our outstanding debt securities in the open market or through privately negotiated transactions. We will evaluate any such transactions in light of the existing market conditions. The amounts involved in any such transaction, individually or in the aggregate, may be material. We or our affiliates may, at any time and from time to time, seek to retire or purchase our outstanding debt through cash purchases and/or exchanges for equity or debt, in open-market purchases, privately negotiated transactions or otherwise. Such repurchases or exchanges, if any, will be upon such terms and at such prices as we may determine, and will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors. The amounts involved may be material.
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Acquisition of Sprint Communications
The Sprint Business’s cash flow was negative at the time of negotiations and during its recent history. Due to the dire financial condition of the Sprint Business, it was understood that a payment from T-Mobile to any potential buyer would be required to execute a transaction to give a buyer sufficient cash inflows to offset losses that would be expected until a buyer could optimize the business. Based on management’s internal modeling at the culmination of the due diligence process, management determined this cash payment to be $700.0 million. Management intends to reduce the negative cash flow of the Sprint Business through the payments from the IP Transit Services Agreement, reducing operating costs and increasing revenue primarily by providing optical wavelength and optical transport services over our fiber network, including the owned network we acquired with the Sprint Business. We are selling these services to our existing customers, customers we acquired with the Sprint Business and to new customers who require dedicated optical transport connectivity without the capital and ongoing expenses associated with owning and operating network infrastructure. As part of the Transaction, we began incurring costs associated with the TSA. The amount of these costs will be dependent upon our ability to integrate the operations of the Sprint Business into our operations. Our cash flow requirements related to the acquisition of the Sprint Business will be dependent upon our ability to reduce the acquired operating costs, our success in retaining the acquired customers and our ability to sell optical wavelength and optical transport services over our fiber network.
In light of the economic uncertainties associated with the global recessionary economy, the cash flow requirements of the Sprint Business, the lingering impact of the COVID-19 pandemic and recent bank failures and liquidity concerns at certain other banks, our executive officers and Board of Directors have continued to carefully monitor our liquidity and cash requirements. Based on current circumstances, we currently plan to continue our current dividend policy. Given uncertainties regarding the lingering business impact of the pandemic, the cash flow requirements of the Sprint Business and the timing for economic recovery, we will continue to monitor our capital spending. As we do each year, we will continue to monitor our future sources and uses of cash, and anticipate that we will make adjustments to our capital allocation strategies when, as and if determined by our Board of Directors.
Cash Flows
The following table sets forth our consolidated cash flows.
Nine Months Ended September 30,
(in thousands)
2023
2022
Net cash provided by operating activities
$
66,043
$
137,384
Net cash provided by (used in) investing activities
16,607
(59,380)
Net cash used in financing activities
(193,116)
(76,548)
Effect of exchange rates changes on cash
626
(6,416)
Net decrease in cash and cash equivalents and restricted cash
$
(109,840)
$
(4,960)
Net Cash Provided by Operating Activities. Our primary source of operating cash is receipts from our customers who are billed on a monthly basis for our services. Our primary uses of operating cash are payments made to our vendors, employees and interest payments made to our finance lease vendors and our note holders. Our changes in cash provided by operating activities are primarily due to changes in our operating profit and changes in our interest payments. On the Closing Date, we entered into a TSA with the Seller, pursuant to which the Seller will provide to us, and we will provide to the Seller on an interim basis following the Closing Date, Transition Services to ensure an orderly transition following the separation of the Sprint Business from Sprint Communications. Amounts billed under the TSA are due 30 days from receipt of the related invoice. As of September 30, 2023, we owed $69.6 million to the Seller and the Seller owed $16.8 million to us under the TSA agreement resulting in an increase in cash provided by operating activities. During the nine months ended September 30, 2023 we were billed $218.0 million and paid $153.1 million under the TSA agreement.
Net Cash Provided by (Used in) Investing Activities. Our primary use of cash for investing activities is for purchases of property and equipment. Purchases of property and equipment were $86.0 million and $59.4 million for the nine months ended September 30, 2023 and 2022, respectively. The changes in purchases of property and equipment are primarily due to the timing and scope of our network expansion activities including geographic expansion, purchases in anticipation of the closing of our acquisition of the Sprint Business and adding buildings to our network. We paid $61.1 million, net of $47.1 million of cash acquired, for a net total of $14.0 million paid for our acquisition of the Sprint Business. On the Closing Date, we entered into the IP Transit Services Agreement pursuant to which TMUSA will pay us an aggregate of $700.0 million, consisting of (i) $350.0 million in equal monthly
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installments during the first year after the Closing Date and (ii) $350.0 million in equal monthly installments over the subsequent 42 months. During the nine months ended September 30, 2023 we were paid $116.7 million under the IP Transit Services Agreement.
Net Cash Used In Financing Activities. Our primary uses of cash for financing activities are for payments to redeem and extinguish our debt, dividend payments and principal payments under our finance lease obligations and for purchases of our common stock. During the nine months ended September 30, 2023 and 2022, we paid $135.4 million and $125.9 million, respectively, for our quarterly dividend payments. Our quarterly dividend payments have increased due to increases in our quarterly dividend per share amounts. Principal payments under our finance lease obligations were $58.5 million and $21.0 million for the nine months ended September 30, 2023 and 2022, respectively. The changes in our principal payments under our finance lease obligations are primarily due to the timing and extent of our network expansion activities including geographic expansion, purchases in anticipation of the closing of our acquisition of the Sprint Business and adding buildings to our network. There were no purchases of our common stock in the nine months ended September 30, 2023 and 2022.
Cash Position and Indebtedness
At September 30, 2023, our total indebtedness, at par, was $1.4 billion and our total cash, cash equivalents and restricted cash ($56.4 million) was $166.1 million. Our total indebtedness at September 30, 2023 includes $483.2 million of finance lease obligations for dark fiber under long-term IRU agreements.
Summarized Financial Information of Holdings
Holdings is not a restricted subsidiary as defined under the indentures governing our 2026 Notes and our 2027 Notes (the “Indentures”). Holdings is a guarantor under these notes. Under the Indentures, we are required to disclose financial information of Holdings including its assets, liabilities and its operating results (“Holdings Financial Information”). The Holdings Financial Information as of and for the nine months ended September 30, 2023 is detailed below (in thousands).
September 30, 2023
(Unaudited)
Cash and cash equivalents
$
1,185
Accrued interest receivable
4
Total assets
$
1,189
Investment from subsidiaries
$
559,311
Common stock
49
Accumulated deficit
(558,171)
Total equity
$
1,189
Nine Months
Ended
September 30, 2023
(Unaudited)
Equity‑based compensation expense
22,644
Interest income
551
Net loss
$
(22,093)
Common Stock Buyback Program
Our Board of Directors has approved purchases of shares of our common stock under a buyback program (the “Buyback Program”). There were no purchases of shares of our common stock in the three or nine months ended September 30, 2023 and 2022. As of September 30, 2023, there was a total of $30.4 million available under the Buyback Program that is authorized to continue through December 31, 2024.
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Dividends on Common Stock and Return of Capital Program
On November 1, 2023, our Board of Directors approved the payment of our quarterly dividend of $0.955 per common share. This estimated $45.1 million dividend payment is expected to be made on December 8, 2023.
The payment of any future dividends and any other returns of capital, including stock buybacks, will be at the discretion of our Board of Directors and may be reduced, eliminated or increased and will be dependent upon our financial position, results of operations, available cash, cash flow, capital requirements, limitations under our debt indentures and other factors deemed relevant by our Board of Directors. We are a Delaware corporation and under the General Corporation Law of the State of Delaware, distributions may be restricted including a restriction that distributions, including stock purchases and dividends, do not result in an impairment of a corporation’s capital, as defined under Delaware Law. The indentures governing our notes limit our ability to return cash to our stockholders. See Note 3 of our interim condensed consolidated financial statements for additional discussion of limitations on distributions.
Future Capital Requirements
We believe that our cash on hand and cash generated from our operating activities will be adequate to meet our working capital, capital expenditure, debt service, dividend payments and other cash requirements for the next twelve months if we execute our business plan.
Any future acquisitions or other significant unplanned costs or cash requirements in excess of amounts we currently hold may require that we raise additional funds through the issuance of debt or equity. Such financing may not be available on terms acceptable to our stockholders, or us or at all. Insufficient funds may require us to delay or scale back the number of buildings and markets that we add to our network, reduce our planned increase in our sales and marketing efforts, or require us to otherwise alter our business plan or take other actions that could have a material adverse effect on our business, results of operations and financial condition. If issuing equity securities raises additional funds, substantial dilution to existing stockholders may result.
We may need to, or elect to, refinance all or a portion of our indebtedness at or before maturity and we cannot provide assurances that we will be able to refinance any such indebtedness on commercially reasonable terms or at all. In addition, we may elect to secure additional capital in the future, at acceptable terms, to improve our liquidity or fund acquisitions or for general corporate purposes. In addition, in an effort to reduce future cash interest payments as well as future amounts due at maturity or to extend debt maturities, we may, from time to time, issue new debt, enter into debt for debt, or cash transactions to purchase our outstanding debt securities in the open market or through privately negotiated transactions. We will evaluate any such transactions in light of the existing market conditions. The amounts involved in any such transaction, individually or in the aggregate, may be material.
Off-Balance Sheet Arrangements
We do not have relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. In addition, we do not engage in trading activities involving non-exchange traded contracts. As such, we are not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in these relationships.
Impact of COVID-19 on Our Liquidity and Operating Performance
As of September 30, 2023, we had cash, cash equivalents and restricted cash ($56.4 million) totaling $166.1 million. The COVID-19 pandemic and its lingering effects has not affected our credit rating to date, nor do we believe that it has materially changed our cost of capital. We believe we are able to timely service our debt obligations and will not require any concessions to do so. We believe we will have access to additional capital from a variety of sources and the public capital markets for debt and equity.
Beginning with and throughout the COVID-19 pandemic, we witnessed a deteriorating real estate market in and around the buildings we service in central business districts in North America. Because of the rising vacancy levels and falling lease initiations or renewals, we experienced a slowdown in new sales to our corporate customers, which negatively affected our legacy corporate revenue results. As the option to fully or partially work from home becomes permanently established at many companies, our
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corporate customers are integrating some of the new applications that became part of the remote work environment, which benefits our corporate business as these customers upgrade their Internet access infrastructure to higher capacity connections. Further, if and when companies eventually return to the buildings in which we operate, we believe it will present an opportunity for increased sales. While we are seeing a return to pre-pandemic leasing activity and a return to in-office work in a number of regions, the exact timing and path of these positive trends remains uncertain, and as the after effects of the COVID-19 pandemic linger, we may continue to see increased corporate customer turnover, fewer upgrades of existing corporate customer configurations and fewer new tenant opportunities, which would negatively affect our corporate revenue growth.
While worldwide capital markets have remained unstable or unpredictable since then, particularly for non-investment grade issuers, legislative bodies and reserve banks have taken various actions in response to the pandemic that have impacted the capital markets, and we expect that these efforts may continue. We cannot predict whether new COVID-19 variants will arise and spread widely, the impact of the spread of new COVID-19 variants on the global economy, how national and local governments may react to the spread of new variants nor predict the impact the variants and any measures taken in response may have on our operations, employee retention, revenue growth, cash flows and our profitability.
Critical Accounting Estimates
Management believes that as of September 30, 2023, there have been no material changes to our critical accounting policies and significant estimates from those listed in Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our annual report on Form 10-K for the year ended December 31, 2022, except as noted below.
Acquisition of Sprint Business
In connection with our acquisition of the Sprint Business we made the following significant changes to our critical accounting policies and significant estimates.
In connection with the Transaction, the identifiable assets acquired and liabilities assumed were recorded at their fair values as of the acquisition date. Assigning fair market values to the assets acquired and liabilities assumed at the date of an acquisition requires the use of significant judgment regarding estimates and assumptions. For the fair values of the assets acquired and liabilities assumed, we used the cost, income and market approaches, including market participant assumptions.
In connection with the Transaction, we acquired customer relationship intangible assets the value of which were determined using an income approach. This fair value measurement was based on significant inputs not observable in the market and, therefore, represents a Level 3 measurement. The key assumptions in applying the income approach include the discount rate, projected revenue from existing customers, customer attrition rate and projected capital and operating expenditures.
The Purchase Agreement includes an estimated payment from Seller to Buyer related to short-term lease obligations. This amount was recorded at its present value resulting in a discount. The interest rate used in determining the present value was derived considering rates on similar issued debt instruments with comparable durations, amongst other market factors. The determination of the discount rate requires some judgment.
On the Closing Date, we entered into the IP Transit Services Agreement. We evaluated what elements were part of the business combination and the consideration exchanged to complete the acquisition. We concluded that the payments to be made represent consideration received from T-Mobile to complete the acquisition of a distressed business. We concluded that T-Mobile did not represent a customer, the stated contract price did not represent consideration for services to be delivered, and the transaction did not satisfy the definition of revenue. We also considered whether the IP Transit Services Agreement would be considered separable from the business combination. We concluded that the cash consideration was not separately identifiable from the business combination and was therefore not meant to be in exchange for a distinct good or service. As a result, the IP Transit Services Agreement was recorded in connection with the Transaction at its discounted present value resulting in a discount. The interest rate used in determining the present value was derived considering rates on similar issued debt instruments with comparable durations, amongst other market factors. The determination of the discount rate and the conclusions reached related to the IP Transit Services Agreement required significant judgment.
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Text extracted from the filing as submitted to EDGAR. Formatting, tables and exhibits are simplified for reading; the original document is authoritative for anything you rely on.