INTERNET AMERICA INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Edgar Glimpses Via Acquire Media NewsEdge) Certain statements contained in this Quarterly Report on Form 10-Q constitute "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements, identified by words such as "anticipate," "believe," "estimate," "should," "expect" and similar expressions include our expectations and objectives regarding our future financial position, operating results and business strategy. These statements reflect the current views of management with respect to future events and are subject to risks, uncertainties and other factors that may cause our actual results, performance or achievements, or industry results, to be materially different from those described in the forward-looking statements. We do not intend to update the forward-looking information to reflect actual results or changes in the factors affecting such forward-looking information. Our Annual Report on Form 10-K for the fiscal year ended June 30, 2012 and other publicly filed reports discuss some additional important factors that could cause our actual results to differ materially from those in any forward-looking statements. Some of these factors are also discussed under the heading "Safe Harbor Statement and Risk Factors" later in this Item 2.

Overview The quarter ended September 30, 2012 continued to show improved results of operations and related cash flow. Improving our operating performance through a disciplined focus on managing our costs while laying the foundation for stronger internal revenue growth through an increasing subscriber base will further increase our expected future results. We are also continually evaluating accretive opportunities to secure subscribers through strategic acquisitions of Internet service providers in underserved markets where we can introduce our model for delivering wireless broadband internet services. We anticipate that these efforts should yield a better fiscal 2013 relative to fiscal 2012.

9 Statement of Operations Internet services revenue is derived from dial-up Internet access, including analog and ISDN access, DSL access, dedicated connectivity, wireless access, bulk dial-up access, web hosting services, and value-added services, such as multiple e-mail boxes, personalized e-mail addresses and Fax-2-Email services.

A brief description of each element of our operating expenses follows: Connectivity and operations expenses consist primarily of setup costs for new subscribers, telecommunication costs, merchant processing fees, and wages of network operations and customer support personnel. Connectivity costs include fees paid to telephone companies for subscribers' dial-up connections to our network, fees paid to backbone providers for connections from our network to the Internet, and equipment and tower lease costs for our new wireless networks.

Sales and marketing expenses consist primarily of creative and production costs, costs of media placement, management salaries and call center wages. Advertising costs are expensed as incurred.

General and administrative expenses consist primarily of administrative salaries, professional services, rent and other general office and business expenses.

Bad debt expenses (recoveries) consist primarily of customer accounts that have been deemed uncollectible and will potentially be written off in future periods, net of recoveries. Historically, the expense has been based on the aging of customer accounts whereby all customer accounts that are 90 days or older have been provided for as a bad debt expense.

Depreciation expense is computed using the straight-line or double declining method over the estimated useful lives of the assets or the capital lease term, as appropriate. Data communications equipment, computers, data servers and office equipment are depreciated over five years. Furniture, fixtures and leasehold improvements are depreciated over five years or the lease term.

Buildings are depreciated over fifteen years. Amortization expense consists of the amortization of subscriber acquisition costs, which are amortized over four years.

Our business is not subject to any significant seasonal influences.

10 Results of Operations Three Months Ended September 30, 2012 Compared to Three Months Ended September 30, 2011 The following table sets forth certain unaudited financial data for the three months ended September 30, 2012 and September 30, 2011. Operating results for any period are not indicative of results for any future period. Dollar amounts are shown in thousands (except per share data, shares and subscriber counts).

Three Months Ended September 30, % of % of 2012 Revenues 2011 Revenues REVENUES: Internet services $ 1,912 100.0 % $ 1,836 100.0 % TOTAL REVENUES 1,912 100.0 % 1,836 100.0 % OPERATING EXPENSES: Connectivity and operations 992 51.9 % 1,070 58.3 % Sales and marketing 106 5.5 % 96 5.2 % General and administrative 353 18.5 % 353 19.2 % Depreciation and amortization 209 10.9 % 190 10.3 % TOTAL OPERATING EXPENSES 1,660 86.8 % 1,709 93.1 % INCOME FROM OPERATIONS 252 13.2 % 127 6.9 % OTHER INCOME (EXPENSE) Interest income 1 0.1 % 1 0.1 % Interest expense (5 ) (0.3 )% (11 ) (0.6 )% OTHER INCOME (EXPENSE), net (4 ) (0.2 )% (10 ) (0.5 )% INCOME BEFORE INCOME TAX EXPENSE 248 13.0 % 117 6.4 % Income tax expense 12 0.6 % 6 0.3 % NET INCOME and COMPREHENSIVE INCOME $ 236 12.3 % $ 111 6.0 % NET INCOME PER COMMON SHARE: BASIC $ 0.01 $ 0.01 DILUTED $ 0.01 $ 0.01 WEIGHTED AVERAGE COMMON SHARES OUTSTANDING: BASIC 16,729,562 16,729,562 DILUTED 19,447,990 19,447,990 OTHER DATA: Adjusted EBITDA(1) $ 461 $ 325 Adjusted EBITDA margin(2) 24.1 % 17.7 % CASH FLOW DATA: Cash flow provided by operations $ 532 $ 346 Cash flow used in investing activities $ (155 ) $ (88 ) Cash flow used in financing activities $ (61 ) $ (136 ) Reconciliation of net income to Adjusted EBITDA(1): Net Income $ 236 $ 111 Add: Depreciation and amortization 209 190 Stock compensation - 8 Interest expense 5 11 Income tax expense 12 6 Less: Interest income (1 ) (1 ) Adjusted EBITDA(1) $ 461 $ 325 -------------------------------------------------------------------------------- (1) Adjusted EBITDA, which as used herein means earnings before the effect of interest, taxes, depreciation, amortization and stock based compensation is not a measurement of financial performance under generally accepted accounting principles (GAAP) and should not be considered an alternative to net income as a measure of performance. Management has consistently used Adjusted EBITDA on a historical basis as a measurement of the Company's current operating cash income.

11 (2) Adjusted EBITDA margin represents Adjusted EBITDA as a percentage of total revenue.

Total revenue. Total revenue increased by $76,000, or 4.1%, to $1,912,000 for the three months ended September 30, 2012, from $1,836,000 for the three months ended September 30, 2011. The Company's total subscriber count increased by 1,800, or 7.2%, to approximately 26,800 as of September 30, 2012 compared to approximately 25,000 as of September 30, 2011. The Company's wireless broadband Internet subscriber count increased by 1,300 to approximately 9,100 as of September 30, 2012 compared to approximately 7,800 as of September 30, 2011.

Wireless broadband Internet revenue increased by $158,000 to $1,491,000 for the three months ended September 30, 2012 compared to $1,333,000 for the three months ended September 30, 2011. This increase was primarily due to the stability of the subscriber base and customers migrating to upgraded service levels during the quarter ended September 30, 2012, as well as a result of successful acquisitions of wireless subscribers completed in the twelve months ended September 30, 2012. Increased revenues derived from wireless broadband Internet subscribers were partially offset by the net decrease in other types of Internet service revenues of $82,000 to $421,000 during the three months ended September 30, 2012 as compared to $503,000 for the prior year period, attributed to the expected decline of dial-up customers who may move to other providers' broadband service.

Connectivity and operations. Connectivity and operations expense decreased by $78,000, or 7.3%, to $992,000 for the three months ended September 30, 2012, from $1,070,000 for the three months ended September 30, 2011. Data and telecommunications expense decreased by $78,000 to $248,000 for the three months ended September 30, 2012 compared to $326,000 for the three months ended September 30, 2011 due to our renegotiating more favorable terms with telecommunications service providers. Expensed assets decreased $16,000 to $70,000 for the three months ended September 30, 2012 compared to $86,000 for the three months ended September 30, 2011 due to the decreases in supplies, installation costs, and repairs. Salaries, wages and related personnel expense decreased by $4,000 to $482,000 for the three months ended September 30, 2012 compared to $486,000 for the three months ended September 30, 2011, which is attributed mainly to the reduction in headcount to streamline our efficiencies gained from quality process initiatives. Merchant fees decreased by $3,000 to $41,000 for the three months ended September 30, 2012 compared to $44,000 for the three months ended September 30, 2011.

The above described decreases in expenses were partially offset by an increase in tower leases costs of $23,000 to $151,000 for the three months ended September 30, 2012 compared to $128,000 for the three months ended September 30, 2011, attributed to customer growth in established and new regions requiring additional tower infrastructure.

Sales and marketing. Sales and marketing expense increased by $10,000, or 10.4%, to $106,000 for the three months ended September 30, 2012, compared to $96,000 for the three months ended September 30, 2011. Personnel expense increased $36,000 to $65,000 for the three months ended September 30, 2012 compared to $29,000 for the prior year period due to the addition of sales management and other personnel. The overall increase in sales and marketing expense was partially offset by the decrease in advertising expense of $14,000 to $8,000 for the three months ended September 30, 2012 compared to $22,000 for the three months ended September 30, 2011 due to a reduction in our postcard marketing efforts during the current quarter compared to prior year period. Outside sales expense decreased by $12,000 to $27,000 for the three months ended September 30, 2012 compared to $39,000 for the prior year period, due to utilization of in house sales efforts and increased personnel.

General and administrative. General and administrative expense remained constant at $353,000 for the three months ended September 30, 2012 and 2011. Personnel costs increased by $59,000 to $162,000 for the three months ended September 30, 2012 compared to $103,000 for the three months ended September 30, 2011, attributed to the addition of full time employees and related benefits. Due to the conditions of the economy and expected higher cost of services, minimal increases totaling $12,000 in travel, insurance, facilities and other general and administrative costs were realized for the three months ended September 30, 2012 compared to the prior year period.

The above described increases were partially offset by the decrease in telecom expense of $41,000 to $11,000 for the three months ended September 30, 2012 compared to $52,000 for the three months ended September 30, 2011 primarily due to refunds received from four telecom providers for sales tax billed in error in previous periods. Stock based compensation expense and directors' fees decreased by $17,000 to $6,000 for the three months ended September 30, 2012 from $23,000 for the three months ended September 30, 2011 due to the decrease in the number of directors and due to the lack of amortization of stock based compensation expense during this quarter. Professional fees decreased by $13,000 for the three months ended September 30, 2012 to $46,000 compared to $59,000 for the three months ended September 30, 2011, due to the payment of recruiting fees in connection with the hiring of a new Controller in the prior year period which did not occur in the three months ended September 30, 2012.

12 Depreciation and amortization. Depreciation and amortization expense increased by $19,000, or 10.0%, to $209,000 for the three months ended September 30, 2012 from $190,000 for the three months ended September 30, 2011, primarily due to an $18,000 increase in amortization expense of acquired subscriber costs, resulting from four wireless acquisitions completed since September 30, 2011. Depreciation expense also increased slightly by $1,000 to $173,000 for the three months ended September 30, 2012 compared to $172,000 for the prior year period.

Interest (expense) income, net. Interest expense decreased by $6,000, or 54.5%, to $5,000 for the three months ended September 30, 2012, as compared to $11,000 for the three months ended September 30, 2011, primarily resulting from the reduction in the Company's long-term debt. Interest income remained constant at $1,000 for the three months ended September 30, 2012 and September 30, 2011.

Income tax expense. Income tax expense, consisting of Texas franchise tax, increased $6,000, or 100%, to $12,000 for the three months ended September 30, 2012, as compared to $6,000 for the three months ended September 30, 2011. Due to a true up for past years' franchise tax due, completed in a prior period, the Company has adjusted their monthly accrual rate on a go-forward basis. The Company currently does not provide for Federal income taxes due to the availability of its net operating loss carryforward which is fully reserved at this time due to uncertainty of the Company's ability to have taxable earnings in the future. The Company continually monitors its valuation allowance considering all evidence both positive and negative. Should the Company determine that it is more likely than not that a portion of its deferred tax assets will be realized, a reversal of the valuation allowance representing an estimate of what is recoverable will be recorded within income tax expense in the period that the determination is made.

Liquidity and Capital Resources We have historically financed our operations to date primarily through (i) cash flows from operations, (ii) public and private sales of equity securities and (iii) loans from shareholders and third parties. During the three months ended September 30, 2012, the Company recognized net income and positive cash flow from operations of approximately $236,000 and $532,000, respectively, enabling the Company to fund its operations from current period operating cash flow and resulting in cash on hand of approximately $1,749,000 as of September 30, 2012.

The Company expects to continue to fund its operations during fiscal 2013 with cash flow from operations. The Company will continue to focus on sales and expense management during fiscal 2013 and expects future cash flow from operations to remain strong.

The Company plans to pursue strategic acquisitions in the near and medium term in addition to upgrading its systems to provide higher speeds and increased reliability for its customers. We expect that our capital expenditures and any future acquisitions will be funded from available cash, public or private sales of debt or equity securities, or borrowing from commercial banks and/or third parties; however there is no assurance that such financing will be able to be obtained when needed at desirable rates which could affect our success in achieving any or all of our initiatives. Any unexpected decreases in revenue or subscriber count may adversely affect our liquidity and plans for future growth.

Cash provided by operating activities is net income adjusted for certain non-cash items and changes in assets and liabilities. For the three months ended September 30, 2012, cash provided by operations was $532,000 compared to $346,000 for the three months ended September 30, 2011. For the three months ended September 30, 2012, net income plus non-cash items contributed cash of $445,000 compared to $307,000 contributed during the prior year period. Changes in operating assets and liabilities provided cash of $86,000 and of $40,000 for the three months ended September 30, 2012 and 2011, respectively.

Cash used in investing activities totaled $155,000 and $88,000 for the three months ended September 30, 2012 and 2011, respectively, due primarily to the improvements in existing wireless broadband Internet infrastructure and acquisition of subscribers, partially offset by release of restricted cash of $6,000.

Cash used in financing activities totaled $61,000 and $136,000 for the three months ended September 30, 2012 and 2011, respectively, and consisted of principal payments on long term debt, including notes related to acquisitions.

Cash on hand increased by $315,000 during the quarter ended September 30, 2012.

As of September 30, 2012, cash on hand was $1,749,000 compared to $1,433,000 as of June 30, 2012. We believe our continuing efforts to improve the quality and efficiency of our operations, along with our focus on increasing revenues, may lead to a more rapid rate of growth and improving cash flow from operations.

Off Balance Sheet Arrangements None.

13 "Safe Harbor" Statement and Risk Factors The following "Safe Harbor" Statement is made pursuant to the Private Securities Litigation Reform Act of 1995.

Certain of the statements contained in the body of this Quarterly Report are 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 in the forward-looking statements. With respect to such forward-looking statements, we seek the protections afforded by the Private Securities Litigation Reform Act of 1995. These risks include, without limitation, that (1) we will not be able to increase our rural customer base at the expected rate, (2) we will not improve EBITDA, profitability or product margins,(3) Internet revenue in high-speed broadband will continue to increase at a slower pace than the decrease in revenue from other Internet services resulting in greater operating losses in future periods, (4) financing will not be available to us if and as needed, (5) we will not be competitive with existing or new competitors, (6) we will not keep up with industry pricing or technological developments impacting the Internet, (7) we will be adversely affected by dependence on network infrastructure, telecommunications providers and other vendors or by regulatory changes, (8) service interruptions or impediments could harm our business, (9) acts of God and other events outside our control, such as hurricanes and other dangerous weather conditions, fires and lightning, could damage or destroy our facilities and network infrastructure, (10) we may be accused of infringing upon the intellectual property rights of third parties, which will be costly to defend and could limit our ability to use certain technologies in the future, (11) government regulations could force us to change our business practices, (12) we may be unable to hire and retain qualified personnel, including our key officers, (13) future acquisitions of wireless broadband Internet customers and infrastructure may not be available on attractive terms and, if available, we may not successfully integrate those acquisitions into our operations, (14) provisions in our certificate of incorporation, bylaws and shareholder rights plan could limit our share price and delay a change of management and (15) our stock price has historically been thinly traded and volatile and may continue to be thinly traded and volatile. This list is intended to identify certain of the principal factors that could cause actual results to differ materially from those described in the forward-looking statements included elsewhere herein but is not a comprehensive list of all of such factors.

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