ITC DELTACOM INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations.

(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion should be read in conjunction with the accompanying unaudited Consolidated Financial Statements and related Notes thereto and with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the audited Consolidated Financial Statements and the Notes thereto contained in the Annual Report on Form 10-K for the year ended December 31, 2012.

Overview ITC^DeltaCom, Inc., together with its consolidated subsidiaries, provides integrated communications services in the southeastern United States. We operate one reportable segment. We provide a broad range of data and voice communications services to business customers, including high-speed or broadband data communications, local exchange, long-distance, mobile data and voice and equipment services. We also sell transmission capacity to other communications providers on a wholesale basis. We offer these services primarily over our regional fiber optic network.

In December 2010, we were acquired by EarthLink, Inc. ("EarthLink") for $3.00 per share, with ITC^DeltaCom, Inc. surviving as a wholly-owned subsidiary of EarthLink (the "Acquisition"). Subsequent to the Acquisition, our integrated communication services were rebranded as EarthLink Business and our wholesale services were rebranded as EarthLink Carrier, an EarthLink Business company.

Acquisition On March 2, 2011, we acquired Saturn Telecommunication Services Inc. and affiliates ("STS Telecom"), a privately-held provider of IP communication and information technology services to small and medium-sized businesses primarily in Florida. STS Telecom operates a sophisticated VoIP platform. The primary reason for the acquisition was to leverage STS Telecom's expertise in managed hosted VoIP as part of our VoIP offerings.

Revenue Sources We provide a broad range of data, voice and equipment services to businesses and communications carriers. We present our revenue in the following three categories: (1) retail services, which includes data, voice and mobile data and voice services provided to business customers; (2) wholesale services, which includes the sale of transmission capacity to other telecommunications carriers; and (3) other services, which includes the sale of customer premises equipment.

Our retail customers range from large enterprises with many locations, to small and medium-sized multi-site businesses, to business customers with one site. Our wholesale customers consist primarily of telecommunications carriers and network resellers. Revenues generally consist of monthly recurring fees; usage fees; installation fees; termination fees and equipment sales.

Trends in our Business Our financial results are impacted by several significant trends, which are described below.

Industry factors. We operate in the communications industry, which is characterized by intense competition, industry consolidation resulting in larger competitors, an evolving regulatory environment, changing technology and changes in customer needs. We expect these trends to continue. In addition, merger and acquisition transactions and other factors have reduced the number of vendors from which we may purchase network elements that we leverage to operate our business.

Revenue declines. Our traditional voice services have been declining due to competitive pressures and changes in the industry, and we expect this trend to continue. Churn has been improving, but the rate of new customer bookings of legacy products have not kept up with expectations. In addition, revenues have been adversely impacted as a result of rules adopted by the FCC in late 2011 regarding intercarrier compensation. The rules include the elimination of terminating switched access rates and other per-minute terminating charges between service providers by 2018, through annual reductions in the rates. To counteract trends in our revenue, we are focused on building long-term customer relationships based a customizable communications portfolio using a blend of access technologies for connectivity and personalized customer service. However, we expect to continue to experience pressure on revenue.

Economic conditions. Many of our existing and target customers are small and medium-sized businesses. We believe these businesses are more likely to be affected by economic downturns than larger, more established businesses. We believe that the financial and economic pressures faced by our customers in this environment of diminished consumer spending, corporate downsizing and tightened credit have had, and may continue to have, an adverse effect on our results of operations, including 20-------------------------------------------------------------------------------- Table of Contents longer sales cycles and increased customer demands for price reductions in connection with contract renewals. Additionally, our consumer access services are discretionary and dependent upon levels of consumer spending. Unfavorable economic conditions could cause customers to slow spending in the future, which could adversely affect our revenues and churn.

Results of Operations On December 8, 2010, we were acquired by EarthLink. The accounting for the acquisition was "pushed-down" in our consolidated financial statements. Due to EarthLink's acquisition of us, the financial results have been presented separately for the "Predecessor Entity" period, January 1, 2010 through December 7, 2010, and for the "Successor Entity" period, December 8, 2010 through December 31, 2010. To allow comparison of our results, we combined these periods into a year period from January 1, 2010 through December 31, 2010. Our discussions below will refer to this combined period to compare to the prior period as we feel this provides a useful and more accurate comparison. However, due to adjustments to our assets and liabilities in connection with purchase accounting, results from the Successor Entity and Predecessor Entity combined may not be indicative of our future results. This combination is not a U.S. GAAP measure and it is only provided to allow the reader to more easily compare the results of the operations for the periods presented.

The following table sets forth statement of operations data for the combined year ended December 31, 2010 and the years ended December 31, 2011 and 2012 (in thousands): Successor Predecessor Entity Entity Successor Entity January 1, December 8, Combined through through Year Ended Year Ended December 7, December 31, December 31, December 31, 2010 2010 2010 2011 2012 Revenues: Retail services $ 343,227 $ 21,307 $ 364,534 $ 364,066 $ 349,703 Wholesale services 58,003 4,267 62,270 71,955 76,474 Other services 13,616 1,029 14,645 13,693 14,167 Total revenues 414,846 26,603 441,449 449,714 440,344 Operating costs and expenses: Cost of revenues (exclusive of depreciation and amortization shown separately below) 197,567 13,845 211,412 219,400 225,793 Selling, general and administrative (exclusive of depreciation and amortization shown separately below) 138,544 9,389 147,933 138,765 136,154 Depreciation and amortization 52,339 4,885 57,224 71,659 70,912 Acquisition and integration-related costs 7,987 6,765 14,752 5,272 2,491 Total operating costs and expenses 396,437 34,884 431,321 435,096 435,350 Income (loss) from operations 18,409 (8,281 ) 10,128 14,618 4,994 Interest expense and other, net (29,118 ) (2,089 ) (31,207 ) (30,882 ) (29,117 ) Write-off of debt discount and issuance cost (7,948 ) - (7,948 ) - - Loss before income taxes (18,657 ) (10,370 ) (29,027 ) (16,264 ) (24,123 ) Income tax benefit (provision) 604 - 604 (734 ) (183 ) Net loss $ (18,053 ) $ (10,370 ) $ (28,423 ) $ (16,998 ) $ (24,306 ) 21-------------------------------------------------------------------------------- Table of Contents The following table sets forth certain operating data as of December 31, 2011 and 2012: December 31, December 31, 2011 2012 Colocations (1) 299 299 Voice and data switches 21 21 Employees (2) 1,222 1,202 Retail business voice lines in service (3) UNE-T and other UNE lines (4) 374,643 367,105 Resale and UNE-P lines (5) 44,278 40,279 Total retail voice lines in service 418,921 407,384 Wholesale lines in service (6) 5,382 4,761 Total business lines in service (7) 424,303 412,145 _________________ (1) Two colocations in the same physical facility are reflected as one location.

(2) Includes full-time and part-time employees.

(3) Lines in service include only voice lines in service. Conversion of data services provided to customers to a voice line equivalent is excluded.

(4) Facilities-based service offering in which we provide local transport through our owned and operated switching facilities.

(5) Resale service offerings in which we provide local and mobile services.

(6) Represents primary rate interface circuits provided as part of our local interconnection services for Internet service providers.

(7) Reported net of lines disconnected or canceled.

Revenues The following table presents revenues by groups of similar services for the combined year ended December 31, 2010 and the years ended December 31, 2011 and 2012: Combined Year Ended Year Ended December 31, December 31, 2011 vs 2010 2012 vs 2011 2010 2011 2012 $Change % Change $ Change % Change (dollars in thousands) Retail services $ 364,534 $ 364,066 $ 349,703 $ (468 ) - % $ (14,363 ) (4 )% Wholesale services 62,270 71,955 76,474 9,685 16 % 4,519 6 % Other services 14,645 13,693 14,167 (952 ) (7 )% 474 3 % Total revenues $ 441,449 $ 449,714 $ 440,344 $ 8,265 2 % $ (9,370 ) (2 )% Retail services. The decrease in retail services revenues from the combined year ended December 31, 2010 to the year ended December 31, 2011 was primarily due to declines in traditional local and long-distance voice revenues due to continued loss of retail voice lines in service. Retail voice revenues and voice lines in service have been decreasing due to competition in the industry and customers migrating to more advanced services. This was mostly offset by the inclusion of STS Telecom revenues. The results of operations of STS Telecom have been included since the acquisition date on March 2, 2011.

The decrease in retail services revenues from the year ended December 31, 2011 to the year ended December 31, 2012 was primarily attributable to continued declines in local and long-distance voice service revenues. Also contributing to the decrease was a decrease in carrier access billing revenues due to new rules adopted by the FCC in November 2011 regarding intercarrier compensation.

The new rules include the elimination of terminating switched access rates and other per-minute terminating charges between service providers by 2018, through annual reductions in the rates. We expect these trends to continue. The decreases in retail services revenues were partially offset by the inclusion of STS Telecom revenues for a full period in 2012 compared to a partial period in 2011.

22-------------------------------------------------------------------------------- Table of Contents Wholesale services. The increases in wholesale services revenues during the years ended December 31, 2011 and 2012 compared to the prior years were primarily due to increases in broadband capacity revenues and voice revenues.

Partially offsetting the increases was a decrease in local interconnection revenues resulting from a decrease in local interconnection lines.

Other services. The change in revenues from other services during the years ended December 31, 2011 and 2012 compared to the prior years resulted from changes in volumes of telephone systems sold. We decided to exit telecom systems sales early in 2013 to enable focus on our hosted VoIP platform for new voice customers, which will negatively impact future revenues from equipment services.

We will continue to provide equipment maintenance to existing customers.

Cost of revenues The following table presents cost of revenues for the combined year ended December 31, 2010 and the years ended ended December 31, 2011 and 2012: Combined Year Ended Year Ended December 31, December 31, 2011 vs 2010 2012 vs 2011 2010 2011 2012 $ Change % Change $ Change % Change (dollars in thousands)Cost of revenues $ 211,412 $ 219,400 $ 225,793 $ 7,988 4 % $ 6,393 3 % Cost of revenues includes costs directly associated with providing services to our customers. Cost of revenues primarily consists of the cost of connecting customers to our networks via leased facilities; the costs of leasing components of our network facilities; costs paid to third-party providers for interconnect access and transport services; and the costs of equipment sold to customers. We utilize other carriers to provide services where we do not have facilities. We utilize a number of different carriers to terminate our long distance calls outside the southeastern United States. The provision of local services over our network generally reduces the amounts we otherwise would be required to pay to other telephone companies to use their networks and facilities in order to provide local services related to the decline in revenues for these services.

The increase in cost of revenues from the combined year ended December 31, 2010 to the year ended December 31, 2011 was primarily due to the inclusion of STS Telecom cost of revenues and an increase in wholesale services cost of revenues.

These were partially offset by a decline in local voice services and interconnection services.

The increase in cost of revenues from the year ended December 31, 2011 to year ended December 31, 2012 was primarily due to an $8.3 million charge recorded in the second quarter of 2012 to increase our reserves for regulatory audits, primarily an audit currently being conducted by the Universal Service Administrative Company on previous Universal Service Fund assessments and payments; an increase in reserves for billing disputes with certain vendors; and the inclusion of STS Telecom cost of revenues for a full period in 2012 compared to a partial period in 2011. Partially offsetting these increases was a decline in local voice services.

Selling, general and administrative expense The following table presents our selling, general and administrative expenses for the combined year ended December 31, 2010 and the years ended December 31, 2011 and 2012: Combined Year Ended Year Ended December 31, December 31, 2011 vs 2010 2012 vs 2011 2010 2011 2012 $ Change % Change $ Change % Change (dollars in thousands) Selling, general and administrative expenses $ 147,933 $ 138,765 $ 136,154 $ (9,168 ) (6 )% $ (2,611 ) (2 )% Selling, general and administrative expenses consist of expenses related to sales and marketing, customer service, network operations, information technology, regulatory, billing and collections, corporate administration, and legal and accounting. Such costs include salaries and related employee costs (including stock-based compensation), outsourced labor, professional fees, property taxes, travel, insurance, rent, advertising and other administrative expenses.

23-------------------------------------------------------------------------------- Table of Contents The decrease in selling, general and administrative expenses from the combined year ended December 31, 2010 to the year ended December 31, 2011 was primarily due to a favorable tax settlement recognized during year ended December 31, 2011, which was recorded as a offset to selling, general and administrative expenses. Also contributing were decreases in facilities costs, professional fees, data processing, bad debt expense and other corporate overhead expenses due to a reduction in headcount during the year and synergies recognized from EarthLink's acquisition of us. Partially offsetting these decreases was the inclusion of STS Telecom's selling, general and administrative expenses and an increase in stock-based compensation expense.

The decrease in selling, general and administrative expenses from the year ended December 31, 2011 to the year ended December 31, 2012 was primarily attributable to decreases in stock-based compensation, repairs and maintenance, bad debt expense and payment processing. Partially offsetting this was the inclusion of STS Telecom's selling, general and administrative expenses for a full period in 2012 compared to a partial period in 2011 and the favorable tax settlement recognized during 2011.

Depreciation and amortization The following table presents our depreciation and amortization expense for the combined year ended December 31, 2010 and the years ended December 31, 2011 and 2012: Combined Year Ended Year Ended December 31, December 31, 2011 vs 2010 2012 vs 2011 2010 2011 2012 $ Change % Change $ Change % Change (dollars in thousands) Depreciation expense $ 53,506 $ 45,229 $ 43,977 $ (8,277 ) (15)% $ (1,252 ) (3)% Amortization expense 3,718 26,430 26,935 22,712 611% 505 2% Total $ 57,224 $ 71,659 $ 70,912 $ 14,435 25% $ (747 ) (1)% Depreciation and amortization includes depreciation of property and equipment and amortization of definite-lived intangible assets acquired in purchases of businesses. Property and equipment is depreciated using the straight-line method over the estimated useful lives of the various asset classes. Leasehold improvements are depreciated using the straight-line method over the shorter of the estimated useful life or the remaining term of the lease. Definite-lived intangible assets, which primarily consist of customer relationships, developed technology and trade names, are amortized on a straight-line basis over their estimated useful lives, which range from three to six years. The customer relationships are being amortized using the straight-line method because this matches the estimated cash flow generated by such asset, and the developed technology and trade name are being amortized using the straight-line method because a pattern to which the expected benefits will be consumed or otherwise used up could not be reliably determined.

The decrease in depreciation expense from the combined year ended December 31, 2010 to the year ended December 31, 2011 was due to property and equipment becoming fully depreciated over the past year and a reduction in property and equipment recorded at fair value in connection with EarthLink's acquisition of us, partially offset by an increase in depreciation expense resulting from property and equipment obtained in the acquisition of STS Telecom. The increase in amortization expense from the combined year ended December 31, 2010 to the year ended December 31, 2011 was due to amortization of identifiable intangible assets established in connection with EarthLink's acquisition of us and our acquisition of STS Telecom. In December 2010, we began amortizing the intangible assets arising from the EarthLink acquisition, and in March 2011 we began amortizing the STS intangible assets.

The decrease in depreciation expense from the year ended December 31, 2011 to the year ended December 31, 2012 was primarily due to property and equipment becoming fully depreciated during the year. The increase in amortization expense from the year ended December 31, 2011 to the year ended December 31, 2012 was due to including a full period of amortization expense for the STS Telecom identifiable intangible assets in 2012 compared to a partial period in 2011.

Acquisition and integration-related costs Acquisition and integration-related costs consist of costs related to acquisitions. Such costs include: 1) transaction-related costs, which are direct costs incurred to effect a business combination, such as advisory, legal, accounting, valuation and other professional fees; 2) severance and retention costs; 3) costs to settle postcombination stock awards; 4) integration-related costs, such as system conversion, rebranding costs and integration-related consulting and employee costs; and 5) facility-related costs.

24-------------------------------------------------------------------------------- Table of Contents Acquisition and integration-related costs are expensed in the period in which the costs are incurred and the services are received and are included in acquisition and integration-related costs in the Consolidated Statements of Comprehensive Loss. Acquisition and integration-related costs consisted of the following for the periods presented (in thousands): Predecessor Entity Successor Entity January 1, December 8, through through Year Ended Year Ended December 7, December 31, December 31, December 31, 2010 2010 2011 2012 Transaction-related costs $ 7,987 $ - $ 111 $ - Severance and retention costs - 4,699 3,561 938 Costs to settle postcombination stock awards - 2,066 - - Integration-related costs - - 872 1,246 Facility-related costs - - 728 307 Total acquisition and integration-related costs $ 7,987 $ 6,765 $ 5,272 $ 2,491 We incurred more acquisition and integration-related costs during the year ended December 31, 2010 as EarthLink's acquisition of us was transacted in December 2010 and such costs were pushed down. The decreases in acquisition and integration-related costs during the years ended December 31, 2011 and 2012 compared to the prior years were primarily due to a decline in severance and transaction-related costs costs. Partially offsetting the decrease was an increase in integration-related costs, as we incur costs to integrate operating support systems and networks.

Interest expense and other, net The following table presents our interest expense and other, net, for the combined year ended December 31, 2010 and the years ended December 31, 2011 and 2012: Combined Year Ended Year Ended December 31, December 31, 2011 vs 2010 2012 vs 2011 2010 2011 2012 $ Change % Change $ Change % Change (dollars in thousands) Interest expense and other, net $ (31,207 ) $ (30,882 ) $ (29,117 ) $ 325 1 % $ 1,765 6 % Interest expense and other, net, is primarily comprised of interest expense incurred on our outstanding indebtedness, including our 10.5% senior secured notes due 2016 (the "Notes") and capital leases; amortization of debt premium; interest income earned on our cash and cash equivalents; and other miscellaneous income and expense items.

The decrease in interest expense and other, net, from the combined year ended December 31, 2010 to the year ended December 31, 2011 was primarily attributable to the amortization of the debt premium resulting from the increase in fair value of debt recorded in the Acquisition. As a result of EarthLink's acquisition of us, the Notes were recorded at acquisition date fair value. The fair value was based on publicly-quoted market prices. The resulting debt premium is being amortized over the remaining life of the Notes using the effective interest method. This was partially offset by having a full year of interest expense for the Notes in 2011.

The decrease in interest expense and other, net, from the year ended December 31, 2011 to the year ended December 31, 2012 was primarily attributable to a the redemption of a portion of our outstanding Notes. In December 2012, we exercised our right to call for the redemption of 10% of the aggregate principal amount of our outstanding Notes. We redeemed $32.5 million aggregate principal amount of the Notes on December 6, 2012. The redemption price was equal to 103% of the principal amount thereof, plus accrued and unpaid interest, resulting in an $0.8 million gain on redemption of debt. After the redemption, $292.3 million aggregate principal amount of the Notes remained outstanding. Also contributing to the decrease was a $0.4 million decrease in loss on sale and disposal of fixed assets.

25-------------------------------------------------------------------------------- Table of Contents Write-off debt issuance cost and discount The write-off of debt issuance cost and discount of $7.9 million during the combined year ended December 31, 2010 was a result of the issuance of the Notes in April 2010 and the retirement of our first and second lien facilities.

Income tax benefit (provision) We recorded an income tax benefit of $0.6 million during the combined year ended December 31, 2010. We recorded an income tax provision of $0.7 million and $0.2 million during the years ended December 31, 2011 and 2012, respectively. We utilize the liability method of accounting for income taxes. Under the liability method, deferred taxes are determined based on the difference between the financial and tax bases of assets and liabilities using enacted tax rates in effect in the years in which the differences are expected to reverse. A valuation allowance has been recorded against deferred tax assets, as we are unable to conclude under relevant accounting standards that it is more likely than not that deferred tax assets will be realizable.

To the extent we report income in future periods, we intend to use our net operating loss carryforwards to the extent available to offset taxable income and reduce cash outflows for income taxes. Our ability to use our federal and state net operating loss carryforwards and federal and state tax credit carryforwards may be subject to restrictions attributable to certain transactions such as equity transactions in the future resulting from changes in ownership as defined under the Internal Revenue Code.

Liquidity and Capital Resources The following table sets forth summarized cash flow data for the combined year ended December 31, 2010 and the years ended December 31, 2011 and 2012 (in thousands): Successor Predecessor Entity Entity Successor Entity January 1, December 8, Combined through through Year Ended Year Ended December 7, December 31, December 31, December 31, 2010 2010 2010 2011 2012 Net cash provided by (used in) operating activities $ 47,205 $ (5,138 ) $ 42,067 $ 37,159 $ 50,615 Net cash used in investing activities (53,787 ) (20,514 ) (74,301 ) (72,110 ) (52,813 ) Net cash (used in) provided by financing activities (1,967 ) 10,000 8,033 26,296 (392 ) Net decrease in cash and cash equivalents $ (8,549 ) $ (15,652 ) $ (24,201 ) $ (8,655 ) $ (2,590 ) Operating activities Net cash provided by operating activities decreased during the year ended December 31, 2011 compared to the combined year ended December 31, 2010 primarily due to an increase in cash used for prepaid assets and cash used for accounts payable, accrued and other liabilities.

Net cash provided by operating activities increased during the year ended December 31, 2012 compared to the year ended December 31, 2011 primarily due to an increase in accounts payable and accrued liabilities, primarily related to timing of certain payments to network providers. Also contributing to the increase was a reduction in operating expenses, a decrease in cash used for severance and other acquisition-related expenses and incremental cash generated by the operating activities of STS Telecom.

Investing activities Net cash used in investing activities decreased during the year ended December 31, 2011 compared to the combined year ended December 31, 2010 primarily due to a $15.6 million decrease in capital expenditures and a $9.1 million decrease in cash used to settle postcombination stock awards. Partially offsetting this was $22.9 million of cash used for the acquisition of STS Telecom in 2011.

Net cash used in investing activities decreased during the year ended December 31, 2012 compared to the year ended December 31, 2011 primarily due to $22.9 million of cash paid to acquire STS Telecom during the year ended December 31, 2011. No cash was used for acquisitions during the year ended December 31, 2012. Partially offsetting this was a $3.8 million increase in capital expenditures.

26-------------------------------------------------------------------------------- Table of Contents Financing activities The change in net cash flows from financing activities during the year ended December 31, 2011 was primarily due to $30.0 million received from the issuance of stock to EarthLink during the year ended December 31, 2011, compared to $10.0 million received during the combined year ended December 31, 2010 . This funding was primarily provided for our acquisition of STS Telecom in March 2011. During the year ended December 31, 2011, we used $3.6 million for repayments of long-term debt and capital leases. Under the indenture for the Notes, following the consummation of EarthLink's acquisition of us, we were required to offer to repurchase any or all of the Notes at 101% of their principal amount. The tender window was open from December 20, 1010 through January 18, 2011. As a result, approximately $0.2 million outstanding principal amount of the Notes was repurchased in January 2011. Also during the year ended December 31, 2011, we repaid $3.0 million of debt assumed in the STS Telecom acquisition and made $0.4 million payments on capital leases assumed in the STS Telecom acquisition.

Net cash provided by (used in) financing activities decreased during the year ended December 31, 2012 compared to the year ended December 31, 2011 primarily due to a decrease in repayment of debt and capital lease obligations. During the year ended December 31, 2011, we repaid $3.0 million of debt assumed in the STS Telecom acquisition and repurchased approximately $0.2 million outstanding principal amount of the Notes. During the year ended December 31, 2012, we repaid $34.0 million of debt and capital lease obligations. Partially offsetting this change was an increase in EarthLink's investments in us, which was $33.5 million during the year ended December 31, 2012 used to fund the debt repayment, compared to $30.0 million during the year ended December 31, 2011 used to fund the STS Telecom acquisition.

Future Uses of Cash Our primary future cash requirements will be for outstanding indebtedness, capital expenditures and general business working capital requirements.

Debt and interest. We expect to use cash related to our outstanding indebtedness, including payments for interest. In December 2012, we redeemed 10%, or $32.5 million aggregate principal amount, of our outstanding ITC^DeltaCom Notes at a redemption price of 103% pursuant to the terms of the related indenture, which was funded by EarthLink. However, we may use additional cash to redeem our Notes in accordance with the terms of the related indenture, to purchase them in the open market or to refinance with new debt.

Capital expenditures. We believe that to remain competitive with much larger communications companies, we will require significant additional capital expenditures to enhance and operate our fiber network. We plan to make capital expenditures relating to acquiring new customers and to maintain and upgrade our network and technology infrastructure. The actual amount of capital expenditures may fluctuate due to a number of factors which are difficult to predict and could change significantly over time. Additionally, technological advances may require us to make capital expenditures to develop or acquire new equipment or technology in order to replace aging or obsolete equipment.

Other. We also expect to use cash for required payment of wages and salaries to employees, purchase of network capacity and access under contracts, and payment of fees for other goods and services, including maintenance and commission payments.

Our cash requirements depend on numerous factors, including the costs required to maintain our network infrastructure, the outcome of various telecommunications-related disputes and proceedings, the pricing of our services, and the level of resources used for our sales and marketing activities, among others.

Sources of Cash Our principal sources of liquidity are our cash and cash equivalents, as well as the cash flow we generate from our operations. During the combined year ended December 31, 2010 and the years ended December 31, 2011 and 2012, we generated $42.1 million, $37.2 million and $50.6 million in cash from operations, respectively. As of December 31, 2012, we had $32.3 million in cash and cash equivalents.

We believe that our cash on hand and the cash flows we expect to generate from operations under our current business plan will provide us with sufficient funds to enable us to fund our planned capital expenditures, satisfy our debt service requirements, and meet our other cash needs under our current business plan for at least the next 12 months. Our ability to meet all of our cash needs during the next 12 months and thereafter could be adversely affected by various circumstances, including an increase in customer attrition, employee turnover, service disruptions and associated customer credits, acceleration of critical operating payables, lower than expected collections of accounts receivable, and other circumstances outside of our immediate and direct 27-------------------------------------------------------------------------------- Table of Contents control. We may determine that it is necessary or appropriate to obtain additional funding through new debt financing to address such contingencies or changes to our business plan. We cannot provide any assurance as to whether, or as to the terms on which, we would be able to obtain such debt financing, which would be subject to limitations imposed by covenants contained in our Notes and which would be negatively affected by adverse developments in the credit and capital markets.

Contractual Obligations and Commitments The following table sets forth our contractual obligations and commercial commitments as of December 31, 2012: Payment Due by Period 2014- 2016- Total 2013 2015 2017 After 5 Years (in thousands) Long-term debt (1) $ 292,300 $ - $ - $ 292,300 $ - Interest payments on long-term debt (2) 130,448 30,694 61,387 38,367 -Purchase commitments (3) 53,233 27,341 24,959 919 14 Operating leases (4) 42,165 12,117 15,514 8,632 5,902 Capital leases (5) 623 302 321 - - Total (6) $ 518,769 $ 70,454 $ 102,181 $ 340,218 $ 5,916 __________________________________________ (1) Long-term debt includes principal payments on outstanding debt obligations. Long-term debt excludes unamortized premiums. As of December 31, 2012, we had $292.3 million of 10.5% senior secured notes due on April 1, 2016.

(2) Interest payments on long-term debt includes interest due on outstanding debt through maturity.

(3) Purchase commitments represent non-cancellable contractual obligations for services and equipment and minimum commitments under network access agreements with several carriers.

(4) These amounts represent base rent payments under non-cancellable operating leases for facilities and equipment that expire in various years through 2020.

(5) Represents remaining payments under capital leases, including interest.

(6) The table does not include our reserve for uncertain tax positions, as the specific timing of any cash payments relating to this obligation cannot be projected with reasonable certainty. We have $17.6 million of uncertain tax positions. Of this amount, $15.9 million would reduce prior net operating losses if assessed. The remaining $1.7 million has been reflected on the balance sheet as of December 31, 2012 and would impact the effective tax rate upon settlement. Of the total uncertain tax positions, none is expected to reverse within the next twelve months.

Debt Covenants Under the indenture governing our Notes, acceleration on principal payments would occur upon payment default or violation of debt covenants. We were in compliance with all covenants under the indenture governing our Notes as of December 31, 2012.

Off-Balance Sheet Arrangements As of December 31, 2012, we did not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors.

Related Party Transactions We have a services agreement with EarthLink pursuant to which EarthLink and its subsidiaries provide us certain support services in exchange for management fees. In addition, we provide EarthLink and its subsidiaries certain support services in exchange for management fees. The management fees are determined based on the costs to provide such services. Net operating expenses recorded were $0.6 million and $1.5 million during the years ended December 31, 2011 and 2012, respectively.

28-------------------------------------------------------------------------------- Table of Contents Critical Accounting Policies and Estimates Set forth below is a discussion of the accounting policies and related estimates that we believe are the most critical to understanding our consolidated financial statements, financial condition and results of operations and which require complex management judgments, uncertainties and/or estimates. The preparation of financial statements in accordance with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities and the reported amounts of revenues and expenses during a reporting period; however, actual results could differ from those estimates. Management has discussed the development, selection and disclosure of the critical accounting policies and estimates with the Audit Committee of the Board of Directors.

Information regarding our other accounting policies is included in the Notes to our Consolidated Financial Statements.

Judgments and Effect if Actual Results Description Uncertainties Differ From Assumptions Sales Credit Reserves We make estimates for The determination of the We have not made any potential future sales general sales credit and material changes in the credits to be issued customer dispute credit accounting methodology we related to billing errors, reserves contain use to record sales credit service interruptions and uncertainties because they reserves during the past customer disputes, which require management to make three years.

are recorded as a reduction assumptions and apply in revenue. We analyze judgment about the amount We do not believe there is historical credit activity and timing of unknown a reasonable likelihood and changes in customer billing errors and that there will be a demands related to current disputes. material change in the billing and service future estimates or interruptions when assumptions used to record evaluating our credit sales credit reserves.

reserve requirements.

Experience indicates that A 10% difference in our the invoices that are sales credit reserves as provided to other of December 31, 2012 would telecommunications have affected net loss by providers are often subject approximately $0.4 million to significant billing during the year ended disputes. Experience also December 31, 2012.

has shown that these disputes can require a significant amount of time to resolve given the complexities and regulatory issues surrounding the customer relationships.

Allowance for Doubtful Accounts We maintain an allowance The determination of our We have not made any for doubtful accounts for allowance for doubtful material changes in the accounts receivable amounts accounts contains accounting methodology we that may not be uncertainties because it use to record our collectible. In assessing requires management to allowance for doubtful the adequacy of the make assumptions and apply accounts during the past allowance for doubtful judgment about future three years.

accounts, management uncollectible accounts.

considers a number of We do not believe there is factors, including the a reasonable likelihood aging of the accounts that there will be a receivable balances, material change in the historical collection future estimates or experience and a specific assumptions used to record customer's ability to meet our allowance for doubtful its financial obligations accounts.

to us.

A 10% difference in our allowance for doubtful accounts as of December 31, 2012 would have affected net loss by approximately $0.2 million during the year ended December 31, 2012.

Cost of Revenues We rely on other carriers Our cost of revenues We have not made any to provide services where methodology contains material changes in the we do not have facilities, uncertainties because it accounting methodology we and we use a number of requires management to use to estimate reserves different carriers to make assumptions and apply for billing disputes terminate our long distance judgment regarding the during the past three calls. These costs are amount of future billing years.

expensed as incurred. dispute resolutions.

Experience indicates that We do not believe there is the invoices that are a reasonable likelihood received from other that there will be a telecommunications material change in the providers are often subject future estimates or to significant billing assumptions we use for disputes. Experience also these reserves.

has shown that these disputes can require a significant amount of time to resolve given the complexities and regulatory issues surrounding the vendor relationships.

We maintain reserves for any anticipated exposure associated with these billing disputes. The reserves are reviewed on a monthly basis, but are subject to changes in estimates and management judgment as new information becomes available.

29-------------------------------------------------------------------------------- Table of Contents Goodwill We perform an impairment Application of the goodwill We have not made any test of our goodwill impairment test requires material changes in the annually during the fourth judgment, including accounting methodology used quarter of our fiscal year performing the qualitative to evaluate impairment of (October 1) or when events assessment, the goodwill during the last and circumstances indicate identification of reporting three years other than the goodwill might be impaired. units, assigning assets and adoption of the new Impairment testing of liabilities to reporting guidance allowing the goodwill is required at the units, assigning goodwill option to first assess reporting unit level and to reporting units, and qualitative factors to involves a two-step determining the fair value determine whether it is process. However, we may of each reporting unit. necessary to perform the first assess the two-step quantitative qualitative factors to We estimate the fair values impairment test.

determine whether it is of our reporting units necessary to perform the using the income approach. We did not record any two-step quantitative This models uses impairment of goodwill goodwill impairment test. significant unobservable during the years ended inputs, or Level 3 inputs, 2010, 2011 or 2012. As of The first step of the as defined by the fair December 31, 2012, we had impairment test involves value hierarchy. Under the approximately $194.7 comparing the estimated income approach, we million of goodwill. We fair value of our reporting calculate the fair value of elected to forgo the units with the reporting the reporting unit based on qualitative assessment on unit's carrying amount, the present value of our goodwill for our fiscal including goodwill. If we estimated cash flows using 2012 impairment test. We determine that the carrying a discounted cash flow determined we were one value of a reporting unit method. The significant reporting unit for exceeds its estimated fair assumptions used in the evaluating goodwill for the value, we perform a second discounted cash flow method 2012 impairment test. Our step to compare the include internal forecasts fiscal 2012 impairment test carrying amount of goodwill and projections developed indicated the estimated to the implied fair value by management for planning fair value of our reporting of that goodwill. The purposes, available unit substantially exceeded implied fair value of industry/market data, the carrying value and goodwill is determined in strategic plans, discount therefore was not at risk the same manner as utilized rates and the growth rate of future impairment. We to recognize goodwill in a to calculate the terminal continue to monitor events business combination. If value. and circumstances which may the carrying amount of affect the fair value of goodwill exceeds the The assumptions with the this reporting unit.

implied fair value of that most significant impact on goodwill, an impairment the fair value of the There have been no loss would be recognized in reporting unit are those significant events since an amount equal to the related to the discount the timing of our excess. rate, the terminal value, impairment test that would future operating cash flows have triggered additional We evaluate our reporting and the growth rate. impairment testing.

units on an annual basis and allocate goodwill to This type of analysis our reporting units based contains uncertainties on the reporting units because they require expected to benefit from management to make the acquisition generating assumptions and to apply the goodwill. judgment to estimate industry economic factors and the profitability of future business strategies.

Long-lived assets We depreciate property and Estimates of useful lives We have not made any equipment and amortize can differ from actual material changes in the intangible assets using a useful lives due to the accounting methodology we straight-line method over inherent uncertainty in use to account for the estimated useful lives making these estimates. long-lived assets during of the assets. Estimates of the past three years. We useful lives are based on Our impairment tests did not recognize any the nature of the contain uncertainties material impairment charges underlying assets as well because they require for our long-lived assets as our experience with management to make during the past three similar assets and intended assumptions and apply years.

use. judgment to estimate future cash flows and asset fair We do not believe there is We perform tests of values including, a reasonable likelihood impairment for long-lived subscriber additions, that there will be a assets such as property and churn, prices, marketing material change in the equipment and spending, operating costs future estimates or definite-lived intangible and capital spending. assumptions used to account assets when certain events Significant judgment is for long-lived assets.

or changes in circumstances involved in estimating indicate that the carrying these factors, and they However, if other amount may not be include inherent assumptions and estimates recoverable. uncertainties. had been used in the current period, the balances for noncurrent assets could have been materially impacted.

Furthermore, if management uses different assumptions or if different conditions occur in future periods, future operating results could be materially impacted.

Business Combinations We recognize separately Accounting for business Although we believe the from goodwill the assets combinations requires our assumptions and estimates acquired and the management to make we have made in the past liabilities assumed at significant estimates and have been reasonable and their acquisition date fair assumptions, especially at appropriate, they are based values. Goodwill as of the the acquisition date with in part on historical acquisition date is respect to intangible experience and information measured as the excess of assets, obligations assumed obtained from the consideration transferred and pre-acquisition management of the acquired and the net of the contingencies, including companies and are acquisition date fair uncertain tax positions and inherently uncertain.

values of the assets tax-related valuation Unanticipated events and acquired and the allowances, reserves for circumstances may occur liabilities assumed. While billing disputes and that may affect the we use our best estimates revenue reserves. Examples accuracy or validity of and assumptions as a part of critical estimates in such assumptions, estimates of the purchase price valuing certain of the or actual results.

allocation process to intangible assets include, accurately value assets but are not limited to, acquired and liabilities future expected cash flows assumed at the acquisition from customer contracts and date, our estimates are acquired developed inherently uncertain and technologies, the acquired subject to refinement. As a company's brand and result, during the competitive position, as measurement period, which well as assumptions about may be up to one year from the period of time the the acquisition date, we acquired brand will record adjustments to the continue to be used in the assets acquired and combined company's product liabilities assumed, with portfolio and discount the corresponding offset to rates.

goodwill. Upon the conclusion of the measurement period, any subsequent adjustments are recorded to our consolidated statements of comprehensive loss.

30-------------------------------------------------------------------------------- Table of Contents Loss Contingencies We are party to various The determination of our During the year ended legal proceedings and other loss contingencies contain December 31, 2012, we disputes arising in the uncertainties because they recorded an $8.3 million normal course of business, require management to make charge to increase our including, but not limited assumptions and apply reserves for regulatory to, regulatory audits, judgment about unknown audits, primarily an audit trademark and patent resolution of matters. In currently being conducted infringement, billing addition, regulatory by the Universal Service disputes, rights of access, matters are subject to Administrative Company on tax, consumer protection, differing interpretations. previous Universal Service employment and tort. We Fund assessments and accrue for such matters payments, because the when it is both probable amount became probable and that a liability has been estimable during the incurred and the amount of period.

the loss can be reasonably We have not made any estimated. Where it is material changes in the probable that a liability accounting methodology has been incurred and there used to accrue for loss is a range of expected loss contingencies during the for which no amount in the last three years.

range is more likely than any other amount, we accrue at the low end of the range. We review our accruals each reporting period.

31-------------------------------------------------------------------------------- Table of Contents Safe Harbor Statement The Management's Discussion and Analysis and other portions of this Quarterly Report on Form 10-Q include "forward-looking" statements (rather than historical facts) that are subject to risks and uncertainties that could cause actual results to differ materially from those described. Although we believe that the expectations expressed in these forward-looking statements are reasonable, we cannot promise that our expectations will turn out to be correct. Our actual results could be materially different from and worse than our expectations. With respect to such forward-looking statements, we seek the protections afforded by the Private Securities Litigation Reform Act of 1995. These risks and uncertainties (1) that if we are unable to adapt to changes in technology and customer demands, we may not remain competitive, and our revenues and operating results could suffer; (2) that unfavorable general economic conditions could harm our business; (3) that we face significant competition in the communications industry that could reduce our profitability; (4) that decisions by the Federal Communications Commission relieving incumbent carriers of certain regulatory requirements, and possible further deregulation in the future, may restrict our ability to provide services and may increase the costs we incur to provide these services; (5) that if we are unable to interconnect with AT&T and other incumbent carriers on acceptable terms, our ability to offer competitively priced local telephone services will be adversely affected; (6) that our operating performance will suffer if we are not offered competitive rates for the access services we need to provide our long distance services; (7) that we may experience reductions in switched access and reciprocal compensation revenue; (8) that failure to obtain and maintain necessary permits and rights-of-way could interfere with our network infrastructure and operations; (9) that we have substantial business relationships with several large telecommunications carriers, and some of our customer agreements may not continue due to financial difficulty, acquisitions, non-renewal or other factors, which could adversely affect our wholesale revenue and results of operations; (10) that we obtain a majority of our network equipment and software from a limited number of third-party suppliers; (11) that work stoppages experienced by other communications companies on whom we rely for service could adversely impact our ability to provision and service our customers; (12) that if we, or other industry participants, are unable to successfully defend against disputes or legal actions, we could face substantial liabilities or suffer harm to our financial and operational prospects; (13) that we may be accused of infringing upon the intellectual property rights of third parties, which is costly to defend and could limit our ability to use certain technologies in the future; (14) that we may not be able to protect our intellectual property; (15) that we may be unable to hire and retain sufficient qualified personnel, and the loss of any of our key executive officers could adversely affect us; (16) that our business depends on effective business support systems and processes; (17) that privacy concerns relating to our business could damage our reputation and deter current and potential users from using our services; (18) that cyber security breaches could harm our business; (19) that interruption or failure of our network and information systems and other technologies could impair our ability to provide our services, which could damage our reputation and harm our operating results; (20) that government regulations could adversely affect our business or force us to change our business practices; (21) that regulatory audits have in the past, and could in the future, result in increased costs; (22) that our business may suffer if third parties are unable to provide services or terminate their relationships with us; (23) that we may be required to recognize impairment charges on our goodwill and intangible assets, which would adversely affect our results of operations and financial position; (24) that we may have exposure to greater than anticipated tax liabilities; (25) that we are a wholly-owned subsidiary of EarthLink and therefore subject to strategic decisions of EarthLink and affected by EarthLink's performance; (26) that as a wholly-owned subsidiary of EarthLink, any arrangements or agreements between the two entities may have different terms than would have been negotiated by independent, unrelated parties; (27) that our indebtedness could adversely affect our financial health and limit our ability to react to changes in our industry; (28) that we will require substantial capital to support business growth or refinance existing indebtedness, and this capital may not be available to us on acceptable terms, or at all; and (29) that our debt agreements include restrictive covenants, and failure to comply with these covenants could trigger acceleration of payment of outstanding indebtedness. These risks and uncertainties are described in greater detail in Item 1A of Part I, "Risk Factors."

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