Condensed Notes to Consolidated Financial Statements
(Unaudited)
1. Organization
Switch, Inc. was formed as a Nevada corporation in June 2017 for the purpose of completing an initial public offering (“IPO”) and related organizational transactions in order to carry on the business of Switch, Ltd. and its subsidiaries (collectively, “Switch,” and together with Switch, Inc., the “Company”).
Switch is comprised of limited liability companies that provide colocation space and related services to global enterprises, financial companies, government agencies, and others that conduct critical business on the internet. Switch develops and operates data centers in Nevada, which are Tier IV Gold certified, and in Michigan, and is developing data centers in Georgia, delivering redundant services with low latency and super capacity transport environments.
As the manager of Switch, Ltd., Switch, Inc. operates and controls all of the business and affairs of Switch.
2. Summary of Significant Accounting Policies
Basis of Presentation
The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the rules and regulations of the Securities and Exchange Commission (the “SEC”) for quarterly reports on Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain footnote disclosures normally included in annual financial statements prepared in accordance with GAAP have been condensed or omitted. These consolidated financial statements should be read in conjunction with the Company’s 2017 Annual Report on Form 10-K for the year ended
December 31, 2017
.
Management believes that the accompanying consolidated financial statements reflect all adjustments, which include only normal recurring adjustments (except as disclosed below in “—Prior Period Adjustments”), necessary for the fair statement of these consolidated financial statements. The consolidated results of operations for the
three and nine months ended September 30, 2018
are not necessarily indicative of the results to be expected for the year ending
December 31, 2018
, or for any other future annual or interim period.
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of the Company and all significant intercompany transactions and balances have been eliminated.
As the sole manager of Switch, Ltd., Switch, Inc. operates and controls all of the business and affairs of Switch, and has the sole voting interest in, and controls the management of, Switch, and has the obligation to absorb the losses of, and receive benefits from, Switch. Accordingly, Switch, Inc. identifies itself as the primary beneficiary of Switch and began consolidating Switch in its consolidated financial statements as of October 11, 2017, the closing date of the IPO, resulting in a non-controlling interest related to the common units of Switch, Ltd. (“Common Units”) held by members other than Switch, Inc. on its consolidated financial statements.
Switch has been determined to be the predecessor for accounting purposes and, accordingly, the consolidated financial statements for periods prior to the IPO and the related organizational transactions have been adjusted to combine the previously separate entities for presentation purposes. Amounts for the period from January 1, 2017 through
September 30, 2017
presented in the consolidated financial statements and condensed notes to consolidated financial statements herein represent the historical operations of Switch. The amounts as of December 31, 2017 and for the period from January 1, 2018 reflect the consolidated operations of the Company.
The Company periodically evaluates entities for consolidation either through ownership of a majority voting interest, or through means other than voting interest, in accordance with the Variable Interest Entity (“VIE”) accounting model. A VIE is an entity in which either (i) the equity investors as a group, if any, lack the power through voting or similar rights to direct the activities of such entity that most significantly impact such entity’s economic performance or (ii) the equity investment at risk is insufficient to finance that entity’s activities without additional subordinated financial support.
Use of Estimates
The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from these estimates. On an ongoing basis, the
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Company evaluates its estimates, including, but not limited to, those related to the allowance for doubtful accounts, useful lives of property and equipment, equity-based compensation, deferred revenue, fair value of leased property at inception of lease term, fair value of deliverables under multiple element arrangements, and probability assessments of exercising renewal options on leases. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable.
Significant Accounting Policies
A description of the Company’s significant accounting policies is included in the audited financial statements within its Annual Report on Form 10-K for the year ended
December 31, 2017
.
No other changes to significant accounting policies have occurred since the year ended
December 31, 2017
, with the exception of those detailed below.
Cash and Cash Equivalents
The Company considers all highly liquid instruments with an original maturity of
three
months or less to be cash equivalents. Cash equivalents as of
September 30, 2018
were comprised of money market funds totaling
$75.9 million
. Cash equivalents comprised of money market funds totaling
$241.4 million
were incorrectly classified as cash as of
December 31, 2017
.
Derivative Financial Instruments
During the
three and nine months ended September 30, 2018
, the Company operated under two agreements for the purchase of electricity (
Note 6
). The accounting guidance for derivative instruments provides a scope exception for commodity contracts that meet the normal purchases and normal sales criteria specified in the standard. The normal purchases and normal sales exception requires, among other things, physical delivery in quantities expected to be used or sold over a reasonable period in the normal course of business. Contracts that are designated as normal purchases and normal sales are not recorded on the consolidated balance sheets at fair value.
Concentration of Credit and Other Risks
Although the Company operates primarily in Nevada, realization of its customer accounts receivable and its future operations and cash flows could be affected by adverse economic conditions, both regionally and elsewhere in the United States. During the
three months ended September 30, 2018
and
2017
, the Company’s largest customer and its affiliates comprised
10.9%
and
11.8%
, respectively, of the Company’s revenue. During the
nine months ended September 30, 2018
and
2017
, the Company’s largest customer and its affiliates comprised
10.2%
and
10.4%
, respectively, of the Company’s revenue.
No single
customer accounted for
10%
or more of accounts receivable as of
September 30, 2018
and
only one
customer accounted for
10%
or more of accounts receivable as of
December 31, 2017
.
The Company generally carries cash on deposit with financial institutions in excess of federally insured limits.
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Income Taxes
The Staff of the SEC issued Staff Accounting Bulletin No. 118 (“SAB No. 118”) to provide guidance to registrants in applying Accounting Standards Codification Topic 740 (“ASC 740”) in connection with the Tax Cuts and Jobs Act. SAB No. 118 provides that in the period of enactment, the income tax effects of the Tax Cuts and Jobs Act may be reported as a provisional amount based on a reasonable estimate to the extent a reasonable estimate can be determined, which would be subject to adjustment during a “measurement period.” The measurement period begins in the reporting period of the Tax Cuts and Jobs Act’s enactment and ends when a registrant has obtained, prepared, and analyzed the information that was needed in order to complete the accounting requirements under ASC 740. SAB No. 118 also describes supplemental disclosures that should accompany the provisional amounts. The Company has applied the guidance in SAB No. 118 to account for the financial accounting impacts of the Tax Cuts and Jobs Act as of
December 31, 2017
.
During the
three and nine months ended September 30, 2018
, there were no changes made to the provisional estimates that were recorded in the fourth quarter of 2017. The Company will continue to analyze the effects of the Tax Cuts and Jobs Act on the consolidated financial statements.
For interim periods, the Company recognizes income taxes based on its estimated annual effective tax rate expected tor the full year.
Tax Receivable Agreement
In connection with the IPO, the Company entered into a Tax Receivable Agreement (“TRA”) with members of Switch, Ltd. In the event that such parties exchange any or all of their Common Units for Class A common stock, the TRA requires the Company to make payments to such holders for
85%
of the tax benefits realized by the Company by such exchange. The annual tax benefits are computed by calculating the income taxes due, including such tax benefits, and the income taxes due without such benefits.
The timing and amount of aggregate payments due under the TRA may vary based on a number of factors, including the amount and timing of the taxable income the Company generates each year and the tax rate then applicable. The payment obligations under the TRA are obligations of Switch, Inc. and not of Switch, Ltd. Payments are generally due under the TRA within a specified period of time following the filing of the Company’s tax return for the taxable year with respect to which the payment obligation arises, although interest on such payments will begin to accrue at a rate of LIBOR plus
100 basis points
from the due date (without extensions) of such tax return. Any late payments that may be made under the TRA will continue to accrue interest at LIBOR plus
500 basis points
until such payments are subsequently made.
Recent Accounting Pronouncements
ASU 2014-09–Revenue from Contracts with Customers
In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”). The standard supersedes much of the current guidance regarding revenue recognition including most industry-specific guidance. The core principle of the standard is to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. An entity will be required to identify the contract with a customer, identify the performance obligations in the contract, determine the transaction price, allocate the transaction price to the performance obligation in the contract, and recognize revenue when (or as) the entity satisfies a performance obligation. In addition to the new revenue recognition requirements, entities will be required to disclose sufficient information to enable users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The standard also provides guidance on the recognition of costs related to obtaining customer contracts. The standard allows for either full retrospective adoption, meaning the guidance is applied for all periods presented, or modified retrospective adoption, meaning the guidance is applied only to the most current period presented in the financial statements with the cumulative effect of initially applying the guidance recognized at the date of initial application. In August 2015, the FASB deferred the effective date by one year (ASU 2015-14) to December 15, 2018 for annual reporting periods beginning after that date, and interim periods within annual periods beginning after December 15, 2019, and permitted early adoption of the standard, but not before the original effective date of December 15, 2017.
In March 2016, the FASB issued ASU 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net) (“ASU 2016-08”). The core principle of the guidance in ASU 2014-09 is not changed by the amendments in ASU 2016-08. The amendments clarify the implementation guidance on principal versus agent considerations. Per ASU 2016-08, when another party is involved in providing goods or services to a customer, an entity is required to determine whether the nature of its
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promise is to provide the specified good or service itself (principal) or to arrange for that good or service to be provided by the other party (agent). When an entity that is a principal satisfies a performance obligation, the entity recognizes revenue in the gross amount of consideration to which it expects to be entitled in exchange for the specified good or service transferred to the customer. When an entity that is an agent satisfies a performance obligation, the entity recognizes revenue in the amount of any fee or commission to which it expects to be entitled. The effective date and transition requirements for ASU 2016-08 are the same as the effective date and transition requirements for ASU 2014-09.
In April 2016 and May 2016, the FASB issued guidance which amends certain other aspects of ASU 2014-09. The amendments include the identification of performance obligations and the licensing implementation guidance (ASU 2016-10) and the collectability of revenue, presentation of sales tax and other similar taxes collected from customers, contracts containing noncash considerations, and contract modifications and completed contracts at transition (ASU 2016-12). In December 2016, the FASB amended ASU 2014-09 to make minor corrections and minor improvements to the guidance that are not expected to have a significant effect on current accounting practice or create a significant administrative cost (ASU 2016-20). The effective date and transition provisions in these amendments are aligned with the requirements of ASU 2014-09.
The Company expects to adopt this guidance effective January 1, 2019 using the modified retrospective approach for adoption. The Company has assigned internal resources and engaged consulting service providers to assist in evaluating the impact the adoption of this guidance will have on its consolidated financial statements.
ASU 2016-02–Leases
On February 25, 2016, the FASB issued ASU 2016-02, Leases (Topic 842) (“ASU 2016-02”). The principle of ASU 2016-02 is that a lessee should recognize the assets and liabilities that arise from leases. Lessees will need to recognize a right-of-use asset and a lease liability for virtually all of their leases (other than leases that meet the definition of a short-term lease). The liability will be equal to the present value of lease payments. The asset will be based on the liability. For income statement purposes, ASU 2016-02 requires leases to be classified as either operating or finance. Operating leases will result in straight-line expense while finance leases will result in a front-loaded expense pattern. Lessor accounting will remain largely unchanged, other than certain targeted improvements intended to align lessor accounting with the lessee accounting model and with the updated revenue recognition guidance. ASU 2016-02 is effective for fiscal years beginning after December 15, 2019 with early adoption permitted. In addition, in January 2018, the FASB issued ASU 2018-01, which permits an entity to elect an optional transition practical expedient to not evaluate land easements that exist or expired before the entity’s adoption of ASU 2016-02 and were not previously accounted for as leases. In July 2018, the FASB also issued ASU 2018-10, which provides clarifications and improvements on sections of ASU 2016-02, and ASU 2018-11, which provides lessees the option to apply the new guidance to all open leases as of the adoption date and recognize a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption and lessors with a practical expedient to account for qualifying non-lease components with associated lease components. The Company is evaluating the impact the adoption of this guidance will have on its consolidated financial statements. The Company has not decided if early adoption will be considered.
ASU 2016-13–Financial Instruments–Credit Losses
In June 2016, the FASB issued ASU 2016-13, Financial Instruments
–
Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”). Under this guidance, a company will be required to use a new forward-looking “expected loss” model for trade and other receivables that generally will result in the earlier recognition of allowances for losses. The amendments in ASU 2016-13 are effective for fiscal years beginning after December 15, 2020, and interim periods within fiscal years beginning after December 15, 2021, and requires a modified-retrospective approach to adoption. Early adoption is permitted in fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The Company is evaluating the impact the adoption of this guidance will have on its consolidated financial statements. The Company has not decided if early adoption will be considered.
ASU 2016-15–Statement of Cash Flows
In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (“ASU 2016-15”). The areas affected by ASU 2016-15 are debt prepayment and debt extinguishment costs, settlement of zero-coupon debt instruments or other debt instruments with coupon interest rates that are insignificant in relation to the effective interest rate of the borrowing, contingent consideration payments made after a business combination, proceeds from the settlement of insurance claims, proceeds from the settlement of corporate-owned life insurance policies (including bank-owned life insurance policies), distributions received from equity method investees, beneficial interests in securitization transactions, and separately identifiable cash flows and application of the predominance principle. Specifically, under this guidance, cash payments for debt
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prepayment or debt extinguishment costs will be classified as cash outflows for financing activities. The amendments in ASU 2016-15 are effective for fiscal years beginning after December 15, 2018, and interim periods within fiscal years beginning after December 15, 2019. Early adoption is permitted, including adoption in an interim period. If an entity early adopts the amendments in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. The amendments in ASU 2016-15 will be applied using a retrospective transition method to each period presented. The adoption of ASU 2016-15 is not expected to materially impact the Company’s consolidated financial statements. The Company has not decided if early adoption will be considered.
ASU 2017-09–Compensation–Stock Compensation
In May 2017, the FASB issued ASU 2017-09, Compensation
–
Stock Compensation (Topic 718): Scope of Modification Accounting (“ASU 2017-09”). This update provides clarity and reduces both diversity in practice and cost and complexity when applying the guidance in Topic 718, Compensation
–
Stock Compensation, to a change to the terms or conditions of a share-based payment award. The amendments in this update provide guidance about which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting. For all entities, the amendments in ASU 2017-09 are effective for annual and interim reporting periods beginning after December 15, 2017. The adoption of this guidance during the first quarter of 2018 did not impact the Company’s consolidated financial statements.
ASU 2018-02–Income Statement–Reporting Comprehensive Income
In February 2018, the FASB issued ASU 2018-02, Income Statement
–
Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income (“ASU 2018-02”). The amendments in this update allow a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Cuts and Jobs Act. For all entities, the amendments in ASU 2018-02 are effective for annual and interim reporting periods beginning after December 15, 2018. Early adoption of this ASU is permitted, including adoption in any interim period. The Company is evaluating the impact the adoption of this guidance will have on its consolidated financial statements. The Company has not decided if early adoption will be considered.
ASU 2018-09–Codification Improvements
In July 2018, the FASB issued ASU 2018-09, Codification Improvements (“ASU 2018-09”). The amendments in this update make clarifications and minor improvements to the Accounting Standards Codification. Certain updates of ASU 2018-09 are applicable immediately while others are effective for annual periods beginning after December 15, 2018. The Company is evaluating the impact the adoption of this guidance will have on its consolidated financial statements.
ASU 2018-13–Fair Value Measurement
In August 2018, the FASB issued ASU 2018-13, Disclosure Framework
–
Changes to the Disclosure Requirements for Fair Value Measurement (“ASU 2018-13”). The amendments in this update modify the disclosure requirements for fair value measurements by removing, modifying, or adding certain disclosures. The amendments in ASU 2018-13 are effective for fiscal years beginning after December 15, 2019. Early adoption of this ASU is permitted, including adoption in any interim period. The Company is evaluating the impact the adoption of this guidance will have on its consolidated financial statements. The Company has not decided if early adoption will be considered.
ASU 2018-15–Intangibles–Internal Use Software
In August 2018, the FASB issued ASU 2018-15, Intangibles
–
Goodwill and Other
–
Internal Use Software: Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract (“ASU 2018-15”). The amendments in this update align requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal use software (and hosting arrangements that include an internal use software license). The amendments in ASU 2018-15 are effective for annual and interim periods beginning after December 15, 2020. Early adoption of this ASU is permitted, including adoption in any interim period. The Company early adopted this guidance as of October 1, 2018. The early adoption of this guidance is not expected to materially impact the Company’s consolidated financial statements.
Reclassification
Certain amounts in the accompanying consolidated balance sheets as of December 31, 2017 and consolidated statements of cash flows for the nine months ended September 30, 2017 have been reclassified to be consistent with the current period presentation.
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Prior Period Adjustments
During the
three months ended September 30, 2018
, the Company identified
$15.0 million
of property and equipment, which was included in construction in progress, that should have been placed in service during the three months ended June 30, 2017, at which time the Company should have begun depreciating the asset and ceased capitalizing interest. To correct for such errors in previously issued consolidated financial statements, during the three months ended September 30, 2018, the Company recognized
$1.5 million
of incremental depreciation expense in cost of revenue and
$0.7 million
of incremental interest expense as out of period adjustments. Considering both quantitative and qualitative factors, the Company has determined the amounts were not material to any previously issued consolidated financial statements and would not be material to the expected full year results for 2018.
3. Property and Equipment, Net
Property and equipment, net, consists of the following:
|
|
|
|
|
|
|
|
|
|
September 30,
2018
|
|
December 31,
2017
|
|
(in thousands)
|
Land and land improvements
|
$
|
180,440
|
|
|
$
|
151,286
|
|
Data center equipment
|
875,386
|
|
|
763,790
|
|
Capitalized leased assets
|
33,975
|
|
|
35,974
|
|
Buildings, building improvements and leasehold improvements
|
381,323
|
|
|
338,763
|
|
Substation equipment
|
4,247
|
|
|
4,247
|
|
Cloud computing equipment
|
5,661
|
|
|
5,661
|
|
Fiber facilities
|
8,850
|
|
|
8,459
|
|
Computer equipment, furniture and fixtures
|
34,001
|
|
|
30,745
|
|
Vehicles
|
1,685
|
|
|
1,573
|
|
Construction in progress
|
153,552
|
|
|
110,559
|
|
Core network equipment
|
33,949
|
|
|
31,472
|
|
Deferred installation charges
|
—
|
|
|
4,436
|
|
Property and equipment, gross
|
1,713,069
|
|
|
1,486,965
|
|
Less: accumulated depreciation and amortization
|
(432,012
|
)
|
|
(353,393
|
)
|
Total property and equipment, net
|
$
|
1,281,057
|
|
|
$
|
1,133,572
|
|
Accumulated amortization for capitalized leased assets totaled
$9.5 million
and
$8.3 million
as of
September 30, 2018
and
December 31, 2017
, respectively.
During the
nine months ended September 30, 2018
and
2017
, capitalized interest was
$3.1 million
and
$2.1 million
, respectively.
The Company capitalized internal use software costs of
$0.3 million
and
$0.1 million
during the
three months ended September 30, 2018
and
2017
, respectively, and
$1.1 million
and
$1.2 million
during the
nine months ended September 30, 2018
and
2017
, respectively.
Total depreciation and amortization of property and equipment recognized on the consolidated statements of comprehensive income was as follows:
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|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
September 30,
|
|
Nine Months Ended
September 30,
|
|
2018
|
|
2017
|
|
2018
|
|
2017
|
|
(in thousands)
|
Cost of revenue
|
$
|
28,327
|
|
|
$
|
22,489
|
|
|
$
|
77,448
|
|
|
$
|
63,647
|
|
Selling, general and administrative expense
|
662
|
|
|
401
|
|
|
1,862
|
|
|
1,029
|
|
Total depreciation and amortization of property and equipment
|
$
|
28,989
|
|
|
$
|
22,890
|
|
|
$
|
79,310
|
|
|
$
|
64,676
|
|
4. Equity Method Investments
The Company currently holds
two
investments accounted for under the equity method of accounting, SUPERNAP International, S.A. (“SUPERNAP International”) and Planet3, Inc. (“Planet3”), in which the Company holds a
50%
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ownership interest and a
45%
ownership interest, respectively. As of
September 30, 2018
and
December 31, 2017
, the Company determined that it continued to have a variable interest in both SUPERNAP International and Planet3, as the entities do not have sufficient equity at risk. However, the Company concluded that it is not the primary beneficiary of SUPERNAP International or of Planet3 as it does not have deemed control of either entity. As a result, it does not consolidate either entity into its consolidated financial statements.
As of March 31, 2018, the Company’s carrying value of its investment in SUPERNAP International was reduced to
zero
as a result of recording its share of the investee’s losses. Accordingly, as the Company does not have any guaranteed obligations and is not otherwise committed to provide further financial support to SUPERNAP International, the Company discontinued the equity method of accounting for its investment in SUPERNAP International as of March 31, 2018 and will not provide for additional losses until its share of future net income or comprehensive income, if any, equals the share of net losses not recognized during the period the equity method was suspended. Losses recorded will continue to include the foreign currency translation adjustment in the Company’s investment. The Company’s share of net loss recorded for the
nine months ended September 30, 2018
amounted to
$0.3 million
. The Company’s share of net loss recorded for the
three and nine months ended September 30, 2017
amounted to
$0.2 million
and
$1.0 million
, respectively. As of
September 30, 2018
and
December 31, 2017
, the Company recorded amounts consisting of reimbursable expenses due from SUPERNAP International of
$0.3 million
within accounts receivable on the consolidated balance sheets.
Additionally, as of
December 31, 2016
, as the Company did not have any guaranteed obligations and was not otherwise committed to provide further financial support to Planet3, the Company discontinued the equity method of accounting for its investment in Planet3 and will not provide for additional losses until its share of future net income, if any, equals the share of net losses not recognized during the period the equity method was suspended.
5. Leases
During the
three months ended September 30, 2018
and
2017
, rent expense related to operating leases was
$2.0 million
and
$1.8 million
, respectively. During the
nine months ended September 30, 2018
and
2017
, rent expense related to operating leases was
$5.9 million
and
$5.4 million
, respectively. Related party rent included in these amounts was
$1.2 million
and
$1.3 million
for the
three months ended September 30, 2018
and
2017
, respectively, and
$3.7 million
and
$3.6 million
for the
nine months ended September 30, 2018
and
2017
, respectively.
In October 2018, the Company entered into an agreement that reduced its future minimum payment obligations from
$2.3 million
to
$0.3 million
on its capital lease assets related to the Nevada Broadband Telemedicine Initiative fiber network. The impact of the agreement was recognized on the consolidated balance sheet as of
September 30, 2018
.
6. Commitments and Contingencies
Purchase Commitments
In January 2018, a wholly-owned subsidiary of Switch, Ltd. entered into a Master Power Purchase & Sale Agreement of electricity with Tenaska Power Services Co. to purchase a firm commitment of
10
megawatts per energy hour for a term of
23
months, or a purchase commitment of
$4.9 million
during the term, which started February 1, 2018. Additionally, scheduling services for the purchased power from the agreement are provided by Morgan Stanley Capital Group Inc., resulting in an additional purchase commitment of
$0.3 million
during the term, for a total purchase commitment of
$5.2 million
related to this agreement. The remaining total purchase commitment was
$3.4 million
as of
September 30, 2018
. Future power purchase commitments for the remainder of 2018 and 2019 are
$0.7 million
and
$2.7 million
, respectively, with no additional commitments upon termination of the agreement thereafter.
Legal Proceedings
On August 7, 2017, Switch, Ltd. filed a lawsuit in the U.S. District Court for the Eastern District of Texas against Aligned Data Centers LLC (“Aligned”) and MTechnology Inc. The lawsuit alleged, among other things, that Aligned used and promoted technology at its data centers to attract clients to its facility, directly and indirectly infringing at least three of Switch’s patents and using Switch’s patented technology to attempt to unlawfully compete with Switch. The complaint also alleged that Aligned hired a consultant to design their data centers; that this consultant had toured Switch under a non-disclosure agreement; and that this consultant breached his confidentiality agreements with Switch by using Switch’s designs to design the Aligned data centers. On September 12, 2017, Switch filed a complaint in the Eighth Judicial District of Nevada against the consultant, Stephen Fairfax, and his business, MTechnology Inc. Among other claims, Switch raised allegations of breach of contract and misappropriation of trade secrets. In July 2018, all claims in the subject litigation filed by Switch, Ltd. in the U.S. District Court for the Eastern
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District of Texas against Aligned and all counterclaims by Aligned against Switch, Ltd. in the subject litigation were dismissed with prejudice pursuant to a joint stipulation of dismissal filed by the parties.
On September 7, 2017, Switch, Ltd. and Switch, Inc. were named in a lawsuit filed in the U.S. District Court for the District of Nevada by V5 Technologies formerly d/b/a Cobalt Data Centers (now defunct). The lawsuit alleges, among other things, that Switch, Ltd. and Switch, Inc. monopolized the Las Vegas Metropolitan area of Southern Nevada’s data center colocation market and engaged in unfair business practices leading to the failure of Cobalt Data Centers in 2015 and seeks monetary damages in an amount yet to be disclosed. Switch, Ltd. and Switch, Inc. are vigorously defending the case.
Four substantially similar putative class action complaints, captioned Martz v. Switch, Inc. et al. (filed April 20, 2018); Palkon v. Switch, Inc. et al. (filed April 30, 2018); Chun v. Switch, Inc. et al. (filed May 11, 2018); and Silverberg v. Switch, Inc. et al. (filed June 6, 2018), were filed in the Eighth Judicial District of Nevada, and subsequently consolidated into a single case (the “State Court Securities Action”). Additionally, on June 11, 2018, one putative class action complaint captioned Cai v. Switch, Inc. et al. was filed in the United States District Court for the District of New Jersey (the “Federal Court Securities Action”) and subsequently transferred to the Eighth Judicial District of Nevada in August 2018 and the federal court appointed Oscar Farach lead plaintiff. These lawsuits were filed against Switch, Inc., certain current and former officers and directors and certain underwriters of Switch, Inc.’s IPO alleging federal securities law violations in connection with the IPO. These lawsuits were brought by purported stockholders of Switch, Inc. seeking to represent a class of stockholders who purchased Class A common stock in or traceable to the IPO, and seek unspecified damages and other relief. Switch, Inc. believes that these lawsuits are without merit and intends to continue to vigorously defend against them.
On September 10, 2018, two purported stockholders of Switch, Inc. filed substantially similar shareholder derivative complaints, respectively captioned Liu v. Roy et al., and Zhao v. Roy et al., in the Eighth Judicial District of Nevada. These lawsuits allege breaches of fiduciary duty, unjust enrichment, waste of corporate assets, abuse of control, and gross mismanagement against certain current and former officers and directors of Switch, Inc. The plaintiffs also named Switch, Inc. as a nominal defendant. The complaints arise generally from the same allegations described in the State Court Securities Action and Federal Court Securities Action. In October 2018, the parties submitted a stipulation and proposed order to the court that provided for the cases to be consolidated and for a lead plaintiff to be appointed.
The outcomes of the legal proceedings are inherently unpredictable, subject to significant uncertainties, and could be material to the Company’s financial condition, results of operations, and cash flows for a particular period. Where the Company is a defendant, it will vigorously defend against the claims pleaded against it. These actions are each in preliminary stages and management has determined that based on proceedings to date, it is currently unable to determine the probability of the outcome of these actions or the range of reasonably possible loss, if any.
7. Income Taxes
As a result of the increase in Switch, Inc.’s ownership of Switch, Ltd. following the exchanges of non-controlling interest for Class A common stock in May 2018 and August 2018 described in
Note 10
, the Company recorded a deferred tax asset related to the increase in the tax basis of Switch, Inc.’s ownership interest in Switch, Ltd. of
$21.9 million
as of
September 30, 2018
, with a corresponding increase to additional paid in capital. The Company has determined it is more-likely-than-not that it will be able to realize this deferred tax asset in the future. Additionally, during the
three and nine months ended September 30, 2018
, the Company recorded a return to provision adjustment of
$0.6 million
due to changes in estimated depreciation expense.
Tax Receivable Agreement
As of
September 30, 2018
, the Company has recorded a liability of
$45.4 million
under the TRA, which provides for the payment of
85%
of the amount of the tax benefits, if any, that Switch, Inc. is deemed to realize as a result of increases in the tax basis of its ownership in Switch, Ltd. related to exchanges of non-controlling interest for Class A common stock.
8. Stockholders’ Equity
Dividends
In April 2018, June 2018, and September 2018, the Company paid cash dividends of
$0.0147
per share of Class A common stock and recorded a total of
$2.1 million
as a reduction of retained earnings from cash dividends declared during the
nine months ended September 30, 2018
.
Switch, Inc.
|
Q3 2018 Form 10-Q
|
14
Common Unit Repurchase Program
In August 2018, Switch, Inc.’s Board of Directors authorized a program by which Switch, Ltd. may repurchase up to
$150.0 million
of its outstanding Common Units for cash and Switch, Inc. will cancel a corresponding amount of Class B common shares. The program was effective immediately upon authorization. The authorization may be suspended or discontinued at any time without notice. Repurchases under the Common Unit repurchase program will be funded from Switch’s existing cash and cash equivalents.
In August 2018, Switch, Ltd. repurchased
6.1 million
of its outstanding Common Units for
$60.6 million
. Pursuant to this repurchase, Switch, Inc. canceled an equivalent amount of Class B common shares.
9. Equity-Based Compensation
Common Unit Awards
The following table summarizes information related to Common Unit awards for the period indicated below:
|
|
|
|
|
|
|
|
|
Number of Unvested Common Units Outstanding
(in thousands)
|
|
Weighted Average Grant Date Fair Value per Common Unit
|
Unvested Common Unit awards outstanding—December 31, 2017
|
4,783
|
|
|
$
|
11.11
|
|
Common Unit awards vested
|
(598
|
)
|
|
$
|
11.11
|
|
Unvested Common Unit awards outstanding—September 30, 2018
|
4,185
|
|
|
$
|
11.11
|
|
As of
September 30, 2018
, total equity-based compensation cost related to all unvested Common Unit awards was
$28.1 million
, which is expected to be recognized over a weighted average period of
3.03
years. If a forfeiture of unvested Common Unit awards occurs, the associated shares of Class B common stock and Class C common stock, as applicable, are also forfeited.
2017 Incentive Award Plan
On September 22, 2017, Switch, Inc.’s Board of Directors adopted the 2017 Incentive Award Plan (the “2017 Plan”). The 2017 Plan, effective as of its adoption date, provides that the initial aggregate number of shares of Class A common stock reserved and available for issuance be
25.0 million
shares of Class A common stock plus an increase each January 1, beginning on January 1, 2018 and ending on and including January 1, 2027, equal to the lesser of (A)
17.0 million
shares of Class A common stock, (B)
5%
of the aggregate number of shares of Switch, Inc.’s Class A common stock, Class B common stock and Class C common stock outstanding on the final day of the immediately preceding calendar year and (C) such smaller number of shares of Class A common stock as is determined by the Board of Directors. Effective January 1, 2018, Switch, Inc.’s Board of Directors approved an increase of
7.9 million
shares (the “2018 Annual Increase”) in the aggregate number of shares of Class A common stock reserved and available for issuance under the 2017 Plan. The 2018 Annual Increase, and each annual increase thereafter, is subject to adjustment in the event of a stock split, stock dividend or other defined changes in Switch, Inc.’s capitalization.
The 2017 Plan also provides for dividend equivalent units (“DEUs”) based on the value of the dividends per share paid on the Company’s Class A common stock, which are accumulated on restricted stock units (“RSUs”) during the vesting period. The DEUs vest and will be settled with shares of the Company’s Class A common stock concurrently with the vesting of the associated RSUs based on the closing share price on the vesting date. Pursuant to the Company’s policy, DEUs are treated as a reduction of retained earnings or, if the Company is in a retained deficit position, as a reduction of additional paid in capital.
Switch, Inc.
|
Q3 2018 Form 10-Q
|
15
The following table summarizes information related to stock options for the period indicated below:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Number of Stock Options (in thousands)
|
|
Weighted Average Exercise Price per Stock Option
|
|
Weighted Average Remaining Contractual Life (Years)
|
|
Aggregate
Intrinsic
Value
(1)
(in thousands)
|
Stock options outstanding—December 31, 2017
|
5,725
|
|
|
$
|
17.00
|
|
|
9.77
|
|
$
|
6,813
|
|
Stock options expired
|
(409
|
)
|
|
$
|
17.00
|
|
|
|
|
|
Stock options outstanding—September 30, 2018
|
5,316
|
|
|
$
|
17.00
|
|
|
8.94
|
|
$
|
—
|
|
Stock options vested and exercisable—December 31, 2017
|
5,626
|
|
|
$
|
17.00
|
|
|
9.77
|
|
$
|
6,695
|
|
Stock options vested and exercisable—September 30, 2018
|
5,217
|
|
|
$
|
17.00
|
|
|
8.93
|
|
$
|
—
|
|
________________________________________
|
|
(1)
|
The intrinsic value is calculated as the difference between the fair value of the stock option on
September 30, 2018
and
December 31, 2017
and the exercise price of the stock option. There is no intrinsic value of options outstanding and vested and exercisable as of
September 30, 2018
as the closing stock price creates a negative intrinsic value.
|
As of
September 30, 2018
, total equity-based compensation cost related to all unvested stock options was
$0.2 million
, which is expected to be recognized over a weighted average period of
2.02
years.
The following table summarizes information related to RSUs for the period indicated below:
|
|
|
|
|
|
|
|
|
Number of Units
(in thousands)
|
|
Weighted Average Grant Date Fair Value per Unit
|
RSUs outstanding—December 31, 2017
|
31
|
|
|
$
|
18.01
|
|
RSUs granted
|
2,540
|
|
|
$
|
16.78
|
|
RSUs vested
|
(189
|
)
|
|
$
|
15.51
|
|
RSUs forfeited
|
(130
|
)
|
|
$
|
16.93
|
|
RSUs outstanding—September 30, 2018
|
2,252
|
|
|
$
|
16.89
|
|
As of
September 30, 2018
, total equity-based compensation cost related to all unvested RSU awards was
$31.3 million
, which is expected to be recognized over a weighted average period of
3.30
years.
Director Compensation Program
On October 11, 2017, Switch, Inc.’s Board of Directors adopted the Director Compensation Program. The Director Compensation Program, effective as of its adoption date, provides that eligible members of Switch, Inc.’s Board of Directors receive cash and equity compensation. On the date of the Company’s annual stockholder meeting, eligible members of Switch, Inc.’s Board of Directors shall be granted a restricted stock award (“RSA”) comprising of shares of Class A common stock equal to
$0.2 million
. The RSAs vest in full on the earlier of (A) the one-year anniversary of the grant date or (B) the date of the annual stockholder meeting following the grant date. The vesting of these awards is subject to the eligible director continuing service through the vesting date.
In June 2018, the Company granted
61,000
RSAs with a weighted average grant date fair value per award of
$13.08
. As of
September 30, 2018
, total equity-based compensation cost related to all unvested RSAs was
$0.5 million
, which is expected to be recognized over a weighted average period of
0.68
years.
Total equity-based compensation recognized on the consolidated statements of comprehensive income was as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
September 30,
|
|
Nine Months Ended
September 30,
|
|
2018
|
|
2017
|
|
2018
|
|
2017
|
|
(in thousands)
|
Cost of revenue
|
$
|
358
|
|
|
$
|
50
|
|
|
$
|
1,141
|
|
|
$
|
148
|
|
Selling, general and administrative expense
|
7,270
|
|
|
1,265
|
|
|
27,053
|
|
|
4,731
|
|
Total equity-based compensation expense
|
$
|
7,628
|
|
|
$
|
1,315
|
|
|
$
|
28,194
|
|
|
$
|
4,879
|
|
Switch, Inc.
|
Q3 2018 Form 10-Q
|
16
10. Non-controlling Interest
Ownership
Switch, Inc. owns an indirect minority economic interest in Switch, Ltd., where “economic interests” means the right to receive any distributions, whether cash, property or securities of Switch, Ltd., in connection with Common Units. Switch, Inc. presents interest held by non-controlling interest holders within non-controlling interest in the consolidated financial statements. In May 2018 and August 2018, Switch, Inc. issued an aggregate of
13.4 million
shares and
2.5 million
shares, respectively, of Class A common stock to members of Switch, Ltd. in connection with such members’ redemptions of an equivalent number of Common Units and the corresponding cancellation of an equivalent number of Switch, Inc.’s Class B common stock. The redemptions occurred pursuant to the terms of the Switch operating agreement entered into in connection with the Company’s IPO. Additionally, as described in
Note 8
, Switch, Ltd. repurchased
6.1 million
of its outstanding Common Units in August 2018. The ownership of the Common Units is summarized as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
September 30, 2018
|
|
December 31, 2017
|
|
|
Units
|
|
Ownership %
|
|
Units
|
|
Ownership %
|
|
|
(units in thousands)
|
Switch, Inc.’s ownership of Common Units
(1)
|
|
52,022
|
|
|
21.5
|
%
|
|
35,938
|
|
|
14.5
|
%
|
Non-controlling interest holders’ ownership of Common Units
(2)
|
|
190,375
|
|
|
78.5
|
%
|
|
211,675
|
|
|
85.5
|
%
|
Total Common Units
|
|
242,397
|
|
|
100.0
|
%
|
|
247,613
|
|
|
100.0
|
%
|
________________________________________
|
|
(1)
|
Common Units held by Switch, Inc. as of
September 30, 2018
exclude
61,000
Common Units underlying unvested RSAs.
|
|
|
(2)
|
Common Units held by non-controlling interest holders as of
September 30, 2018
exclude
4.2 million
unvested Common Unit awards. Common Units held by non-controlling interest holders as of
December 31, 2017
exclude
4.8 million
unvested Common Unit awards and
110,000
vested and exercisable unit options.
|
The Company uses the weighted average ownership percentages during the period to calculate the pretax income attributable to Switch, Inc. and the non-controlling interest holders of Switch, Ltd.
Distributions
Prior to each payment of the Company’s Class A common stock dividends in April 2018, June 2018, and September 2018, Switch, Ltd. made cash distributions to holders of Common Units, excluding Switch, Inc., of
$0.0147
per Common Unit for a total distribution of
$8.9 million
during the
nine months ended September 30, 2018
.
During the
nine months ended September 30, 2017
, Switch, Ltd. made cash distributions to holders of Common Units of
$180.4 million
, comprised of
$107.0 million
to the members in accordance with their percentage interests and
$73.4 million
to certain members with unreturned capital contributions as required by Switch, Ltd.’s then-current operating agreement.
Switch, Inc.
|
Q3 2018 Form 10-Q
|
17
11. Net Income Per Share/Unit
The following table sets forth the calculation of basic and diluted net income per share/unit:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
September 30,
|
|
Nine Months Ended
September 30,
|
|
2018
|
|
2017
|
|
2018
|
|
2017
|
|
(in thousands, except per share/unit data)
|
Net income per share/unit:
|
|
|
|
|
|
|
|
Numerator—basic and diluted:
|
|
|
|
|
|
|
|
Net income attributable to Switch, Inc.—basic and diluted
|
$
|
6
|
|
|
$
|
16,486
|
|
|
$
|
1,498
|
|
|
$
|
51,766
|
|
Denominator—basic:
|
|
|
|
|
|
|
|
Weighted average shares/units outstanding—basic
(1)
|
50,669
|
|
|
200,747
|
|
|
43,063
|
|
|
200,416
|
|
Net income per share/unit—basic
|
$
|
0.00
|
|
|
$
|
0.08
|
|
|
$
|
0.03
|
|
|
$
|
0.26
|
|
Denominator—diluted:
|
|
|
|
|
|
|
|
Weighted average shares/units outstanding—basic
(1)
|
50,669
|
|
|
200,747
|
|
|
43,063
|
|
|
200,416
|
|
Weighted average effect of dilutive securities:
|
|
|
|
|
|
|
|
Unit options
|
25
|
|
|
88
|
|
|
67
|
|
|
114
|
|
Unvested incentive unit awards
|
—
|
|
|
8,138
|
|
|
—
|
|
|
6,866
|
|
DEUs
|
9
|
|
|
—
|
|
|
5
|
|
|
—
|
|
RSAs
|
7
|
|
|
—
|
|
|
7
|
|
|
—
|
|
Weighted average shares/units outstanding—diluted
(1)
|
50,710
|
|
|
208,973
|
|
|
43,142
|
|
|
207,396
|
|
Net income per share/unit—diluted
|
$
|
0.00
|
|
|
$
|
0.08
|
|
|
$
|
0.03
|
|
|
$
|
0.25
|
|
________________________________________
|
|
(1)
|
Amounts for the
three and nine months ended September 30, 2018
represent shares of Class A common stock. Amounts for the
three and nine months ended September 30, 2017
represent Common Units.
|
Shares of Class B common stock and Class C common stock do not share in the earnings or losses of Switch, Inc. and are therefore not participating securities. As such, separate presentation of basic and diluted net income per share for each of Class B common stock and Class C common stock under the two-class method has not been presented.
The following table presents potentially dilutive securities excluded from the computation of diluted net income per share/unit for the periods presented because their effect would have been anti-dilutive.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
September 30,
|
|
Nine Months Ended
September 30,
|
|
2018
|
|
2017
|
|
2018
|
|
2017
|
|
(in thousands)
|
Weighted average unvested incentive units
|
—
|
|
|
—
|
|
|
—
|
|
|
163,817
|
|
Stock options
(1)
|
5,316
|
|
|
—
|
|
|
5,316
|
|
|
—
|
|
RSUs
(1)
|
2,252
|
|
|
—
|
|
|
2,242
|
|
|
—
|
|
Shares of Class B and Class C common stock
(2)
|
194,561
|
|
|
—
|
|
|
194,561
|
|
|
—
|
|
________________________________________
|
|
(1)
|
Represents the number of instruments outstanding at the end of the period. Application of the treasury stock method would reduce this amount if they had a dilutive effect and were included in the computation of diluted net income per share.
|
|
|
(2)
|
Shares of Class B common stock and Class C common stock at the end of the period are considered potentially dilutive shares of Class A common stock under application of the if-converted method.
|
Switch, Inc.
|
Q3 2018 Form 10-Q
|
18
12. Fair Value of Financial Instruments
As of
September 30, 2018
and
December 31, 2017
, the carrying amounts of cash and cash equivalents, accounts receivable, and accounts payable approximate their estimated fair values due to the short maturity of these instruments. Management believes the fair value of the Company’s long-term debt was
$595.5 million
and
$599.2 million
based on Level 2 inputs using quoted market prices on or about
September 30, 2018
and
December 31, 2017
, respectively.
Management has elected not to adopt the option available under GAAP to measure any of its eligible financial instruments or other items at fair value. Accordingly, the Company continues to measure all of its assets and liabilities on the historical cost basis of accounting, except as otherwise required under GAAP.
13. Segment Reporting
The Company’s chief operating decision maker is its Chief Executive Officer. The Company manages its operations as a single operating segment for the purposes of assessing performance and making operating decisions. All of the Company’s assets are maintained in the United States, although the Company holds an equity method investment in SUPERNAP International, which has deployed facilities in Italy and Thailand. The Company derives almost all of its revenue from sales to customers in the United States, based upon the billing address of the customer. Revenue derived from customers outside the United States, based upon the billing address of the customer, was less than
2%
of revenue for each of the
three and nine months ended September 30, 2018
and
2017
.
The Company’s revenue is comprised of the following:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
September 30,
|
|
Nine Months Ended
September 30,
|
|
2018
|
|
2017
|
|
2018
|
|
2017
|
|
(in thousands)
|
Colocation
|
$
|
82,445
|
|
|
$
|
79,429
|
|
|
$
|
241,314
|
|
|
$
|
225,753
|
|
Connectivity
|
18,482
|
|
|
17,111
|
|
|
55,566
|
|
|
49,201
|
|
Other
|
1,841
|
|
|
1,149
|
|
|
5,766
|
|
|
3,993
|
|
Revenue
|
$
|
102,768
|
|
|
$
|
97,689
|
|
|
$
|
302,646
|
|
|
$
|
278,947
|
|
14. Subsequent Events
In November 2018, Switch, Inc.’s Board of Directors declared a dividend of
$0.0147
per share of Class A common stock, for a total estimated to be
$0.8 million
, to be paid on December 6, 2018 to holders of record as of November 26, 2018. Prior to the payment of this dividend, Switch, Ltd. will make a cash distribution to all holders of record of Common Units, including Switch, Inc., of
$0.0147
per Common Unit, for a total estimated to be
$3.6 million
.
Switch, Inc.
|
Q3 2018 Form 10-Q
|
19