S-1/A 1 ds1a.htm AMENDMENT NO.3 TO FORM S-1 Amendment No.3 to Form S-1
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As filed with the Securities and Exchange Commission on February 2, 2011

Registration No. 333-170229

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Amendment No. 3

to

Form S-1

REGISTRATION STATEMENT

Under

The Securities Act of 1933

 

 

Masergy Communications, Inc.

(Exact name of Registrant as specified in its charter)

 

 

 

Delaware   4813   75-2899198

(State or other jurisdiction of

incorporation or organization)

 

(Primary Standard Industrial

Classification Code Number)

 

(I.R.S. Employer

Identification Number)

2740 North Dallas Parkway, Suite 260

Plano, TX 75093

Tel: (214) 442-5700

(Address, including zip code, and telephone number, including area code, of Registrant’s principal executive offices)

 

 

Robert E. Bodnar

Executive Vice President and Chief Financial Officer

2740 North Dallas Parkway, Suite 260

Plano, TX 75093

Tel: (214) 442-5700

(Name, address, including zip code, and telephone number, including area code, of agent for service)

 

 

Copies to:

 

Thomas R. Nelson

Miller, Egan, Molter & Nelson LLP

600 Congress Avenue, Suite 200

Austin, TX 78701

Tel: (512) 505-4184

 

Michael J. Schiavone

Shearman & Sterling LLP

599 Lexington Avenue

New York, NY 10022

Tel: (212) 848-4000

 

 

Approximate date of commencement of proposed sale to the public: As soon as practicable after the effective date of this Registration Statement.

If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box.    ¨

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.    ¨

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.    ¨

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.    ¨

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   ¨
Non-accelerated filer   x  (Do not check if a smaller reporting company)    Smaller reporting company       ¨                             

 

 

CALCULATION OF REGISTRATION FEE

 

 

Title of Each Class of

Securities to be Registered

 

Amount to

be Registered

 

Proposed

Maximum
Offering Price

Per Share

 

Proposed

Maximum
Aggregate Offering

Price(1)(2)

 

Amount of

Registration

Fee(3)

Common Stock, $0.001 par value

  8,855,000   $14.00   $123,970,000   $14,393
 
(1) Estimated solely for the purpose of computing the amount of the registration fee pursuant to Rule 457(a) under the Securities Act of 1933, as amended.
(2) Includes the aggregate offering price of additional shares that the underwriters have the option to purchase.
(3) $7,130 of the registration fee has been paid in connection with the initial filing of the Registration Statement.

The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine.

 

 

 


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The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted.

 

Subject to Completion

Preliminary Prospectus dated February 2, 2011

PROSPECTUS

7,700,000 Shares

LOGO

Common Stock

 

 

This is Masergy Communications, Inc.’s initial public offering. We are selling 3,850,000 shares of common stock and the selling stockholders are selling 3,850,000 shares of common stock. We will not receive any proceeds from the sale of shares of common stock by the selling stockholders.

We expect the public offering price to be between $12.00 and $14.00 per share. Currently, no public market exists for the shares. Our common stock has been approved for listing on the New York Stock Exchange under the symbol “MSGY.”

Investing in the common stock involves risks that are described in the “Risk Factors” section beginning on page 10 of this prospectus.

 

 

 

       Per Share        Total  

Public offering price

           $                      $          

Underwriting discount

           $                      $          

Proceeds, before expenses, to us

           $                      $          

Proceeds, before expenses, to the selling stockholders

           $                      $          

The underwriters may also exercise their option to purchase up to an additional 1,155,000 shares from the selling stockholders, at the public offering price, less the underwriting discount, for 30 days after the date of this prospectus to cover overallotments, if any.

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense.

The shares will be ready for delivery on or about                     , 2011.

 

 

Joint Book-Running Managers

 

BofA Merrill Lynch    Deutsche Bank Securities

 

 

Co-Managers

 

Stifel Nicolaus Weisel    Pacific Crest Securities

 

 

The date of this prospectus is                     , 2011.


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LOGO


Table of Contents

TABLE OF CONTENTS

 

     Page  

Glossary of Terms

     i   

Prospectus Summary

     1   

Risk Factors

     10   

Special Note Regarding Forward-Looking Statements and Industry Data

     23   

Special Note Regarding Non-GAAP Financial Measures

     24   

Use of Proceeds

     25   

Dividend Policy

     26   

Capitalization

     27   

Dilution

     29   

Selected Consolidated Financial Data

     31   

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     34   

Business

     60   

Management

     71   

Executive Compensation

     79   

Certain Relationships and Related Party Transactions

     102   

Principal and Selling Stockholders

     104   

Description of Capital Stock

     108   

Shares Eligible for Future Sale

     113   

Material U.S. Federal Income Tax and Estate Tax Consequences to Non-U.S. Holders

     115   

Underwriting

     120   

Legal Matters

     126   

Experts

     126   

Where You Can Find Additional Information

     126   

Index to Consolidated Financial Statements

     F-1   

 

 

We have not authorized anyone to provide any information or to make any representations other than those contained in this prospectus. We take no responsibility for, and can provide no assurance as to the reliability of, any other information that others may give you.


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GLOSSARY OF TERMS

Our industry uses many terms and acronyms that may not be familiar to you. To assist you in reading this prospectus, we have provided definitions of some of these terms and acronyms below:

Access circuit: Refers to a local telecom connection from a carrier’s aggregation point to the customer premise.

Backbone: A major fiber optic network that interconnects other networks.

Burstable: A method of measuring bandwidth based on peak utilization. It also allows bandwidth usage to exceed a specified threshold for brief periods of time without the financial penalty of purchasing a higher committed bandwidth level.

Channel partners: Industry participants with whom we collaborate for sales and marketing, such as system integrators, value-added resellers, agents and referral partners.

Cloud computing: An Internet-based or intranet-based computing environment wherein computing resources are distributed across the network (i.e. the “cloud”) and are dynamically allocated on an individual or pooled basis, and are increased or reduced as circumstances warrant, to handle the computing task at hand.

CPE, or customer premise equipment: Any equipment located at the customer’s location that connects to a service provider’s network.

CRM, or customer relationship management: a broadly recognized, widely-implemented strategy for managing a company’s interactions with customers, clients and sales prospects. It involves using technology to organize, automate, and synchronize business processes, principally for sales activities, marketing, customer service and technical support.

Data center: A data center is a facility used to house computer systems and associated components, such as telecommunications and storage systems.

ERP, or enterprise resource planning: an integrated computer-based system used to manage internal and external resources, including tangible assets, financial resources, materials, and human resources. Built on a centralized database and normally utilizing a common computing platform, ERP systems consolidate all business operations into a uniform and enterprise-wide system environment.

Ethernet: The standard local area network (LAN) protocol. Ethernet was originally specified to connect devices on a company or home network as well as to a cable modem or DSL modem for Internet access. Due to its ubiquity in the LAN, Ethernet has become a popular transmission protocol in metropolitan, regional and long haul networks as well.

Extranet: A computer network that allows controlled access from the outside for specific business or educational purposes. An extranet can be viewed as an extension of a company’s intranet that is extended to users outside the company, usually partners, vendors, and suppliers.

Fully-meshed (or meshed): A type of networking wherein each node in the network may act as an independent router, regardless of whether it is connected to another network or not. It allows for continuous connections and reconfiguration around broken or blocked paths by “hopping” from node to node until the destination is reached.

 

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Gigabit: A multiple of the unit bit for digital information or computer storage. The prefix giga (symbol G) is defined in the International System of Units (SI) as a multiplier of 109 (1 billion, short scale), and therefore 1 gigabit = 109bits = 1,000,000,000 bits.

HD Video, or high-definition video: Any video system of higher resolution than standard-definition (SD) video, and most commonly involves display resolutions of 1,280×720 pixels (720p) or 1,920×1,080 pixels (1080i/1080p).

IP, or Internet protocol: The protocol used in the transmission of data over the Internet.

IT, or information technology: The study, design, development, application, implementation, support or management of computer-based information systems, particularly software applications and computer hardware.

LAN, or local area network: In contrast to a WAN, a LAN covers only one location.

Latency: A measure of time delay experienced in a system. Latency in a packet-switched network is measured either one-way (the time from the source sending a packet to the destination receiving it), or round-trip (the one-way latency from source to destination plus the one-way latency from the destination back to the source).

Layer 2: The data link layer of the seven-layer OSI model of computer networking that provides the functional and procedural means to transfer data between network entities and might provide the means to detect and possibly correct errors that may occur in the physical layer of the seven-layer OSI model of computer networking. 

Layer 3: The network layer of the seven-layer OSI model of computer networking that is responsible for routing packet delivery including routing through intermediate routers, whereas the data link layer is responsible for media access control, flow control and error checking.

MPLS, or multi-protocol label switching: A standards-based technology for speeding up data services provided over a network and making those data services easier to manage.

NOC, or network operations center: A location that is used to monitor networks, troubleshoot network degradations and outages, and ensure customer network outages and other network degradations are restored.

Off-net: Locations that are not on a service provider’s physical infrastructure.

OSI, or open systems interconnection: An effort to standardize networking, started in 1977, by the International Organization of Standardization.

Packet loss: When one or more packets of data traveling across a computer network fail to reach their destination, which can result in noticeable performance issues with HD video, VoIP and other network applications.

Packet Switched: A digital networking communications method that groups all transmitted data, regardless of content, type, or structure, into suitably-sized blocks, called packets. Packet switching features delivery of variable-bit-rate data streams (sequences of packets) over a shared network.

QoS, or quality of service: The ability to provide different priority to different applications, users, or data flows, or to guarantee a certain level of performance to a data flow.

SaaS, or software as a service: Sometimes referred to as “software on demand,” SaaS is software that is deployed over a network (including the Internet but increasingly over secure VPNs), where a provider licenses an application to customers either as a service on demand, through a subscription, in a “pay-as-you-go” model, or at no charge.

 

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SI, or systems integrators: A person or company that specializes in bringing together IT component subsystems into a whole and ensuring that those subsystems function together.

SLA, or service level agreement: A part of a service contract where the level of service is formally defined. In practice, the term SLA is sometimes used to refer to the contracted delivery time (of the service) or performance.

Telepresence: A higher level of videotelephony which deploys greater technical sophistication and improved fidelity of both video and audio than in traditional videoconferencing; a set of technologies which allow a person to feel as if they were present or to give the appearance that they were present at a place other than their true location.

Tier 1 technician: The first level of NOC personnel who perform network trouble-shooting and problem resolution.

Trunking facilities: A concept by which a communications system can provide network access to many clients by sharing a set of lines or frequencies instead of providing them individually.

Unified communications: A general term for a family of methodologies, communication protocols, and transmission technologies for delivery of voice communications and multimedia sessions over IP networks.

USAC, or Universal Service Administrative Company: An independent non-profit corporation that administers the Universal Service Fund in the United States.

USF, or Universal Service Fund: A fund administered by USAC by which certain communications providers are required to contribute funds to be used to, among other things, help provide services to rural and other areas.

VARs: Value-added resellers.

VoIP, or voice over Internet protocol: A general term for a family of methodologies, communication protocols, and transmission technologies for delivery of voice communications and multimedia over IP networks.

VPLS, or virtual private LAN service: A way to provide Ethernet based multipoint-to-multipoint communications over IP MPLS networks.

VPWS, or virtual private wire service: A way to provide Ethernet based point-to-point communications over IP MPLS networks.

VPN, or virtual private network: A private computer network that is implemented as an overlay on top of an existing larger network.

WAN, or wide area network: In contrast to a LAN, a WAN spans multiple physical locations.

 

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PROSPECTUS SUMMARY

This summary highlights information contained elsewhere in this prospectus and does not contain all of the information you should consider in making your investment decision. You should read this entire prospectus carefully, especially the risks of investing in our common stock discussed under “Risk Factors” and the consolidated financial statements and accompanying notes included elsewhere in this prospectus, before making an investment decision.

Overview

We provide managed, secure virtualized network services to enterprises with complex information technology needs across multiple locations throughout the world. By delivering enhanced network performance, flexibility and control, together with consultative technical support, we believe we offer a unique value proposition. We enable customers to seamlessly deploy and manage video, voice and other data applications on a global basis by integrating our proprietary cloud-based software with our network. As of December 31, 2010, we served customer locations in 51 countries, representing most major industry verticals. We have generated net income and positive cash flow for the last three fiscal years and we currently have no debt. Our total revenue has grown from $48.4 million in the fiscal year ending June 30, 2006 to $97.5 million in the fiscal year ending June 30, 2010, or 19.2% on an average annual compounded basis.

Our network services platform is purpose-built and designed to deliver consistent performance across the enterprise and around the globe. Our model of leveraging third-party long-haul fiber assets and utilizing local access connections allows us to increase capacity and scale our network as dictated by customer demand, avoiding the cost of unused network capacity typical of legacy networks. We provide standard Ethernet connections to all customer locations, regardless of the available local access technology, to simplify the customer interface to our services. By overlaying our proprietary cloud-based software on a private IP architecture, we offer our customers more flexible and measurable application performance. For a depiction of a typical customer solution see “Business—Products and Services—Intelligent Transport Product Line.” Our platform delivers the high performance and low latency demanded by complex applications such as HD video conferencing, unified communications, SaaS, CRM and ERP.

We believe that our comprehensive managed service offering, together with our award-winning customer service, differentiates us from our competitors. In addition to meeting bandwidth needs, we provide tools to enterprise network administrators so that they can prioritize more important business applications over less critical or less latency-sensitive applications. Our embedded software enables IT professionals to monitor usage, prioritize traffic, optimize bandwidth and perform application and network diagnostics from any location in real time. In addition, we offer a highly consultative sales and service approach, acting as an extension of our customers’ IT departments.

Industry

The global enterprise network infrastructure market is growing rapidly, driven by globalization and the demand for complex applications. The challenges involved in managing these applications over a global network has strained the budgets and resources of enterprise IT departments. In response, IT departments must either expand internally or seek globally available managed service offerings.

The adoption of Ethernet has greatly enhanced the ability of IT departments to integrate various network technologies to ensure consistent and predictable performance. Ethernet is the most cost-effective network interface, reducing hardware costs and the risks of obsolescence, and is the desired interface for enterprise virtual private networks. In a report entitled Ethernet and IP MPLS VPN Services dated June 15, 2010, Infonetics Research, an independent research firm, estimates that the global Ethernet services market was $21 billion in 2009 and expects it to grow to $39 billion by 2014, representing a compounded annual growth rate of approximately 14%.

 

 

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VPNs provide enterprises the ability to connect their disparate locations, operations and resources over a secure, managed network. IP MPLS is the predominant underlying technology used in the delivery of enterprise VPNs. Infonetics Research, in the same report, estimates that the global market for IP MPLS VPN services was $17 billion in 2009 and will grow to $29 billion by 2014, representing a compounded annual growth rate of approximately 11%. VPNs must be capable of supporting a variety of complex enterprise applications. Many of these applications require tremendous bandwidth, delivered with low latency and without packet loss, to function effectively. For example, as large corporations seek to reduce travel expenses and increase collaboration and productivity across their enterprises, they have increasingly adopted HD video conferencing and Telepresence applications. In a market analysis report entitled Worldwide Enterprise Videoconferencing and Telepresence 2010 – 2014 Forecast dated March 2010, International Data Corporation, an independent market research firm, estimates that the global market for video conferencing and Telepresence equipment and services will grow from $1.9 billion in 2009 to $8.8 billion in 2014, representing a compounded annual growth rate of 36%. While communications applications are an important component to an enterprise’s business strategy, IT departments also have critical core business applications to manage, leading many to adopt managed solutions to maximize their limited time and resources.

To deploy their VPNs on a global basis, multinational enterprises typically rely on multiple service providers with varying levels of service, costs and responsiveness. These providers are often constrained by protocols and technology native to their geography and in which they have invested heavily. As a result, IT professionals are often faced with a lack of a standard infrastructure, additional equipment and operational costs, and poor application performance. Issues are usually handled through generic call centers, rather than a single point of contact, resulting in multiple touch points and leading to lost productivity, poor service levels, inferior application performance and uneven IT resource availability. Given these difficulties and the continuing drive toward globalization, IT professionals are increasingly seeking a unified global solution.

Competitive Strengths

Singular focus on enterprise network solutions. Unlike many legacy service providers, our only business is providing virtualized network solutions to enterprises. This singular focus allows us to offer enterprise customers network solutions that reduce costs, simplify IT management and improve network performance. Our entire company is focused exclusively on addressing the needs of global enterprises, which more closely aligns our priorities with those of our customers and we believe provides us a competitive advantage.

Purpose-built, global network platform. Our global network platform was purpose-built to deliver IP VPN services cost efficiently. We seamlessly deliver an identical suite of solutions to all customer locations anywhere in the world, regardless of the available local access technology. Unencumbered by legacy network infrastructure, we chose technologies that deliver the highest performance and lowest latency demanded by complex business applications.

Reduced information technology costs for our customers. Our Ethernet-based global network platform eliminates the need for our customers to purchase expensive equipment often required to interconnect to carrier networks. Our ability to deliver multiple services on a single access circuit reduces the number of customer access points, thereby simplifying network administration and reducing costs. These advantages of our platform enable our customers to focus their IT budgets and resources on projects that improve their businesses.

Enhanced customer visibility and control. Our proprietary software provides customers a detailed view into their business applications and network performance, allowing IT professionals to prioritize network usage in real time. These tools integrate with the customer’s business processes, creating a level of dependence and customer loyalty, which we believe contributes to our ability to both attract and retain customers.

Capital-efficient operations. Our model of leveraging third-party long-haul fiber assets and utilizing local access connections provides maximum global reach while minimizing the costs associated with unused network

 

 

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capacity. We invest capital only after winning sufficient business to justify an investment and are not exposed to the costly maintenance and upgrades associated with the ownership and operation of legacy networks. This flexibility enables us to scale efficiently, increase network capacity economically and reduce additional capital investment.

Industry-leading quality of service and customer care. We regard customer support and a consultative sales approach as an integral part of our network services platform. Our first line of customer support are Tier 1 technicians, who typically resolve customer issues without further escalation. Our network performance and quality of service permit us to offer some of the strongest service level agreements in the industry.

Our Strategy

Acquire new customers by increasing our sales distribution. We intend to expand our domestic and international sales force, in both existing and new markets. We believe this expansion will also create opportunities for establishing new channel partner relationships. We expect such expansion to be a key driver of future growth for our business.

Sell additional services to existing enterprise customers. Because we generally do not capture all of our new customers’ potential spend in their initial contract, our sales force works proactively with our existing customers to identify expansion and up-selling opportunities, including additional services, new locations and increased bandwidth. We have significantly increased our customer base over the past few years, and we believe we are well-positioned to increase sales to this expanded customer base.

Extend our technology leadership and product depth and breadth. Our role as an extension of our customers’ IT departments gives us unique insight into customer needs and technological changes. The consultative approach we take with the design and implementation of solutions for our customers often leads to new product development. We intend to continue to expand our service offerings and solutions to meet the evolving needs of our customers.

Pursue collaborations and strategic acquisitions that complement our strategy. To date, we have successfully collaborated with a number of industry-leading companies on technology initiatives and intend to continue to pursue these collaborations to enhance our solutions, especially in the areas of unified communications, managed services and cloud computing. We also plan to opportunistically pursue strategic acquisitions that expand our sales geographies or broaden our product and service offerings.

Risks Affecting Us

Investing in our common stock involves substantial risk. While we have set forth our competitive strengths and growth strategies above, we are engaged in a very competitive industry and our business involves numerous risks and uncertainties. The factors that could adversely affect our results and performance are discussed under the heading “Risk Factors” immediately following this summary. Before you invest in our common stock, you should carefully consider all of the information in this prospectus, including matters set forth under the heading “Risk Factors.” In particular, you should consider the following risks, which are discussed more fully in “Risk Factors”:

 

   

Our historical revenue growth has been driven by new service orders from existing customers. If we are unable to offset any future decline in new service orders from existing customers by growing sales to new customers, our revenue growth could stall and revenue could decline.

 

   

Our business depends substantially on customers renewing their contractual commitments for our solutions and any increase in customer cancellations or decline in customer renewals would cause our future operating results to suffer.

 

 

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We rely on our relationships with channel partners to generate a significant amount of our sales. If we fail to expand or maintain these relationships, we risk losing a significant source of our business referrals and our ability to cost-effectively market and sell our solutions and services may be impaired.

 

   

Our industry is intensely competitive and if we do not compete successfully, we could experience a decline in revenue or suffer losses.

 

   

Our services are dependent on facilities and infrastructure owned and maintained by third parties over which we have no direct control, the failure of which could harm our business materially.

 

   

We depend on third parties for network technology, equipment, software and support. Our success depends upon the quality, availability and pricing offered to us by these third parties.

Corporate Information

We are headquartered in Plano, Texas and have operations in London, United Kingdom and sales offices in New York City, San Francisco, California and Fairfax, Virginia. Our NOC facilities are located in Plano and London, which together provide 24-hour technical customer support.

We were incorporated in the State of Delaware in August 2000. Our principal executive offices are located at 2740 North Dallas Parkway, Suite 260, Plano, Texas 75093, and our telephone number is (214) 442-5700. Our website address is www.masergy.com. The information on, or that can be accessed through, our website is not part of this prospectus.

“MASERGY®,” “inControl,” “Masergy Network Analyst,” and “Masergy Intelligent Network Analyst” are our trademarks and registered trademarks appearing in this prospectus. All other trademarks and trade names appearing in this prospectus are the property of their respective owners.

 

 

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The Offering

 

Common stock offered by us

3,850,000 shares

 

Common stock offered by the selling stockholders

3,850,000 shares (5,005,000 shares if the underwriters exercise in full their option to purchase 1,155,000 additional shares)

 

Total common stock offered

7,700,000 shares (8,855,000 shares if the underwriters exercise in full their option to purchase 1,155,000 additional shares)

 

Common stock to be outstanding after this offering

16,830,738 shares

 

Significant stockholders after this offering

Entities affiliated with Centennial Ventures, Meritage Funds and Special Private Equity Partners will beneficially own approximately 46% (or 40% if the underwriters exercise in full their option to purchase additional shares). See “Principal and Selling Stockholders.”

 

Use of proceeds

We intend to use the net proceeds from this offering for general corporate purposes, including capital expenditures and working capital. We also may use a portion of the net proceeds for the future acquisition of businesses that could enhance our sales footprint or broaden our product and service offerings. We will not receive any proceeds from the sale of shares by the selling stockholders. See “Use of Proceeds.”

 

NYSE listing

Our common stock has been approved for listing on the NYSE under the symbol “MSGY.”

The number of shares of common stock that will be outstanding after this offering is based on 12,980,738 shares of our common stock outstanding as of December 31, 2010 and excludes:

 

   

2,562,517 shares of common stock issuable upon the exercise of options outstanding as of December 31, 2010 under our 2001 Stock Option/Stock Issuance Plan, with a weighted average exercise price of $4.14 per share;

 

   

707,120 shares of common stock reserved for future issuance under our 2010 Incentive Compensation Plan, (including 207,120 shares of common stock reserved for future issuance under our 2001 Stock Option/Stock Issuance Plan, which were added to the shares reserved under our 2010 Incentive Compensation Plan); and

 

   

356,531 shares of common stock issuable upon the exercise of warrants outstanding as of December 31, 2010, with a weighted average exercise price of $3.76 per share.

Unless otherwise indicated, the information in this prospectus assumes:

 

   

an initial public offering price of $13.00 per share of common stock, the midpoint of the range of the estimated initial public offering price set forth on the cover of this prospectus;

 

 

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the conversion of all outstanding shares of our convertible preferred stock into 8,925,277 shares of common stock effective upon the completion of this offering;

 

   

no exercise by the underwriters of their right to purchase up to 1,155,000 shares of common stock to cover over-allotments; and

 

   

the filing of our amended and restated certificate of incorporation and the effectiveness of our amended and restated bylaws, which will occur immediately upon the completion of this offering.

 

 

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Summary Consolidated Financial Information and Other Data

The following tables set forth summary consolidated financial information and other operating data.

The historical balance sheet data as of June 30, 2009 and 2010, and the historical statement of operations data for the fiscal years ended June 30, 2008, 2009 and 2010 have been derived from our audited financial statements, which are included elsewhere in this prospectus. The historical balance sheet data as of June 30, 2008 has been derived from our audited balance sheet as of June 30, 2008, which is not included in this prospectus. Our financial statements as of and for the fiscal years ended June 30, 2008, 2009 and 2010 were audited by Grant Thornton, LLP, independent registered public accounting firm. Our historical results are not necessarily indicative of results to be expected for any future period.

The historical balance sheet data as of December 31, 2009 and 2010 and the historical statement of operations data for the six months ended December 31, 2009 and 2010 have been derived from our unaudited financial statements, which are included elsewhere in this prospectus. The unaudited financial statements as of and for the six-month periods ended December 31, 2009 and 2010 have been prepared on a basis consistent with our audited financial statements and, in the opinion of management, include all adjustments, consisting of normal accruals, necessary for the fair presentation of our financial condition as of such dates and our results of operations for such periods. Interim results are not necessarily indicative of results that may be expected for any future period.

The information presented below should be read in conjunction with “Capitalization,” “Selected Consolidated Financial Data,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and our consolidated financial statements and accompanying notes, which are included elsewhere in this prospectus.

 

    Year Ended June 30,     Six Months
Ended
December 31,
 
    2008     2009     2010     2009     2010  
(in thousands, except per share data)                     (unaudited)  

Consolidated Statement of Operations Data:

         

Revenue:

         

Customer services

  $ 86,850      $ 98,159      $ 98,869      $ 48,589      $ 54,636   

Universal Service Fund fees

    6,063        6,549        (1,331     2,543        1,860   
                                       

Total revenue

    92,913        104,708        97,538        51,132        56,496   
                                       

Operating expenses:

         

Cost of services

    54,775        60,434        51,394        28,564        29,981   

Selling, general and administrative

    29,781        31,109        31,472        15,259        17,304   

Depreciation

    4,343        7,857        5,783        2,722        3,399   

Impairment of property and equipment

    —          2,107        —          —          —     
                                       

Total operating expenses

    88,899        101,507        88,649        46,545        50,684   
                                       

Operating income

    4,014        3,201        8,889        4,587        5,812   

Interest expense, net

    (289     (60     (34     (19     (22

Other income (expense), net

    4        (42     (203     (144     (82
                                       

Income before income taxes

    3,729        3,099        8,652        4,424        5,708   

Income tax (expense) benefit

    —          —          13,643        —          (253
                                       

Net income

  $ 3,729      $ 3,099      $ 22,295      $ 4,424      $ 5,455   
                                       

Net income attributable to common stockholders

  $ 1,123      $ 950      $ 6,902      $ 1,368      $ 1,696   
                                       

Net income per share attributable to common stockholders:

         

Basic

  $ .29      $ .24      $ 1.72      $ .34      $ .42   

Diluted

  $ .25      $ .22      $ 1.65      $ .33      $ .38   

 

 

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    Year Ended June 30,     Six Months Ended
December 31,
 
    2008     2009     2010     2009     2010  
(in thousands, except per share data)                     (unaudited)  

Weighted average common shares used in computing net income per share attributable to common stockholders:

         

Basic

    3,840        3,945        4,002        3,994        4,028   

Diluted

    4,534        4,312        4,196        4,185        4,519   

Pro forma net income per share attributable to common stockholders (unaudited) (1):

         

Basic

      $ 1.72        $ .42   

Diluted

      $ 1.70        $ .40   

Pro forma weighted average shares outstanding used in computing net income per share attributable to common stockholders (unaudited) (2):

         

Basic

        12,928          12,953   

Diluted

        13,121          13,491   

Consolidated Statement of Cash Flows Data:

         

Net cash provided by operating activities

  $ 10,655      $ 16,039      $ 12,394      $ 2,173      $ 11,694   

Net cash used in investing activities

    (6,807     (8,189     (11,196     (6,862     (6,125

Net cash provided by (used in) financing activities

    (3,007     (1,001     231        231        70   

Other Financial Data (unaudited):

         

Adjusted EBITDA (3)

  $ 8,908      $ 13,883      $ 15,105      $ 7,541      $ 9,461   

Capital expenditures (4)

    7,001        8,238        10,697        6,863        4,971   
    As of June 30,     As of
December 31,
 
    2008     2009     2010     2009     2010  
(in thousands)                     (unaudited)  

Consolidated Balance Sheet Data:

         

Cash and cash equivalents

  $ 4,199      $ 10,882      $ 12,378      $ 6,249      $ 17,810   

Working capital

    (556     4,996        14,956        5,392        18,699   

Total assets

    36,099        39,828        68,467        39,761        74,233   

Notes payable, including current portion

    1,016        —          —          —          —     

Total liabilities

    13,888        14,455        20,324        9,675        20,444   

Total stockholders’ equity

    22,211        25,373        48,143        30,086        53,789   
    Year Ended June 30,     Six Months Ended
December 31,
 
    2008     2009     2010     2009     2010  
(unaudited)                        

Operating Data:

         

Customer bookings, in thousands (5)

  $ 2,529      $ 2,123      $ 2,789      $ 1,349      $ 1,554   

Average contract term of customer bookings, in months (6) (9)

    25.5        26.3        28.4        28.4        28.6   

Average monthly churn rate (7) (9)

    1.6     1.6     1.9     2.2     1.1

Employees (end of period)

    153        154        156        152        159   

Average customer services revenue per employee, in thousands (8)

  $ 627      $ 639      $ 638      $ 635      $ 694   

 

(1) Pro forma net income per share represents net income divided by the pro forma weighted average shares outstanding as though the conversion of our convertible preferred stock into common stock occurred on the original dates of issuance.

 

(2) Pro forma weighted average shares outstanding reflects the conversion of our convertible preferred stock (using the if-converted method) into common stock as though the conversion had occurred on the original dates of issuance.

 

(3) Adjusted EBITDA is not defined under generally accepted accounting principles as applied in the United States, or GAAP. We define Adjusted EBITDA as net income (loss) before interest, income taxes, depreciation and amortization (EBITDA) excluding, when applicable, asset impairment charges, stock-based compensation expense, and other income (expense), net, consisting of foreign currency impacts on transactions and gains and losses on the disposal of property and equipment. EBITDA and Adjusted EBITDA are not measurements of our financial performance under GAAP and should not be considered in isolation or as alternatives to net income or any other performance measures derived in accordance with GAAP or as alternatives to cash flows from operating activities as measures of our liquidity.

 

 

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We use Adjusted EBITDA to evaluate our operating performance and this non-GAAP financial measure is among the primary measures used by management for planning and forecasting for future periods. By excluding the impact of expenses that may vary from period to period without any correlation to underlying operating performance, we believe we are able to gain a clearer view of the operating performance of our business. We believe the presentation of Adjusted EBITDA is relevant and useful for investors because it allows investors to view our results in the same manner as management and makes it easier to compare our results with the results of other companies that have different financing and capital structures.

Adjusted EBITDA has limitations as an analytical tool and should not be considered in isolation from, or as a substitute for, net income (loss) or any other measure of our performance reported in accordance with GAAP. For example, Adjusted EBITDA (i) does not reflect capital expenditures, or contractual commitments, (ii) does not reflect changes in, or cash requirements for, our working capital needs, (iii) does not reflect interest expense, or the cash requirements necessary to service interest payments, on debt, (iv) does not reflect income taxes and (v) does not consider the costs or potentially dilutive impact of issuing equity-based compensation.

Our computation of Adjusted EBITDA may not be comparable to other similarly titled measures computed by other companies, because all companies do not calculate Adjusted EBITDA in the same manner.

The following table provides a reconciliation of EBITDA and Adjusted EBITDA to net income, which is the most directly comparable financial measure presented in accordance with GAAP:

 

     Year Ended June 30,     Six Months Ended
December 31,
 
     2008     2009      2010         2009              2010      
(in thousands, unaudited)                          

Net income

   $ 3,729      $ 3,099       $ 22,295      $ 4,424       $ 5,455   

Interest expense, net

     289        60         34        19         22   

Income tax expense (benefit)

     —          —           (13,643     —           253   

Depreciation

     4,343        7,857         5,783        2,722         3,399   
                                          

EBITDA

     8,361        11,016         14,469        7,165         9,129   

Impairment of property and equipment

     —          2,107         —          —           —     

Stock-based compensation expense

     551        718         433        232         250   

Other (income) expense, net

     (4 )     42         203        144         82   
                                          

Adjusted EBITDA

   $ 8,908      $ 13,883       $ 15,105      $ 7,541       $ 9,461   
                                          

 

(4) Represents purchases of property and equipment, including equipment financed with notes payable.

 

(5) Calculated as the total monthly value of qualified customer service orders received during the period less the total monthly value of any service orders that were cancelled during the same period. In order to qualify as a booking, customer service orders must include a minimum one-year service term and a defined service implementation schedule, and may not be subject to any contingencies.

 

(6) For customer service orders received during a period, calculated as the total recurring fixed monthly fees to be paid over the initial term divided by the total monthly value of those service orders.

 

(7) Calculated as the recurring fixed monthly fees associated with customer locations disconnected during a period divided by our total recurring customer services revenue during the same period, expressed as a percentage.

 

(8) Calculated as customer services revenue for a period divided by the average of the number of employees as of the beginning of the period and the end of the period. Amounts for the six-month periods ended December 31, 2009 and 2010 have been annualized. We utilize average customer services revenue per employee to periodically evaluate our operating efficiency and employee productivity, and believe presentation of this measurement is relevant and useful for investors as it makes it easier to compare our results with other companies that either publicly disclose this measurement or are the subject of analyst or industry reports that present this information.

 

(9) We use average contract term and average monthly churn rates as (i) leading indicators of future revenues, (ii) key performance indicators of the effectiveness of our sales organization in securing long-term customer contracts and renewing customer contracts as their prior contracts expire, and (iii) indicators of customer satisfaction. Our computation of average contract term and average monthly churn rates may not be comparable to other similarly titled measures computed by other companies because such measures may not be calculated in the same manner.

 

 

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RISK FACTORS

An investment in our common stock involves a high degree of risk. You should carefully consider the risks and uncertainties described below, together with the financial and other information contained in this prospectus, including our consolidated financial statements and accompanying notes, before deciding whether to purchase shares of our common stock. If any of the following risks actually occurs, our business, financial condition, results of operations and future prospects could be materially and adversely affected. In that event, the market price of our common stock could decline and you could lose part or all of your investment.

Risks Related to Our Business

Our historical revenue growth has been driven by new service orders from existing customers. If we are unable to offset any future decline in new service orders from existing customers by growing sales to new customers, our revenue growth could stall and revenue could decline.

A substantial amount of our past revenue growth was derived from existing customers increasing the amount of services purchased from us. New service orders from our existing customers accounted for approximately 60%, 61% and 49% of our new bookings in fiscal years 2008, 2009 and 2010, respectively. Our ability to increase revenues from existing customers will depend upon our ability to maintain the quality and reliability of the solutions and services we provide, as well as our ability to successfully develop enhancements to existing solutions and new solutions that effectively address our customers’ evolving needs. Sales to existing customers may also be adversely affected by factors outside of our control, including, but not limited to:

 

   

unfavorable general economic conditions that cause our customers to reduce their capital expenditures in general or their IT spending specifically, or that cause delays or cancellations of IT projects that would otherwise create new sales opportunities for us; and

 

   

service interruptions outside of our control which adversely affect our customers’ perceptions of the reliability or quality of our services and solutions.

We cannot assure you that we can continue to grow or maintain the revenue we receive from existing customers. If we are unable to offset any future decline in sales to existing customers by growing sales to new customers, our revenue growth could stall and revenue could decline.

Our ability to increase sales to new customers will be affected by many of the same factors that drive additional sales to existing customers, as well as our ability, directly or in conjunction with our channel partners, to cost-effectively market our solutions and services to new customers in existing or new geographic or vertical markets.

Our business depends substantially on customers renewing their contractual commitments for our solutions and any increase in customer cancellations or decline in customer renewals would cause our future operating results to suffer.

Our service agreements with customers that have already satisfied their initial terms are subject to termination by the customer on short notice. After expiration of their current agreements, our customers have no obligation to renew their contracts and may choose not to continue to purchase services or the same level of services. In addition, under specific circumstances, our customers have the right to cancel their service agreements before they expire, without paying a cancellation fee (such as in the event of an uncured material breach by us). Historical data with respect to rates of customer renewals, terminations, and expansions may not accurately predict future trends in customer renewals. Our customers’ renewal rates may decline or fluctuate for a number of reasons, including, but not limited to, their satisfaction or dissatisfaction with our solutions, our pricing, our competitors’ pricing and any changes in the growth or performance of our customers’ business and their IT spending levels. If our customers cancel their agreements with us during their term, do not renew their agreements, or renew on less favorable terms, our future operating results will suffer.

 

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We rely on our relationships with channel partners to generate a significant amount of our sales. If we fail to expand or maintain these relationships, we risk losing a significant source of new business referrals and our ability to cost-effectively market and sell our solutions and services may be impaired.

We rely on relationships with a variety of industry participants, which we refer to as channel partners, to generate a significant amount of our sales. Our channel partners include systems integrators, value-added resellers, agents and referral partners, many of whom separately maintain business relationships with current or prospective customers and, in many cases, provide products and services that are complementary to our services. Our channel partners play a critical role in referring sales opportunities and marketing our solutions and services. In fiscal 2010, our channel partners were involved in approximately 74% of our new bookings.

Although we maintain contractual arrangements with our channel partners, these arrangements are typically non-exclusive and incentive-based. In order to maintain the productivity of our channel partner relationships, we must continue to offer compelling solutions and services that our channel partners are willing to recommend to their clients, as well as offer competitive compensation structures in the form of commissions and referral fees. At the same time, our channel partners may receive greater incentives to promote our competitors’ products in lieu of ours, particularly for our competitors with larger order volumes, more diverse product offerings and longer relationships with the channel partners. If we are unable to maintain productive relationships with channel partners, we risk losing a significant source of business referrals for both new and existing customers and our ability to cost-effectively market and sell our solutions and services may be impaired.

If we do not effectively expand and train our sales force, we may be unable to effectively market and sell our solutions and services and our revenues may decline.

We are highly dependent on the ability of our sales force to generate sales to new and existing customers, both directly and by establishing and maintaining productive relationships with channel partners. We believe that there is significant competition for sales personnel with the skills and technical knowledge that we require. Our ability to achieve significant revenue growth will depend, in large part, on our success in recruiting, training and retaining sufficient numbers of sales personnel to support our growth. New hires require significant training and, in most cases, take significant time before they achieve full productivity. Our recent and planned hires may not become as productive as we expect, and we may be unable to hire or retain sufficient numbers of qualified individuals in the markets where we do business or plan to do business. If we are unable to hire, train and retain sufficient numbers of effective sales personnel, or our sales personnel are not successful in establishing and maintaining productive channel partner relationships and generating sales to new and existing customers, our revenues may decline.

Our services are dependent on facilities and infrastructure owned and maintained by third parties over which we have no direct control, the failure of which could harm our business materially.

We do not own any long-haul communications assets but instead lease capacity on long-haul fiber optic transmission lines owned and maintained by third parties. We place our owned or leased network equipment in leased space within data centers owned and maintained by third parties. We also rely on local providers in each market where we have customers to provision, install and maintain local access lines to our customers and for elements of their local network. While our network architecture allows us to constantly monitor these and other components of our network, we do not control the facilities, network elements and other system assets maintained by these third parties. All of these facilities, network elements and other system assets are vulnerable to interruption or damage from a number of sources, many of which are beyond our control, including:

 

   

human error;

 

   

power loss;

 

   

fire, earthquake, hurricane, flood and other natural disasters;

 

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software and hardware errors;

 

   

network environment disruptions such as computer viruses and electronic security breaches;

 

   

physical security breaches, theft, sabotage and vandalism; and

 

   

the effect of war, terrorism, and any related conflicts or similar events worldwide.

The occurrence of an extended service interruption at one or more of our suppliers’ facilities could result in lengthy interruptions in our services. Our service level agreements generally require us to refund a prorated portion of our fees if we fail to satisfy our service level commitments. Any extended service outage in the future could result in material refunds to our customers and harm our customer relationships. If our third-party providers fail to maintain their assets or facilities or fail to respond quickly to network or other problems, our customers may experience interruptions or failures in the service they obtain from us. Any service interruptions experienced by our customers could negatively impact our reputation, cause us to lose customers and limit our ability to attract new customers.

We depend on third parties for network technology, equipment, software and support. Our success depends upon the quality, availability and pricing offered to us by these third parties.

A key component of our network design is the use of equipment and software, and related support, provided by third parties, such as Alcatel-Lucent, Cisco Systems, and IBM. We obtain the majority of our network equipment and software from Alcatel-Lucent. In addition, we rely on many of these third parties for technical support and assistance with their equipment and software. Although we believe that we maintain a good relationship with our suppliers, if any of our key suppliers were to terminate our relationship or were to cease making the equipment and software we use, our ability to maintain, upgrade or expand our network could be impaired. Although we believe that we would be able to address our future equipment needs with equipment obtained from other suppliers, we cannot assure you that such equipment would be compatible with our network without significant modifications or cost, if at all. If we were unable to obtain the equipment necessary to maintain our network, our ability to attract and retain customers and provide our services would be impaired. In addition, our success depends in part on our obtaining network technology, equipment and software at affordable prices. Significant increases in the price of these products would harm our financial results and may increase our capital requirements.

We depend on third-party manufacturers to supply the customer premise equipment, or Intelligent Bridges, that our customers require to obtain our solutions and services. We also depend on third parties to install our Intelligent Bridges at many of our customers’ locations. If we are unable to obtain these Intelligent Bridges and installation services as we require and at reasonable costs, our revenue growth may be limited and our profitability may be impaired.

The installation of specific customer premise equipment devices that enable our customers to obtain our solutions and services is critical to our success. We rely on a limited number of manufacturers to supply these devices and on a few vendors to install them for customers that are not equipped to perform self-installation. In order to provide our customers with reliable equipment and a positive installation experience, we must ensure that these vendors adhere to the timelines we establish and quality standards that we maintain. If we are not able to obtain a sufficient number of Intelligent Bridges of the quality that we require for our customers, or if we cannot arrange for the installation of such equipment in a timely and professional manner, we may fail to expand our customer base and grow our revenue. If we are unable to obtain these devices and installation services at reasonable costs, our profitability may suffer.

 

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We may be unable to successfully develop or acquire enhancements and new solutions necessary to remain competitive in our evolving industry.

Our industry is characterized by rapidly changing customer requirements, technological developments and evolving industry standards. Our ability to attract new customers and increase sales to existing customers will depend in large part on our ability to successfully develop or acquire enhancements to our existing solutions and new solutions that effectively respond to the changes in our industry. Any enhancements or new solutions that we develop or acquire may not be introduced to the market in a timely or cost-effective manner and may not achieve the broad market acceptance necessary to generate the revenue required to offset the operating expenses and capital expenditures related to their development or acquisition. If we are unable to timely develop or acquire enhancements and new solutions that keep pace with the changes in our industry, our revenue will not grow as expected and we may not be able to maintain or meet profitability expectations.

Our quarterly operating results have fluctuated in the past and may fluctuate in the future, which could cause our stock price to decline or lead to volatility in our stock price.

Our quarterly operating results may fluctuate as a result of a variety of factors, many of which are outside of our control. The primary factors that could cause quarterly fluctuations include:

 

   

our ability to attract new customers and increase sales to existing customers; and

 

   

our ability to retain existing customers.

Other important factors that could cause quarterly fluctuations include:

 

   

changes in our pricing and that of our competitors;

 

   

unanticipated technical difficulties or service interruptions; and

 

   

the amount and timing of operating expenses or capital expenses related to the maintenance and expansion of our operations or infrastructure.

Fluctuations in our quarterly operating results may lead analysts to change their long-term model for valuing our common stock, cause us to face short-term liquidity issues, impact our ability to retain or attract key personnel or cause other unanticipated issues, all of which could cause our stock price to decline or lead to volatility in our stock price. As a result of the potential variations in our quarterly revenue and operating results, we believe that quarter-to-quarter comparisons of our revenues and operating results may not be meaningful and the results of any one quarter should not be relied upon as an indication of future performance. Consequently, our future operating results may be materially lower than in recent periods, which could cause our stock price to decline.

Acquisitions and other strategic transactions could result in operating difficulties, dilution, and adversely affect our results of operations.

We periodically evaluate and consider a wide range of potential strategic transactions, including business combinations and acquisitions of businesses, technologies, services, products and other assets. Any of these transactions could be material to our financial condition and results of operations. We may not realize the anticipated benefits of any of these transactions, or may not realize them in the time frame expected. As a company, we have not completed any strategic business combinations or acquisitions and therefore have not demonstrated an ability to successfully integrate the operations and employees of an acquired business and to retain and motivate key personnel from such a business. Any of these transactions may divert management’s attention, disrupt our ongoing operations, increase our expenses and adversely impact our business and results of

 

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operations. Acquisitions of foreign operations involve additional risks, including the need to integrate operations across different cultures and languages and to address the particular economic, currency, political, and regulatory risks associated with specific countries. Any significant business acquisitions and in particular any acquisitions of businesses with global operations could increase the complexity of our operations in ways we may not be able to predict or adequately address. Any acquisitions or strategic transactions may require us to issue additional equity securities, which could be dilutive to our shareholders, spend our cash, or incur debt, liabilities, amortization expenses related to intangible assets or write-offs of assets or goodwill, any of which could adversely affect our results of operations and harm our business.

If we are unable to protect our intellectual property rights, we may not be able to compete successfully and our business may be harmed materially.

Our ability to compete successfully depends in part on our ability to protect our intellectual property and proprietary rights. We rely on a combination of patent, copyright, service mark, trademark and trade secret laws, as well as confidentiality procedures and contractual restrictions, to establish and protect our intellectual property rights, all of which provide only limited protection. Currently, we possess a limited number of issued patents covering only a portion of our service offerings and products. We can provide no assurance that our pending patent applications will be allowed or that our issued patents, and any future patents we obtain, will provide us with the protection that we seek. Our existing and any future patents may be successfully challenged by and held invalid and unenforceable against third parties or narrowed in scope.

We do not know whether the steps we have taken will deter unauthorized use of our technology and monitoring unauthorized use of our technologies or possible infringement of our rights is difficult and costly. Even if we identify unauthorized use or possible infringement, enforcement of our intellectual property rights is time consuming and costly and ultimately depends on whether the legal actions we bring against infringers are successful. The legal standards relating to the validity, enforceability and scope of protection of intellectual property rights in technology-related industries are uncertain and still evolving. For this reason, any infringement claims we bring may not succeed, even if our rights have been infringed. Despite our efforts to establish and protect our intellectual property rights, unauthorized persons may be able to copy, reverse engineer or otherwise use some of our technology.

We believe that our proprietary technology provides us a competitive advantage by enabling us to offer solutions and services that are superior to those offered by our competitors. If we are unable to protect our intellectual property and proprietary rights adequately, our competitors could use proprietary technology we have developed to enhance their own products and services or replicate ours, which could reduce or eliminate our competitive advantage and materially harm our business.

Additionally, effective patent, trademark, service mark, copyright and trade secret protection may not be available or as robust in every country in which our solutions are available. As a result, we may not be able to effectively prevent competitors outside the United States from infringing or otherwise misappropriating our intellectual property rights, which could impair our ability to compete internationally.

Claims by others that we infringe their proprietary technology could harm our business.

Third parties, including some of our competitors, may in the future assert claims of infringement of intellectual property rights against us or against our customers or channel partners for which we may be liable. Much of our business relies on, and many of our products incorporate, proprietary technologies of third parties, and we may not be able to obtain, or continue to obtain, licenses from such third parties on reasonable terms. As our business expands and the number of products and competitors in our markets increases and overlaps occur, we expect that infringement claims may increase in number and significance. Intellectual property lawsuits are subject to inherent uncertainties due to the complexity of the technical issues involved, and we cannot be certain that we will be successful in defending ourselves against intellectual property claims. In addition, we currently

 

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have a limited portfolio of issued patents, and therefore may not be able to effectively utilize our intellectual property portfolio to assert defenses or counterclaims in response to patent infringement claims or litigation brought against us by third parties. Some of our competitors or other third parties may have been more aggressive than us in applying for or obtaining patent protection for innovative proprietary technologies, both in the United States and internationally. Furthermore, a successful claimant could secure a judgment that requires us to pay substantial damages or prevents us from distributing certain products or services. We might also be required to seek a license for the use of such intellectual property, which may not be available on commercially acceptable terms or at all. Alternatively, we may be required to develop non-infringing technology, which could require significant effort and expense and may ultimately not be successful. Any claims or proceedings against us, whether meritorious or not, could be time consuming, result in costly litigation, require significant amounts of management time, result in the diversion of significant operational resources, or require us to enter into royalty or licensing agreements, any of which could materially and adversely affect our business and results of operations.

Some of our software may be derived from “open source” software and, as such, subject to restrictions limiting its use or our ability to protect our intellectual property rights thereto.

Some of our software may be derived from so-called “open source” software that is made generally available to the public by its authors and/or other third parties. Such open source software is often made available to us under licenses, such as the GNU General Public License, that impose certain obligations on us in the event we were to make available derivative works of the open source software. These obligations may require us to make source code for the derivative works available to the public, or license such derivative works under a particular type of license, rather than the forms of license customarily used to protect our intellectual property. In addition, there is little or no legal precedent for interpreting the terms of certain of these open source licenses, including the determination of which works are subject to the terms of such licenses. While we believe we have complied with our obligations under the applicable licenses for open source software, in the event the copyright holder of any open source software were to successfully establish in court that we had not complied with the terms of a license for a particular work, we could be required to release the source code of that work to the public or stop distribution of that work.

Impairment analyses of property and equipment and intangible assets may result in charges, which may be significant.

GAAP requires us to evaluate finite-lived property and equipment and intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. In fiscal 2009, our results of operations were adversely affected by a charge of $2.1 million for the impairment of property and equipment. The most likely cause of impairment of the types of property and equipment we own result from the obsolescence of such equipment due to technological advances requiring us to replace such equipment. If we conclude that there is significant impairment of our property and equipment or intangible assets as a result of any impairment analysis, we would be required to record corresponding non-cash impairment charges, which could negatively and materially affect our operating results and the market price of our common stock.

The increased costs and expenses that we will incur to comply with the laws and regulations applicable to public companies will be significant and could make it more difficult for us to sustain profitability.

As a public company, we will incur significant legal, accounting, investor relations and other expenses that we did not incur as a private company, including costs associated with public company reporting requirements. We also have incurred and will incur costs associated with current corporate governance and internal controls requirements, including requirements under Section 404 and other provisions of the Sarbanes-Oxley Act, as well as rules implemented by the Securities and Exchange Commission and the NYSE. We expect these rules and regulations to increase our legal and financial compliance costs substantially and to make some activities more time-consuming and costly. We also expect that, as a public company, it will be more expensive for us to obtain director and officer liability insurance and that it may be more difficult and more expensive for us

 

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to attract and retain qualified individuals to serve on our board of directors or as our executive officers. We expect these costs to be significant and could make it more difficult for us to sustain profitability.

If we fail to maintain proper and effective internal controls, our ability to produce accurate and timely financial statements could be impaired, which could limit our ability to effectively manage our business, reduce investors’ confidence in our reported results and cause a decline in our stock price.

Ensuring that we have adequate internal financial and accounting controls and procedures in place so that we can produce accurate financial statements on a timely basis is a costly and time-consuming effort that needs to be re-evaluated frequently. Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with GAAP. We are in the process of documenting, reviewing and improving our internal controls and procedures for compliance with Section 404 of the Sarbanes-Oxley Act, which requires annual management assessment of the effectiveness of our internal control over financial reporting and a report by our independent auditors. We expect both we and our independent auditors will be testing our internal controls in connection with the audit of our financial statements for the year ending June 30, 2012 and, as part of that testing, may identify areas for further attention and improvement. If we fail to maintain proper and effective internal controls, our ability to produce accurate and timely financial statements could be impaired, which could limit our ability to effectively manage our business, reduce investors’ confidence in our reported results and cause a decline in our stock price.

Our ability to use net operating losses to offset future taxable income may be subject to limitations.

We have historically paid minimal income taxes due primarily to our net operating losses, or NOLs. As of June 30, 2010, we had $98.1 million of NOL carryforwards available to offset future U.S. taxable income. However, under Section 382 of the Internal Revenue Code of 1986, as amended, or the Internal Revenue Code, a corporation that undergoes an “ownership change” is subject to limitations on its ability to utilize its pre-change NOLs to offset future taxable income. Stock sales by our existing stockholders during or after completion of this offering may trigger an ownership change under Section 382, resulting in limitations on the amount of the NOLs we can utilize in any particular year. We currently expect that, upon or shortly after completion of this offering, Section 382 may limit the amount of NOLs that we may use to offset U.S. taxable income in any fiscal year.

We are highly dependent on our management team and will need to attract and retain additional qualified personnel to grow our business in the United States and internationally. The loss of one or more members of our management or our inability to attract and retain qualified personnel could inhibit our ability to grow and adversely affect our business.

Our success and future growth depend on the skills, working relationships and continued services of our management team. The loss of our Executive Chairman, Chief Executive Officer or other senior executives would adversely affect our business. We do not maintain key-man insurance coverage on any of the members of our management team. Our future success also will depend on our ability to attract, retain and motivate highly skilled network engineers, software developers, sales personnel, and technical support and product development personnel in the United States and internationally. All of our employees work for us on an at-will basis. Competition for these types of personnel is intense. Any inability to attract or retain qualified personnel in the United States or internationally could inhibit our growth and adversely affect our business.

Our operations in international markets involve inherent risks that we may not be able to control.

We do business in 51 countries. Accordingly, our results could be materially and adversely affected by a variety of uncontrollable and changing factors relating to international business operations, including:

 

   

macroeconomic conditions adversely affecting geographies where we do business;

 

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foreign currency exchange rates;

 

   

political or social unrest or economic instability in a specific country or region;

 

   

higher costs of doing business in foreign countries;

 

   

infringement claims on foreign patents, copyrights or trademark rights;

 

   

difficulties in staffing and managing operations across disparate geographic areas;

 

   

difficulties associated with enforcing agreements and intellectual property rights through foreign legal systems;

 

   

legal and regulatory requirements, which could affect our ability to provide or obtain services in various countries;

 

   

adverse tax consequences;

 

   

military conflict, terrorist activities, natural disasters and medical epidemics; and

 

   

our ability to recruit and retain channel partners in foreign jurisdictions.

Risks Related to our Industry

Our industry is intensely competitive and if we do not compete successfully, we could experience a decline in revenue or suffer losses.

The market for our services and solutions is intensely competitive and characterized by continuous technological change, and we expect competition to intensify significantly in the future. Our competitors include a variety of communication service providers and system integrators. We compete with the enterprise solutions business units of established network telecommunications companies such as Verizon Business, AT&T, British Telecom, Tata Communications and Global Crossing, and global system integrators such as IBM, Dell/Perot Systems and HP/EDS, all of whom provide, or are capable of providing, products and services that are competitive with ours. To date, we have grown our business by targeting medium to large global enterprises who cannot currently obtain from these larger competitors the mix of product solutions and the high level of customer service and responsiveness that we offer. As the competition among our larger competitors intensifies, they may decide to expand their focus by directing more effort and resources toward our profile customers and may begin to offer our existing and potential customers a higher and more competitive level of service. If we are unable to continue to distinguish ourselves by the breadth and quality of the services we provide, our business could suffer materially.

Many of our existing and potential competitors have longer operating histories, greater brand recognition and significantly greater financial, technical, sales, marketing and other resources than we have, which may make it more difficult for us to compete. For example, our competitors may commence or intensify price competition at any time, including shortly after we complete this offering and, because many of these competitors have greater resources or alternative sources of revenue, they may be able to sustain this price competition indefinitely. In addition, we expect our various communications competitors to devote considerable resources to improve the performance of their current products and to develop and introduce new communications products, software, services and technologies. Technological changes, such as the use of wireless or other network access connections in place of the access lines we lease from local service providers, could render aspects of the technology we employ suboptimal or obsolete and provide a competitive advantage to new or larger competitors who can capitalize on these opportunities more quickly and easily. In certain countries, including the United Arab Emirates, China, India, Sweden, Singapore, New Zealand, Portugal and Thailand, companies with which we compete may be government owned, sponsored or supported, which may place us at a competitive disadvantage. For example, governments in these countries may require us to be regulated or may determine not to provide us with a necessary license.

 

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Our ability to compete successfully depends upon our ability to continue to provide customers with a superior user experience founded on the quality and reliability of our solutions and services, as well as our ability to successfully develop enhancements to existing solutions and new solutions that effectively address our customers’ rapidly evolving needs. If we are unsuccessful in this regard for any reason, our business will suffer.

New entrants employing IP and MPLS technologies and improvements in quality of service of IP technology provided over the public Internet could increase competition.

Our success is based partly on our use of IP technology to provide communications services over a secure private network and with sophisticated software solutions. Other IP-based communication providers could enter the market. Networks using IP technology can be deployed with less capital investment than traditional networks. Although we believe the software services we provide in our solutions provide us competitive advantages, our business model of leasing capacity, leasing space at data centers and leasing local access lines to connect with customers only after securing a contractual commitment with such customers could be replicated by competitors. As a result, there are limited barriers to entry in this market, and it may be easier for new entrants to emerge and for other competitors to introduce competitive solutions. Increased competition may require us to lower our prices or increase our operating expenses and may make it generally more difficult for us to retain our existing customers or add new customers.

We do not believe we currently face competition from service providers who use the public Internet to transmit communications traffic, as these providers generally do not provide the level and quality of service typically demanded by the business customers we serve. However, future advances in IP technology may enable these providers to offer an improved level and quality of service to business customers over the public Internet and with lower costs than using a private network. This development could result in increased price competition and may adversely affect our business, results of operations and financial condition.

We are subject to regulation that could change or otherwise impact us in an adverse manner.

Our services are subject to regulation at the federal, state, and local levels. These regulations affect our business and our existing and potential competitors. In addition, both the Federal Communications Commission, or FCC, and certain state regulatory authorities require us to file periodic reports, pay various regulatory fees and assessments, and to comply with their regulations, and such compliance can be costly and burdensome and may affect the way we conduct our business. Further, the current regulatory landscape is subject to change through judicial review of current legislation and rulemaking by the FCC. The FCC regularly considers changes to its regulatory framework and fee obligations. Changes in current regulation may make it more difficult to obtain the approvals necessary to operate our business, significantly increase the regulatory fees to which we are subject, or have other adverse effects on our future operations.

We cannot predict when or how the FCC may change rules pertaining to the application of Universal Service Fund fees against the services we provide. Should the FCC rule that all MPLS services be classified as “interstate telecommunications” services and apply this ruling on a retroactive basis, we could be required to remit payment, including possible penalties and interest, for underreported USF fees commencing October 1, 2009, as well as $5.9 million in USF refunds from amended USF filings relating to prior periods. Because our ability to bill customers and collect underreported USF pertaining to prior periods would be limited, future operating results would likely be adversely impacted by such a ruling. However, based on our interpretation of the FCC rules pertaining to the application of USF against MPLS services and the similar USF application practices of many of our competitors, we believe the risk of receiving such an unfavorable ruling associated with our change in USF application methodology is remote. See “Business—Government Regulation—Change in USF Application Methodology.”

Unfavorable general economic conditions in the United States and abroad could negatively impact our operating results and financial condition.

Unfavorable general economic conditions negatively affect our business. Although it is difficult to predict the impact of general economic conditions on our business, these conditions could adversely affect the affordability of our services, and could cause customers to delay or forgo purchases of our services. These

 

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circumstances could cause our revenue to decline. Also, our customers may not be able to obtain adequate access to credit, which could affect their ability to purchase our services or make timely payments to us. The current economic conditions, the federal stimulus package, and other proposed spending measures may lead to inflationary impacts on our operating expenses. This could harm our margins and profitability if we are unable to increase prices or reduce costs sufficiently to offset the effects of inflation in our cost base. For these reasons, among others, if challenging economic conditions persist or worsen, our operating results and financial condition could be adversely affected.

We may not be able to sustain our profitability.

We reported income before taxes of $3.7 million, $3.1 million and $8.7 million for each of the fiscal years ended June 30, 2008, 2009 and 2010, respectively. We incurred losses before taxes in all prior fiscal years since our inception. We reported an accumulated deficit of $81.2 million as of June 30, 2010. We may incur losses again and cannot assure you that we will be profitable in the future or that, if we are, we will be able to sustain our profitability. We believe that our profitability will depend, among other factors, on our ability to:

 

   

generate sustained revenue growth through sales to new and existing customers; and

 

   

manage the costs of our business, including the costs associated with maintaining and developing our network, software solutions, customer support and services, and local access costs.

Terrorism and natural disasters could adversely impact our business.

The ongoing threat of terrorist activity and other acts of war or hostility have had, and may continue to have, an adverse effect on business, financial and general economic conditions. Effects from these events and any future terrorist activity may increase our costs due to the need to provide enhanced security, which would adversely affect our business and results of operations. Terrorist activity could damage or destroy our network infrastructure and may adversely affect our ability to attract and retain customers and raise capital. We are also susceptible to other catastrophic events such as major natural disasters, extreme weather, fires or similar events that could affect our headquarters and network operations center, other offices, and infrastructure, all of which could adversely affect our business.

Risks Related to this Offering and Ownership of our Common Stock

The concentration of our capital stock upon the completion of this offering will limit your ability to influence corporate matters.

We anticipate that our executive officers, directors, current 5% or greater stockholders and entities affiliated with them will together beneficially own approximately 40.1% of our common stock following this offering, or 45.6% if the underwriters exercise their over-allotment option in full. This significant concentration of ownership may adversely affect the trading price for our common stock because investors often perceive disadvantages in owning stock in companies with controlling stockholders. Such stockholders acting together will be able to control our management and affairs and matters requiring stockholder approval, including the election of directors and the approval of significant corporate transactions, such as mergers, consolidations or the sale of substantially all of our assets. Consequently, this concentration of ownership may have the effect of delaying or preventing a change of control, including a merger, consolidation or other business combination involving us, or discouraging a potential acquirer from making a tender offer or otherwise attempting to obtain control, even if that change of control would benefit our other stockholders.

An active, liquid and orderly trading market for our common stock may not develop, the price of our stock may be volatile and you could lose all or part of your investment.

Before this offering, there has been no public market for shares of our common stock. We cannot predict the extent to which investor interest in our company will lead to the development of a trading market or how

 

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liquid that market might become. The initial public offering price for the shares of our common stock will be determined by negotiations among us, the selling stockholders and the underwriters, and may not be indicative of the price that will prevail in the trading market following this offering. In addition, the trading price of our common stock following this offering is likely to be highly volatile and could be subject to wide fluctuations in response to various factors, including, but not limited to, those described in this “Risk Factors” section, some of which are beyond our control. Factors affecting the trading price of our common stock will include:

 

   

variations in our operating results or in expectations regarding our operating results;

 

   

variations in operating results of similar companies;

 

   

announcements of technological innovations, new solutions or enhancements, strategic alliances or agreements by us or by our competitors;

 

   

announcements by competitors regarding their entry into new markets, and new product, service and pricing strategies;

 

   

marketing and advertising initiatives by us or our competitors;

 

   

the gain or loss of customers;

 

   

threatened or actual litigation;

 

   

major changes in our board of directors or management;

 

   

recruitment or departure of key personnel;

 

   

changes in the estimates of our operating results or changes in recommendations by any research analyst that follows our common stock;

 

   

market conditions in our industry and the economy as a whole;

 

   

the overall performance of the equity markets;

 

   

sales of our shares of common stock by existing stockholders;

 

   

volatility in our stock price; and

 

   

adoption or modification of laws and regulations applicable to our business.

In addition, the stock market in general, and the market for technology and communications companies, has experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of those companies. Broad market and industry factors may harm the market price of our common stock regardless of our actual operating performance. These fluctuations may be even more pronounced in the trading market for our stock shortly following this offering. Moreover, in the past, following periods of volatility in the overall market and the market price of a particular company’s securities, securities class action litigation has often been instituted against these companies. This litigation, if instituted against us, could result in substantial costs and a diversion of our management’s attention and our resources, whether or not we are successful in such litigation.

Our stock price could decline due to the large number of outstanding shares of our common stock eligible for future sale.

Sales of substantial amounts of our common stock in the public market following this offering, or the perception that these sales could occur, could cause the market price of our common stock to decline. These sales could also make it more difficult for us to sell equity or equity-related securities in the future at a time and price that we deem appropriate.

 

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Upon completion of this offering, we will have 16,830,738 shares of common stock outstanding, assuming no exercise of outstanding options or warrants after December 31, 2010. The shares sold in this offering will be immediately tradable without restriction. Of the remaining shares:

 

   

no shares will be eligible for sale immediately upon completion of this offering;

 

   

no shares will be eligible for sale beginning 90 days after the date of this prospectus; and

 

   

9,130,738 shares will be eligible for sale upon the expiration of lock-up agreements, subject in some cases to volume and other restrictions of Rule 144 and Rule 701 under the Securities Act of 1933, as amended, or the Securities Act.

The lock-up agreements expire 180 days after the date of this prospectus, except that the 180-day period may be extended by up to 34 additional days under certain circumstances. See “Underwriting—No Sales of Similar Securities.” Merrill Lynch, Pierce, Fenner & Smith Incorporated may, in its sole discretion and at any time without notice, release all or any portion of the securities subject to lock-up agreements.

Following this offering, holders of 54.3% of our common stock not sold in this offering will be entitled to rights with respect to the registration of these shares under the Securities Act. See “Description of Capital Stock—Registration Rights.” If we register their shares of common stock following the expiration of the lock-up agreements, these stockholders could sell those shares in the public market without being subject to the volume and other restrictions of Rule 144 and Rule 701.

After the closing of this offering, we intend to register approximately 3,312,469 shares of common stock that have been issued or reserved for future issuance under our stock incentive plans. Of these shares, 1,572,975 shares will be eligible for sale upon the exercise of vested options after the expiration of the lock-up agreements.

Because our initial public offering price is substantially higher than the pro forma as adjusted net tangible book value per share of our outstanding common stock, new investors will incur immediate and substantial dilution.

We expect the initial public offering price of our common stock to be substantially higher than the pro forma as adjusted net tangible book value per share of our common stock based on the total value of our tangible assets less our total liabilities immediately following this offering. Therefore, if you purchase common stock in this offering, you will experience immediate and substantial dilution of approximately $7.13 per share, the difference between the price you pay for our common stock and its pro forma as adjusted net tangible book value after the completion of this offering. Furthermore, investors purchasing common stock sold by us in this offering will own only approximately 22.9% of our shares outstanding after the completion of this offering even though they will have contributed 28.1% of the total consideration received by us in connection with our sales of common stock. After this offering, we will have approximately 29 million shares of common stock authorized but unissued and not reserved for issuance under our stock option plans or otherwise. We intend to opportunistically pursue strategic acquisitions. We may pay for such acquisitions, partly or in full, through the issuance of additional equity. Following the completion of this offering, we may issue approximately 3.5 million shares of our common stock without any action or approval by our stockholders. Any issuance of shares in connection with our acquisitions, the exercise of stock options or otherwise would dilute the percentage ownership held by the investors who purchase our shares in this offering.

Our management will have broad discretion over the use of the proceeds we receive in this offering and might not apply the proceeds in ways that increase the value of your investment.

Our management will have broad discretion in the application of the net proceeds of this offering. We intend to use net proceeds of this offering primarily for capital expenditures, working capital and other general

 

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corporate purposes. We may also use a portion of the net proceeds for the future acquisition of businesses that could enhance our sales footprint or broaden our product and service offerings. We cannot specify with certainty how we will apply these net proceeds and our use of the net proceeds of this offering may not increase the value of your investment.

Our charter documents and Delaware law could prevent a takeover that stockholders consider favorable and could also reduce the market price of our stock.

We expect that our amended and restated certificate of incorporation and our amended and restated bylaws, to be effective upon the completion of this offering, will contain provisions that could delay or prevent a change in control of our company. These provisions could also make it more difficult for stockholders to elect directors and take other corporate actions. These provisions include:

 

   

not providing for cumulative voting in the election of directors;

 

   

authorizing our board of directors to issue, without stockholder approval, preferred stock with rights senior to those of our common stock;

 

   

prohibiting stockholder action by written consent; and

 

   

requiring advance notification of stockholder nominations and proposals.

These and other provisions we expect to be included in our amended and restated certificate of incorporation and our amended and restated bylaws, to be effective upon the completion of this offering, and under Delaware law could discourage potential takeover attempts, reduce the price that investors might be willing to pay in the future for shares of our common stock and result in the market price of our common stock being lower than it would be without these provisions. See “Description of Capital Stock—Preferred Stock” and “Description of Capital Stock—Anti-Takeover Effects of Delaware Law and Our Certificate of Incorporation and Bylaws.”

If securities analysts do not publish research or reports about our business or if they publish negative evaluations of our stock, the price of our stock could decline.

We expect that the trading price for our common stock may be affected by research or reports that industry or financial analysts publish about us or our business. If one or more of the analysts who cover us downgrade their evaluations of our stock, the price of our stock could decline. If one or more of these analysts cease coverage of our company, we could lose visibility in the market for our stock, which in turn could cause our stock price to decline.

We do not anticipate paying any dividends on our common stock.

We do not anticipate paying any cash dividends on our common stock in the foreseeable future and the terms of our credit facility currently restrict our ability to pay dividends. If we do not pay cash dividends, you could receive a return on your investment in our common stock only if the market price of our common stock has increased when you sell your shares. The market price for our common stock after this offering might not exceed the price you pay for our common stock in this offering.

 

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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS AND INDUSTRY DATA

This prospectus contains forward-looking statements that are based on our management’s beliefs and assumptions and on information currently available to our management. The forward-looking statements are included throughout this prospectus, including in the sections entitled “Prospectus Summary,” “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Business” and “Executive Compensation.” Forward-looking statements include information concerning our possible or assumed future results of operations, business strategies, competitive position, industry environment, potential growth opportunities, potential market opportunities and the effects of competition. Forward-looking statements include statements that are not historical facts and can be identified by terms such as “anticipates,” “believes,” “could,” “seeks,” “estimates,” “expects,” “intends,” “may,” “plans,” “potential,” “predicts,” “projects,” “should,” “will,” “would” or similar expressions and the negatives of those terms.

Forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from the expectation of any future results, performance or achievements expressed or implied by the forward-looking statements. We discuss these risks in greater detail in “Risk Factors” and elsewhere in this prospectus. Given these uncertainties and risks, you should not place undue reliance on these forward-looking statements. Also, forward-looking statements represent our management’s beliefs and assumptions only as of the date of this prospectus. You should read this prospectus and the documents that we have filed as exhibits to the registration statement, of which this prospectus is a part, completely and with the understanding that our actual future results may be materially different from what we expect.

Except as required by law, we assume no obligation to update these forward-looking statements publicly, even if new information becomes available in the future.

This prospectus also contains estimates and other information concerning our industry, including market opportunity, size and growth rates, that are based on industry publications, reports and forecasts, including those generated by Infonetics Research and International Data Corporation, independent market research firms, and on assumptions that we have made that are based on that data. This information involves a number of assumptions and limitations, and you are cautioned not to give undue weight to these estimates. With respect to information contained in industry publications, we have assessed the information in the publications and found it to be reasonable and believe the publications are reliable, but we have not independently verified the data and cannot guarantee its accuracy or completeness. While we believe the market opportunity and market size information included in this prospectus is based on reasonable assumptions, such information is inherently imprecise. In addition, projections, assumptions and estimates of the future development of the industry in which we operate and the markets we serve are necessarily subject to a high degree of uncertainty and risk, including those described in “Risk Factors.”

 

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SPECIAL NOTE REGARDING NON-GAAP FINANCIAL MEASURES

We have included certain financial measures in this prospectus that are not defined under GAAP, including EBITDA and Adjusted EBITDA. We define EBITDA as net income (loss) before interest, income taxes, depreciation and amortization. We define Adjusted EBITDA as EBITDA, excluding, when applicable, asset impairment charges, stock-based compensation expense, and other income (expense), net, consisting of foreign currency impacts on transactions and gains and losses on the disposal of property and equipment.

We use Adjusted EBITDA to evaluate our operating performance and this non-GAAP financial measure is among the primary measures used by management for planning and forecasting for future periods. By excluding the impact of expenses that may vary from period to period without any correlation to underlying operating performance, we believe we are able to gain a clearer view of the operating performance of our business. We believe the presentation of Adjusted EBITDA is relevant and useful for investors because it allows investors to view our results in the same manner as management and makes it easier to compare our results with the results of other companies that have different financing and capital structures.

Adjusted EBITDA has limitations as an analytical tool and should not be considered in isolation from, or as a substitute for, net income (loss) or any other measure of our performance reported in accordance with GAAP or as an alternative to cash flows from operating activities as a measure of our liquidity. For example, Adjusted EBITDA (i) does not reflect capital expenditures or contractual commitments, (ii) does not reflect changes in, or cash requirements for, our working capital needs, (iii) does not reflect interest expense, or the cash requirements necessary to service interest payments, on debt, (iv) does not reflect income taxes and (v) does not consider the costs or potentially dilutive impact of issuing equity-based compensation. We compensate for the inherent limitations associated with using the Adjusted EBITDA measure through disclosure of these limitations, presentation of our financial statements in accordance with GAAP and reconciliation of Adjusted EBITDA to the most directly comparable GAAP measure, net income (loss).

Our computation of Adjusted EBITDA may not be comparable to other similarly titled measures computed by other companies, because all companies do not calculate Adjusted EBITDA in the same manner.

 

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USE OF PROCEEDS

We estimate that the net proceeds from our sale of 3,850,000 shares of common stock in this offering at an assumed initial public offering price of $13.00 per share, the midpoint of the price range set forth on the front cover of this prospectus, after deducting the underwriting discount and estimated offering expenses payable by us, will be approximately $44.9 million. A $1.00 increase (decrease) in the assumed initial public offering price of $13.00 per share would increase (decrease) our net proceeds to us from this offering by approximately $3.6 million, assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same and after deducting the underwriting discount and estimated offering expenses payable by us.

We intend to use the net proceeds from this offering for general corporate purposes, including capital expenditures and working capital. We may also use a portion of the net proceeds for the future acquisition of businesses that could enhance our sales footprint or broaden our product and service offerings. We have no agreements or commitments for any specific acquisition at this time.

We will not receive any proceeds from the sale of shares of our common stock by the selling stockholders.

Pending use of the proceeds from this offering, we intend to invest the proceeds in short-term, interest-bearing investment grade securities.

 

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DIVIDEND POLICY

We have never paid dividends on our common stock and we do not expect to pay dividends on our common stock for the foreseeable future. Instead, we anticipate that all of our earnings will be used for the operation and growth of our business. Any future determination to declare cash dividends would be subject to the discretion of our board of directors and would depend upon various factors, including our results of operations, financial condition and liquidity requirements, restrictions that may be imposed by applicable law and our contracts and other factors deemed relevant by our board of directors. In addition, in the event we were to borrow funds under our credit facility, the terms of our credit facility currently restrict our ability to pay dividends.

 

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CAPITALIZATION

The following table sets forth our consolidated cash and cash equivalents and capitalization as of December 31, 2010 on:

 

   

an actual basis;

 

   

a pro forma basis to reflect the conversion of all outstanding shares of our convertible preferred stock into shares of our common stock upon the closing of this offering; and

 

   

a pro forma as adjusted basis to reflect our receipt of the net proceeds from our sale of shares of common stock in this offering at an assumed initial public offering price of $13.00 per share, the midpoint of the range set forth on the front cover of this prospectus, after deducting the underwriting discount and estimated offering expenses payable by us.

The information below is illustrative only and our capitalization following the completion of this offering will be adjusted based on the actual initial public offering price and other terms of this offering determined at pricing. You should read this table in conjunction with “Selected Consolidated Financial Data” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and accompanying notes included elsewhere in this prospectus.

 

     As of December 31, 2010  
     Actual     Pro
Forma
    Pro Forma
As Adjusted
 
(in thousands except per share amounts, unaudited)       

Cash and cash equivalents and short-term investments

   $ 19,478      $ 19,478      $ 64,425   
                        

Stockholders’ equity:

      

Series A-1 convertible, redeemable preferred stock, $0.001 par value, 10,000 authorized, 8,925 issued and outstanding, actual; no shares authorized, issued or outstanding, pro forma or pro forma as adjusted

     9        —          —     

Common stock, $0.001 par value per share, 16,200 shares authorized, 4,055 issued and outstanding, actual; 16,200 shares authorized, 12,981 issued and outstanding, pro forma; 50,000 shares authorized, 16,831 issued and outstanding, pro forma as adjusted

     4        13        17   

Additional paid-in capital

     130,169        130,169        175,112   

Accumulated deficit

     (75,783     (75,783     (75,783

Accumulated other comprehensive income

     (610     (610     (610
                        

Total stockholders’ equity

   $ 53,789      $ 53,789      $ 98,736   
                        

Total capitalization

   $ 53,789      $ 53,789      $ 98,736   
                        

The number of pro forma and pro forma as adjusted shares of common stock shown as issued and outstanding in the table are based on the number of shares of our common stock outstanding as of December 31, 2010 and excludes:

 

   

2,562,517 shares of common stock issuable upon the exercise of options outstanding as of December 31, 2010 under our 2001 Stock Option/Stock Issuance Plan, with a weighted average exercise price of $4.14 per share;

 

   

707,120 shares of common stock reserved for future issuance under our 2010 Incentive Compensation Plan, which will become effective in connection with this offering (including 207,120 shares of

 

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common stock reserved for future issuance under our 2001 Stock Option/Stock Issuance, which were added to the shares reserved under our 2010 Incentive Compensation Plan upon its effectiveness); and

 

   

356,531 shares of common stock issuable upon the exercise of warrants outstanding as of December 31, 2010, with a weighted average exercise price of $3.76 per share.

A $1.00 increase (decrease) in the assumed initial public offering price would result in an approximately $3.6 million increase (decrease) in each of pro forma as adjusted cash and cash equivalents, additional paid-in capital, total stockholders’ equity and total capitalization.

 

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DILUTION

As of December 31, 2010, our pro forma net tangible book value was approximately $53.8 million, or $4.14 per share of common stock. Our pro forma net tangible book value per share represents the amount of our total tangible assets less our liabilities, divided by the shares of common stock outstanding at December 31, 2010 after giving effect to the conversion of all outstanding shares of our convertible preferred stock into 8,925,277 shares of common stock effective upon the completion of this offering.

Our pro forma as adjusted net tangible book value at December 31, 2010 would have been $98.8 million, or $5.87 per share of common stock after giving effect to our sale of 3,850,000 shares of common stock in this offering at an assumed initial public offering price of $13.00 per share, the midpoint of the price range set forth on the front cover of this prospectus. Our pro forma as adjusted net tangible book value (i) reflects the pro forma adjustments contemplated in the preceding paragraph and (ii) also assumes the deduction of the underwriting discount and estimated offering expenses payable by us.

This represents an immediate increase in net tangible book value of $1.73 per share to existing stockholders and an immediate dilution in net tangible book value of $7.13 per share to purchasers of common stock in this offering.

The following table illustrates this dilution:

 

Assumed initial offering price per share

    $ 13.00   

Pro forma net tangible book value per share as of December 31, 2010

  $ 4.14     

Increase per share attributable to this offering

    1.73     
         

Pro forma as adjusted net tangible book value per share after this offering

      5.87   
         

Net tangible book value dilution per share to new investors in this offering

    $ 7.13   
         

If all our outstanding options and warrants had been exercised, our pro forma net tangible book value as of December 31, 2010 would have been $65.7 million, or $4.14 per share, and the pro forma as adjusted net tangible book value after this offering would have been $110.8 million, or $5.61 per share, causing dilution to new investors of $7.39 per share.

The following table summarizes, on a pro forma as adjusted basis as of December 31, 2010, the total number of shares of common stock purchased from us, the total consideration paid to us and the average price per share paid to us by existing stockholders and by new investors purchasing shares in this offering at the initial public offering price of $13.00, the midpoint of the price range set forth on the front cover of this prospectus, before deducting the underwriting discount and estimated offering expenses payable by us:

 

     Shares Purchased     Total     Average Price Per
Share
 
     Number      Percent     Amount      Percent    
(in thousands, except per share data)                                 

Existing stockholders

     12,981         77.1   $ 128,145         71.9   $ 9.87   

New investors

     3,850         22.9        50,050         28.1        13.00   
                                          

Total

     16,831         100.0   $ 178,195         100.0   $ 10.59   
                                          

The calculations in the foregoing table are based on 12,980,738 shares of our common stock as of December 31, 2010 and exclude:

 

   

2,562,517 shares of common stock issuable upon the exercise of options outstanding as of December 31, 2010 under our 2001 Stock Option/Stock Issuance Plan, with a weighted average exercise price of $4.14 per share;

 

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707,120 shares of common stock reserved for future issuance under our 2010 Incentive Compensation Plan, which will become effective in connection with this offering (including 207,120 shares of common stock reserved for future issuance under our 2001 Stock Option/Stock Issuance, which were added to the shares reserved under our 2010 Incentive Compensation Plan upon its effectiveness); and

 

   

356,531 shares of common stock issuable upon the exercise of warrants outstanding as of December 31, 2010, with a weighted average exercise price of $3.76 per share.

 

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SELECTED CONSOLIDATED FINANCIAL DATA

The following sets forth selected consolidated financial data derived from (a) our audited consolidated statements of operations for the fiscal years ended June 30, 2008, 2009 and 2010 and our audited consolidated balance sheets as of June 30, 2009 and 2010, which are included elsewhere in this prospectus, (b) our audited consolidated statements of operations for the fiscal years ended June 30, 2006 and 2007 and our audited consolidated balance sheets as of June 30, 2006, 2007 and 2008, which are not included in this prospectus, and (c) our unaudited consolidated financial statements as of and for the six-month periods ended December 31, 2009 and 2010, which are included elsewhere in this prospectus. The unaudited consolidated financial statements as of and for the six-month periods ended December 31, 2009 and 2010 have been prepared on a basis consistent with our audited financial statements and, in the opinion of management, include all adjustments, consisting of normal accruals, necessary for the fair presentation of our financial condition as of such dates and our results of operations for such periods. Our results of operations for the six months ended December 31, 2010 are not necessarily indicative of the results of operations that may be achieved for the entire year.

You should read the following selected consolidated financial data in conjunction with our consolidated financial statements and accompanying notes, the information in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the other financial information included elsewhere in this prospectus. Our historical results are not necessarily indicative of our future results.

 

    Year Ended June 30,     Six Months Ended
December 31,
 
    2006     2007     2008     2009     2010     2009     2010  
(in thousands, except per share data)                                 (unaudited)  

Consolidated Statement of Operations Data:

             

Revenue:

             

Customer services

  $ 45,016      $ 69,508      $ 86,850      $ 98,159      $ 98,869      $ 48,589      $ 54,636   

Universal Service Fund fees

    3,353        4,526        6,063        6,549        (1,331     2,543        1,860   
                                                       

Total revenue

    48,369        74,034        92,913        104,708        97,538        51,132        56,496   
                                                       

Operating expenses:

             

Cost of services

    33,362        44,479        54,775        60,434        51,394        28,564        29,981   

Selling, general and administrative

    20,698        25,592        29,781        31,109        31,472        15,259        17,304   

Depreciation

    2,234        3,776        4,343        7,857        5,783        2,722        3,399   

Impairment of property and equipment

    833        —          —          2,107        —          —          —     
                                                       

Total operating expenses

    57,127        73,847        88,899        101,507        88,649        46,545        50,684   
                                                       

Operating income (loss)

    (8,758     187        4,014        3,201        8,889        4,587        5,812   

Interest expense, net

    (570     (616     (289     (60     (34     (19     (22

Other income (expense), net

    9        (8     4        (42     (203     (144     (82
                                                       

Income (loss) before income taxes

    (9,319     (437     3,729        3,099        8,652        4,424        5,708   

Income tax (expense) benefit

    —          —          —          —          13,643        —          (253
                                                       

Net income (loss)

  $ (9,319   $ (437   $ 3,729      $ 3,099      $ 22,295      $ 4,424      $ 5,455   
                                                       

Net income (loss) attributable to common stockholders

  $ (2,907   $ (131   $ 1,123      $ 953      $ 6,902      $ 1,368      $ 1,696   
                                                       

Net income (loss) per share attributable to common stockholders:

             

Basic

  $ (.76   $ (0.03   $ .29      $ .24      $ 1.72      $ .34      $ .42   

Diluted

  $ (.76   $ (0.03   $ .25      $ .22      $ 1.65      $ .33      $ .38   

Weighted average common shares used in computing net income (loss) per share attributable to common stockholders:

             

Basic

    3,805        3,819        3,840        3,945        4,002        3,994        4,028   

Diluted

    3,805        3,819        4,534        4,312        4,196        4,185        4,519   

 

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    Year Ended June 30,     Six Months Ended
December 31,
 
    2006     2007     2008     2009     2010         2009             2010      
(in thousands, except per share data)               (unaudited)   

Pro forma net income per share attributable to common stockholders (unaudited) (1):

             

Basic

          $ 1.72        $ .42   

Diluted

          $ 1.70        $ .40   

Pro forma weighted average shares outstanding used in computing net income per share attributable to common stockholders (unaudited) (2) :

             

Basic

            12,928          12,953   

Diluted

            13,121          13,491   

Consolidated Statement of Cash Flows Data:

           

Net cash provided by operating activities

  $ (5,114   $ 4,194      $ 10,655      $ 16,039      $ 12,394      $ 2,173      $ 11,694   

Net cash used in investing activities

    (3,348     (2,702     (6,807     (8,189     (11,196     (6,862     (6,125

Net cash provided by (used in) financing activities

    (357     (5,582     (3,007     (1,001     231        231        70   

Other Financial Data (unaudited):

             

Adjusted EBITDA (3)

  $ (5,691   $ 4,072      $ 8,908      $ 13,883      $ 15,105      $ 7,541      $ 9,461   

Capital expenditures (4)

    5,586        6,190        7,001        8,238        10,697        6,863        4,971   
    As of June 30,     As of December 31,  
    2006     2007     2008     2009     2010     2009     2010  
(in thousands)                                 (unaudited)  

Consolidated Balance Sheet Data:

             

Cash and cash equivalents

  $ 7,298      $ 3,360      $ 4,199      $ 10,882      $ 12,378      $ 6,249      $ 17,810   

Working capital

    1,324        369        (556     4,996        14,956        5,392        18,699   

Total assets

    32,485        32,197        36,099        39,828        68,467        39,761        74,233   

Long-term debt, including current portion (5)

    6,012        3,923        1,016        —          —          —          —     

Total liabilities

    14,644        14,407        13,888        14,455        20,324        9,675        20,444   

Total stockholders’ equity

    17,841        17,790        22,211        25,373        48,143        30,086        53,789   

 

(1) Pro forma net income per share represents net income divided by the pro forma weighted average shares outstanding as though the conversion of our convertible preferred stock into common stock occurred on the original dates of issuance.

 

(2) Pro forma weighted average shares outstanding reflects the conversion of our convertible preferred stock (using the if-converted method) into common stock as though the conversion had occurred on the original dates of issuance.

 

(3) We define Adjusted EBITDA as net income (loss) before interest, income taxes, depreciation and amortization (EBITDA), excluding, when applicable, asset impairment charges, stock-based compensation expense and other (income) expense, net, consisting of foreign currency impacts on transactions and gains and losses on the disposal of property and equipment.

 

     The following table presents a reconciliation of net income (loss) to Adjusted EBITDA:

 

    Year Ended June 30,     Six Months Ended
December 31,
 
    2006     2007     2008     2009     2010     2009     2010  
(in thousands, unaudited)                                    

Net income (loss)

  $ (9,319   $ (437   $ 3,729      $ 3,099      $ 22,295      $ 4,424      $ 5,455   

Interest expense, net

    570        616        289        60        34        19        22   

Income tax expense (benefit)

    —          —          —          —          (13,643     —          253   

Depreciation

    2,234        3,776        4,343        7,857        5,783        2,722        3,399   
                                                       

EBITDA

    (6,515     3,955        8,361        11,016        14,469        7,165        9,129   

Impairment of property and equipment

    833        —          —          2,107        —          —          —     

Stock-based compensation expense

    —          109        551        718        433        232        250   

Other (income) expense, net

    (9     8        (4     42        203        144        82   
                                                       

Adjusted EBITDA

  $ (5,691   $ 4,072      $ 8,908      $ 13,883      $ 15,105      $ 7,541      $ 9,461   
                                                       

 

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EBITDA and Adjusted EBITDA are not defined under GAAP. EBITDA and Adjusted EBITDA are not measurements of our financial performance under GAAP and should not be considered in isolation or as alternatives to net income (loss) or any other measures of our performance reported in accordance with GAAP or as alternatives to cash flows from operating activities as measures of our liquidity. See “Special Note Regarding non-GAAP Financial Measures.”

 

(4) Represents purchases of property and equipment, including equipment obtained under notes payable.

 

(5) Includes notes payable.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of our financial condition and results of operations should be read together with “Selected Consolidated Financial Data” and our consolidated financial statements and accompanying notes included elsewhere in this prospectus. This discussion contains forward-looking statements, based on current expectations and related to our plans, estimates, beliefs and anticipated future financial performance. These statements involve risks and uncertainties and our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including those set forth under “Risk Factors,” “Special Note Regarding Forward-Looking Statements and Industry Data” and elsewhere in this prospectus.

Overview

We provide managed, secure virtualized network services to enterprises that have complex IT needs across multiple locations. Our integrated network and software solutions enable our customers to seamlessly deploy and manage video, voice and other data applications on a global basis. As of December 31, 2010, we served over 4,000 customer locations across 51 countries, representing most major industry verticals, including financial and professional services, health care, entertainment, broadcasting, hospitality and manufacturing.

We utilize an integrated sales model pursuant to which our sales force sells directly to end users or in combination with a channel partner. Our channel partners, which consist of systems integrators, value-added resellers, agents and referral partners, often have business relationships with prospective customers and, in many cases, provide products and services that complement our own services. A significant number of our new customers are generated by referrals from our channel partners, with approximately 93% of new customer bookings and 74% of total bookings in fiscal 2010 generated by leads from our channel partners. Sales agents, SIs and referral partners are compensated on a success-basis, receiving monthly residual commission payments based on a percentage of the customer services revenue received from customers identified by them. VARs do not receive any payments from us, but instead resell our services and markup our fees when billing to end users.

We primarily compete with the enterprise solutions business units of global telecommunications service providers, including AT&T, Verizon Business, British Telecom, Global Crossing and Tata Communications, and global systems integrators, including IBM, Dell/Perot Systems and HP/EDS. The key differentiators that enable us to compete effectively with these larger competitors include our purpose-built network platform, proprietary embedded software, end-to-end quality of service and an overall customer experience that we believe exceeds that available from other providers.

In fiscal 2009 and 2010, our operating results were affected by the global economic recession, which started in the second half of calendar year 2008 (the first half of our fiscal 2009) and continues to affect many enterprises. Many of our current and prospective customers responded to the financial and credit crisis and general macroeconomic uncertainty by consolidating their operations, reducing IT expenses and suspending or delaying new IT initiatives. These conditions negatively impacted our customer bookings for approximately four quarters starting in the second quarter of fiscal 2009 and increased average monthly churn over historical levels for approximately four quarters beginning in the fourth quarter of fiscal 2009. We responded by emphasizing the acquisition of new customers and more closely managing our operating expenses to ensure continuing growth in our profitability and cash flows. These initiatives contributed to a significant increase in customer bookings and modest improvements in customer services revenue and Adjusted EBITDA in fiscal 2010 as compared to fiscal 2009. Additionally, improving trends in average monthly churn beginning in the fourth quarter of fiscal 2010 contributed to improvements in customer services revenue, operating income, Adjusted EBITDA and net income for the six months ended December 31, 2010 as compared to the six months ended December 31, 2009. We believe we are well positioned to continue to add new customers, sell additional services to existing customers and increase customer services revenue as global economic conditions continue to improve.

 

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We were founded in August 2000 and we began generating revenue in fiscal 2002. From inception through February 2006, we raised approximately $122 million in cash proceeds from the issuance of preferred stock. These funds were used for the build-out of our network, development of certain intellectual property and expansion of our operations. Since the fourth quarter of fiscal 2007, we have funded our operations principally with cash provided by operating activities. We had no debt outstanding and $17.8 million of cash and cash equivalents at December 31, 2010.

Key Performance Indicators

Key performance indicators that we use to manage our business and evaluate our financial results and operating performance include:

 

   

customer bookings,

 

   

average monthly churn rates,

 

   

customer services revenue,

 

   

gross margins,

 

   

operating costs,

 

   

net income, and

 

   

Adjusted EBITDA.

After completion of this offering, we will also use net income per common share as a key performance indicator for our business.

Customer bookings are calculated as the total monthly value of qualified customer service orders received during the period less the total monthly value of any service orders that were cancelled during the same period. In order to qualify as a booking, customer service orders must include a minimum one-year service term and a defined service implementation schedule, and may not be subject to any contingencies. Customer bookings are a key indicator of future customer service installations and ultimately customer services revenue. We use customer bookings to evaluate the performance of our sales organization and channel partners and to forecast future customer services revenue.

Average monthly churn rate, which is expressed as a percentage, is calculated as recurring fixed monthly fees associated with customer locations disconnected during a period divided by our total recurring customer services revenue during that same period. We monitor and evaluate our churn rates to better understand the reasons customers cancel services and to forecast future customer services revenue.

The following table sets forth customer bookings and average monthly churn data for the periods indicated:

 

     Year Ended June 30,     Six Months Ended
December 31,
 
     2008     2009     2010     2009     2010  
(unaudited)                         

Customer bookings, in thousands

   $ 2,529      $ 2,123      $ 2,789      $ 1,349      $ 1,554   

Average contract term of customer bookings, in months (1)

     25.5        26.3        28.4        28.4        28.6   

Average monthly churn rate

     1.6     1.6     1.9     2.2     1.1

 

(1) For customer service orders received during the period, calculated as the total recurring fixed monthly fees to be paid over the initial term divided by the total monthly value of those service orders.

 

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We evaluate customer services revenue by product, customer and whether the revenue is recurring or non-recurring. Although we track our revenue by geographical location for statutory reporting purposes, we currently do not allocate resources or make management decisions based on geography. We evaluate customer services revenue performance by comparing our results to our operating budget, management forecasts and prior period performance.

We evaluate gross margins, operating costs, net income and Adjusted EBITDA in a similar manner by comparing our actual results against our operating budget, management forecasts and prior period performance. In addition, by deducting capital expenditures from Adjusted EBITDA, we are able to further assess the impact of our results of operations on our liquidity.

We define Adjusted EBITDA, a non-GAAP measure, as net income (loss) before interest, income taxes, depreciation and amortization, excluding, when applicable, asset impairment charges, stock-based compensation expense and other (income) expense, net, consisting of foreign currency impacts on transactions and gains and losses on the disposal of property and equipment. For a further discussion of Adjusted EBITDA, as well as a reconciliation of Adjusted EBITDA to net income (loss), see “—Reconciliation of Quarterly Non-GAAP Financial Measures” and “Special Note Regarding Non-GAAP Financial Measures.”

In addition to the foregoing key indicators, we also monitor our performance in the following areas:

 

   

customer contract renewals and customer satisfaction survey results;

 

   

status of new service installations and bookings backlog;

 

   

customer service statistics, including network availability, NOC inbound calls and NOC trouble tickets;

 

   

the achievement of target milestones of our product and software development activities; and

 

   

the progress and impact of strategic initiatives.

Components of our Results of Operations

Revenue

Customer services. Our customer services revenue includes recurring revenue and non-recurring and other revenue. Most of our customer services revenue is recurring revenue from fixed monthly fees paid under customer service contracts, with a smaller portion consisting of recurring revenue from usage fees paid based on actual customer usage of our network. The fixed monthly fees are typically comprised of a local access charge to connect the customer’s location to our network and a service fee, or port charge, that covers all other costs and expenses of our services. We base our monthly fees on the customer’s geographic location, the underlying access technology deployed and the customer’s subscribed level of bandwidth. Customers that desire enhanced video or voice quality of service levels pay an additional monthly fee. The initial term of a customer contract typically ranges between two and three years, with an average initial contract length of 28.4 months for new customer service contracts entered into during fiscal 2010.

The other component of our customer services revenue is non-recurring and other revenue from sales of customer premise equipment, early cancellation fees and tax and regulatory compliance fees. We also defer non-recurring service activation fees, which are amortized over the initial term of each contract.

 

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The following table sets forth the major components of customer services revenue for the periods indicated:

 

     Year Ended June 30,     Six Months Ended
December 31,
 
     2008     2009     2010     2009     2010  
(in thousands)                      (unaudited)  

Customer services revenue:

          

Recurring revenue

   $ 81,585      $ 92,167      $ 93,247      $ 45,771      $ 51,991   

Non-recurring and other revenue

     5,265        5,992        5,622        2,818        2,645   
                                        

Total customer services revenue

   $ 86,850      $ 98,159      $ 98,869      $ 48,589      $ 54,636   
                                        
(as a percentage of total customer services revenue)                         

Customer services revenue:

          

Recurring revenue

     93.9     93.9     94.3     94.2     95.2

Non-recurring and other revenue

     6.1        6.1        5.7        5.8        4.8   
                                        

Total customer services revenue

     100.0     100.0     100.0     100.0     100.0
                                        

Universal Service Fund fees. We are required to support and contribute to the Universal Service Fund in the United States. The FCC rules pertaining to the application of the USF for MPLS services are subjective, and we historically collected and remitted USF fees on virtually all services provided to customer locations in the United States. After evaluating competitor USF billing practices pertaining to MPLS services, we implemented a change in USF billing methodology in October 2009 to charge USF fees only on telecommunications services, which generally are comprised of local access and voice charges. This change in USF billing methodology reduced USF fee revenue. We also later revised our previous USF filings from 2009 and 2010 to reflect this change, resulting in USF refunds of $5.9 million, which we intend to refund to customers in the future. These reductions in USF fee revenue resulted in identical reductions in USF fee costs included within cost of services.

Expenses

Cost of services. Cost of services includes all expenses related to the operation of our network platform other than maintenance costs and depreciation expense on our network equipment. Cost of services include access costs, backbone and data center expenses, Internet and voice usage, customer premise equipment sold to customers, and certain telecommunications taxes and fees. We lease cabinets in data centers located in major cities around the globe to house our network equipment, which we also refer to as network hubs. As of December 31, 2010, we had fifteen network hubs located throughout the United States, as well as four network hubs located in Europe, seven in the Asia-Pacific region and one in Canada. Most of our network hubs are leased from data center providers located in carrier-neutral facilities, which gives us the flexibility to order access circuits from multiple carriers.

Access circuits link customer locations to our nearest network hub, thus providing connectivity to our network. Access costs are the largest component of cost of services and are paid to local incumbents and regional carriers in selected countries, as well as to domestic and international wholesale carriers. The cost of access circuits are dependent on a number of factors including the distance between the customer’s location and our nearest network hub, the number of carriers with access to the customer’s location, the access technology utilized and the bandwidth of the circuit. We also defer any non-recurring installation costs and amortize them over the initial term of the customer’s contract.

Our network hubs are connected to each other via backbone links. These backbone links are high-capacity, dedicated circuits that we lease from wholesale carriers. The cost of our backbone links, as well as data center and access costs, are paid to providers on a monthly basis, but contracts for these services typically range from one year to three years. We purchase Internet access and voice services from selected providers primarily

 

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on a usage basis subject to certain contracted minimum amounts. We connect with various Internet and voice providers in selected network hubs based on customer usage patterns and network traffic optimization objectives.

Included within cost of services are USF payments collected on billed access and voice charges to customer locations in the United States. In some limited cases we are responsible for remitting payment of non-exempt taxes to our vendors, including state gross receipts tax, franchise fees and local taxes in certain jurisdictions in the United States and limited foreign local taxes that are subject to payment without recovery.

Selling, general and administrative (“SG&A”) expenses. SG&A expenses include employee-related costs, channel partner sales commissions, network and equipment maintenance, software support costs, marketing expenses, travel costs, office rent and related expenses, professional fees and non income-related taxes. Employee compensation, benefits and related costs represent the largest component of our SG&A expenses. Our SG&A expenses include both fixed and variable costs. Fixed selling expenses include employee salaries and benefits, marketing expenses and sales office rents. Variable selling costs are largely commissions paid to our sales force and channel partners. Fixed general and administrative costs include employee-related costs for IT, engineering, administrative, finance and accounting, and associated costs, such as office rent, internal network costs, legal and accounting fees, property taxes and recruiting costs. Variable general and administrative costs include the cost of services activation staff, which increases with the level of new customer installations, and NOC and billing costs, which increase with the total number of customers served. We expect certain SG&A expenses to increase after completion of this offering, including legal, accounting, investor relations and other expenses associated with public company reporting requirements.

Depreciation expense. Depreciation is applied using the straight-line method over the estimated useful lives of the assets once the assets are placed in service. We generally depreciate network-related equipment and software and IT equipment, which represents the majority of our assets, over periods ranging from three to ten years. We depreciate furniture over seven years. The value of leasehold improvements is generally amortized over two to five years based on the shorter of the respective lease term or duration of economic benefit of the assets.

Impairment of property and equipment. We evaluate whether there has been any impairment on any of our long-lived assets if circumstances indicate that a possible impairment exists. During fiscal 2009, we upgraded some of our network hub equipment. This upgrade resulted in a non-cash impairment charge of $2.1 million relating to equipment to be retired as well as one-time, accelerated depreciation expense of $2.3 million relating to other equipment to be upgraded.

Interest expense, net. Interest expense, net consists of commitment fees and interest charges incurred under our credit facility with Comerica Bank, interest charges recognized under notes payable incurred in connection with the acquisition of certain network equipment from Alcatel-Lucent, amortization of debt discount costs and interest income earned on cash and cash equivalents, marketable securities and short-term investments. In April 2009, we repaid the full balance of our notes payable to Alcatel-Lucent.

Other income (expense), net. Other income (expense), net consists of foreign currency impacts on transactions and gains and losses on the disposal of property and equipment.

Income taxes. We have historically paid minimal income taxes due primarily to our net operating losses, or NOLs. As of June 30, 2010, we had $98.1 million of NOL carryforwards available to offset future U.S. taxable income. However, Section 382 of the Internal Revenue Code places certain limitations on the utilization of previous NOLs to offset future taxable income once a corporation undergoes an “ownership change.” Stock sales by our existing stockholders during or after completion of this offering may trigger an ownership change, resulting in limitations on the amount of NOLs we can utilize in any fiscal year. We currently expect that, upon or shortly after completion of this offering, Section 382 will limit the amount of NOLs that we may use to offset U.S. taxable income in any fiscal year.

 

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Critical Accounting Policies and Estimates

Our consolidated financial statements are prepared in accordance with GAAP. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management’s judgment in its application, while in other cases, management’s judgment is required in selecting among available alternative accounting standards that allow different accounting treatment for similar transactions. The preparation of our consolidated financial statements and related disclosures require us to make estimates, assumptions and judgments that affect the reported amount of assets, liabilities, revenue, costs and expenses, and related disclosures. We base our estimates and assumptions on historical experience and other factors that we believe to be reasonable under the circumstances. In some instances, we could reasonably use different accounting estimates, and in some instances results could differ significantly from our estimates. We evaluate our estimates and assumptions on an ongoing basis. To the extent there are differences between our estimates and actual results, our future financial statement presentation, financial condition, results of operations and cash flows will be affected.

We believe that the assumptions and estimates associated with revenue recognition, accounts receivable, impairment of long-lived assets, stock-based compensation and income taxes have the greatest potential impact on our consolidated financial statements. Therefore, we believe the accounting policies discussed below are critical to understanding our historical and future performance, as these policies relate to the more significant areas involving our management’s judgments, assumptions and estimates.

Revenue Recognition and Receivables

Although most of our customer services revenue is recurring revenue derived from fixed monthly fees paid under customer service contracts, the complex nature of our services, questions over usage-based charges and varying interpretations of contractual terms can result in disputes over billing. Because of this, we defer revenue recognition until cash is collected on certain components of customer services revenue including early cancellation fees and billings for unreturned customer premise equipment. We also reserve for large, known customer billing disputes until they are ultimately resolved with the customer.

We defer non-recurring service activation fees and amortize them over the initial customer service contract term. Similarly, costs associated with these services are also deferred and amortized over the respective initial contract term. We also collect USF fees on certain services provided to customer locations in the United States, which funds affordable telecommunications services across the country. USF fees that we collect are included in revenue and cost of services.

We have established an allowance for doubtful accounts through charges to SG&A expenses. This allowance is established based on amounts we ultimately expect to collect from customers. We estimate our ability to collect customer receivables based on assumptions and other considerations, including customer payment history, credit ratings, customer financial performance, customer contract status and aging analysis. Our allowance for doubtful accounts as a percentage of gross receivables was 12.7% at June 30, 2008, 11.3% at June 30, 2009 and 8.0% at June 30, 2010. These reductions are attributable to improvements in collection activities and overall receivables management.

Cost of Services

Our cost of services include all expenses related to the operation of our network platform other than third-party maintenance costs, which are included in SG&A expenses, and depreciation expense on our network equipment. Our policy is to estimate and record access costs during the period services are provided by vendors. Because vendor invoices containing access costs are often received well in arrears of the period when service was provided, we accrue access costs based on the number of circuits in service, according to our circuit inventory system, and the contracted cost for each circuit. Upon final receipt of vendor invoices, estimated access costs are adjusted to reflect actual expenses incurred.

 

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We perform monthly bill verification procedures to identify vendor billing errors. Our verification procedures include the examination of bills, comparing billed rates with contractual rates during the monthly close process, evaluating the trends of invoiced amounts by vendors, and reviewing the types of charges being assessed. If we believe that we are billed inaccurately, we will dispute the charge with the vendor and begin resolution procedures. We increase cost of services and record a corresponding increase to our network cost liability based on historical loss rates for the particular type of dispute. If we ultimately reach an agreement with a vendor to settle a disputed amount that is different than the corresponding accrual, we recognize the difference in the period that the settlement is finalized as an adjustment to cost of services.

Impairment of Long-lived Assets

We evaluate whether there has been any impairment on any of our long-lived assets if circumstances indicate that a possible impairment exists. Factors we consider important that could trigger an impairment review include, but are not limited to, significant under-performance relative to projected future operating results, significant changes in the manner of use of the assets or our overall business and/or product strategies and significant industry or economic trends. When we determine that the carrying value of a long-lived asset may not be recoverable based upon the existence of one or more of these indicators, we determine the recoverability by comparing the carrying amount of the asset to net future undiscounted cash flows that the asset is expected to generate. We then recognize an impairment charge equal to the amount by which the carrying amount exceeds the fair market value of the asset.

Stock-Based Compensation

We recognize compensation expense based on the fair value of all share-based awards granted, modified, repurchased or cancelled. Our stock-based compensation is measured on the grant date based on the fair value of the award and is recognized as an expense over the requisite service period, which is generally the vesting period, on a straight-line basis. The fair value of share-based awards is calculated through the use of option pricing models. These models require subjective assumptions regarding future share price volatility and the expected life of each option grant.

Since July 2008, we estimated the fair value of employee stock options on the grant date using the Black-Scholes option pricing model and the following weighted-average assumptions:

 

Risk-free interest rates

     3.3-4.8

Expected option life (in years)

     6   

Dividend yield

     0

Expected volatility

     50-60

At each stock option grant date, we utilized peer group data to calculate our expected volatility. Expected volatility was based on historical and expected volatility rates of comparable publicly traded peers. The expected life of each option grant is based on existing employee exercise patterns and our historical pre-vested forfeiture experience. The risk-free interest rate was based on the treasury yield rate with a maturity corresponding to the expected option life assumed at the grant date.

Changes to the underlying assumptions may have a significant impact on the underlying value of the stock options, which could have a material impact on our consolidated financial statements.

We have typically granted stock options at exercise prices above the fair market value of our common stock as of the grant date, as determined by our board of directors on a contemporaneous basis. Given the absence of any active market for our common stock, the fair market value of the common stock underlying stock options granted was determined by our board of directors, with input from our management. In arriving at the valuation for options granted in September 2010, our board of directors and management also considered a contemporaneous third-party valuation.

 

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Valuation of Common Stock

Since July 2008, we granted options to purchase shares of our common stock as follows:

 

Grant Date

   Options
Granted
     Exercise
Price
Per Share
     Black-Scholes
Option Value
Per Share
     Aggregate
Grant Date
Option Value
 
(in thousands, except per share data)       

July 2008

     56       $ 5.05       $ 1.60       $ 89   

October 2008

     116         5.05         1.10         127   

February 2009

     309         5.05         0.67         207   

April 2009

     15         5.05         0.71         11   

August 2009

     231         5.05         0.70         161   

October 2009

     27         5.05         0.68         18   

January 2010

     35         5.05         0.65         22   

April 2010

     27         5.05         0.90         24   

September 2010

     225         5.32         3.05         685   

July 2008 to April 2010 Valuations. For all grant dates through April 2010, we granted employees options at exercise prices greater than the fair market value of the underlying common stock at the time of grant, as determined by our board of directors on a contemporaneous basis. To determine the fair market value of our common stock, our board of directors considers many factors, including:

 

   

our current and historical operating performance;

 

   

our expected future operating performance;

 

   

our financial condition at the grant date;

 

   

the liquidation rights and other preferences of our preferred stock;

 

   

the lack of marketability of our common stock;

 

   

the potential future marketability of our common stock;

 

   

the business risks inherent in our business and in technology companies, generally;

 

   

the market performance of comparable publicly traded companies; and

 

   

the U.S. and global capital market conditions.

For the valuations of our common stock that we performed from July 2008 through April 2010, our management estimated our enterprise value as of the various valuation dates using a market approach. This market approach utilized the market multiple based on comparable public companies’ equity pricing and, when available, acquisition multiples from recent acquisitions of comparable companies; however, there have been a limited number of comparable transactions in recent years. Each valuation also reflects a marketability discount, resulting from the illiquidity of our common stock, as well as the liquidation preference of our Series A-1 convertible preferred stock.

Using the market multiple methodology, management determined, as of each valuation date, a range of trading multiples for a group of comparable public companies. In selecting the comparable public companies, management focused on non-incumbent, enterprise focused networking companies and IT solutions providers. For the valuations from July 2008 through August 2009, the group of comparable public companies consisted of

 

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12 public companies that, at the time, we considered to be the most comparable to us. In October 2009, we added one additional public company to the list of comparable public companies and continued to use this list of 13 companies for each subsequent valuation through April 2010. The range of trading multiples used to estimate our enterprise value was based 50% on trailing 12 months revenue and 50% on trailing 12 months Adjusted EBITDA for the comparable companies.

The average of the last four median revenue multiples and the average of the last four median Adjusted EBITDA multiples from the range of comparable public companies were applied to our actual trailing 12 months revenue and Adjusted EBITDA, as the case may be, as of each valuation date to determine an estimated overall enterprise value for our company, which was then increased by our cash balance (net of debt, if any) to determine our total equity value. The aggregate preference of our outstanding Series A-1 preferred stock as of each valuation date was then deducted from our total equity value to estimate the aggregate value available to our common equity holders. The per share value of our common stock was estimated by dividing the resulting value by the number of diluted shares of common stock outstanding, using the treasury method. We also applied marketability discounts as considered appropriate to reflect the illiquidity of our common stock. The number of outstanding shares used in determining diluted shares of common stock outstanding included shares issuable upon the exercise of outstanding stock options and warrants to purchase Series A-1 preferred stock.

Based on the foregoing valuation methodology, our internal valuations estimated that as of July 23, 2008, October 29, 2008, February 4, 2009, February 25, 2009, April 23, 2009, August 5, 2009, October 22, 2009, January 27, 2010 and April 23, 2010, the fair market value of a share of our common stock was $3.64, $2.91, $2.26, $2.26, $2.33, $2.27, $2.26, $2.19 and $2.61, respectively.

August 2010 Valuation. In late July 2010, our board of directors instructed management to commence a formal process to pursue an IPO. This was followed by informal discussions with potential underwriters starting in late August 2010 and formal discussions in September 2010. As a result of these steps, our board of directors considered several additional factors in determining fair value, including review of a third-party valuation report from a valuation expert. The third-party valuation report determined the fair market value of our common stock using valuations based on a market approach of comparable companies and an income approach. Under the market approach, an indication of value was developed through a comparison to valuation multiples of publicly-traded companies that were deemed to be reasonably comparable to us. The income approach measured the value of a company as the present value of its future economic benefits by applying an appropriate risk-adjusted discount rate to expected cash flows, based on forecasted revenues and costs. We prepared a financial forecast for each valuation to be used in the computation of the enterprise value for both the market approach and the income approach. The financial forecasts took into account our past experience and future expectations. The risks associated with achieving these forecasts were assessed in selecting the appropriate discount rate. The enterprise values for each of these two valuation approaches were then weighted based on our estimation of the likelihood of specified scenarios, namely a sale scenario and IPO scenario.

The third-party valuation report as of August 30, 2010 determined a fair market value of our common stock of $5.32 per share on a nonmarketable basis. This report calculated our enterprise value based 50% on a market approach of comparable companies and 50% using an income approach. Our enterprise value was estimated based on the predicted likelihood and timing of potential liquidity events using non-marketability discounts ranging from 21% to 31% depending on the timing of potential liquidity events. Based on this valuation and other factors, our board of directors determined the fair market value of our common stock was $5.32 per share and approved the grant of stock options on September 7, 2010 with an exercise price of $5.32 per share.

 

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We believe the increase in the fair value of our common stock from August 30, 2010 as determined by our compensation committee to the price range set forth on the cover of this prospectus results primarily from the following factors:

Substantially Enhanced Balance Sheet and Financial Condition. The proceeds of a successful public offering will strengthen our balance sheet by increasing our cash balance. Additionally, the completion of a public offering will provide us with access to the public company debt and equity markets. Such improvements in the financial position influenced the increased valuation.

Substantially Enhanced Liquidity and Marketability of our Stock. The third-party valuation report prepared for our board of directors and delivered on August 30, 2010 reflected the fact that the common stock on that date was illiquid and the risk that, in view of difficult market conditions, a public offering remained uncertain. An estimated initial public offering price assumes a successful offering and represents an estimate of the fair value of the unrestricted, freely tradeable stock that would be sold in the public offering market without liquidity and marketability discounts.

IPO Scenario Probability. The third-party valuation of our common stock used by our board of directors on August 30, 2010 assumed a 50% probability of a liquidity event occurring on June 30, 2011 and 50% of a liquidity event occurring on June 30, 2012, with the assumed liquidity events being a 60% probability of an IPO and 40% probability of a private sale as there were still significant execution and timing risks associated with the completion of a public offering. However, the price range included on the cover of this preliminary prospectus assumes the successful completion of our initial public offering, resulting in an increased common stock valuation as compared to our prior valuation.

Conversion of Preferred Stock. Our redeemable convertible preferred stock currently enjoys substantial economic rights and preferences over our common stock, including redemption rights and liquidation preferences. The price range included on the cover of this preliminary prospectus assumes the conversion of our redeemable convertible preferred stock in connection with the public offering and the corresponding elimination of these preferences resulting in an increased common stock valuation.

Capitalized Software Costs

We capitalize costs to develop software for internal use incurred during the application development stage as well as costs to develop significant upgrades or enhancements to existing internal-use software. Development costs relating to customer software, including our Intelligent Network Analyst product, incurred prior to the establishment of technological feasibility are expensed as incurred to SG&A expenses. External software development costs incurred subsequent to the establishment of technological feasibility are capitalized until the software is available for general release to customers. For each software release, judgment is required to evaluate when technological feasibility has occurred. All capitalized software costs are amortized on a straight-line basis over an estimated useful life of three years.

Income Taxes

Provision for income taxes are based on the liability method, which results in income tax assets and liabilities arising from temporary differences. Temporary differences are differences between the tax basis of assets and liabilities and their reported amounts in the financial statements that will result in taxable or deductible amounts in future years. The liability method requires the effect of tax rate changes on current and accumulated deferred income taxes to be reflected in the period in which the rate change was enacted. The liability method also requires that deferred tax assets be reduced by a valuation allowance unless it is more likely than not that the assets will be realized.

 

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We recognize the tax benefit from uncertain tax positions only if it is at least more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon settlement with the taxing authorities. Prior to fiscal 2010, there was no liability for uncertain tax positions due to the fact that there were no material identified tax benefits that were considered uncertain positions.

We establish valuation allowances when necessary to reduce deferred tax assets to the amounts expected to be realized. We evaluate the need for, and the adequacy of, valuation allowances based on the expected realization of our deferred tax assets. The factors used to assess the likelihood of realization include historical earnings, our latest forecast of taxable income and available tax planning strategies that could be implemented to realize the net deferred tax assets. In fiscal 2010, based on current year income before taxes and our projections of future operating results, we concluded that it is more likely than not that a portion of the net deferred tax assets could be realized. Based on these factors, we decreased the valuation allowance by $17.5 million in June 2010.

Our effective tax rates are primarily affected by the amount of our taxable income or losses in the various taxing jurisdictions in which we operate, the amount of federal and state net operating losses and tax credits, the extent to which we can utilize these net operating loss carryforwards and tax credits and certain benefits related to stock option activity.

Results of Operations

The following table sets forth our results of operations for the specified periods. The period-to-period comparison of financial results is not necessarily indicative of future results.

Consolidated Statements of Operations

 

     Year Ended June 30,     Six Months Ended
December 31,
 
     2008     2009     2010     2009     2010  
(in thousands)          (unaudited)  

Revenue:

          

Customer services

   $ 86,850      $ 98,159      $ 98,869      $ 48,589      $ 54,636   

Universal Service Fund fees

     6,063        6,549        (1,331     2,543        1,860   
                                        

Total revenue

     92,913        104,708        97,538        51,132        56,496   

Operating expenses:

          

Cost of services

     54,775        60,434        51,394        28,564        29,981   

Selling, general and administrative

     29,781        31,109        31,472        15,259        17,304   

Depreciation

     4,343        7,857        5,783        2,722        3,399   

Impairment of property and equipment

     —          2,107        —          —          —     
                                        

Total operating expenses

     88,899        101,507        88,649        46,545        50,684   
                                        

Operating income

     4,014        3,201        8,889        4,587        5,812   

Interest expense, net

     (289     (60     (34     (19     (22

Other income (expense), net

     4        (42     (203     (144     (82
                                        

Income before income taxes

     3,729        3,099        8,652        4,424        5,708   

Income tax (expense) benefit

     —          —          13,643        —          (253
                                        

Net income

   $ 3,729      $ 3,099      $ 22,295      $ 4,424      $ 5,455   
                                        

 

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The following table sets forth our results of operations for the specified periods as a percentage of our revenue for those periods. The period-to-period comparison of financial results is not necessarily indicative of future results.

 

     Year Ended June 30,     Six Months Ended
December 31,
 
     2008     2009     2010     2009     2010  
(as a percentage of total revenue)                      (unaudited)  

Revenue:

          

Customer services

     93.5     93.7     101.4     95.0     96.7

Universal Service Fund fees

     6.5        6.3        (1.4     5.0        3.3   
                                        

Total revenue

     100.0        100.0        100.0        100.0        100.0   

Operating expenses:

          

Cost of services

     59.0        57.7        52.7        55.9        53.1   

Selling, general and administrative

     32.0        29.7        32.3        29.8        30.6   

Depreciation

     4.7        7.5        5.9        5.3        6.0   

Impairment of property and equipment

     —          2.0        —          —          —     
                                        

Total operating expenses

     95.7        96.9        90.9        91.0        89.7   
                                        

Operating income

     4.3        3.1        9.1        9.0        10.3   

Interest expense, net

     (0.3     (0.1     (0.0     (0.0     (0.0

Other income (expense), net

     0.0        (0.0     (0.2     (0.3     (0.2
                                        

Income before income taxes

     4.0        3.0        8.9        8.7        10.1   

Income tax (expense) benefit

     —          —          14.0        —          (0.4
                                        

Net income

     4.0     3.0     22.9     8.7     9.7
                                        

Six Months Ended December 31, 2010 compared with Six Months Ended December 31, 2009

Revenue

 

     Six Months Ended December 31,  
     2009      2010      Change     %
Change
 
(in thousands)    (unaudited)               

Revenue:

          

Customer services

   $ 48,589       $ 54,636       $ 6,047        12.4

Universal Service Fund fees

     2,543         1,860         (683     (26.9 )% 
                            

Total revenue

   $ 51,132       $ 56,496       $ 5,364        10.5
                            

Customer services revenue increased for the six months ended December 31, 2010, compared to the six months ended December 31, 2009, due to increases in customer bookings and reductions in average monthly churn during the last 12 months, which resulted in increases in both the number of customers and customer locations that we serve in comparison to the prior year period. These improvements in customer bookings and average monthly churn were attributable to improvement in global economic conditions, pent-up demand for enterprise IT initiatives and improved performance of our sales organization.

The reduction in USF fees was the result of a change in USF billing methodology implemented in October 2009 after an analysis of competitor USF billing practices. Prior to this change, we collected and remitted USF fees on virtually all services provided to customer locations in the United States. Effective October 2009, we now bill and remit USF fees only on telecommunications services, which generally are comprised of local access and voice charges. This reduction of USF fee revenue resulted in an identical reduction in USF fee costs included within cost of services.

The combination of the increase in customer services revenue coupled with the decrease in USF fees resulted in a 10.5% increase in total revenue for the six months ended December 31, 2010, compared to the six months ended December 31, 2009.

 

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Cost of Services

 

     Six Months Ended December 31,  
     2009      2010      Change     %
Change
 
(in thousands)    (unaudited)               

Cost of services:

          

Access costs

   $ 22,508       $ 24,406       $ 1,898        8.4

Infrastructure and data center costs

     2,349         2,657         308        13.1

Deferred installation and other costs

     1,164         1,058         (106     (9.1 )% 

Universal Service Funds costs

     2,543         1,860         (683     (26.9 )% 
                            

Total cost of services

   $ 28,564       $ 29,981       $ 1,417        5.0
                            

Cost of services increased during the six months ended December 31, 2010, compared to the six months ended December 31, 2009, due to the increase in number of customer locations served coupled with increases in infrastructure and data center costs. These increases were somewhat mitigated by a decrease in USF costs resulting from the change in USF billing methodology implemented in October 2009. Contributing to the increase in infrastructure and data center costs were an increase in the number of network hubs to 27 at December 31, 2010, from 26 at December 31, 2009, coupled with increased capacity added on selected backbone routes. As a percentage of total revenue, cost of services decreased to 53.1% for the six months ended December 31, 2010 from 55.9% for the six months ended December 31, 2009. This reduction as a percentage of total revenue was due to more efficient network utilization coupled with the reduction in USF costs resulting from the USF billing methodology change.

Selling, General and Administrative Expenses

 

     Six Months Ended December 31,  
     2009      2010      Change      %
Change
 
(in thousands)    (unaudited)                

Selling, general and administrative expenses:

           

Employee costs, excluding stock based compensation

   $ 10,301       $ 11,507       $ 1,206         11.7

Stock-based compensation

     232         250         18         7.8

Marketing costs

     379         506         127         33.5

Other selling, general and administrative

     4,347         5,041         694         16.0
                             

Total selling, general and administrative expenses

   $ 15,259       $ 17,304       $ 2,045         13.4
                             

SG&A expenses increased during the six months ended December 31, 2010, compared to the six months ended December 31, 2009, primarily due to increased employee costs, including bonuses accrued under our fiscal 2011 corporate bonus plan. The increase in employee costs was attributable to an increase in the number of employees to 159 at December 31, 2010 from 152 at December 31, 2009, coupled with increases in accrued corporate bonus, payroll taxes, recruiting costs and employee training costs, and a decrease in capitalized software development costs due to an increase in software maintenance releases in the current year.

Other SG&A expenses, which includes channel partner sales commissions, third-party maintenance expenses, rent and other facilities costs, professional fees, travel and entertainment costs, property and franchise taxes, FCC fees and bad debt expense, increased during the six months ended December 31, 2010 compared to the six months ended December 31, 2009. This increase was largely attributable to increases in channel partner sales commissions, resulting from an increase in the percentage of new bookings sold through channel partners and the overall increase in customer services revenue from the prior year, as well as increases in marketing and travel costs. These increases were partially offset by decreased third-party maintenance expense, resulting from a program implemented in fiscal 2010 to self-spare certain equipment utilized in our network hubs.

 

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Depreciation Expense

Depreciation expense increased $0.7 million, or 24.9%, to $3.4 million during the six months ended December 31, 2010 from $2.7 million during the six months ended December 31, 2009. This increase is attributable to depreciation expense on property and equipment purchases made during the last 18 months.

Interest Expense, Net

Interest expense, net was $22,000 during the six months ended December 31, 2010 and $19,000 during the six months ended December 31, 2009. Interest income and Comerica loan costs were essentially flat in both periods.

Other Income (Expense), Net

Other income (expense), net consists of foreign currency impacts on transactions and gains and losses on the disposal of property and equipment. Other expense, net decreased to $82,000 during the six months ended December 31, 2010 from $144,000 during the six months ended December 31, 2009. This decrease was primarily the result of reduced foreign exchange losses due to reduced volatility in foreign currency exchange rates.

Provision for Taxes

Other than the payment of required alternative minimum taxes, we have not incurred income taxes due to the carryforward of net operating losses. Prior to the quarter ended June 30, 2010, we historically offset all of our net deferred tax assets by a valuation allowance. However, in June 2010, based on fiscal 2010 income before taxes and our projections of future operating results, we concluded that it was more likely than not that certain of our deferred tax assets would be realizable, and therefore the valuation allowance was reduced by $17.5 million. Commencing with the quarter ended September 30, 2010, we now accrue current income tax expense on a quarterly basis at our marginal effective tax rate. We also continue to monitor our cumulative NOL position and other evidence each quarter to determine the appropriateness of our deferred tax asset valuation allowance. Based on these considerations, we reduced the valuation allowance by the same amount as current U.S. income tax expense during the six-month period ended December 31, 2010. However, because we had previously recognized all deferred tax benefits associated with our international subsidiary, we also incurred $253,000 of foreign income tax expense during the six months ending December 31, 2010.

Fiscal Year Ended June 30, 2010 compared with Fiscal Year Ended June 30, 2009

Revenue

 

     Year Ended June 30,  
     2009      2010     Change     %
Change
 
(in thousands)                          

Revenue:

         

Customer services

   $ 98,159       $ 98,869      $ 710        0.7

Universal Service Fund fees

     6,549         (1,331     (7,880     (120.3 )% 
                           

Total revenue

   $ 104,708       $ 97,538      $ (7,170     (6.8 )% 
                           

Customer services revenue increased slightly in fiscal 2010 compared to fiscal 2009 as increases in customer bookings and new service installations were largely offset by increases in average monthly churn due to the impacts of the global recession, which resulted in many customers consolidating their operations or reducing IT expenses. Also mitigating the increase in customer services revenue was a reduction in deferred installation revenue due to additional installation fee discounts offered on longer-term contracts, coupled with an increase in

 

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average customer term on new contracts, to 28.4 months in fiscal 2010 from 26.3 months in fiscal 2009, and general competitive pressures. The global economic downturn that started in the fall of 2008 contributed to an increase in our average monthly churn rate to 1.9% in fiscal 2010 from 1.6% in fiscal 2009.

Universal Service Fund fees decreased for the fiscal year ended June 30, 2010, compared to the fiscal year ended June 30, 2009, primarily due to a change in USF billing methodology implemented in October 2009 after an evaluation of competitor USF billing practices. We also later revised our previous USF filings from fiscal years 2009 and 2010 to reflect this change, resulting in USF refunds of $5.9 million, which we intend to refund to customers in the future. Prior to this change, we collected and remitted USF fees on virtually all services provided to customer locations in the United States. We now charge USF only on telecommunications services which generally are comprised of local access and voice charges. This reduction in USF fee revenue resulted in an identical reduction in USF fee costs included within cost of services.

The combination of the increase in customer services revenue coupled with the decrease in USF fees resulted in a 6.8% decrease in total revenue for fiscal 2010 compared to fiscal 2009.

Cost of Services

 

     Year Ended June 30,  
     2009      2010     Change     %
Change
 
(in thousands)                          

Cost of services:

         

Access costs

   $ 47,054       $ 45,511      $ (1,543 )     (3.3 )% 

Infrastructure and data center costs

     4,322         4,930        608        14.1

Deferred installation and other costs

     2,509         2,284        (225     (9.0 )% 

Universal Service Funds costs

     6,549         (1,331 )     (7,880     (120.3 )% 
                           

Total cost of services

   $ 60,434       $ 51,394      $ (9,040 )     (15.0 )% 
                           

Cost of services decreased in fiscal 2010 compared to fiscal 2009 due to decreases in USF costs, access costs and deferred installation and other costs. These decreases were partially offset by an increase in infrastructure and data center costs resulting from the expansion of the number of network hubs coupled with increased capacity added on selected backbone routes. The number of network hubs grew to 27 at June 30, 2010, from 23 at June 30, 2009. This increase in hubs also contributed to the decrease in access costs due to the reduced mileage of access circuits in new hub markets. The remaining decrease in access costs was the result of cost reduction initiatives to optimize access network costs and effectively lower unit prices. The reduction in deferred installation and other costs was due to a reduction in installation charges billed to us by our access providers. The reduction in USF costs resulted from the change in USF application methodology implemented in October 2009 coupled with $5.9 million in USF refunds. These changes resulted in a decrease in cost of services as a percentage of total revenue to 52.7% in fiscal 2010 from 57.7% in fiscal 2009.

Selling, General and Administrative Expenses

 

     Year Ended June 30,  
     2009      2010      Change     %
Change
 
(in thousands)                           

Selling, general and administrative expenses:

          

Employee costs, excluding stock based compensation

   $ 20,675       $ 21,641       $ 966        4.7

Stock-based compensation

     718         433         (285     (39.7 )% 

Marketing costs

     757         736         (21     (2.8 )% 

Other selling, general and administrative

     8,959         8,662         (297     (3.3 )% 
                            

Total selling, general and administrative expenses

   $ 31,109       $ 31,472       $ 363        1.2
                            

 

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SG&A expenses increased in fiscal 2010 compared to fiscal 2009 primarily due to increased employee costs. The increase in employee costs was attributable to an increase in the number of employees, to 156 at June 30, 2010 from 154 at June 30, 2009, coupled with increases in internal sales commissions and corporate bonus expense. The increase in sales commissions resulted from increases in bookings and installation activity while the increase in corporate bonus expense was due to overachievement on the customer satisfaction survey portion of the bonus plan. Stock-based compensation declined in fiscal 2010 compared to fiscal 2009 due to options granted to certain company executives in previous years becoming fully vested throughout the year.

Other SG&A expenses decreased in fiscal 2010 compared to fiscal 2009. This decrease was attributable to decreases in third-party maintenance expense, resulting from a program to self-spare certain equipment utilized in our network hubs, as well as decreases in occupancy costs, professional fees and bad debt expense. These decreases were partially offset by an increase in channel partner sales commissions resulting from an increase in the percentage of new business sold through channel partners.

Depreciation Expense

Depreciation expense decreased $2.1 million, or 26.4%, to $5.8 million in fiscal 2010 from $7.9 million in fiscal 2009. During fiscal 2009, we upgraded certain network hub equipment, which resulted in accelerated depreciation expense of $2.3 million resulting from the reduction of the estimated useful life of the equipment. The absence of this accelerated depreciation expense coupled with elimination of depreciation expense on equipment that was removed from the network as part of the fiscal 2009 upgrades were responsible for the decrease in depreciation expenses in fiscal 2010 compared to fiscal 2009. These decreases were partially offset by depreciation expense on property and equipment purchases made during fiscal years 2010 and 2009.

Impairment of Property and Equipment

As part of the fiscal 2009 network hub equipment upgrades, we determined that certain equipment to be upgraded as part of the plan had been impaired. As a result, we recorded a non-cash impairment charge of $2.1 million in fiscal 2009 to write-off this equipment.

Interest Expense, Net

Interest expense, net declined to $34,000 in fiscal 2010 from $60,000 in fiscal 2009 due to elimination of interest charges recognized under notes payable incurred in connection with the previous acquisition of certain network equipment from Alcatel-Lucent. These notes payable were repaid in full in April 2009.

Other Income (Expense), Net

Other income (expense), net consists of the foreign currency impacts on transactions and gains and losses on the disposal of property and equipment. Other expense, net increased in fiscal 2010 to $203,000 from $42,000 in fiscal 2009 primarily as a result of recording foreign exchange losses in fiscal 2010 compared with foreign exchange gains in the prior year. This change was partially offset by net gains recorded on the disposal of property and equipment in fiscal 2010 compared to losses recorded on asset disposals in fiscal 2009.

Provision for Taxes

Other than the payment of required alternative minimum taxes, we have not incurred income tax expense due to the carryforward of NOLs. At June 30, 2010, we had NOL carryforwards of $98.1 million for U.S. tax purposes that will begin to expire in fiscal 2021 and $6.7 million for foreign tax reporting purposes. We have historically offset all of our net deferred tax assets by a valuation allowance. However, in June 2010, based on fiscal 2010 income before taxes and our projections of future operating results, we concluded that it was more likely than not that certain of our deferred tax assets would be realizable, and therefore the valuation allowance was reduced by $17.5 million.

 

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Fiscal Year Ended June 30, 2009 compared with Fiscal Year Ended June 30, 2008

Revenue

 

     Year Ended June 30,  
     2008      2009      Change      %
Change
 
(in thousands)                            

Revenue:

           

Customer services

   $ 86,850       $ 98,159       $ 11,309         13.0

Universal Service Fund fees

     6,063         6,549         486         8.0
                             

Total revenue

   $ 92,913       $ 104,708       $ 11,795         12.7
                             

Customer services revenue increased for the fiscal year ended June 30, 2009, compared to the fiscal year ended June 30, 2008, largely due to customer bookings exceeding the impact of average monthly churn, which resulted in a net increase in customer locations served in fiscal 2009 compared to fiscal 2008. Also contributing to the increase in customer services revenue in fiscal 2009 was an increase in the number of higher-bandwidth circuits installed during the period coupled with an increase in cancellation fees paid by customers who terminated their service prior to the contract expiration date. These increases were partially offset by decreases in deferred installation revenue and customer premise equipment sales compared to the prior year period and the impact of foreign currency fluctuations. Our average monthly churn rate was 1.6% in both fiscal years. USF fees also increased in fiscal 2009 as compared to fiscal 2008 due to a net increase in customer services to locations in the United States.

The combination of the increase in customer services revenue coupled with the increase in USF fees resulted in a 12.7% increase in total revenue for the fiscal year ended June 30, 2009 compared to the fiscal year ended June 30, 2008.

Cost of Services

 

     Year Ended June 30,  
     2008      2009      Change     %
Change
 
(in thousands)                           

Cost of services:

          

Access costs

   $ 41,813       $ 47,054       $ 5,241        12.5

Infrastructure and data center costs

     4,363         4,322         (41     (0.9 )% 

Deferred installation and other costs

     2,536         2,509         (27     (1.1 )% 

Universal Service Funds costs

     6,063         6,549         486        8.0
                            

Total cost of services

   $ 54,775       $ 60,434       $ 5,659        10.3
                            

Cost of services increased in fiscal 2009 compared to fiscal 2008 due to the increase in number of customer locations served in fiscal 2009. As a percentage of total revenue, cost of services was 57.7% in fiscal 2009 compared to 59.0% in fiscal 2008. The decrease in cost of services as a percentage of revenue is due to more efficient network utilization coupled with negotiated contractual rate reductions from various underlying service providers. While data center costs increased in fiscal 2009 due to increasing demand for data center space, savings achieved on the renewal of our North American backbone coupled with the elimination of certain low-utilized backbone routes mitigated these cost increases, resulting in total infrastructure and data center costs declining slightly in fiscal 2009 from the prior year period. The increase in USF costs in fiscal 2009 compared to fiscal 2008 was directly attributable to the increase in customer services revenue generated from locations in the United States.

 

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Selling, General and Administrative Expenses

 

     Year Ended June 30,  
     2008      2009      Change     %
Change
 
(in thousands)                           

Selling, general and administrative expenses:

          

Employee costs, excluding stock based compensation

   $ 19,939       $ 20,675       $ 736        3.7

Stock-based compensation

     551         718         167        30.3

Marketing costs

     778         757         (21     (2.7 )% 

Other selling, general and administrative

     8,513         8,959         446        5.2
                            

Total selling, general and administrative expenses

   $ 29,781       $ 31,109       $ 1,328        4.5
                            

The increase in SG&A expenses in fiscal 2009 compared to fiscal 2008 was directly attributable to the growth in our business. SG&A expenses as a percentage of total revenue declined to 29.7% in fiscal 2009 from 32.0% in fiscal 2008 due to the fixed nature of certain SG&A costs. The increase in employee costs was attributable to employee cost of living salary increases, coupled with increases in employee benefits and corporate bonus expense. These employee cost increases were somewhat mitigated by increased capitalized software development labor costs and reduced commissions paid to our internal sales representatives. Stock-based compensation increased in fiscal 2009 compared to fiscal 2008 due to additional employee option grants made during those years.

Other SG&A expenses increased in fiscal 2009 compared to fiscal 2008 due to increases in channel partner sales commissions, resulting from the increase in total revenue, coupled with increases in travel and entertainment costs, third-party maintenance expenses, software licensing fees and bad debt expense in comparison to the prior year. These expense increases were partially offset by decreases in occupancy costs, internal network costs, professional fees and certain non-income related taxes in fiscal 2009 compared to fiscal 2008.

Depreciation Expense

Depreciation expense increased $3.6 million, or 80.9%, to $7.9 million in fiscal 2009 from $4.3 million in fiscal 2008. During 2009, we upgraded certain network hub equipment, which resulted in accelerated depreciation expense of $2.3 million relating to the upgraded equipment. This accelerated depreciation expense, coupled with depreciation expense on property and equipment purchases made during both fiscal years, were responsible for the overall increase in depreciation expense in fiscal 2009 compared to fiscal 2008.

Impairment of Property and Equipment

As part of the network hub equipment upgrades in fiscal 2009, we determined that certain equipment to be upgraded had been impaired. We therefore recorded a non-cash impairment charge of $2.1 million in fiscal 2009 to write-off this equipment.

Interest Expense, Net

Interest expense, net declined to $60,000 in fiscal 2009 from $289,000 in fiscal 2008 due to reductions in average amounts outstanding under our credit facility with Comerica Bank and notes payable incurred in connection with the previous acquisition of network equipment from Alcatel-Lucent. Total long-term debt outstanding inclusive of notes payable balances declined to $0 at June 30, 2009 from $1.0 million at June 30, 2008 and $3.9 million at June 30, 2007. These reductions in interest expense were partially offset by a decline in interest earned on our cash and short-term investments between fiscal 2008 and fiscal 2009.

 

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Other Income (Expense), Net

Other expense, net was $42,000 in fiscal 2009 compared to other income, net of $4,000 in fiscal 2008. This change in other income (expense), net resulted from an increase in losses recorded on asset disposals in fiscal 2009 compared to fiscal 2008, partially offset by an increase in foreign exchange gains in fiscal 2009 compared to fiscal 2008 due to currency fluctuations at that time.

Quarterly Results of Operations

The following table presents our unaudited consolidated quarterly results of operations for the four quarters in the fiscal years ended June 30, 2009 and 2010, along with the first two quarters of fiscal 2011 ended December 31, 2010. This information is derived from our unaudited consolidated financial statements, which include all adjustments, consisting of normal accruals, that management considers necessary for the fair presentation of our results of operations for the fiscal quarters presented. Operating results for any fiscal quarter are not necessarily indicative of the operating results to be expected in any future period. You should read this data together with our consolidated financial statements and the accompanying notes included elsewhere in this prospectus.

 

    Three Months Ended,  
    Sep. 30,
2008
    Dec. 31,
2008
    Mar. 31,
2009
    Jun. 30,
2009
    Sep. 30,
2009
    Dec. 31,
2009
    Mar. 31,
2010
    Jun. 30,
2010
    Sep. 30,
2010
    Dec. 31,
2010
 
(in thousands, unaudited)            

Revenue:

                   

Customer services

  $ 24,024      $ 24,613      $ 25,203      $ 24,319      $ 24,132      $ 24,457      $ 24,764      $ 25,516      $ 26,776      $ 27,860   

Universal Service Fund fees

    1,721        1,778        1,476        1,574        1,765        778        928        (4,802     986        874   
                                                                               

Total revenue

    25,745        26,391        26,679        25,893        25,897        25,235        25,692        20,714        27,762        28,734   
                                                                               

Operating expenses:

                   

Cost of services

    14,955        15,189        15,213        15,077        14,636        13,928        14,131        8,699        14,839        15,142   

Selling, general and administrative

    7,921        7,833        7,748        7,607        7,704        7,555        7,969        8,244        8,452        8,852   

Depreciation

    1,287        1,857        1,623        3,090        1,313        1,409        1,506        1,555        1,673        1,726   

Impairment of property & equipment

    —          —          —          2,107        —          —          —          —          —          —     
                                                                               

Total operating expenses

    24,163        24,879        24,584        27,881        23,653        22,892        23,606        18,498        24,964        25,720   
                                                                               

Operating income (loss)

    1,582        1,512        2,095        (1,988     2,244        2,343        2,086        2,216        2,798        3,014   

Interest expense, net

    (17     (11     (19     (13     (10     (9     (4     (11     (11     (11

Other income (expense), net

    (129     123        (45     9        (128     (16     (58     (1     (42     (40
                                                                               

Income (loss) before taxes

    1,436        1,624        2,031        (1,992     2,106        2,318        2,024        2,204        2,745        2,963   

Income tax (expense) benefit

    —          —          —          —          —          —          —          13,643        (107     (146
                                                                               

Net income (loss)

  $ 1,436      $ 1,624      $ 2,031      $ (1,992   $ 2,106      $ 2,318      $ 2,024      $ 15,847      $ 2,638      $ 2,817   
                                                                               

 

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The following table sets forth our unaudited results of operations for the specified periods as a percentage of our revenue for those periods. The period-to-period comparison of financial results is not necessarily indicative of future results.

 

    Three Months Ended,  
    Sep. 30,
2008
    Dec. 31,
2008
    Mar. 31,
2009
    Jun. 30,
2009
    Sep. 30,
2009
    Dec. 31,
2009
    Mar. 31,
2010
    Jun. 30,
2010
    Sep. 30,
2010
    Dec. 31,
2010
 
(as a percentage of total revenue, unaudited)                  

Revenue:

                   

Customer services

    93.3     93.3 %     94.5 %     93.9 %     93.2 %     96.9 %     96.4 %     123.2 %     96.4     97.0

Universal Service Fund fees

    6.7        6.7        5.5        6.1        6.8        3.1        3.6        (23.2 )     3.6        3.0   
                                                                               

Total revenue

    100.0        100.0        100.0        100.0        100.0        100.0        100.0        100.0        100.0        100.0   
                                                                               

Operating expenses:

                   

Cost of services

    58.1        57.6        57.0        58.2        56.5        55.2        55.0        42.0        53.5        52.7   

Selling, general and administrative

    30.8        29.7        29.0        29.4        29.7        29.9        31.0        39.8        30.4        30.8   

Depreciation

    5.0        7.0        6.1        11.9        5.1        5.6        5.9        7.5        6.0        6.0   

Impairment of property & equipment

    —          —          —          8.1        —          —          —          —          —          —     
                                                                               

Total operating expenses

    93.9        94.3        92.1        107.6        91.3        90.7        91.9        89.3        89.9        89.5   
                                                                               

Operating income (loss)

    6.1        5.7        7.9        (7.6 )     8.7        9.3        8.1        10.7        10.1        10.5   

Interest expense, net

    (0.0     (0.0     (0.1     (0.1     (0.1     (0.0     (0.0     (0.1     (0.0     (0.0

Other income (expense), net

    (0.5     0.5        (0.2     0.0        (0.5     (0.1     (0.2     (0.0     (0.2     (0.2
                                                                               

Income (loss) before taxes

    5.6        6.2        7.6        (7.7     8.1        9.2        7.9        10.6        9.9        10.3   

Income tax (expense) benefit

    —          —          —          —          —          —          —          65.9        (0.4     (0.5
                                                                               

Net income (loss)

    5.6     6.2 %     7.6 %     (7.7 )%     8.1 %     9.2 %     7.9 %     76.5 %     9.5     9.8
                                                                               

Our quarterly results can vary significantly due to many factors including those outside of our control such as general economic conditions. Historical customer services revenue generally increased each quarter until the fourth quarter of fiscal 2009 when operations were adversely impacted by the global economic downturn, which resulted in increased monthly churn as certain customers consolidated their operations, reduced IT expenditures or in some cases simply went out of business. We experienced growth in customer services revenue starting in the second quarter of fiscal 2010 as monthly churn declined closer to historical levels, thus resulting in increases in the number of customer locations that we serve. USF fee revenue declined starting in the second quarter of fiscal 2010 due to the change in USF billing methodology implemented in October 2009. USF fee revenue for the quarter ending June 30, 2010 was reduced by an additional $5.9 million due to USF refunds relating to prior periods, which we intend to refund to customers in the future.

Cost of services has fluctuated over the quarters presented above primarily due to quarterly changes in customer services revenue and the change in USF billing methodology implemented October 2009, which resulted in an equal reduction in USF costs. Cost of services as a percentage of total revenue has also declined in recent quarters due to cost reduction initiatives to optimize network costs, the impact of price reductions from renegotiated vendor agreements and the USF billing change. Cost of services for the fiscal quarter ending June 30, 2010 was reduced by an additional $5.9 million due to USF refunds relating to prior periods.

Changes in quarterly SG&A expenses are generally the result of the number of individuals employed by us and the variability in sales commissions paid due to changes in customer services revenue and other sales objectives. SG&A expenses as a percentage of total revenue declined during the first three quarters of fiscal 2009 due to the fixed nature of certain SG&A expenses in relation to the increase in total revenue. SG&A expenses as a percentage of total revenue increased beginning in the fourth quarter of fiscal 2009 through the fourth quarter of fiscal 2010 due to changes in quarterly revenue, the impact of the USF billing methodology change implemented in October 2009 and an increase in the total number of employees, especially in sales and sales

 

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support. We expect future SG&A expenses as a percentage of total revenue to decline slightly from recent quarters due to the fixed nature of certain costs offset by the additional costs we expect to incur related to reporting and other obligations associated with being a public company.

The increase in depreciation expense and impairment of property and equipment reflected for the quarter ended June 30, 2009 were the result of network hub equipment upgrades completed during the quarter. These one-time expenses resulted in an operating loss for the quarter ended June 30, 2009.

Due to the uncertainty in future operating results, we had historically offset all of our net deferred tax assets by a valuation allowance. In June 2010, we concluded that it was more likely than not that certain of our deferred tax assets would be realizable, and therefore reduced the valuation allowance by $17.5 million at that time.

Reconciliation of Quarterly Non-GAAP Financial Measures

We use Adjusted EBITDA to evaluate our operating performance and this non-GAAP financial measure is among the primary measures used by management for planning and forecasting for future performance. We define Adjusted EBITDA as net income (loss) before interest, income taxes, depreciation and amortization (EBITDA), excluding, when applicable, asset impairment charges, stock-based compensation expense and other (income) expense, net, consisting of foreign currency impacts on transactions and gains and losses on the disposal of property and equipment. By excluding the impact of expenses that may vary from period to period without any correlation to our underlying operating performance, we believe that we are able to gain a clearer view of the operating performance of our business. We use Adjusted EBITDA in conjunction with traditional GAAP operating performance measures as part of our overall assessment of our performance, for planning purposes, including the preparation of our annual operating budget, to evaluate the effectiveness of our business strategies and to communicate with our board of directors concerning our financial performance.

We believe the presentation of Adjusted EBITDA is relevant and useful for investors because it allows investors to view our results in the same manner as management. We believe Adjusted EBITDA also provides investors and other users of our financial statements consistency and comparability with our past financial performance, facilitates period-to-period comparisons of operations and facilitates comparisons with our peer companies, many of which use similar non-GAAP financial measures to supplement their GAAP results.

We do not place undue reliance on Adjusted EBITDA as our only measure of operating performance. Adjusted EBITDA has limitations as an analytical tool and should not be considered in isolation from, or as a substitute for, net income (loss) or any other measure of our performance reported in accordance with GAAP. For example, Adjusted EBITDA (i) does not reflect capital expenditures or contractual commitments, (ii) does not reflect changes in, or cash requirements for, our working capital needs, (iii) does not reflect interest expense, or the cash requirements necessary to service interest payments, on debt, (iv) does not reflect income taxes and (v) does not consider the costs or potentially dilutive impact of issuing equity-based compensation. We compensate for the inherent limitations associated with using the Adjusted EBITDA measures through disclosure of these limitations, presentation of our financial statements in accordance with GAAP and reconciliation of Adjusted EBITDA to the most directly comparable GAAP measure, net income (loss).

Our computation of Adjusted EBITDA may not be comparable to other similarly titled measures computed by other companies, because all companies do not calculate Adjusted EBITDA in the same manner.

 

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Table of Contents

The following table presents a reconciliation of net income (loss) to Adjusted EBITDA for the four fiscal quarters in the fiscal years ended June 30, 2009 and June 30, 2010, along with the first two fiscal quarters of fiscal 2011 ended December 31, 2010:

 

    Three Months Ended,  
    Sep. 30,
2008
    Dec. 31,
2008
    Mar. 31,
2009
    Jun. 30,
2009
    Sep. 30,
2009
    Dec. 31,
2009
    Mar. 31,
2010
    Jun. 30,
2010
    Sep. 30,
2010
    Dec. 31,
2010
 
(in thousands, unaudited)                                                      

Net income (loss)

  $ 1,436      $ 1,624      $ 2,031      $ (1,992   $ 2,106      $ 2,318      $ 2,024      $ 15,847      $ 2,638     $ 2,817   

Interest expense, net

    17        11