TWER Towerstream Corporation (CE)

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion and analysis summarizes the significant factors affecting our condensed consolidated results of operations, financial condition and liquidity position for the three months ended March 31, 2014. This discussion and analysis should be read in conjunction with our audited financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2013 and the condensed consolidated unaudited financial statements and related notes included elsewhere in this filing. The following discussion and analysis contains forward-looking statements that reflect our plans, estimates, and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements.

Forward-Looking Statements

Forward-looking statements in this Quarterly Report on Form 10-Q, including without limitation, statements related to our plans, strategies, objectives, expectations, intentions and adequacy of resources, are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Investors are cautioned that such forward-looking statements involve risks and uncertainties including without limitation the following: (i) our plans, strategies, objectives, expectations and intentions are subject to change at any time at our discretion; (ii) our plans and results of operations will be affected by our ability to manage growth and competition; and (iii) other risks and uncertainties indicated from time to time in our filings with the Securities and Exchange Commission.

In some cases, you can identify forward-looking statements by terminology such as “may,’’ “will,’’ “should,’’ “could,’’ “expects,’’ “plans,’’ “intends,’’ “anticipates,’’ “believes,’’ “estimates,’’ “predicts,’’ “potential,’’ or “continue’’ or the negative of such terms or other comparable terminology. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance, or achievements. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of such statements. Readers are cautioned not to place too much reliance on these forward-looking statements which speak only as of the date hereof. We are under no duty to update any of the forward-looking statements after the date of this Quarterly Report on Form 10-Q.

Non-GAAP Measures and Reconciliations to GAAP Measures

We prepare our financial statements in accordance with generally accepted accounting principles (“GAAP”). We use certain Non-GAAP measures to monitor our business performance and that of our segments. These Non-GAAP measures are not recognized under GAAP. Accordingly, investors are cautioned about using or relying on these measures as alternatives to recognized GAAP measures. Our methods of calculating these measures may not be comparable to similar measures presented by other companies.

Characteristics of Revenues and Expenses

Our Fixed Wireless segment offers broadband services under agreements for periods normally ranging between one to three years. Pursuant to these agreements, we bill customers on a monthly basis, in advance, for each month of service. Payments received in advance of services performed are recorded as deferred revenues and recognized as revenue ratably over the service period. Our Shared Wireless Infrastructure segment offers to rent space, channels, and ports on our street level rooftops at a fixed monthly rent.

Costs of revenues consists of expenses that are directly related to providing services to our customers, including Core Network expenses (tower and street level rooftop rent and utilities, bandwidth costs, maintenance and other) and Customer Network expenses (customer maintenance, non-installation fees and other customer specific expenses).  We collectively refer to Core Network and Customer Network as our “Network,” and Core Network costs and Customer Network costs as “Network Costs.”  When we first enter a new market, or expand in an existing market, we are required to incur up-front costs in order to be able to provide services to commercial customers.  We refer to these activities as establishing a “Network Presence.” For the Fixed Wireless segment, these costs include constructing Points-of-Presence (“PoPs”) in buildings in which we have a lease agreement (“Company Locations”) where we install a substantial amount of equipment in order to connect numerous customers to the Internet. For the Shared Wireless Infrastructure segment, these costs include installing numerous access points, backhaul, and other equipment on street level rooftops that we refer to as “Hotzones.” The costs to build PoPs and construct Hotzones are capitalized and expensed over a five year period.  In addition, we also enter into tower and roof rental agreements, secure bandwidth and incur other Network Costs.  Once we have established a Network Presence in a new market or expanded our Network Presence in an existing market, we are capable of servicing a significant number of customers through that Network Presence.  The variable cost to add new customers is relatively modest, especially compared to the upfront cost of establishing or expanding our Network Presence.  However, we may experience variability in gross margins during periods in which we are expanding our Network Presence in a market.

Sales and marketing expenses primarily consist of the salaries, benefits, travel and other costs of our sales and marketing teams, as well as marketing initiatives and business development expenses.

Customer support services include salaries and related payroll costs associated with our customer support services, customer care, and installation and operations staff.

General and administrative expenses include costs attributable to corporate overhead and the overall support of our operations. Salaries and other related payroll costs for executive management, finance, administration and information systems personnel are included in this category. Other costs include office rent, utilities and other facilities costs, accounting, legal and other professional services, and other general operating expenses.

Overview – Fixed Wireless

We provide fixed wireless broadband services to commercial customers and deliver access over a wireless network transmitting over both regulated and unregulated radio spectrum. Our service supports bandwidth on demand, wireless redundancy, virtual private networks, disaster recovery, bundled data and video services. We currently provide service to business customers in twelve metropolitan markets.

Market Information – Fixed Wireless

As of March 31, 2014, we operated in twelve metropolitan markets consisting of New York, Boston, Los Angeles, Chicago, San Francisco, Miami, Seattle, Dallas-Fort Worth, Houston, Philadelphia, Las Vegas-Reno and Providence-Newport. Although we provide services in multiple markets, these operations have been aggregated into one reportable segment based on the similar economic characteristics among all markets, including the nature of the services provided and the type of customers purchasing such services. The markets were launched at different times, and as a result, may have different operating metrics based on their size and stage of maturation. We incur significant up-front costs in order to establish a Network Presence in a new market. These costs include building PoPs and Network Costs. Other material costs include hiring and training sales and marketing personnel who will be dedicated to securing customers in that market. Once we have established a Network Presence in a new market, we are capable of servicing a significant number of customers. The rate of customer additions varies from market to market, and we are unable to predict how many customers will be added in a market during any specific period. We believe that providing operating information regarding each of our markets provides useful information to shareholders in understanding the leveraging potential of our business model and the operating performance of our mature markets. Set forth below is a summary of our operating performance on a per-market basis, and a description of how each category is determined.

Revenues : Revenues are allocated based on which market each customer is located in.

Costs of Revenues : Includes Core Network costs and Customer Network costs that can be allocated to a specific market.

Operating Costs : Represents costs that can be specifically allocated to a market which include direct sales personnel, certain direct marketing expenses, certain customer support and installation payroll expenses and third party commissions.

Corporate : Includes corporate overhead and centralized activities which support our overall operations. Corporate overhead includes administrative personnel, including executive management, and other support functions such as information technology and facilities. Centralized operations include network operations, customer care, and the management of network assets.

Shared Wireless Infrastructure, net: Represents the net operating results for that business segment.

Adjusted Market EBITDA : Represents a market’s income (loss) before interest, taxes, depreciation, amortization, stock-based compensation, and other income (expense). We believe this metric provides useful information regarding the operating cash flow being generated in a market.

We entered the Houston market in February 2013 through the acquisition of Delos Internet (“Delos”). We exited the Nashville market effective March 31, 2014.

Three months ended March 31, 2014

Three months ended March 31, 2013  

Overview - Shared Wireless Infrastructure

Our Shared Wireless Infrastructure segment offers a range of rental options on street level rooftops related to (i) the installation of customer owned Small Cells, (ii) Wi-Fi access and the offloading of mobile data, and (iii) backhaul, power and other related telecommunications. To date, our operating activities have been primarily focused in New York City, and to a lesser degree, San Francisco, Chicago, and Southern Florida. Costs incurred to establish and operate this business segment include (a) rent payments under lease agreements which provide us with the right to install wireless technology equipment and (b) construction of a carrier-class network to deliver the services being offered by our shared wireless segment.

In June 2013, we entered into the Wi-Fi Agreement with a major cable operator (the “Cable Operator”). The Wi-Fi Agreement provides leased access to certain access points, primarily within New York City and Bergen County, New Jersey. The Cable Operator has a limited right to expand access in our other markets. The term of the Wi-Fi Agreement is for an initial three year period, and provides for automatic renewals for two additional years.  

In April 2014, we entered into a Wi-Fi Agreement with an international provider of Wi-Fi access services in major urban markets. This agreement provides leased access to access points within New York City, Chicago, San Francisco, and Miami. The term of the agreement is for an initial three year period, includes annual escalations of 2%, and provides for automatic annual renewals for two additional years.

Supplemental Segment Information  

Operating information about each segment in accordance with GAAP is disclosed in Note 14 of the financial statements. In addition, we use other non-GAAP measurements to assess the operating performance of each segment. These non-GAAP financial measures are commonly used by investors, financial analysts, and rating agencies. Management believes that these non-GAAP financial measures should be available so that investors have the same data that management employs in assessing our overall operations.

EBITDA, a non-GAAP financial measure, is calculated as net income (loss) before interest, income taxes, depreciation and amortization. We define Adjusted EBITDA as net income (loss) before interest, income taxes, depreciation and amortization expenses, excluding when applicable, stock-based compensation, deferred rent expense, other non-operating income or expenses as well as gain or loss on (i) disposal of property and equipment, (ii) nonmonetary transactions, and (iii) business acquisitions.

Net Cash Flow is another commonly used non- GAAP financial measure. Net Cash Flow is defined as Adjusted EBITDA less capital expenditures.

Three Months Ended March 31, 2014 Compared to Three Months Ended March 31, 2013

Revenues . Revenues totaled $8,379,906 during the three months ended March 31, 2014 compared to $8,299,223 during the three months ended March 31, 2013 representing an increase of $80,683, or 1%. Shared Wireless revenues totaled $740,349 during the three months ended March 31, 2014 compared to $158,476 during the three months ended March 31, 2013 representing an increase of $581,873, or greater than 100%. Substantially all of the increase related to revenues associated with a Wi-Fi service agreement signed with a major cable operator in June 2013. Fixed Wireless segment revenues totaled $7,685,526 during the three months ended March 31, 2014 compared to $8,186,736 during the three months ended March 31, 2013 representing a decrease of $501,210, or 6%. The decrease principally related to a 4% decrease in monthly recurring billings, lower short term contract revenues, and higher than normal customer churn (as further described below).

Average revenue per user (“ARPU”) for the Fixed Wireless segment totaled $758 as of March 31, 2014 compared to $727 as of March 31, 2013 representing an increase of $31, or 4%. ARPU for new customers totaled $636 during the quarter ended March 31, 2014 compared to $630 during the quarter ended March 31, 2013 representing an increase of $6, or 1%. The increase in ARPU primarily related to customers upgrading to higher bandwidth service which generates higher monthly recurring revenue.

Customer churn, calculated as a percent of revenue lost on a monthly basis from customers terminating or reducing their recurring service level, totaled 2.33% during the three months ended March 31, 2014 compared to 1.63% during the three months ended March 31, 2013. Our goal is to maintain churn levels between 1.40% and 1.70% which we believe is below industry averages of approximately 2.00%. Churn levels can fluctuate from quarter to quarter depending upon whether customers move to a location not serviced by the Company, go out of business, or a myriad of other reasons. Churn has averaged 1.70% over the past 36 months and we do not believe that the higher than targeted churn level experienced in the first quarter of 2014 is indicative of any long term business developments or trends. We have recently formed a customer retention department which has adopted an active communications program with our customers and believe that these efforts will return churn levels to our targeted range.

Cost of Revenues. Cost of revenues totaled $5,855,944 during the three months ended March 31, 2014 compared to $4,981,306 during the three months ended March 31, 2013 representing an increase of $874,638, or 18%. On a consolidated basis, gross margin during the three months ended March 31, 2014 was 30% as compared to 40% during the three months ended March 31, 2013 representing a decrease of 10 percentage points.  Higher rent expense associated with both PoPs for the fixed wireless network and street level rooftops for the shared wireless infrastructure network increased cost of revenues by $209,455 and $714,214, respectively, and reduced gross margin by 2 and 9 percentage points, respectively. The increase for the fixed wireless network primarily related to lease amendments which provide for additional equipment to be installed for additional rent. The increase for the shared wireless network primarily related to a higher number of lease agreements in the 2014 period as compared to the 2013 period. These increases were partially offset by lower Customer Network and other costs which decreased by $49,031 and benefited gross margin by 1 percentage points. On a per market basis, the increase in cost of revenues is largely attributable to New York and Chicago which are two of the markets in which we have constructed a shared wireless infrastructure network. These two markets represented $699,793 or 80% of the total increase in cost of revenues for the three months ended March 31, 2014.

Depreciation and Amortization. Depreciation and amortization totaled $3,695,415 during the three months ended March 31, 2014 compared to $3,871,087 during the three months ended March 31, 2013 representing a decrease of $175,672, or 5%. Depreciation expense totaled $3,110,389 during the three months ended March 31, 2014 compared to $3,118,487 during the three months ended March 31, 2013 representing a decrease of $8,098, or less than 1%. The net base of assets subject to depreciation was approximately $40 million during both the three months ended March 31, 2014 and 2013 resulting in depreciation expense which was comparable for both periods.

Amortization expense totaled $585,026 during the three months ended March 31, 2014 compared to $752,600 during the three months ended March 31, 2013 representing a decrease of $167,574, or 22%. Amortization expense relates to customer related intangible assets recorded in connection with acquisitions and can fluctuate significantly from period to period depending upon the timing of acquisitions, the relative amounts of intangible assets recorded, and the amortization periods. The decrease was primarily related to the acquisition of One Velocity Inc. (“One Velocity”) for which $232,953 of amortization expense was recognized in the 2013 period with zero recognized in the 2014 period as the related asset became fully amortized in November 2013. The decrease was partially offset by higher amortization expense associated with the Delos acquisition which was completed in February 2013, and for which $98,068 and $32,689 of expense was recorded in the 2014 and 2013 periods, respectively.

Customer Support Services. Customer support services totaled $1,172,135 during the three months ended March 31, 2014 compared to $1,396,894 during the three months ended March 31, 2013 representing a decrease of $224,759, or 16%. The decrease was primarily related to lower payroll costs as average headcount totaled 66 during the 2014 period as compared to 77 during the 2013 period.

Sales and Marketing. Sales and marketing expenses totaled $1,421,599 during the three months ended March 31, 2014 compared to $1,440,856 during the three months ended March 31, 2013 representing a decrease of $19,257, or 1%. Average headcount totaled 46 during the 2014 period as compared to 50 during the 2013 period representing a decrease of 4, or 8%.

General and Administrative. General and administrative expenses totaled $2,677,939 during the three months ended March 31, 2014 compared to $3,137,599 during the three months ended March 31, 2013 representing a decrease of $459,660, or 15%. Payroll costs totaled $989,291 during the 2014 period compared to $1,126,417 during the 2013 period representing a decrease of $137,126, or 12%. The decrease primarily related to non-recurring bonuses related to a corporate financing and an acquisition that were completed in the 2013 period that were not applicable during the 2014 period. Stock-based compensation totaled $292,269 during the 2014 period compared to $396,481 during the 2013 period representing a decrease of $104,212, or 26%. Stock-based compensation can fluctuate significantly from period to period depending on the timing, quantity and valuation of stock option grants. Professional services expenses totaled $374,609 during the 2014 period compared to $447,926 during the 2013 period representing a decrease of $73,317, or 16%. The decrease primarily related to non-recurring expenses associated with the formation of Hetnets which were incurred in the 2013 period. Finally, facility expenses totaled $98,083 during the 2014 period compared to $163,909 during the 2013 period representing a decrease of $65,826, or 40%. The decrease related to the consolidation of the Company's corporate offices which was completed in the fourth quarter of 2013.

Interest Income . Interest income totaled $7,420 during the three months ended March 31, 2014 compared to $154 during the three months ended March 31, 2013 representing an increase of $7,266, or greater than 100%. The increase relates to more interest earned on our cash accounts during the 2014 period.

Interest Expense. Interest expense totaled $70,471 during the three months ended March 31, 2014 compared to $35,768 during the three months ended March 31, 2013 representing an increase of $34,703, or 97%. The increase in interest expense was primarily related to additional capital leases for network equipment and information technology infrastructure.

Gain on Business Acquisition.  There was no gain on business acquisition during the three months ended March 31, 2014 compared to $941,457 during the three months ended March 31, 2013.  The gain in the 2013 period related to the acquisition of Delos in February 2013. The challenging economic environment during 2012 made it difficult for smaller companies like Delos to raise sufficient capital to sustain their growth. As a result, we were able to acquire the customer relationships and wireless network of Delos at a discounted price.

Net Loss. Net loss totaled $6,509,807 during the three months ended March 31, 2014 compared to $5,626,306 during the three months ended March 31, 2013 representing an increase of $883,501, or 16%. Revenues increased by $80,683, or 1%, while operating expenses decreased by $4,710, or less than 1%. In addition, non-operating expense totaled $66,681 during the three months ended March 31, 2014 compared with non-operating income, primarily related to gain on business acquisition, of $902,213 during the three months ended March 31, 2013.

Liquidity and Capital Resources

We have historically met our liquidity and capital requirements primarily through the public sale and private placement of equity securities and debt financing. Changes in capital resources during the three months ended March 31, 2014 and 2013 are described below.

Net Cash Used in Operating Activities.     Net cash used in operating activities for the three months ended March 31, 2014 totaled $5,089,126 compared to $4,422,727 for the three months ended March 31, 2013 representing an increase of $666,399, or 15%. Cash used in operations for the three months ended March 31, 2014 totaled $2,441,362 as compared to $2,287,184 for the three months ended March, 31, 2013. Changes in operating assets and liabilities generally represent timing differences regarding payments and receipts, and are normally not indicative of operating results.  Changes in operating assets and liabilities used cash of $2,647,764 during the three months ended March 31, 2014 compared to $2,135,543 for the three months ended March 31, 2013.

Net Cash Used in Investing Activities.     Net cash used in investing activities for the three months ended March 31, 2014 totaled $1,689,140 compared to $975,853 for the three months ended March 31, 2013 representing an increase of $713,287, or 73%. Cash capital expenditures for the fixed wireless segment increased from $689,742 in the 2013 period to $1,307,376 in the 2014 period representing an increase of $617,634, or 90%. Cash capital expenditures for the shared wireless infrastructure segment increased from zero in the 2013 period to $701,501 in the 2014 period representing an increase of $701,501 or 100%. In addition, we received an incentive payment of $380,000 from our landlord in connection with entering a new lease agreement for our corporate offices. These funds were used to pay for qualified leasehold improvements to the facility. Finally, we paid cash of $225,000 for the acquisition of Delos in the 2013 period. There were no acquisitions in the 2014 period.

Net Cash (Used In) Provided by Financing Activities .  Net cash used in financing activities for the three months ended March 31, 2014 totaled $197,322 compared to net cash provided by financing activities of $30,575,672 for the three months ended March 31, 2013, representing a decrease of $30,772,994, or greater than 100%. The decrease was primarily related to net proceeds of $30,500,836 received in the first quarter of 2013 from the sale of 11,000,000 shares of our common stock at a public offering of $3.00 per share.

Acquisition of Delos. In February 2013, we completed the acquisition of Delos which was based in the Houston, Texas area. The aggregate consideration for the acquisition included (i) approximately $225,000 in cash, (ii) 385,124 shares of common stock with a fair value of approximately $951,000 based on the market price of our common stock on the closing date, and (iii) approximately $166,000 in assumed liabilities. The acquisition of Delos was a business combination accounted for under the acquisition method.

Underwritten Offering. In the first quarter of 2013, we completed an underwritten offering of 11,000,000 shares of our common stock at a public offering price of $3.00 per share. The total gross proceeds of the offering were $33,000,000. Net proceeds were approximately $30,500,836 after underwriting discounts, commissions and offering expenses.

Working Capital.     As of March 31, 2014, we had working capital of $18,937,133. Based on our current operating activities and plans, we believe our working capital position at the end of March 31, 2014 will enable us to meet our anticipated cash requirements for at least the next twelve months.