10-Q 1 cbey-2013630x10q.htm 10-Q CBEY-2013.6.30-10Q
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q 
(Mark One)
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2013
OR
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from              to             
Commission file number 000-51588 
CBEYOND, INC.
(Exact name of registrant as specified in its charter) 
Delaware
 
59-3636526
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
 
 
 
320 Interstate North Parkway, Suite 500
Atlanta, GA
 
30339
(Address of principal executive offices)
 
(Zip Code)
Registrant’s telephone number, including area code: (678) 424-2400
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ý    No  ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ý    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer
¨

 
Accelerated filer
 
ý
 
 
 
 
 
 
 
Non-accelerated filer
¨
(Do not check if a smaller reporting company)
 
Smaller reporting company
 
¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  ý
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
Title of Class
 
Number of Shares Outstanding on July 26, 2013
Common Stock, $0.01 par value
 
30,593,043


INDEX
 
 
 
 
Page
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 



CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS
In this document, Cbeyond, Inc. and its subsidiary are referred to as “we,” “our,” “us,” the “Company” or “Cbeyond.”
This document contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements include, but are not limited to, statements identified by words such as “expectation,” “guidance,” “believe,” “expect,” “anticipate,” “estimate,” “intend,” “plan,” “target,” “project,” and similar expressions. Such statements are based upon the current beliefs and expectations of our management and are subject to significant risks and uncertainties. Actual results may differ from those set forth in the forward-looking statements. Factors that might cause future results to differ include, but are not limited to, the following: a significant reduction in economic activity, which particularly affects our target market of small to mid-sized businesses; the risk that we may be unable to experience revenue growth at anticipated levels; the risk of unexpected increase in customer churn levels; changes in federal or state regulation or decisions by regulatory bodies that affect us; periods of economic downturn or unusual volatility in the capital markets or other negative macroeconomic conditions that could harm our business, including our access to capital markets and the impact on certain of our customers to meet their payment obligations; the timing of the initiation, progress or cancellation of significant contracts or arrangements; the mix and timing of services sold in a particular period; our dependence on third-party vendors who might increase prices or cause service disruptions beyond our control; our ability to recruit and retain experienced management and personnel; rapid technological change and the timing and amount of startup costs incurred in connection with the introduction of new services or the entrance into new markets; our ability to comply with our credit facility covenants; our ability to maintain or attract sufficient customers in existing or new markets; our ability to respond to increasing competition; our ability to manage the growth of our operations; changes in estimates of taxable income or utilization of deferred tax assets which could significantly affect our effective tax rate; regulatory action relating to our compliance with customer proprietary network information; the possibility that economic benefits of future opportunities in an emerging industry may never materialize, including unexpected variations in market growth and demand for products and technologies; unfamiliarity with the economic characteristics of new geographic markets; ongoing personnel and logistical challenges of managing a larger organization; external events outside of our control, including extreme weather, natural disasters, pandemics or terrorist attacks that could adversely affect our target markets; our ability to implement and execute successfully our new strategic focus; our ability to expand fiber availability; the extent to which small and medium sized businesses continue to spend on cloud, network and security services; our ability to recruit, maintain and grow a sales force focused exclusively on our technology-dependent customers; our ability to integrate new products into our existing infrastructure; the effects of realignment activities; the extent to which our customer mix becomes more technology-dependent; our ability to achieve future cost savings related to our capital expenditures and investment in Ethernet technology; and general economic and business conditions. You are advised to consult any further disclosures we make on related subjects in the reports we file with the Securities and Exchange Commission, or SEC, including our Annual Report on Form 10-K for the year ended December 31, 2012 and any updates that may occur in our quarterly reports on Form 10-Q and Current Reports on Form 8-K and this report in the sections titled “Part I, Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Part II, Item 1A. Risk Factors.” Such disclosure covers certain risks, uncertainties and possibly inaccurate assumptions that could cause our actual results to differ materially from expected and historical results. We undertake no obligation to correct or update any forward-looking statements, whether as a result of new information, future events or otherwise.

1

PART I. FINANCIAL INFORMATION
Item 1.    Financial Statements
CBEYOND, INC. AND SUBSIDIARY
Condensed Consolidated Balance Sheets
(Amounts in thousands, except per share amounts)
(Unaudited)
 
As of
 
June 30,
2013
 
December 31,
2012
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
27,515

 
$
30,620

Accounts receivable, net of allowance for doubtful accounts of $2,063 and $2,240
23,050

 
23,328

Prepaid expenses
12,329

 
8,780

Inventory, net
1,341

 
1,468

Other assets
1,903

 
2,175

Total current assets
66,138

 
66,371

Property and equipment, net of accumulated depreciation and amortization of $414,301 and $385,068
157,769

 
157,624

Goodwill
19,814

 
19,814

Intangible assets, net of accumulated amortization of $3,413 and $2,791
6,196

 
6,818

Other non-current assets
3,959

 
4,421

Total assets
$
253,876

 
$
255,048

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
12,485

 
$
15,870

Accrued telecommunications costs
12,713

 
15,653

Deferred customer revenue
11,933

 
11,344

Other accrued liabilities
17,962

 
24,304

Current portion of long-term debt
2,919

 
1,322

Total current liabilities
58,012

 
68,493

Non-current portion of long-term debt
12,759

 
6,947

Other non-current liabilities
7,167

 
7,722

Stockholders’ equity:
 
 
 
Common stock, $0.01 par value; 50,000 shares authorized; 30,751 and 29,924 shares issued and outstanding
308

 
299

Preferred stock, $0.01 par value; 15,000 shares authorized; no shares issued and outstanding
—

 
—

Additional paid-in capital
328,224

 
323,584

Accumulated deficit
(152,594
)
 
(151,997
)
Total stockholders’ equity
175,938

 
171,886

Total liabilities and stockholders’ equity
$
253,876

 
$
255,048

See accompanying notes to Condensed Consolidated Financial Statements.

2

CBEYOND, INC. AND SUBSIDIARY
Condensed Consolidated Statements of Operations
(Amounts in thousands, except per share amounts)
(Unaudited)
 
For the three months ended June 30,
 
For the six months ended June 30,
 
2013
 
2012
 
2013
 
2012
Revenue
$
118,215

 
$
123,762

 
$
238,161

 
$
247,605

Operating expenses:
 
 
 
 
 
 
 
Cost of revenue (exclusive of depreciation and amortization of $10,006, $10,192, $19,331 and $20,578 respectively, shown separately below)
39,491

 
40,164

 
78,279

 
80,648

Selling, general and administrative (exclusive of depreciation and amortization of $8,454, $8,178, $16,734 and $16,668 respectively, shown separately below)
59,840

 
59,585

 
123,611

 
125,393

Depreciation and amortization
18,460

 
18,370

 
36,065

 
37,246

Total operating expenses
117,791

 
118,119

 
237,955

 
243,287

Operating income
424

 
5,643

 
206

 
4,318

Other expense:
 
 
 
 
 
 
 
Interest expense, net
(196
)
 
(144
)
 
(349
)
 
(271
)
Income (loss) before income taxes
228

 
5,499

 
(143
)
 
4,047

Income tax expense
(269
)
 
(2,805
)
 
(454
)
 
(2,547
)
Net (loss) income
$
(41
)
 
$
2,694

 
$
(597
)
 
$
1,500

Net (loss) income per common share:
 
 
 
 
 
 
 
Basic
$
—

 
$
0.09

 
$
(0.02
)
 
$
0.05

Diluted
$
—

 
$
0.09

 
$
(0.02
)
 
$
0.05

Weighted average common shares outstanding:
 
 
 
 
 
 
 
Basic
30,427

 
29,275

 
30,302

 
29,244

Diluted
30,427

 
29,900

 
30,302

 
29,860

See accompanying notes to Condensed Consolidated Financial Statements.


3

CBEYOND, INC. AND SUBSIDIARY
Condensed Consolidated Statement of Stockholders’ Equity
(Amounts in thousands)
(Unaudited)
 
Common Stock
 
Additional
 
 
 
Total
 
Shares
 
Par
Value
 
Paid-in
Capital
 
Accumulated
Deficit
 
Stockholders’
Equity
Balance at December 31, 2012
29,924

 
$
299

 
$
323,584

 
$
(151,997
)
 
$
171,886

Exercise of stock options
29

 
—

 
132

 
—

 
132

Issuance of employee benefit plan stock
288

 
3

 
110

 
—

 
113

Issuance of employee bonus plan stock
283

 
3

 
2,044

 
—

 
2,047

Share-based compensation from options to employees
—

 
—

 
453

 
—

 
453

Share-based compensation from restricted shares to employees
—

 
—

 
3,494

 
—

 
3,494

Share-based compensation for non-employees
—

 
—

 
15

 
—

 
15

Vesting of restricted shares
432

 
4

 
(4
)
 
—

 
—

Common stock withheld as payment for withholding taxes upon the vesting of restricted shares
(205
)
 
(1
)
 
(1,604
)
 
—

 
(1,605
)
Net loss
—

 
—

 
—

 
(597
)
 
(597
)
Balance at June 30, 2013
30,751

 
$
308

 
$
328,224

 
$
(152,594
)
 
$
175,938

See accompanying notes to Condensed Consolidated Financial Statements.


4

CBEYOND, INC. AND SUBSIDIARY
Condensed Consolidated Statements of Cash Flows
(Amounts in thousands)
(Unaudited)
 
For the six months ended June 30,
 
2013
 
2012
Operating Activities:
 
 
 
Net (loss) income
$
(597
)
 
$
1,500

Adjustments to reconcile net loss to net cash provided by operating activities:
 
 
 
Depreciation and amortization
36,065

 
37,246

Deferred taxes
232

 
1,762

Provision for doubtful accounts
2,073

 
3,227

Non-cash share-based compensation
6,024

 
6,722

Change in acquisition-related contingent consideration
—

 
23

Changes in operating assets and liabilities:
 
 
 
Accounts receivable
(1,795
)
 
(2,140
)
Inventory
127

 
1,173

Prepaid expenses and other current assets
(3,277
)
 
(2,929
)
Other assets
592

 
(330
)
Accounts payable
(3,385
)
 
(2,691
)
Other liabilities
(9,475
)
 
(4,739
)
Net cash provided by operating activities
26,584

 
38,824

Investing Activities:
 
 
 
Purchases of property and equipment
(27,214
)
 
(29,601
)
Additional acquisition consideration
—

 
(4,950
)
Decrease in restricted cash
—

 
1,295

Net cash used in investing activities
(27,214
)
 
(33,256
)
Financing Activities:
 
 
 
Taxes paid on vested restricted shares
(1,605
)
 
(1,272
)
Principal payments of capital lease obligations
(872
)
 
—

Proceeds from short-term borrowings
—

 
4,250

Repayment of short-term borrowings
—

 
(4,250
)
Financing issuance costs
(130
)
 
(149
)
Proceeds from exercise of stock options
132

 
16

Repurchase of common stock
—

 
(2,005
)
Net cash used in financing activities
(2,475
)
 
(3,410
)
Net (decrease) increase in cash and cash equivalents
(3,105
)
 
2,158

Cash and cash equivalents at beginning of period
30,620

 
8,521

Cash and cash equivalents at end of period
$
27,515

 
$
10,679

Supplemental disclosure:
 
 
 
Interest paid
$
281

 
$
191

Income taxes paid, net of refunds
$
681

 
$
662

Non-cash purchases of property and equipment
$
8,302

 
$
3,357

See accompanying notes to Condensed Consolidated Financial Statements.

5

CBEYOND, INC. AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in thousands, except per share amounts)
(Unaudited)
Note 1. Description of Business, Basis of Presentation and Summary of Significant Accounting Policies
Cbeyond, Inc., a managed information technology (or “IT”) and communications service provider, incorporated on March 28, 2000 in Delaware.
Our services include cloud applications such as Microsoft® Exchange, data center infrastructure-as-a-service, cloud private branch exchange (or “PBX”) phone systems, Microsoft® SQL Server®, Metro Ethernet, broadband Internet access, Multi-Protocol Label Switching (or "MPLS"), Virtual Private Networking (or "VPN"), mobile voice and data, information security, local and long distance voice services, administration management, and professional services to migrate and manage customer environments. We market our service offerings under four product families: TotalNetwork, TotalVoice, TotalCloud, and TotalAssist. We combine these service offerings into a wide range of bundles to satisfy the individual needs of our customers.
We operate as one reportable segment based upon the financial information that our Chief Executive Officer, who is the chief operating decision maker, regularly reviews to decide how to allocate resources and assess performance.
Unaudited Interim Results
The accompanying unaudited interim Condensed Consolidated Financial Statements and information have been prepared in accordance with generally accepted accounting principles in the United States (or “GAAP”) and in accordance with the instructions for Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and disclosures required by GAAP for complete financial statements. In the opinion of management, these financial statements contain all normal and recurring adjustments considered necessary to present fairly the financial position, results of operations and cash flows for the periods presented. The results for the three and six months ended June 30, 2013 are not necessarily indicative of the results to be expected for the full year. These statements should be read in conjunction with our audited Consolidated Financial Statements and the notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2012.
Reclassifications
Reclassifications have been made to the three and six months ended June 30, 2012 Condensed Consolidated Statement of Operations to condense Customer revenue and Terminating access revenue and conform to our current presentation of Revenue for the three and six months ended June 30, 2013.
Recently Adopted Accounting Standards
In February 2013, the FASB issued amended guidance on providing information about the amounts reclassified out of accumulated other comprehensive income. The new guidance requires an entity to present, either on the face of the financial statements or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income, but only if the amount reclassified is required to be reclassified in its entirety in the same reporting period. For amounts that are not required to be reclassified in their entirety to net income, an entity is required to cross-reference to other disclosures that provide additional details about those amounts. This guidance is effective for reporting periods beginning after December 15, 2012, and is applied prospectively. As we do not currently have components of other comprehensive income, the adoption of this guidance did not have any effect on our Condensed Consolidated Financial Statements.
Note 2. Earnings per Share
Basic and Diluted Net (Loss) Income
We calculate basic net (loss) income per share by dividing net (loss) income by the weighted average number of shares of common stock outstanding for the period. Our diluted net (loss) income per share is calculated in a similar manner, but includes the effect of dilutive common equivalent shares outstanding during the year. To the extent any common equivalent shares from stock options and other common stock equivalents are anti-dilutive, they are excluded from the computation of dilutive net (loss) income per share. We were in a net loss position for the three and six months ended June 30, 2013, resulting in no difference between basic net loss per share and diluted net loss per share.

6

The following table summarizes our basic and diluted net (loss) income per share calculations:
 
Three months ended June 30,
 
Six months ended June 30,
 
2013
 
2012
 
2013
 
2012
Net (loss) income
$
(41
)
 
$
2,694

 
$
(597
)
 
$
1,500

Basic weighted average common shares outstanding
30,427

 
29,275

 
30,302

 
29,244

Effect of dilutive securities
—

 
625

 
—

 
616

Diluted weighted average common shares outstanding
30,427

 
29,900

 
30,302

 
29,860

Basic (loss) income per common share
$
—

 
$
0.09

 
$
(0.02
)
 
$
0.05

Diluted (loss) income per common share
$
—

 
$
0.09

 
$
(0.02
)
 
$
0.05

Securities that were not included in the diluted net (loss) income per share calculations because they were anti-dilutive, inclusive of unexercised stock options and unvested restricted stock (described in Note 5 to the Condensed Consolidated Financial Statements), are as follows:
 
Three months ended June 30,
 
Six months ended June 30,
 
2013
 
2012
 
2013
 
2012
Anti-dilutive shares
4,476

 
3,842

 
4,488

 
3,791

Note 3. Debt
The following table summarizes significant components of debt:
 
June 30,
2013
 
December 31,
2012
Fiber Loan
$
2,000

 
$
2,000

Fiber capital lease obligation
10,938

 
4,678

Equipment capital lease obligation
2,740

 
1,591

Total debt
15,678

 
8,269

Current portion of long-term debt
2,919

 
1,322

Non-current portion of long-term debt
$
12,759

 
$
6,947

Credit Facility
We are party to a credit agreement with Bank of America, (or "Credit Facility"), which provides for a $75,000 secured revolving line of credit and a $10,000 senior secured delayed draw term loan (or “Fiber Loan”). Our Credit Facility is available to finance working capital, capital expenditures, and other general corporate purposes.
On March 31, 2012, we entered into the sixth amendment of the Credit Facility to increase the allowable capital lease amounts under the agreement to $30,000. On May 2, 2012, we amended and restated our Credit Facility to provide a senior secured delayed draw term loan (or “Fiber Loan”) of $10,000. On March 4, 2013, we entered into the first amendment to the amended and restated Credit Facility to increase the allowable capital lease and permitted acquisitions amounts to $60,000. We also amended the financial covenants of the Credit Facility, replacing the covenants requiring us to maintain minimum levels of Adjusted EBITDA and maximum levels of annual capital expenditures with a covenant requiring us to maintain a minimum fixed charge coverage ratio. Additionally, we extended the maturity date of the Credit Facility (including the Fiber Loan) to May 2, 2018 and extended the draw period of the Fiber Loan to December 31, 2014. Fiber Loan principal payments are due in quarterly installments as early as June 2014 through the maturity date of May 2, 2018.
Under the terms of the amended and restated Credit Facility, we are subject to certain financial covenants and restrictive covenants, which limit, among other items, our ability to incur additional indebtedness, make investments, pay cash dividends, sell or acquire assets, and grant security interests in our assets. The credit agreement also contains certain customary negative covenants, representations and warranties, affirmative covenants, notice provisions, indemnification and events of default, including change of control, cross-defaults to other debt, and judgment defaults. Through the maturity date of the Credit Facility, we are required to maintain a consolidated leverage ratio less than or equal to 1.5 to 1.0. We are also required to maintain a consolidated fixed charge coverage ratio greater than or equal to 1.2 to 1.0. As of June 30, 2013, we are in compliance with all applicable covenants.
As of June 30, 2013, we had no outstanding borrowings under our revolving line of credit, utilized $1,345 for letters of credit and had $73,655 in remaining availability. Under our Fiber Loan, we had $2,000 outstanding at an annual interest rate of 1.9% and had remaining availability of $8,000 as of June 30, 2013.

7

Borrowings under the Credit Facility approximate fair value due to their variable interest rates and are based on Level 2 inputs. We value long-term debt using market and/or broker ask prices when available. When not available, we use a standard credit-adjusted discounted cash flow model.
As of June 30, 2013, our Fiber Loan will be payable as follows:
Year ending December 31,
Fiber Loan payments
2013
$
—

2014
—

2015
571

2016
571

2017
571

Thereafter
287

Total
$
2,000

Equipment Capital Leases
During the fourth quarter of 2012, we took delivery of servers and computer equipment with minimum capital lease obligations of $1,591. During 2013, we have taken delivery of additional equipment with minimum capital lease obligations of $1,380. Effective interest rates for equipment capital leases range from 2.0% to 5.1%. Fixed monthly payments for equipment under capital leases will be made through 2017.
Fiber Capital Leases
The amendments to our Credit Facility were made in connection with our strategic initiative to focus on technology-dependent customers while delivering higher network bandwidth at a lower overall cost. Starting in March 2012, we began executing agreements with optical fiber providers whereby we will acquire fiber network assets in multiple markets primarily under capital leases, including agreements for the indefeasible rights of use of certain fiber assets. Our contracts include commitments expected to be satisfied through monthly payments over a 5 to 20-year period, and commitments expected to be satisfied through lump sum payments as delivery milestones are met. All lump sum payments will be directly funded by our Fiber Loan, which will be repaid by us through the maturity date of May 2, 2018.
In March 2012, we took delivery of certain fiber network assets and incurred future minimum capital lease obligations of $2,400. This obligation was partially satisfied in May 2012 through a $2,000 lump sum payment directly funded by our Fiber Loan. We intend to satisfy the remaining obligation using our Fiber Loan. During the remainder of 2012, we took delivery of additional fiber assets with future minimum capital lease obligations of $4,342. During 2013, we have taken delivery of fiber assets with future minimum capital lease obligations of $6,901.
As of June 30, 2013, capital lease obligations to equipment and fiber network providers will be payable as follows:
Year ending December 31,
Equipment lease obligations
 
Fiber lease obligations
 
Total
2013
$
667

 
$
1,063

 
$
1,730

2014
1,080

 
2,525

 
3,605

2015
650

 
2,125

 
2,775

2016
531

 
2,125

 
2,656

2017
45

 
2,044

 
2,089

Thereafter
—

 
2,601

 
2,601

Total minimum lease payments
2,973

 
12,483

 
15,456

Amount representing interest
(233
)
 
(1,545
)
 
(1,778
)
Current portion of capital lease obligation
(819
)
 
(2,100
)
 
(2,919
)
Non-current portion of capital lease obligation
$
1,921

 
$
8,838

 
$
10,759


8

We have outstanding construction orders for fiber assets with future minimum lease payments of $5,966, for which we have obtained building access agreements (or "BAAs"). We enter into BAAs with building owners in order to locate equipment on-site that will be used to serve tenants and also access building risers for interior wiring. These commitments are not recognized on our balance sheet as of June 30, 2013 because they are contingent upon third parties completing construction and our testing and acceptance of the fiber assets.
As of June 30, 2013, our commitments to fiber network providers, based on estimated acceptance dates of these fiber assets, will be payable as follows:
Year ending December 31,
Fiber lease commitments
2013
$
602

2014
1,194

2015
652

2016
652

2017
652

Thereafter
2,214

Total minimum lease payments
$
5,966

We have placed additional construction orders that total $11,842 for which we have not yet obtained building access agreements. We do not expect to be able to obtain building access agreements for every order placed. Therefore, we expect a portion of these orders will never be constructed. Additional construction orders may be placed in the future.
Also included in our fiber capital lease agreements are contractual maintenance fees that are due over the lease period and begin upon delivery of the related fiber assets. Our commitment for future fiber maintenance totals $16,698 as of June 30, 2013.
Note 4. Strategic Realignment
In early 2012, we began a strategic shift to directly focus more of our selling and service delivery efforts toward the customers within our target market of technology-dependent small and mid-sized businesses that have complex IT needs. We announced this strategy during the first quarter of 2012 and accelerated efforts to realign our distribution channels by building a new direct sales group dedicated to managing both existing and new technology-dependent customers, reducing our traditional direct sales force, and consolidating certain offices.
We have incurred cumulative realignment costs of $3,385 through June 30, 2013, primarily for employee severance and facility exit costs. We recognized $682 related to non-cash costs in the first quarter of 2012 that are included in Depreciation and amortization. All other realignment costs are included in Selling, general, and administrative expense.
We did not incur any realignment costs during the second quarter of 2013, but have incurred $467 year-to-date. During the three and six months ended June 30, 2012, we incurred realignment costs of $284 and $2,606, respectively. We expect to complete our realignment by the end of 2013 and incur additional expenses up to $1,000, which may include severance and facility exit costs.
The following table summarizes changes to the accrued liability associated with the strategic realignment:
 
Employee
costs (1)
 
Facility exit
costs (2)
 
Other
costs
 
Total
Accrued liability, December 31, 2011
$
—

 
$
—

 
$
—

 
$
—

Expense
1,431

 
696

 
109

 
2,236

Payments
(1,034
)
 
(422
)
 
(109
)
 
(1,565
)
Accrued liability, December 31, 2012
397

 
274

 
—

 
671

Expense
447

 
—

 
20

 
467

Accrual Adjustment
(84
)
 
—

 
—

 
(84
)
Payments
(568
)
 
(250
)
 
(20
)
 
(838
)
Accrued liability, June 30, 2013
$
192

 
$
24

 
$
—

 
$
216

(1) The remaining employee-related liability will be paid within 12 months and approximates fair value due to the short discount period.
(2) Includes costs for consolidating certain leased offices. These charges were measured using fair value measurements with unobservable inputs (Level 3) and represent the present value of expected lease payments and direct costs to obtain a sublease, reduced by estimated sublease rental income. The timing and amount of estimated cash flows will continue to be evaluated each reporting period.

9

Note 5. Share-Based Compensation Plans
We maintain share-based compensation plans, governed under our 2005 Equity Incentive Award Plan, that permit the grant of nonqualified stock options, incentive stock options, restricted stock, and stock purchase rights (collectively referred to as "share-based awards"). Beginning in 2013, service-based awards will generally vest over three years. Vesting of performance-based awards ranges from two to four years with the number of shares determined based upon the achievement of performance metrics. Upon an exercise of options or a release of restricted stock, new shares are issued out of our approved stock plans. As of June 30, 2013, we had 841 share-based awards available for future grant. Compensation expense for share-based awards, including those related to our 401(k) Defined Contribution Plan (or "401(k) Plan") and our corporate bonus plans, totaled $3,045 and $6,024 during the three and six months ended June 30, 2013, respectively, and totaled $2,939 and $6,722 during the three and six months ended June 30, 2012, respectively.
Beginning in 2013, 25% of the share-based awards granted to our Chief Executive Officer and certain other executive officers vest based on share price performance compared to the Russell 2000 Index over a three-year period beginning January 1, 2013 and 25% of the share-based awards vest based upon attaining certain financial performance metrics over a two-year period beginning on January 1, 2013. Each executive is granted a target number of shares and will ultimately earn between 0% and 150% of the target amount of shares based on performance. The fair value of awards with a market condition is determined using a Monte Carlo simulation. Assumptions used in the Monte Carlo valuation model include a risk-free rate of return of 0.3%, an expected term of 2.8 years, and volatility of 48.6%. We considered historic and observable market data when determining these assumptions.
The following table summarizes changes in outstanding share-based awards:
 
 
 
Restricted stock awards
 
Stock options
 
Service-based
 
Performance-based
Outstanding, December 31, 2012
3,298

 
1,172

 
420

Granted
10

 
760

 
189

Stock options exercised (1)
(29
)
 


 


Restricted stock vested (2)


 
(711
)
 
(4
)
Forfeited or canceled
(263
)
 
(78
)
 
(21
)
Outstanding, June 30, 2013
3,016

 
1,143

 
584

Options exercisable, June 30, 2013
2,598

 
 
 
 
(1) The total intrinsic value of options exercised during the six months ended June 30, 2013 was $119.
(2) The fair value of restricted shares that vested during the six months ended June 30, 2013 was $5,763.
As of June 30, 2013, we had $1,405 and $11,382 of unrecognized compensation expense related to unvested options and restricted stock, which are expected to be recognized over a weighted average period of 2.1 and 2.0 years, respectively.
During the first quarter of 2013, management approved a mandatory share-based compensation plan for employee participants that provides for the settlement of 20% of performance-based compensation under our 2013 corporate bonus plan with shares of common stock. The shares earned by the participants in this plan vest at various points in 2014. During the three and six months ended June 30, 2013, we recognized $342 and $831 of share-based compensation expense under our 2013 corporate bonus plan, respectively. Based on the June 30, 2013 share price, 106 shares would be required to satisfy the $831 obligation as of June 30, 2013.
We have a commitment to contribute shares to the 401(k) Plan at the end of each plan year which equates to a matching contribution value as a percentage of eligible employee compensation. We match up to 3.5% of eligible compensation contributed by employees. We fund our matching contribution in Company stock and the number of shares we contribute is based on the share price on the last day of the plan year. Throughout the year, the ultimate number of shares that settles relating to our matching contribution remains variable until the December 31 settlement date. The 401(k) Plan does not limit the number of shares that can be issued to settle the matching contribution and the Board of Directors may elect to fund the matching contribution in cash. During the three and six months ended June 30, 2013, we recognized $673 and $1,318 of share-based compensation expense related to the 401(k) Plan compared to $660 and $1,280 for the three and six months ended June 30, 2012, respectively. Based on the June 30, 2013 share price, 172 shares would be required to satisfy the $1,346 obligation as of June 30, 2013, assuming all participants were fully vested as of June 30, 2013.

10

Note 6. Income Taxes
The following table summarizes significant components of our income tax expense:
 
Six months ended June 30,
 
2013
 
2012
Federal income tax (benefit) expense at statutory rate
$
(50
)
 
$
1,417

State income tax expense, net of federal effect
162

 
356

Nondeductible expenses
159

 
142

Write-off deferred tax assets for non-deductible share-based compensation
1,297

 
1,417

Goodwill amortization
231

 
—

Change in valuation allowance
(1,276
)
 
(769
)
Other
(69
)
 
(16
)
Total
$
454

 
$
2,547

When a reliable estimate of the annual effective tax rate can be made, we recognize interim period income tax expense by determining an estimated annual effective tax rate and then apply this rate to the pre-tax loss for the year-to-date period. Our estimated annual tax rate fluctuates significantly from only slight variances in estimated full year income or loss due to our proximity to break-even results. Accordingly, we recognized interim period tax expense through June 30, 2013 based on our year-to-date effective tax rate. This methodology provides a more accurate portrayal of our year-to-date income tax expense, as well as reduces the impact that future income variances will have on the accuracy of this amount. Our income tax expense includes state income tax expense that results from Texas gross receipts-based tax, which is due regardless of profit levels. This tax is not dependent upon levels of pre-tax income or loss and has a significant influence on our effective tax rate.
Our net deferred tax assets, before valuation allowance, totaled $35,933 at June 30, 2013, and primarily relate to net operating loss carryforwards. We maintain a full valuation allowance, which reduces our deferred income tax assets to the amount that is more likely than not to be realized. In addition to our fully reserved net deferred tax assets, we maintain a deferred tax liability of $1,023 related to goodwill amortization that is deductible for tax purposes but will likely remain non-deductible for book purposes.
Note 7. Other Liabilities
The following table summarizes significant components of other liabilities:
 
June 30,
2013
 
December 31,
2012
Accrued bonus
$
5,171

 
$
11,953

Accrued other compensation and benefits
3,944

 
3,260

Accrued other taxes
4,337

 
4,173

Accrued promotions
395

 
534

Deferred rent
2,061

 
2,261

Other accrued expenses
2,054

 
2,123

Other accrued liabilities
$
17,962

 
$
24,304

 
 
 
 
Non-current portion of deferred rent
$
4,770

 
$
5,656

Non-current other accrued expenses
1,374

 
1,275

Non-current deferred tax liability
1,023

 
791

Other non-current liabilities
$
7,167

 
$
7,722

Note 8. Share Repurchase Program
On May 2, 2011, Cbeyond’s Board of Directors authorized up to $15,000 in repurchases of Cbeyond common shares from time to time in open market purchases, privately negotiated transactions or otherwise. During the first quarter of 2012, we completed the program by repurchasing $2,005 in outstanding shares, representing 250 shares at an average price of $8.01 per share. Since the beginning of the program in May 2011, we repurchased 1,514 shares at an average price of $9.93. Repurchased shares are retired and are no longer issued and outstanding, but remain authorized shares.

11

Note 9. Contingencies
Triennial Review Remand Order
The Federal Communications Commission issued its Triennial Review Remand Order (or “TRRO”) and adopted rules, effective in March 2005, governing the obligations of incumbent local exchange carriers (or “ILECs”), to afford access to certain of their network elements, if at all, and the cost of such facilities. Certain ILECs continue to invoice us at incorrect rates, resulting in an accrual for the estimated difference between the invoiced amounts and the appropriate TRRO pricing. These amounts are generally subject to either a 2-year statutory back billing period limitation or a 12-month contractual back billing limitation and are reversed as telecommunication billing recoveries once they pass the applicable back billing period, or once a settlement agreement is reached that may relieve a previously recognized liability. As of June 30, 2013 and December 31, 2012, respectively, our accrual for TRRO totals $1,074 and $1,207.
Regulatory and Customer-based Taxation Contingencies
We operate in a highly regulated industry and are subject to regulation and oversight by telecommunications authorities at the federal, state, and local levels. Decisions made by these agencies, including the various rulings made to date regarding interpretation and implementation of the TRRO, compliance with various federal and state rules and regulations and other administrative decisions are frequently challenged through both the regulatory process and through the court system. Challenges of this nature often are not resolved for long periods of time and occasionally include retroactive impacts. At any point in time, there are a number of similar matters before the various regulatory agencies that could be either beneficial or adverse to our operations. In addition, we are always at risk of non-compliance, which can result in fines and assessments. We regularly evaluate the potential impact of matters undergoing challenges and matters involving compliance with regulations to determine whether sufficient information exists to require either disclosure and/or accrual. However, due to the nature of the regulatory environment, reasonably estimating the range of possible outcomes and the probabilities of the possible outcomes is difficult since many matters could range from a gain contingency to a loss contingency.
We are required to bill taxes, fees and other amounts (collectively referred to as “taxes”) on behalf of government entities at the county, city, state and federal level (“taxing authorities”). Each taxing authority may have one or more taxes with unique rules as to which services are subject to each tax and how those services should be taxed, the application of which involves judgment and interpretation, and heightens the risk of non-compliance. At times, the statutes and related regulations are ambiguous or appear to conflict, which further complicates our efforts to remain in compliance. Because we sell many of our services on a bundled basis and assess different taxes on the individual components included within a bundle, there is also a risk that a taxing authority could disagree with the taxable value of a bundled component.
Taxing authorities periodically perform audits to verify compliance and include all periods that remain open under applicable statutes, which range from three to four years. At any point in time, we are undergoing audits that could result in significant assessments of past taxes, fines and interest if we were found to be non-compliant. During the course of an audit, a taxing authority may, as a matter of policy, question our interpretation or application of their rules in a manner that, if we were not successful in substantiating our position, could potentially result in a significant financial impact to us. In the course of preparing our financial statements and disclosures, we consider whether information exists which would warrant specific disclosure and/or accrual in such situations.
To date, we have been successful in satisfactorily demonstrating our compliance and have concluded audits with either no assessment or assessments that were not material to us. However, we cannot be assured that in every such audit in the future the merits of our position or the reasonableness of our interpretation and application of rules will prevail.
Legal Proceedings
From time to time, we are involved in legal proceedings arising in the ordinary course of business. We believe that we have adequately reserved for these liabilities and that as of June 30, 2013 there is no litigation pending that could have a material adverse effect on our results of operations and financial condition.

12

Note 10. Subsequent Event
Share Repurchase Program
On July 24, 2013, Cbeyond's Board of Directors authorized the repurchase of up to $20,000 of Cbeyond common shares over a 2-year period. The repurchases, if any, will be made on an opportunistic basis depending on prevailing market conditions, liquidity requirements, contractual restrictions and other discretionary factors. Repurchases will be made from time to time in open market purchases, privately negotiated transactions or otherwise. No share repurchases have been transacted under this program as of the date of this filing.
Commitments
On July 31, 2013, we entered into a master lease agreement to lease lit fiber circuits for a 10-year period with minimum lease payments of $135 in 2014 and $450 annually from 2015 through 2024.

13

Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations
Please read the following discussion together with our Condensed Consolidated Financial Statements and the related notes and other financial information included elsewhere in this periodic report and our Annual Report on Form 10-K. The discussion in this periodic 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. See “Cautionary Notice Regarding Forward-Looking Statements” elsewhere in this report. In this report, Cbeyond, Inc. and its subsidiary are referred to as “we,” “our,” “us,” the “Company” or “Cbeyond.”
Overview
We first launched our service offering in Atlanta in April 2001 and have since expanded service into 13 additional metropolitan markets. From inception, our strategy has been to package big-business technologies and services for small and mid-sized companies in convenient and affordable bundles that they generally could not obtain from any other single supplier. This strategy is based on the belief that small and mid-sized businesses highly value the capabilities and productivity such technologies and services enable, but do not generally have the resources, expertise, or time to purchase and manage them, particularly for the smaller scale of operations typical of our target customers.
Our initial service offering conveniently bundled local and long-distance voice services with T1 Internet access with a higher level of quality and at a lower price than our customers could obtain by purchasing these services separately. Over time, we began adding new technologies and services to our bundles as they became available, including mobile voice and data, email, voicemail, Web hosting, secure backup and file sharing, fax-to-email, VPN, desktop security, Microsoft® Exchange, mobile workforce management, virtual receptionist, MPLS, Metro Ethernet broadband Internet access, and other IT and communications services.
Understanding the capital and operating efficiencies, as well as enhanced data security, that off-premise computing could bring to our customers, we acquired substantially all of the net assets of MaximumASP, LLC, MaximumCOLO, LLC, and Maximum Holdings, LLC (collectively known as "MaximumASP") and the outstanding voting stock of privately-held Aretta Communications, Inc. (or "Aretta") in late 2010 to expand our IT services into cloud computing with virtual and physical cloud servers and cloud PBX. During 2012, we completed the full integration of the operations of MaximumASP and Aretta into our existing operations under common functional leadership. Subsequent to these acquisitions, we began offering professional services to assist customers with their transition to cloud-based services and have expanded these services to additional one-time services, such as MPLS network design, and recurring services, such as remote monitoring. Our four product families include TotalNetwork, TotalVoice, TotalCloud, and TotalAssist, which reflect our service offerings that have evolved over time.
Recognizing that our greatest value proposition for customers is when we are able to bring them those technologies and services that are more resource intensive or difficult to obtain and manage, we focus more of our selling and service delivery efforts toward small and mid-sized businesses that are dependent on technology and have complex IT needs. Our research enables us to define and quantify a segment of the small-business customer market called the “technology-dependent” customer. Technology-dependent customers have the following characteristics:
•
The bulk of their employees use personal computers on the job;
•
They have knowledge workers who need to share data from a centralized source;
•
They have remote workers who need to access data on the go;
•
They need symmetric Metro Ethernet to run their business;
•
They are often multi-location businesses; and
•
They have a willingness to consider outsourcing their infrastructure as a way to preserve capital and increase both focus and productivity.
We announced this strategy in early 2012 and accelerated efforts to realign our distribution channels by building a new direct sales group dedicated to managing both existing and new technology-dependent customers, reducing our traditional direct sales force, and consolidating certain offices. We have incurred cumulative realignment costs of $3.4 million through June 30, 2013.

14

In connection with our focus on technology-dependent customers, we defined certain of our technology-dependent customers as “Cbeyond 2.0” customers. Cbeyond 2.0 customers are those customers that we provide network access at speeds in excess of 10 Mbps or certain cloud-based services, such as virtual servers, physical servers, or cloud PBX services. In addition, we designate customers using our MPLS service as Cbeyond 2.0 customers. We refer to all other customers as Cbeyond 1.0 customers. Although Cbeyond 1.0 customers also frequently purchase cloud-based services from us, we delineate between Cbeyond 1.0 and Cbeyond 2.0 based on how pervasive or significant we believe such services are to a customer’s operation. Specifically, we consider the cloud-based services that qualify a customer as Cbeyond 2.0 as infrastructure-as-a-service in nature. We believe the distinction is important because infrastructure services are generally longer-term in nature, generate higher revenues and provide a gateway for software-as-a-service products.
Our cloud-based services that do not qualify a customer as being designated Cbeyond 2.0 include products such as virtual receptionist, Microsoft® Exchange hosting, Web hosting, and fax-to-email, among others. Depending on the product, we host these types of services for between 5% and 80% of our customers and have been hosting such services for most of our existence, which gives us significant experience in operating in a cloud computing environment. These cloud-based services are typically included within our bundled services, but customers purchase additional quantities to meet their specific needs. Revenue for additional cloud-based services outside of a bundled package was $1.6 million and $3.3 million during the three and six months ended June 30, 2013 as compared to $1.8 million and $3.5 million for the comparable periods in 2012, respectively.
We estimate that almost one-half of our customers are technology-dependent, but are not currently considered Cbeyond 2.0 customers because either they do not currently utilize cloud-based solutions or advanced network services, or they obtain these services from other providers. We believe this makes them strong prospects to become Cbeyond 2.0 customers. During the six months ended June 30, 2013, we generated $29.7 million of revenue from Cbeyond 2.0 customers, which represents a 100.5% increase over the amount recognized during the six months ended June 30, 2012.
Our revenue growth strategy includes offering service bundles that are increasingly oriented toward higher-value, technologically sophisticated solutions; however, a significant portion of our revenue base is derived from providing traditional telecommunications services. For the one-half of our existing customer base that we do not consider technology-dependent, traditional telecommunications services will continue to be our primary source of revenue. Our shift in strategy to focus on revenue growth from technology-dependent customers also includes an adjustment to our pricing philosophy for traditional telecommunications services to adapt to the competitive pricing environment for such services. More specifically, beginning in late 2011, we began adopting our competitors' practice of charging fees to recover a portion of the regulatory costs incurred to provide traditional telecommunications services. Since that time, we have gradually increased those fees to levels comparable to what we have seen in the market.
We currently include all revenue from customers who purchase network access from us (or "network access customers") within our average monthly revenue per customer location (or “ARPU”) calculation. Thus, revenue from customers who purchase cloud-based services independent of network access is excluded from ARPU. After considering all cloud-based services, we believe that Cbeyond 2.0 customers currently provide over 80% higher ARPU than that of our Cbeyond 1.0 customers and we expect that percentage to continue to grow over time. We have not determined the revenue metrics that best represent the results of the consolidated business or the results from customers that purchase cloud-based services independent of network access.
We focus our sales efforts on customers that purchase both network and cloud-based services since we believe that these services, when combined, offer the greatest value proposition to customers and allow us significantly more control over the quality of services. Therefore, we do not expect revenue from customers that only purchase cloud-based services to grow as quickly as revenue from customers who purchase both network access and cloud services from us.
 
Three months ended June 30,
 
Six months ended June 30,
 
2013
 
2012
 
2013
 
2012
Calculation of ARPU (Dollar amounts in thousands, except ARPU)
 
 
 
 
 
 
 
Total revenue
$
118,215

 
$
123,762

 
$
238,161

 
$
247,605

Cloud only revenue
(3,558
)
 
(3,367
)
 
(7,208
)
 
(6,612
)
(A) Network access customer revenue (1)
$
114,657

 
$
120,395

 
$
230,953

 
$
240,993

(B) Average network access customers
57,724

 
62,240

 
58,353

 
62,092

ARPU (A / B / number of months in period)
$
662

 
$
645

 
$
660

 
$
647

(1)
During the third quarter of 2012 we began including revenue from certain cloud-based services provided to network access customers within the ARPU calculation that were not previously included. We have recast all historical disclosures of ARPU for all periods presented in this Form 10-Q to conform to the current presentation.

15

As we accelerate sales of cloud-based services to both new and existing technology-dependent customers, we expect our revenue to include an increasing proportion of higher ARPU Cbeyond 2.0 customers. Our concentrated focus on technology-dependent customers was expected to result in little to no net growth in customers in 2012 and we expect this to continue in the near term; however, we expect that in the longer-term our ARPU will increase as our customer mix becomes more oriented to those who are technology-dependent and are using our services to satisfy their technology needs. In addition, we expect that our future capital expenditures and operating expenses will continue to be more focused on selling to these types of customers. Operating expenses will include the cost of revenue to support a higher bandwidth Metro Ethernet network and the selling expenses of a more focused and consultative sales force. Capital expenditures will include the costs of building out a higher bandwidth network, additional hosting infrastructure, and product development.
Starting in 2012, we began executing agreements with optical fiber providers to acquire fiber network assets in multiple markets primarily under 20-year capital leases, including agreements for the indefeasible rights of use of certain fiber network assets. In March 2012, we took delivery of fiber assets and incurred future minimum capital lease obligations of $2.4 million. This obligation was partially satisfied in May 2012 through a $2.0 million lump sum payment directly funded by our Fiber Loan. During the remainder of 2012, we took delivery of additional fiber assets with future minimum capital lease obligations of $4.3 million. During 2013, we have taken delivery of fiber assets with future minimum capital lease obligations of $6.9 million. The cash outlays for all obligations arising from our fiber assets will be either directly funded by our Fiber Loan or financed through fiber providers and will be payable by us either as debt or capital lease obligations.
We have outstanding construction orders for fiber assets with expected future minimum lease payments of $6.0 million, for which we have obtained building access agreements. These commitments are not recognized on the balance sheet as of June 30, 2013 because they are contingent upon third parties completing construction and our testing and acceptance of the fiber assets. As of June 30, 2013, we have placed additional construction orders that total $11.8 million for which we have not yet obtained building access agreements. We do not expect to be able to obtain building access agreements for every order placed. Therefore, we expect a portion of these orders will never be constructed. Additional construction orders may be placed under these contracts in the future.
Our chief operating decision maker uses Adjusted EBITDA and Free Cash Flow on a consolidated basis, accompanied by disaggregated revenue information by product line, to assess the financial performance of the business. We believe Adjusted EBITDA and Free Cash Flow are important performance metrics for evaluating our ability to generate cash that can potentially be used by the business for capital investments, acquisitions, reduction of debt, or potential payment of dividends or share repurchases. We have also designed our corporate bonus plan to include Adjusted EBITDA as a component.
Management believes that Adjusted EBITDA data should be available to investors so that investors have the same data that management employs in assessing operations. EBITDA is a non-GAAP financial measure commonly used by investors, financial analysts and ratings agencies. EBITDA is generally defined as net income (loss) before interest, income taxes, depreciation and amortization. However, we use Adjusted EBITDA, also a non-GAAP financial measure, to further exclude, when applicable, non-cash share-based compensation, public offering or acquisition-related transaction costs, purchase accounting adjustments, gains or losses on asset dispositions, and non-operating income or expense. Adjusted EBITDA may exclude charges for employee severances, asset or facility impairments, and other exit activity costs associated with a management directed plan (including realignment costs).
We define Free Cash Flow as Adjusted EBITDA less cash capital expenditures. For purposes of calculating Free Cash Flow, we distinguish capital expenditures that require the up-front outlay of cash from those where payment is deferred on a longer-term basis. This distinction is driven primarily by the significant investments we are making to lease fiber network assets that generally have an expected useful life of 20 years, which is substantially longer than our typical asset lives. We believe this distinction is warranted and appropriate since these investments are expected to yield meaningful positive cash flows in future periods when the debt and lease payments occur. These favorable future cash flows will result from fiber infrastructure replacing a portion of the access and transport circuits we currently lease from incumbent local exchange carriers.

16

 
Three months ended June 30,
 
Six months ended June 30,
 
2013
 
2012
 
2013
 
2012
Reconciliation of Capital Expenditures (in thousands)
 
 
 
 
 
 
 
Cash capital expenditures (1)
$
14,780

 
$
14,765

 
$
27,214

 
$
29,601

Non-cash capital expenditures:
 
 
 
 
 
 
 
Fiber capital lease assets
3,884

 
957

 
6,901

 
3,357

Equipment capital lease assets
1,380

 
—

 
1,380

 
—

Leasehold improvements
21

 
—

 
21

 
—

Total capital expenditures
$
20,065

 
$
15,722

 
$
35,516

 
$
32,958

(1)
Represents cash purchases of property and equipment per the Condensed Consolidated Statements of Cash Flows.
Adjusted EBITDA was $42.8 million during the six months ended June 30, 2013, a 14.8% decrease over the comparable period in 2012. Free Cash Flow was $15.5 million during the six months ended June 30, 2013 compared to $20.6 million during the comparable period in 2012. The decline in Adjusted EBITDA reflects the decline in our customer base to whom we provide traditional telecommunications services, partially offset by an increase in fees we charge to our customers to recover the cost of regulatory compliance and an increase in Cbeyond 2.0 revenue. Results during the six months ended June 30, 2013 also include the costs associated with our fully staffed new direct sales group focused on technology-dependent customers.
 
Three months ended June 30,
 
Six months ended June 30,
 
2013
 
2012
 
2013
 
2012
Reconciliation of Free Cash Flow and Adjusted EBITDA to Net (loss) income (in thousands)
 
 
 
 
 
 
 
Free Cash Flow
$
7,149

 
$
12,471

 
$
15,548

 
$
20,609

Cash capital expenditures
14,780

 
14,765

 
27,214

 
29,601

Adjusted EBITDA
$
21,929

 
$
27,236

 
$
42,762

 
$
50,210

Depreciation and amortization
(18,460
)
 
(18,370
)
 
(36,065
)
 
(37,246
)
Non-cash share-based compensation
(3,045
)
 
(2,939
)
 
(6,024
)
 
(6,722
)
Realignment costs (1)
—

 
(284
)
 
(467
)
 
(1,924
)
Interest expense, net
(196
)
 
(144
)
 
(349
)
 
(271
)
Income tax expense
(269
)
 
(2,805
)
 
(454
)
 
(2,547
)
Net (loss) income
$
(41
)
 
$
2,694

 
$
(597
)
 
$
1,500

(1)
During the three and six months ended June 30, 2013, $0 and $467 of realignment costs are included in Selling, general and administrative expense as compared to $284 and $1,924 for the comparable periods in 2012, respectively. Additionally, during the three and six months ended June 30, 2012, $0 and $682 of realignment cost are included in Depreciation and amortization, respectively. See Note 4 to Condensed Consolidated Financial Statements.
Revenue
Our revenue is disaggregated into Network, Voice and Data or Managed Hosting and Cloud. Managed Hosting and Cloud includes virtual servers, physical servers, and cloud PBX services to customers and distribution channels that are not limited by geographical location. Our focus is to provide these services to network access customers; however, certain customers purchase these cloud-based services independent of network access. Managed Hosting and Cloud also includes other services, such as virtual receptionist, Microsoft® Exchange hosting, Web hosting, and fax-to-email, that are purchased by network access customers in quantities that exceed those included in their bundled service package.
We seek to sell our services through three-year contracts, but also offer one-year and two-year contracts at generally higher prices. As a result, customer churn rates impact our projected future revenue streams. We define customer churn rate for a given month as the number of network access customers disconnected in that month divided by the total number of network access customers at the beginning of that month. Due to differences in ARPU between Cbeyond 1.0 customers and Cbeyond 2.0 customers, we believe a unit-based churn metric may become less meaningful than it has been historically. In the future, we may transition to a revenue-based churn metric that will be applicable to all revenue, including revenue from customers that purchase cloud-based services independent of network access.

17

Although not a significant source of our Network, Voice and Data revenue, we charge other communications companies for terminating calls to our customers on our network. Terminating access charges have historically grown at a slower rate than our customer base due to reductions in access rates on interstate calls as mandated by the Federal Communications Commission. These rate reductions are expected to continue in the future.
We charge our customers fees to recover a portion of the costs we incur to comply with federal regulations. Prior to 2012 these regulatory recovery fees were insignificant, but we have since increased them to levels comparable to what we have seen in the market.
Cost of Revenue
Our cost of revenue represents costs directly related to the operation of our network and includes payments for access circuits, interconnection and transport fees, customer circuit installation costs, fees paid for Web hosting services, collocation rents and other facility costs, telecommunications-related taxes and fees, and the cost of mobile handsets. Cost of revenue associated with our cloud-based services includes licensing fees for the required operating systems, broadband service and access fees, and power for our data center facilities.
The primary component of cost of revenue consists of the access fees paid to local telephone companies for circuits we lease on a monthly basis to provide connectivity to our customers. These access circuits link our customers to our network equipment located in a collocation facility, which we also generally lease from local telephone companies.
Historically, most of the circuits we leased have been T1s, which are the largest component of our circuit access fees. However, we have converted many of our existing customer T1 circuits and have begun serving new customers using higher-capacity Metro Ethernet in place of T1 circuits in a number of locations. Although not available to us on an ubiquitous basis in all areas, Ethernet technology provides us with the opportunity to offer a large percentage of our customers' bandwidth at speeds well in excess of T1 circuits while reducing our ongoing operating expenses. We substantially completed our copper-based Metro Ethernet customer conversion project in 2011 and in 2012 we shifted our focus to our optical fiber access initiative. Costs related to our fiber network include maintenance costs for dark fiber (or fiber provided by third parties and operated by us) and access fees for lit fiber (or fiber both provided and operated by third parties). We have experienced increases in access costs associated with higher-capacity Metro Ethernet and expect these increases to continue in 2013 as we expand our fiber network.
Cost of revenue also includes transport costs, which are primarily the costs we incur with ILECs for traffic between central offices where we have collocation equipment, traffic between our collocations and other wire centers, and intercity traffic between our markets. In recent periods, these costs have increased as we have built additional collocations to support our Metro Ethernet initiative; however, this increase is offset by reductions in access fees resulting from our investment in Ethernet technology, which provides significantly lower operating expenses than traditional T1 technology.
Another significant component of our cost of revenue is the cost associated with our mobile offering. These costs include usage-based charges, monthly recurring base charges, or some combination thereof, depending on the type of mobile product in service and the cost of mobile equipment sold to our customers. The cost of mobile devices typically exceeds our selling price due to the highly competitive marketplace and traditional pricing practices for mobile services. We believe these costs are offset over time by the long-term profitability of our service contracts.
We routinely negotiate and receive telecommunication billing recoveries from various local telephone companies to resolve prior errors in billing, including the effect of price decreases retroactively applied upon the adoption of new rates as mandated by regulatory bodies. We also receive payments from local telephone companies in the form of performance penalties that are assessed by state regulatory commissions based on the local telephone companies' performance in the delivery of circuits and other services. Because of the many factors that impact the amount and timing of telecommunication billing recoveries, we are often unable to estimate the outcome of these situations. Accordingly, we generally recognize telecommunication billing recoveries as offsets to cost of revenue when the ultimate resolution and amount are known and verifiable. These items do not follow any predictable trends and often result in variances when comparing the amounts received over multiple periods. In the future, through systematic improvements in process applications, and after gaining further historical experience, we may be able to more reliably estimate the outcome of telecommunication billing recoveries prior to being known and verifiable, which could result in earlier recognition of these recoveries.
Selling, General and Administrative Expense
Our selling, general and administrative expense consist of salaries and related costs for employees and other costs related to sales and marketing, engineering, information technology, billing, regulatory, administrative, collections, legal, and accounting functions. In addition, bad debt expense and share-based compensation expense are included in selling, general and administrative expenses.
Our selling, general and administrative expense includes both fixed and variable costs. Fixed costs include the cost of staffing certain corporate functions such as IT, marketing, administrative, billing and engineering, and other associated costs,

18

such as office rent, legal and accounting fees, property taxes, and recruiting. Variable costs include commissions; bonuses; marketing materials; the cost of provisioning and customer activation staff, which varies with the level of installation of new customers; the cost of customer care and technical support staff, which varies with the level of total customers on our network and the complexity of our product offering.
Reclassifications
Reclassifications have been made to the three and six months ended June 30, 2012 Revenue table within Item 2 herein to present our revenue on a product-line basis, separating Network, Voice and Data from Managed Hosting and Cloud. Reclassifications have also been made to ARPU within Item 2 herein to include revenue from certain cloud-based services provided to network access customers within the calculation that were not previously included. Such reclassifications were made to conform to the current presentation for the three and six months ended June 30, 2013.
Results of Operations
Revenue (Dollar amounts in thousands, except ARPU) 
 
For the three months ended June 30,
 
 
 
 
 
2013
 
2012
 
Change from previous period
 
Dollars
 
% of
Revenue
 
Dollars
 
% of
Revenue
 
Dollars
 
Percent
Revenue
 
 
 
 
 
 
 
 
 
 
 
Network, Voice and Data
$
110,852

 
93.8
%
 
$
117,674

 
95.1
%
 
$
(6,822
)
 
(5.8
)%
Managed Hosting and Cloud
7,363

 
6.2
%
 
6,088

 
4.9
%
 
1,275

 
20.9
 %
Total revenue
118,215

 
 
 
123,762

 
 
 
(5,547
)
 
(4.5
)%
Cost of revenue
39,491

 
33.4
%
 
40,164

 
32.5
%
 
(673
)
 
(1.7
)%
Gross margin (exclusive of depreciation and amortization):
$
78,724

 
66.6
%
 
$
83,598

 
67.5
%
 
$
(4,874
)
 
(5.8
)%
Network access customer data:
 
 
 
 
 
 
 
 
 
 
 
Customer locations at period end
57,013

 
 
 
62,015

 
 
 
(5,002
)
 
(8.1
)%
ARPU
$
662

 
 
 
$
645

 
 
 
$
17

 
2.6
 %
Average monthly churn rate
1.6
%
 
 
 
1.5
%
 
 
 
0.1
%
 
 
 
For the six months ended June 30,
 
 
 
 
 
2013
 
2012
 
Change from previous period
 
Dollars
 
% of
Revenue
 
Dollars
 
% of
Revenue
 
Dollars
 
Percent
Revenue
 
 
 
 
 
 
 
 
 
 
 
Network, Voice and Data
$
224,204

 
94.1
%
 
$
235,761

 
95.2
%
 
$
(11,557
)
 
(4.9
)%
Managed Hosting and Cloud
13,957

 
5.9
%
 
11,844

 
4.8
%
 
2,113

 
17.8
 %
Total revenue
238,161

 
 
 
247,605

 
 
 
(9,444
)
 
(3.8
)%
Cost of revenue
78,279

 
32.9
%
 
80,648

 
32.6
%
 
(2,369
)
 
(2.9
)%
Gross margin (exclusive of depreciation and amortization):
$
159,882

 
67.1
%
 
$
166,957

 
67.4
%
 
$
(7,075
)
 
(4.2
)%
Network access customer data:
 
 
 
 
 
 
 
 
 
 
 
Customer locations at period end
57,013

 
 
 
62,015

 
 
 
(5,002
)
 
(8.1
)%
ARPU
$
660

 
 
 
$
647

 
 
 
$
13

 
2.0
 %
Average monthly churn rate
1.6
%
 
 
 
1.5
%
 
 
 
0.1
%
 
 
Network, Voice and Data revenue decreased in the three and six months ended June 30, 2013 compared to the three and six months ended June 30, 2012 due to our strategic efforts to realign our distribution channels. Our focus on the strategic realignment and on higher-value customers has resulted in lower new customers than we have achieved historically. Because of this, in recent periods, customer churn has exceeded new customer growth resulting in a decline in customers. The revenue impact of the decline in customers was partially offset by an increase in fees we charge our customers to recover certain regulatory costs. Regulatory recovery charges increased $5.9 million and $11.5 million in the three and six months ended June 30, 2013 compared to the three and six months ended June 30, 2012, respectively. We expect these higher regulatory

19

recovery charges to have a continuing benefit in future periods. The increase in Managed Hosting and Cloud revenue is largely due to our focus on technology-dependent customers and sales of our cloud-based service offerings. We expect growth in total revenue to return when ARPU increases, churn declines, the productivity of our Cbeyond 2.0 sales force increases, and as we refine and expand our catalog of products targeted to technology-dependent customers and further expand our Metro Ethernet network.
ARPU increased $17, or 2.6%, and $13, or 2.0%, in the three and six months ended June 30, 2013 compared to the comparable periods in 2012. Excluding regulatory recovery charges, ARPU decreased 2.7% and 3.2% in the three and six months ended June 30, 2013, respectively, compared to the three and six months ended June 30, 2012. The increase in ARPU is due to an increase in regulatory recovery charges and, to a lesser extent, an increasing proportion of higher ARPU, technology-dependent customers, offset by pricing pressure relating to our lower ARPU, Cbeyond 1.0 customers. Longer-term, we expect that our focus on technology-dependent customers, or Cbeyond 2.0 customers, and new product launches will increasingly benefit ARPU. This expectation is evident by the current shift we are seeing between Network, Voice and Data revenue, which declined 5.8% and 4.9% in the three and six months ended June 30, 2013, compared to the comparable periods in 2012, and Managed Hosting and Cloud revenue, which increased 20.9% and 17.8% in the three and six months ended June 30, 2013, compared to comparable periods in 2012. These results reflect the launch of our flagship cloud offerings, TotalCloud Phone System and TotalCloud Data Center, during the fourth quarter of 2012.
Our average customer churn rate was 1.6% in the three and six months ended June 30, 2013, representing a slight increase over the three and six months ended June 30, 2012, but consistent with more recent periods. The increase is primarily attributable to price competition for smaller communications-centric customers.
Cost of Revenue (Dollar amounts in thousands)
 
For the three months ended June 30,
 
 
 
2013
 
2012
 
Change from previous period
 
Dollars
 
% of
Revenue
 
Dollars
 
% of
Revenue
 
Dollars
 
Percent
Cost of revenue (exclusive of depreciation and amortization):
 
 
 
 
 
 
 
 
 
 
 
Circuit access fees
$
18,169

 
15.4
 %
 
$
18,208

 
14.7
 %
 
$
(39
)
 
(0.2
)%
Other cost of revenue
11,871

 
10.0
 %
 
11,393

 
9.2
 %
 
478

 
4.2
 %
Transport cost
6,352

 
5.4
 %
 
6,336

 
5.1
 %
 
16

 
0.3
 %
Mobile cost
3,799

 
3.2
 %
 
4,736

 
3.8
 %
 
(937
)
 
(19.8
)%
Telecommunications billing recoveries
(700
)
 
(0.6
)%
 
(509
)
 
(0.4
)%
 
(191
)
 
37.5
 %
Total cost of revenue
$
39,491

 
33.4
 %
 
$
40,164

 
32.5
 %
 
$
(673
)
 
(1.7
)%
 
 
For the six months ended June 30,
 
 
 
2013
 
2012
 
Change from previous period
 
Dollars
 
% of
Revenue
 
Dollars
 
% of
Revenue
 
Dollars
 
Percent
Cost of revenue (exclusive of depreciation and amortization):
 
 
 
 
 
 
 
 
 
 
 
Circuit access fees
$
36,376

 
15.3
 %
 
$
36,275

 
14.7
 %
 
$
101

 
0.3
 %
Other cost of revenue
23,041

 
9.7
 %
 
22,917

 
9.3
 %
 
124

 
0.5
 %
Transport cost
12,572

 
5.3
 %
 
12,882

 
5.2
 %
 
(310
)
 
(2.4
)%
Mobile cost
8,011

 
3.4
 %
 
9,654

 
3.9
 %
 
(1,643
)
 
(17.0
)%
Telecommunications billing recoveries
(1,721
)
 
(0.7
)%
 
(1,080
)
 
(0.4
)%
 
(641
)
 
59.4
 %
Total cost of revenue
$
78,279

 
32.9
 %
 
$
80,648

 
32.6
 %
 
$
(2,369
)
 
(2.9
)%
The principal drivers of the overall decrease in cost of revenue are an increase telecommunications billing recoveries, the reduction in installation costs from fewer new customer installations, and the overall reduced costs of serving fewer network access customers. These reductions were partially offset by higher circuit costs attributable to delivering higher bandwidth circuits to our customers, higher costs relating to premium mobile devices, and higher telecommunication-related taxes and fees.

20

Circuit access fees, or line charges, represent the largest single component of cost of revenue. These costs primarily relate to the usage of circuits that connect our equipment at network points of collocation to our equipment located at our customers’ premises. Changes in circuit access fees has historically correlated to changes in the number of customers, but there are a number of influences in recent periods that have reduced the level of correlation. We are continuing to realize cost savings from our Metro Ethernet conversion initiative, but are also experiencing increases in access costs as we provide higher bandwidth to our customers. As we serve more technology-dependent customers with higher bandwidth needs, we expect access costs per customer to initially increase. These customers, however, will also generate much higher revenue due to the breadth and type of services enabled by higher bandwidth. Over time, as we increasingly leverage our own fiber assets we expect our access costs on a per-customer basis to decline.

Other cost of revenue includes components such as long distance charges, installation costs to connect new circuits, the cost of local interconnection with ILECs’ networks, Internet access costs, the cost of third-party service offerings we provide to our customers, costs to deliver our cloud-based services, and certain taxes and fees. Other cost of revenue increased in the three and six months ended June 30, 2013 compared to the three and six months ended June 30, 2012, primarily due to an increase in telecommunications-related taxes and fees.
Historically, changes in transport costs have been primarily driven by changes in the number of network access customers, but recent efforts to transition certain traffic to our fiber network has led to a temporary cost increase. Longer-term, as we continue to optimize our network and augment it with Metro Ethernet access, we expect transport costs to decline given the cost profile of Metro Ethernet compared to traditional T1 access.
As a percentage of revenue, mobile costs decreased during the three and six months ended June 30, 2013 compared to the three and six months ended June 30, 2012. The primary driver of this decrease is a reduction in mobile service costs, but we have also experienced a reduction in device shipments related to the decrease in new customers. This has been offset by the higher cost of more recently launched competitive mobile device models.
Selling, General and Administrative and Other Operating Expenses (Dollar amounts in thousands)
 
For the three months ended June 30,
 
 
 
2013
 
2012
 
Change from previous period
 
Dollars
 
% of
Revenue
 
Dollars
 
% of
Revenue
 
Dollars
 
Percent
Selling, general and administrative (exclusive of depreciation and amortization)
 
 
 
 
 
 
 
 
 
 
 
Salaries, wages and benefits (excluding share-based compensation)
$
36,549

 
30.9
%
 
$
35,497

 
28.7
%
 
$
1,052

 
3.0
 %
Share-based compensation
3,045

 
2.6
%
 
2,939

 
2.4
%
 
106

 
3.6
 %
Marketing cost
585

 
0.5
%
 
671

 
0.5
%
 
(86
)
 
(12.8
)%
Realignment cost
—

 
—
%
 
284

 
0.2
%
 
(284
)
 
(100.0
)%
Other selling, general and administrative
19,661

 
16.6
%
 
20,194

 
16.3
%
 
(533
)
 
(2.6
)%
Total SG&A
$
59,840

 
50.6
%
 
$
59,585

 
48.1
%
 
$
255

 
0.4
 %
Other operating expenses:
 
 
 
 
 
 
 
 
 
 
 
    Depreciation and amortization
18,460

 
15.6
%
 
18,370

 
14.8
%
 
90

 
0.5
 %
Total other operating expenses
$
18,460

 
15.6
%
 
$
18,370

 
14.8
%
 
$
90

 
0.5
 %
Other data:
 
 
 
 
 
 
 
 
 
 
 
Average employees
1,643

 
 
 
1,578

 
 
 
65

 
4.1
 %

21

 
For the six months ended June 30,
 
 
 
2013
 
2012
 
Change from previous period
 
Dollars
 
% of
Revenue
 
Dollars
 
% of
Revenue
 
Dollars
 
Percent
Selling, general and administrative (exclusive of depreciation and amortization)
 
 
 
 
 
 
 
 
 
 
 
Salaries, wages and benefits (excluding share-based compensation)
$
75,974

 
31.9
%
 
$
75,336

 
30.4
%
 
$
638

 
0.8
 %
Share-based compensation
6,024

 
2.5
%
 
6,722

 
2.7
%
 
(698
)
 
(10.4
)%
Marketing cost
1,114

 
0.5
%
 
1,384

 
0.6
%
 
(270
)
 
(19.5
)%
Realignment cost
467

 
0.2
%
 
1,924

 
0.8
%
 
(1,457
)
 
(75.7
)%
Other selling, general and administrative
40,032

 
16.8
%
 
40,027

 
16.2
%
 
5

 
—
 %
Total SG&A
$
123,611

 
51.9
%
 
$
125,393

 
50.6
%
 
$
(1,782
)
 
(1.4
)%
Other operating expenses:
 
 
 
 
 
 
 
 
 
 
 
    Depreciation and amortization
36,065

 
15.1
%
 
37,562

 
15.2
%
 
(1,497
)
 
(4.0
)%
Total other operating expenses
$
36,065

 
15.1
%
 
$
37,562

 
15.2
%
 
$
(1,497
)
 
(4.0
)%
Other data:
 
 
 
 
 
 
 
 
 
 
 
Average employees
1,653

 
 
 
1,694

 
 
 
(41
)
 
(2.4
)%
Selling, general and administrative expense increased during the three months ended June 30, 2013 compared to the three months ended June 30, 2012 and decreased during the six months ended June 30, 2013 compared to the six months ended June 30, 2012. These fluctuations are primarily due to changes in the composition of our sales force in both 2012 and 2013, resulting in a net increase in staffing expenses offset by declines in share-based compensation, realignment costs, and bad debt expense.
Salaries, wages and benefits increased in amount and as a percentage of revenue during the three and six months ended June 30, 2013 compared to that of the prior year. The increase in Salaries, wages and benefits is due to an increase in base compensation and medical benefits partially offset by lower commissions and bonus expenses. We reduced the size of our traditional direct sales force in both 2012 and 2013 while adding a new sales force comprised of more experienced professionals and dedicated to Cbeyond 2.0 opportunities. The cost savings that resulted from our strategic realignment has been offset by the costs related to our fully staffed Cbeyond 2.0 sales force and staffing of operations to support our increase in technology-dependent customers.
During the three and six months ended June 30, 2013 we recorded $0.4 million and $0.8 million of Share-based compensation expense related to the market-based restricted shares granted in September 2012. Excluding the expense associated with these restricted shares, Share-based compensation expense decreased by a similar percentage during the three and six months ended June 30, 2013 compared to the prior year. This decrease is primarily due to a decline in the fair value of awards granted based on lower share prices in recent periods. As our share price has declined, we have experienced decreases in our share-based compensation expense related to the full vesting of higher historical valued awards granted.
The strategic realignment, which was announced in early 2012, resulted in $0.3 million and $1.9 million of Selling, general and administrative expense for the three and six months ended June 30, 2012. During the six months ended June 30, 2013, we recognized $0.5 million of employee severances and medical benefits. We did not incur any charges during the second quarter of 2013.
Other selling, general and administrative expenses primarily include professional fees, outsourced services, rent and other facilities costs, maintenance, recruiting fees, travel and entertainment costs, property taxes and bad debt expense. Other selling, general and administrative expenses during the three and six months ended June 30, 2013 were consistent with the comparable periods in 2012 due to a decline in bad debt expense offset by higher consulting and outsourced services relating to our change in strategy.
Bad debt expense was $1.2 million, or 1.0% of revenue, during the three months ended June 30, 2013 compared to $1.6 million, or 1.3% of revenue, during the three months ended June 30, 2012. During the six months ended June 30, 2013 and June 30, 2012, bad debt expense was $2.1 million, or 0.9% of revenue, and $3.2 million, or 1.3% of revenue. The reduction is primarily related to lower revenue, improved customer collections consistent with our tighter credit policies, and improving economic conditions.

22

The decrease in depreciation and amortization for the six months ended June 30, 2013 compared to the six months ended June 30, 2012 relates primarily to further investing in longer-lived fiber optic equipment while focusing less on traditional network purchases compared to the prior period. In addition, we recognized $0.7 million of accelerated depreciation during the six months ended June 30, 2012 on certain long-lived assets at offices which were consolidated as part of the strategic realignment.
Interest Expense and Income Taxes (Dollar amounts in thousands) 
 
For the three months ended June 30,
 
 
 
2013
 
2012
 
Change from previous period
 
Dollars
 
% of
Revenue
 
Dollars
 
% of
Revenue
 
Dollars
 
Percent
Interest expense, net
$
(196
)
 
(0.2
)%
 
$
(144
)
 
(0.1
)%
 
$
(52
)
 
36.1
 %
Income tax (expense) benefit
(269
)
 
(0.2
)%
 
(2,805
)
 
(2.3
)%
 
2,536

 
(90.4
)%
Total
$
(465
)
 
(0.4
)%
 
$
(2,949
)
 
(2.4
)%
 
$
2,484

 
(90.4
)%
 
For the six months ended June 30,
 
 
 
2013
 
2012
 
Change from previous period
 
Dollars
 
% of
Revenue
 
Dollars
 
% of
Revenue
 
Dollars
 
Percent
Interest expense, net
$
(349
)
 
(0.1
)%
 
$
(271
)
 
(0.1
)%
 
$
(78
)
 
28.8
 %
Income tax (expense) benefit
(454
)
 
(0.2
)%
 
(2,547
)
 
(1.0
)%
 
2,093

 
(82.2
)%
Total
$
(803
)
 
(0.3
)%
 
$
(2,818
)
 
(1.1
)%
 
$
2,015

 
(71.5
)%
We recognize our 2013 interim period income tax expense based on our year-to-date effective tax rate because our estimated annual tax rate fluctuates significantly from only slight variances in estimated annual income. The three and six months ended June 30, 2013 income tax expense primarily relates to the tax goodwill amortization that will likely remain non-deductible for book purposes and state income tax expense levied by Texas, which imposes a gross receipts-based tax due regardless of profit levels. This tax is not dependent upon levels of pre-tax income and has a significant influence on our effective tax rate.
Liquidity and Capital Resources (Dollar amounts in thousands):
 
For the six months ended June 30,
 
Change from Previous Period
 
2013
 
2012
 
Dollars
 
Percent
Cash Flows:
 
 
 
 
 
 
 
Net cash provided by operating activities
$
26,584

 
$
38,824

 
$
(12,240
)
 
(31.5
)%
Net cash used in investing activities
(27,214
)
 
(33,256
)
 
6,042

 
(18.2
)%
Net cash (used in) provided by financing activities
(2,475
)
 
(3,410
)
 
935

 
(27.4
)%
Net (decrease) increase in cash and cash equivalents
$
(3,105
)
 
$
2,158

 
$
(5,263
)
 
(243.9
)%
As of June 30, 2013, we have $27.5 million of cash and cash equivalents held in our operating bank accounts, $2.0 million outstanding under the Fiber Loan, and no amounts outstanding under our revolving line of credit. We currently have no plans to draw against the Credit Facility for short-term needs.
We have shifted our focus to our optical fiber access initiative and executed multiple agreements to provide optical fiber access in several markets. We expect to incur costs of between $35.0 million and $40.0 million through 2014 associated with the initial phase of this initiative. The Fiber Loan, secured under our Credit Facility, provides us up to $10.0 million to finance the purchase of fiber network assets from a third party.
In early 2012 we reduced our communications-centric, or Cbeyond 1.0, sales force in order to reinvest in teams focused on selling and delivering services to technology-dependent customers. These reductions in personnel resulted in a significant temporary increase in Free Cash Flow throughout much of 2012. As our Cbeyond 2.0 sales channels are now fully staffed, we expect lower levels of Adjusted EBITDA and Free Cash Flow to continue through 2013. We expect to complete our realignment by the end of 2013 and incur expenses of up to $1.0 million, which may include severance and facility exit costs.

23

We believe that cash on hand, cash generated from operating activities, and cash available under our Credit Facility will be sufficient to fund capital expenditures, debt and capital lease obligations, operating expenses, potential share repurchases, and other cash requirements associated with future growth, including realignment activities. While we do not anticipate a need for additional access to capital or new financing aside from our Credit Facility and related Fiber Loan, we monitor the capital markets and may access those markets if our business prospects or plans change resulting in a need for additional capital, or if additional capital required can be obtained on favorable terms.
Cash Flows from Operating Activities
Our operating cash flows result primarily from cash received from our customers, offset by cash payments for circuit access fees, employee compensation (less amounts capitalized related to internal use software that are reflected as cash used in investing activities), vendor payments and operating leases. Cash received from our customers generally corresponds to our revenue. Because our credit terms are typically less than one month, our receivables settle quickly. Changes to our operating cash flows have historically been driven primarily by changes in operating income and changes to the components of working capital, including changes to receivable and payable days. Operating cash flows may fluctuate favorably or unfavorably depending on the timing of significant vendor payments.
The $12.2 million decrease in operating cash flows is primarily due to a $7.4 million decline in Adjusted EBITDA and changes in working capital. The most significant change in working capital relates to other liabilities. Other liabilities declined $9.5 million during 2013 compared to a $4.7 million decline in 2012. This was driven by a larger amount earned under the 2012 corporate bonus plan than the 2011 plan.
Cash Flows from Investing Activities
Our principal cash investments are purchases of property and equipment, which fluctuate depending on the growth in customers in our existing markets, the timing and number of facility and network additions needed to expand existing markets and upgrade our network, enhancements and development costs related to our operational support systems in order to offer additional applications and services to our customers, and increases to the capacity of our data centers as our customer base and the breadth of our product portfolio expand. We also continue to invest in Metro Ethernet through optical fiber access to reduce operating expenses and provide higher bandwidth and additional services to our customers.
Our cash capital expenditures decreased from $29.6 million during the six months ended June 30, 2012 to $27.2 million during the six months ended June 30, 2013. However, during 2013 we acquired $8.3 million of assets through capital lease arrangements that did not require an initial outlay of cash.
During the first quarter of 2012 we paid $5.0 million in deferred acquisition consideration related to our acquisitions of MaximumASP and Aretta that closed in late 2010. Additionally, during 2012 we transferred $1.3 million of cash formerly classified as restricted cash into our operating account.
Cash Flows from Financing Activities
Cash flows from financing activities relate to activity associated with employee stock option exercises, vesting of restricted shares, borrowings and repayments under our Credit Facility, and repurchases of common stock, and principal payments on capital leases. During the first quarter of 2012, we borrowed $4.3 million against our Credit Facility, most of which was used to settle acquisition-related contingent consideration. We repaid this borrowing during the second quarter of 2012. As of June 30, 2013, we had no amounts outstanding under our Credit Facility and $2.0 million outstanding under our Fiber Loan. We also repurchased 0.3 million shares for $2.0 million during the first quarter of 2012, completing the $15.0 million repurchase program authorized by our Board of Directors in May 2011.
On July 24, 2013, Cbeyond's Board of Directors authorized the repurchase of up to $20.0 million of Cbeyond common shares over a 2-year period. No share repurchases have been transacted under this program as of the date of this filing. We are permitted to draw on our revolving line of credit to finance share repurchases, but expect to use cash on hand and cash generated from operating activities.
Contractual Obligations and Commitments
Our contractual obligations and commitments in connection with our strategic initiative to expand our fiber network through capital lease arrangements are disclosed in Note 3 to the Condensed Consolidated Financial Statements. We have also entered into operating lease arrangements for fiber to support our Metro Ethernet network expansion. These fiber circuits are managed by third-party providers and generally include lease commitments of 3 to 5 years. Over time, the growth of our commitments for fiber circuits will accompany a decline in our legacy T1 commitments. Our lease commitments for managed fiber and T1 circuits appear under the heading "Circuit commitments" within the contractual obligations table disclosed 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, 2012.

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On July 31, 2013, we entered into a master lease agreement to lease lit fiber circuits for a 10-year period with minimum lease payments of $0.1 million in 2014 and $0.5 million annually from 2015 through 2024.
There have been no other material changes with respect to the contractual obligations and commitments disclosed 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, 2012.
Off-Balance Sheet Arrangements
We have no off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on our financial condition, results of operations, liquidity, capital expenditures or capital resources.
Critical Accounting Policies
We prepare consolidated financial statements in accordance with GAAP in the United States, which require us to make estimates and assumptions that affect the reported amounts of assets and liabilities, revenue and expenses, and related disclosures in our consolidated financial statements and accompanying notes. We believe that of our significant accounting policies, which are described in Note 2 to the Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2012, we consider those that involve a higher degree of judgment and complexity as critical. While we have used our best estimates based on the facts and circumstances available to us at the time, different estimates reasonably could have been used in the current period, or changes in the accounting estimates that we used are reasonably likely to occur from period to period which may have a material impact on the presentation of our financial condition and results of operations. Although we believe that our estimates, assumptions and judgments are reasonable, they are based upon information presently available. Actual results may differ significantly from these estimates under different assumptions, judgments or conditions. A description of accounting policies that are considered critical may be found in our 2012 Annual Report on Form 10-K, filed on March 7, 2013, in the “Critical Accounting Policies” section of the “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

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Item 3.    Quantitative and Qualitative Disclosures About Market Risk
Interest Rate Risk
Our variable-rate borrowings under our Credit Facility are subject to fluctuations in interest expense and cash flows. Management actively monitors this exposure when present. At June 30, 2013, we had no borrowings outstanding under our revolving line of credit and utilized $2.0 million of our Fiber Loan. A 100 basis point increase in market interest rates would have resulted in an increase in pre-tax interest expense of less than $0.1 million. As we continue to draw on our Fiber Loan, our sensitivity to interest rate risk will increase. As of June 30, 2013, our cash and cash equivalents were held in non-interest bearing bank accounts.
Item 4.    Controls and Procedures
Disclosure Controls and Procedures
Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(b) as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that as of the end of the period covered by this report, these disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed by us in reports we file or submit under the Exchange Act is (1) recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and (2) is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.
Changes in Internal Control over Financial Reporting
There were no changes in our internal control over financial reporting during the quarter ended June 30, 2013 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II. OTHER INFORMATION
Item 1.    Legal Proceedings
From time to time, we are involved in legal proceedings arising in the ordinary course of business. We believe that we have adequately reserved for these liabilities and that as of June 30, 2013, there is no litigation pending that could have a material adverse effect on our results of operations and financial condition. The information within Note 9 to the Condensed Consolidated Financial Statements under the caption “Legal Proceedings” is incorporated herein by reference.
Item 1A. Risk Factors
Investors should carefully consider the risk factors in Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2012, in addition to the other information contained in our Annual Report and in this quarterly report on Form 10-Q. There have been no material changes to the risk factors disclosed in our Annual Report on Form 10-K for the year ended December 31, 2012.
Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds
None.
Item 3.    Defaults upon Senior Securities
None.
Item 4.    Mine Safety Disclosures
None.
Item 5.    Other Information
On July 29, 2013, the Board of Directors of the Company approved a new Code of Conduct. The Code of Conduct is intended to replace the Company's existing Code of Ethics. The Code of Conduct is filed as Exhibit 14.1 to this Quarterly Report on Form 10-Q and will be available on the Company's website at www.cbeyond.com.
Item 6.    Exhibits
Exhibit No.
  
Description of Exhibit
14.1*
 
Cbeyond Code of Ethics
31.1*
  
Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2*
  
Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1†
  
Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2†
  
Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101††
  
The following financial information from the Quarterly Report on Form 10-Q for the three months ended June 30, 2013, formatted in XBRL (Extensible Business Reporting Language): (i) the Condensed Consolidated Balance Sheets, (ii) the Condensed Consolidated Statements of Operations, (iii) the Condensed Consolidated Statement of Stockholders’ Equity, (iv) the Condensed Consolidated Statements of Cash Flows, and (v) the Unaudited Notes to Condensed Consolidated Financial Statements.
*
Filed herewith.
†
Furnished herewith.
††
Furnished electronically herewith.


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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
 
 
 
 
 
CBEYOND, INC.
 
 
 
 
 
 
By:
 
/s/ James F. Geiger
 
 
Name:
 
James F. Geiger
 
 
Title:
 
Chairman, President and Chief Executive Officer
 
 
 
 
 
 
 
Date:
 
July 31, 2013
 

 
By:
 
/s/ J. Robert Fugate
 
 
Name:
 
J. Robert Fugate
 
 
Title:
 
Executive Vice President and Chief Financial Officer
 
 
 
 
 
 
 
Date:
 
July 31, 2013
 


Exhibit Index
Exhibit No.
 
Description of Exhibit
14.1*
 
Cbeyond Code of Ethics
31.1*
 
Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2*
 
Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1†
 
Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2†
 
Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101††
 
The following financial information from the Quarterly Report on Form 10-Q for the three months ended June 30, 2013, formatted in XBRL (Extensible Business Reporting Language): (i) the Condensed Consolidated Balance Sheets, (ii) the Condensed Consolidated Statements of Operations, (iii) the Condensed Consolidated Statement of Stockholders’ Equity, (iv) the Condensed Consolidated Statements of Cash Flows, and (v) the Unaudited Notes to Condensed Consolidated Financial Statements.
*
Filed herewith.
†
Furnished herewith.
††
Furnished electronically herewith.


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