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FUSION TELECOMMUNICATIONS INTERNATIONAL INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion should be read in conjunction with the information contained in our unaudited consolidated financial statements and the notes thereto appearing elsewhere herein and in conjunction with the Management's Discussion and Analysis set forth in our fiscal 2013 Annual Report on Form 10-K. OVERVIEW Our Business We are a cloud services provider delivering value-added cloud-based solutions to businesses and carriers in the United States and throughout the world. Through our Business Services business segment, we offer business products and services that consist primarily of cloud-based voice and cloud connectivity, as well as a complement of additional cloud solutions such as storage, security and disaster recovery. Our advanced business services are flexible, scalable and rapidly deployed, lowering customers' costs of ownership and increasing productivity. Through our Carrier Services business segment, we offer domestic and international voice termination services to telecommunications carriers throughout the world, with a particular focus on providing services to and from emerging markets in Asia, the Middle East, Africa, Latin America, and the Caribbean. These services primarily utilize VoIP termination. We currently interconnect with over 270 carrier customers and vendors, which include U.S.-based carriers sending voice traffic to international destinations and foreign carriers sending voice traffic to the U.S. and internationally. Our carrier-grade network, advanced switching systems and interconnections with global carriers on six continents also reduce the cost of global voice traffic termination and expand service delivery capabilities for our Business Services segment. We manage our business segments based on gross profit and gross margin, which represents net revenue less the cost of revenue, and on net profitability after excluding certain non-cash and non-recurring items. The majority of our operations, engineering, information systems and support personnel are assigned to either the Business Services or Carrier Services business segment for segment reporting purposes. Although we believe that the Carrier Services business segment continues to be of significant value to our long term strategy, our growth strategy is focused primarily on the higher margin Business Services business segment and marketing to small and mid-sized businesses, as well as larger enterprises, using both our direct and partner distribution channels. This strategy has resulted in an increasing percentage of the Company's total revenues being contributed by the Business Services business segment, which we believe complements the Company's Carrier Services business segment by providing higher margins and a more stable customer base. Recent Acquisitions On December 31, 2013, through our wholly owned subsidiary Fusion BVX LLC ("FBVX"), we completed the acquisition of substantially all of the cloud services assets used by BroadvoxGO!, LLC and its affiliate Cypress Communications, LLC (the "Broadvox Sellers") in the operation of their cloud services business. A definitive agreement to purchase these assets, including the assumption of substantially all of the related on-going liabilities incurred in the ordinary course of business (collectively, the "Broadvox Assets") was entered into on August 30, 2013, and amended on November 15, 2013 and December 16, 2013 (the "BVX Purchase Agreement"). For the year ended December 31, 2013, the business constituted by the Broadvox Assets generated unaudited revenues of approximately $32.7 million. The purchase price of the Broadvox Assets was $32.1 million in cash, plus a working capital adjustment paid to the sellers in accordance with the terms of the BVX Purchase Agreement of approximately $0.2 million. The Broadvox Assets are being integrated into our existing Business Services business segment, and the results of operations generated by the Broadvox Assets are reflected in our consolidated statement of operations effective January 1, 2014. As provided in the BVX Purchase Agreement, we and the Broadvox Sellers entered into a Transitional Services Agreement (the "TSA"), under which we purchase a variety of services from the Broadvox Sellers that are necessary to provide certain services to the customers acquired until such time as those customers are fully transitioned to our own network infrastructure. A failure by the Broadvox Sellers to provide the required services to us until such time as we have completed this transition would have a material adverse effect on our business, results of operations and financial condition. On October 29, 2012, through our wholly owned subsidiary, Fusion NBS Acquisition Corp ("FNAC"), we completed the acquisition of Network Billing Systems, LLC and certain assets and liabilities of its affiliate, Interconnect Services Group II LLC (collectively, "NBS"). NBS is a unified communications and cloud services provider offering a wide range of hosted voice and data products, as well as Internet, data networking and other cloud services solutions to small, medium and large businesses in the United States. For the year ended December 31, 2013, the NBS customer base contributed approximately $28 million of revenue to our Business Services business segment. 21 -------------------------------------------------------------------------------- FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES The aggregate purchase price for the outstanding membership interests of NBS and the assets of ISG, net of assumed liabilities, was $19.6 million, consisting of $17.75 million in cash, $0.6 million to be evidenced by promissory notes payable to the sellers of the NBS membership interests (the "Seller Notes") and 11,363,636 shares of our restricted common stock valued at $1.25 million. The purchase price has been adjusted for certain working capital measurements described in the purchase agreements. As of June 30, 2014, the Seller Notes have been paid in full. Effective as of the date of the acquisition, NBS became our wholly-owned subsidiary, and during 2013 we completed the integration of our pre-acquisition Business Services business segment into NBS' existing business. In connection with our acquisition of NBS, we entered into an Employment and Restrictive Covenant Agreement with Jonathan Kaufman, the founder and principal operating officer of NBS, and Mr. Kaufman became the President of our combined Business Services business segment. The purchase price of the Broadvox Assets and the cash portion of the NBS Purchase Price were primarily financed through the issuance of senior notes by FNAC in the principal amounts of $25.5 million and $16.5 million, respectively (see "Liquidity and Capital Resources"). The acquisition of the Broadvox Assets (the "Broadvox Transaction") and the acquisition of NBS added approximately 11,000 customer locations to our Business Services segment. These transactions are a significant component of our strategy to increase the percentage of our total revenues contributed by the Business Services business segment, which operates at higher profit margins than does our Carrier Services business segment. Our Performance Revenues for the three months ended June 30, 2014 were $23.1 million, an increase of $8.9 million, or 62.6%, compared to the three months ended June 30, 2013. Our operating loss for the three months ended June 30, 2014 was $30,000, as compared to $0.7 million in the same period of a year ago, mainly due to the operating income generated by the Broadvox Assets, which are not reflected in the 2013 results. Our net loss for the three months ended June 30, 2014 was $2.5 million, compared to net income of $1.7 million the three months ended June 30, 2013, as we recognized a non-cash gain of $2.9 million on the extinguishment of a trade payable in June of 2013. Revenues for the six months ended June 30, 2014 were $46.0 million, an increase of $15.6 million, or 51.5%, compared to the six months ended June 30, 2013. Our operating income for the six months ended June 30, 2014 was $0.3 million, as compared to an operating loss of $1.4 million in the same period of a year ago, mainly due to the operating income generated by the Broadvox Assets, which are not reflected in the 2013 results, partially offset by increases in SG&A expenses. Our net loss for the six months ended June 30, 2014 was $1.0 million, as compared to net income of $0.1 million for the six months ended June 30, 2013. Our Outlook We expect that the revenues and gross profit in our Business Services business segment will increase significantly in 2014 as a result of the Broadvox Transaction. However, our ability to achieve positive cash flows from operations and net profitability is dependent upon our ability to grow our revenues and successfully integrate the operations associated with the Broadvox Assets into our existing business. We believe that a successful integration will result in synergistic cost savings and operational efficiencies that would substantially improve our operating performance. Revenues from our Carrier Services business have declined over the last few years due in large part to decreases in market rates for the termination of international traffic, and we have seen this trend continue into the first half of 2014. We believe these declines in market rates resulted largely from increased competition, deregulation in many of the markets we serve and the use of lower cost, Internet-based technologies. While the market demand for international voice termination has seen a corresponding increase over the last few years, we have been unable to increase our revenues accordingly due to capacity limitations on our network switching platform and liquidity constraints. We are in the process of implementing new systems and equipment which, subject to their successful implementation, will bring our network capacity to the levels necessary to compete in the current market and allow us to increase our traffic volumes. In addition, we do not believe we will experience the same liquidity constraints that we have in the past. As a result, while we may experience additional declines in revenue during the remainder of 2014, we expect to reverse this trend as we move into 2015 and see the results of the implementation of our new systems. 22 -------------------------------------------------------------------------------- FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES Reverse Split of Common Stock On May 13, 2014, a reverse split of the Company's common stock became effective, whereby each 50 shares of outstanding common stock of the Company was combined and automatically converted into one share of the Company's common stock (the "Reverse Stock Split") and the conversion and exercise prices of all of the Company's outstanding preferred stock, common stock purchase warrants and options to purchase common stock were proportionately adjusted to reflect the terms of the Reverse Stock Split consistent with the terms of such instruments. As a result of the Reverse Stock Split, all share and per share amounts as of December 31, 2013, as well as for the three months and six months ended June 30, 2013, have been restated at a ratio of one for fifty to give effect to the reverse stock split. CRITICAL ACCOUNTING POLICIES AND ESTIMATES Our discussion and analysis of financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAPP"). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and the related disclosure of contingent liabilities. We base these estimates on our historical experience and on various other assumptions that we believe to be reasonable under the circumstances, and these estimates form the basis for our judgments concerning the carrying values of assets and liabilities that are not readily apparent from other sources. We periodically evaluate these estimates and judgments based on available information and experience. Actual results could differ from our estimates under different assumptions and conditions. If actual results significantly differ from our estimates, our financial condition and results of operations could be materially impacted. We have identified the policies and significant estimation processes discussed below as critical to our business operations and to the understanding of our results of operations. For a detailed discussion on the application of these and other accounting policies, see Note 2 to the Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2013. Revenue Recognition We recognize revenue when persuasive evidence of a sale arrangement exists, delivery has occurred or services have been rendered, the sales price is fixed and determinable and collectability is reasonably assured. We record provisions against revenue for billing adjustments, which are based upon estimates derived from factors that include, but are not limited to, historical results, analysis of credits issued and current economic trends. The provisions for revenue adjustments are recorded as a reduction of revenue when incurred. Our revenue is primarily derived from the monthly recurring and usage fees charged to customers that purchase our business products and services, and from usage fees charged to other telecommunications carriers that terminate voice traffic over the Company's network. Fixed revenue is earned from monthly recurring services provided to the customer, for which the charges are contracted for over a specified period of time. Revenue recognition commences after the provisioning, testing and acceptance of the service by the customer. The recurring customer charges continue until the expiration of the contract, or until cancellation of the service by the customer. To the extent that payments received from a customer are related to a future period, the payment is recorded as deferred revenue until the service is provided or the usage occurs. Variable revenue is earned based on the length of a call, as measured by the number of minutes of duration. It is recognized upon completion of the call, and is adjusted to reflect the allowance for billing adjustments. Revenue for each customer is calculated from information received through our network switches. Our customized software tracks the information from the switches and analyzes the call detail records against stored detailed information about revenue rates. This software provides us with the ability to complete a timely and accurate analysis of revenue earned in a period. We believe that the nature of this process is such that recorded revenues are unlikely to be revised in future periods. Cost of Revenues Cost of revenues for our Carrier Services business segment is comprised primarily of costs incurred from other domestic and international communications carriers to originate, transport, and terminate voice calls for our carrier customers. Thus the majority of our cost of revenues for this business segment is variable, based upon the number of minutes actually used by our customers and the destinations they are calling. Call activity is tracked and analyzed with customized software that analyzes the traffic flowing through our network switch. During each period, the call activity is analyzed and an accrual is recorded for the revenues associated with minutes not yet invoiced. This cost accrual is calculated using minutes from the system and the variable cost of revenue based upon predetermined contractual rates. Fixed expenses reflect the costs associated with connectivity between our network infrastructure, including our New York switching facility, and certain large carrier customers and vendors. 23 -------------------------------------------------------------------------------- FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES For our Business Services business segment, fixed expenses include the monthly recurring charges associated with certain platform services purchased from other service providers, the monthly recurring costs associated with private line services and the cost of broadband Internet access used to provide service to business customers. Accounts Receivable Accounts receivable is recorded net of an allowance for doubtful accounts. On a periodic basis, we evaluate our accounts receivable and adjust the allowance for doubtful accounts based on our history of past write-offs and collections and current credit conditions. Specific customer accounts are written off as uncollectible if the probability of a future loss has been established, collection efforts have been exhausted and payment is not expected to be received. Impairment of Long-Lived Assets We periodically review long-lived assets, including intangible assets, for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable. If an impairment indicator is present, we evaluate recoverability by a comparison of the carrying amount of the asset to future undiscounted net cash flows expected to be generated by the asset. If the carrying value of the asset exceeds the projected undiscounted cash flows, we are required to estimate the fair value of the asset and recognize an impairment charge to the extent that the carrying value of the asset exceeds its estimated fair value. We did not record any impairment charges for the six months ended June 30, 2014 and 2013. Impairment testing for goodwill is performed annually in our fourth fiscal quarter. The impairment test for goodwill uses a two-step approach, which is performed at the reporting unit level. We have determined that our reporting units are our operating segments since that is the lowest level at which discrete, reliable financial and cash flow information is available. The authoritative guidance provides entities with an option to perform a qualitative assessment to determine if the fair value of the reporting unit is less than its carrying value, and we utilize this option where appropriate. Income Taxes We account for income taxes in accordance with U.S. GAAP, which requires the recognition of deferred tax liabilities and assets for the expected future income tax consequences of events that have been recognized in our financial statements. Deferred income tax assets and liabilities are computed for temporary differences between the financial statement and tax bases of assets and liabilities that will result in future taxable or deductible amounts, based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established to reduce deferred income tax assets when we determine that it is more like than not that we will fail to generate sufficient taxable income to be able to utilize the deferred tax assets. Property and Equipment In accordance with Accounting Standards Codification 350-40, Intangibles - Goodwill and Other - Internal-Use Software, we capitalize a portion of our payroll and related costs for the development of software for internal use and amortize these costs over three years. During the six months ended June 30, 2014 and 2013, we capitalized costs pertaining to the development of internally used software in the approximate amount of $0.4 million. Recently Issued Accounting Pronouncements During the six months ended June 30, 2014, there were no new accounting pronouncements adopted by the Company that had a material impact on the Company's consolidated financial statements. In May of 2014, the Financial Accounting Standards Board issued Accounting Standards Update No. 2014-09, "Revenue from Contracts with Customers," ("ASU 2014-09"). ASU 2014-09 outlines a comprehensive new revenue recognition model that requires a company to recognize revenue to depict the transfer of goods or services to a customer at an amount that reflects the consideration it expects to receive in exchange for those goods or services. ASU 2014-09 is effective for annual and interim reporting periods beginning after December 15, 2016 and early adoption is not permitted. Companies may either use a full retrospective or modified retrospective approach to adopt this new standard. The Company is currently evaluating both adoption options and the impact that adoption of ASU 2014-09 will have on its consolidated financial statements. 24 -------------------------------------------------------------------------------- FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES RESULTS OF OPERATIONS As a result of the Broadvox Transaction on December 31, 2013, our results of operations for the three and six months ended June 30, 2014, particularly with respect to our Business Services business segment, are not comparable to the results of operations for the same period in 2013. The following table summarizes our results of operations for the periods indicated Three Months Ended June 30, Six Months Ended June 30, 2014 2013 2014 2013 Revenues $ 23,140,973 100.0 % $ 14,230,178 100.0 % $ 46,045,802 100.0 % $ 30,398,599 100.0 % Cost of revenues, exclusive of depreciation and amortization 12,747,441 55.1 % 9,605,534 67.5 % 24,976,473 54.2 % 21,357,130 70.3 % Gross profit 10,393,532 44.9 % 4,624,644 32.5 % 21,069,329 45.8 % 9,041,469 29.7 % Operating expenses: Depreciation and amortization 2,597,978 11.2 % 872,584 6.1 % 5,165,469 11.2 % 1,722,499 5.7 % Selling general and administrative 7,825,494 33.8 % 4,433,848 31.2 % 15,644,891 34.0 % 8,701,446 28.6 % Total operating expenses 10,423,472 45.0 % 5,306,432 37.3 % 20,810,360 45.2 % 10,423,945 34.3 % Operating income (loss) (29,940 ) -0.1 % (681,788 ) -4.8 % 258,969 0.6 % (1,382,476 ) -4.5 % Interest expense, net (1,597,215 ) -6.9 % (669,731 ) -4.7 % (2,991,761 ) -6.5 % (1,329,250 ) -4.4 % Loss on extinguishment of debt - 0.0 % (92,376 ) -0.6 % - 0.0 % (150,579 ) -0.5 % (Loss) gain on change in fair value of derivative liability (690,878 ) 238,517 1,919,069 105,267 Other income (expenses) 719 0.0 % (17,731 ) -0.1 % (40,355 ) -0.1 % (62,351 ) -0.2 % Total other (expenses) income (2,287,374 ) -9.9 % (541,321 ) -3.8 % (1,113,047 ) -2.4 % (1,436,913 ) -4.7 % Gain on extinguishment of accounts payable 2,908,882 2,908,882 Income (loss) before taxes (2,317,314 ) -10.0 % 1,685,773 11.8 % (854,078 ) -1.9 % 89,493 0.3 % Provision for income taxes 151,583 - 173,078 - Net (loss) income $ (2,468,897 ) -10.7 % $ 1,685,773 11.8 % $ (1,027,156 ) -2.2 % $ 89,493 0.3 % Three Months Ended June 30, 2014 Compared with Three Months Ended June 30, 2013 Revenues Consolidated revenues were $23.1 million during the three months ended June 30, 2014, compared to $14.2 million during the three months ended June 30, 2014, an increase of $8.9 million, or 62.6%. Revenues for the Business Services segment increased by $8.1 million in 2014 compared to 2013 due to completion of the Broadvox Transaction. Carrier services revenue of $7.5 million represents an increase of $0.8 million, or 11.5%, from a year ago, as a 16% increase in the volume of traffic terminated over our network was partially offset by a 4% decrease in the blended rate per minute realized. Cost of Revenues and Gross Margin Consolidated cost of revenues was $12.7 million for the three months ended June 30, 2014, compared to $9.6 million for the three months ended June 30, 2013. The increase is due to $2.4 million of costs attributed to revenues related to the Broadvox Assets not present in 2013, and to the increased traffic volume in the Carrier Services business segment. Consolidated gross margin was 44.9% in the three months ended June 30, 2014, compared to 32.5% in 2013. The increase is due to the higher mix of Business Services revenue in 2014 as a result of the Broadvox Transaction. Gross Margin for the Business Services segment was 61.4% in 2014, compared to 51.1%, in 2013, as a result of the Broadvox Transaction. The Broadvox Assets have historically generated higher margins than our previously existing Business Services business, including NBS, due to a higher concentration of hosted VoIP and SIP Trunking services. Gross margin for the Carrier Services segment was 10.6% for the three months ended June 30, 2014, compared to 11.9% in the three months ended June 30, 2013. The decrease is mainly due to a 4% decrease in the blended rate realized per minute of traffic terminated. 25 -------------------------------------------------------------------------------- FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES Depreciation and Amortization Depreciation and amortization increased by $1.7 million to $2.6 million for the three months ended June 30, 2014 from $0.9 million during the same period of a year ago, mainly due to $1.1 million of amortization expense related to intangibles and $0.6 million of depreciation expense on property and equipment associated with the Broadvox Transaction in 2014 not present in 2013. Selling, General and Administrative Expenses Selling, general, and administrative expenses increased by $3.4 million for the three months ended June 30, 2014 compared to the three months ended June 30, 2013. The increase is mainly due to SG&A expenses attributable to BVX and, to a lesser extent, higher employee related expenses. Operating Loss Our operating loss for the three months ended June 30, 2014 was $30,000, as compared to $0.7 million for the three months ended June 30, 2013. The improvement is due to the increased sales and gross profit in 2014 resulting from the Broadvox Transaction, partially offset by the related increases in SG&A and depreciation and amortization expense. Interest Expense Interest expense increased by $0.9 million in the three months ended June 30, 2014 as compared to the three months ended June 30, 2013, mainly due to an additional $25.5 million of senior debt incurred in December of 2013 to finance the Broadvox Transaction. Loss on Extinguishment of Debt During the three months ended June 30, 2013, we recorded a loss on the extinguishment of debt of approximately $92,000 for the fair value of warrants to purchase shares of our common stock in connection with the conversion of debt into equity, with no comparable amount in the three months ended June 30, 2014. Change in Fair Value of Derivative Liability During the three months ended June 30, 2014, we recognized a loss on the change in fair value of our derivative liabilities in the amount of $0.7 million, as compared to a gain of $0.2 million for the three months ended June 30, 2013. These gains and losses are related to the derivatives associated with the warrants that we issued to our senior lenders in 2012 and 2013 and with the warrants we issued to purchasers of our preferred stock, the terms of which require them to be treated as liabilities and not equity instruments. The changes in their fair value are required to be recorded through the statement of operations at each accounting period. The warrants are valued using a Black-Scholes pricing model, such that increases to our stock price result in a higher valuation of the derivative and a charge to our income statement, and decreases to our stock price result in a lower valuation and a gain being recorded in our income statement. We expect that we will be subject to additional significant fluctuations in our income statement in 2014 and beyond based on changes in our stock price and the corresponding changes in fair value of our derivative liabilities. Other Income (Expenses) Other income, net for the three months ended June 30, 2014 reflects a net loss on the disposal of certain property and equipment in the amount of $84,000, which was offset by a refund granted to us by the Federal Communications Commission for an overpayment of certain regulatory fees. Gain on Extinguishment of Accounts Payable In June of 2013, pursuant to the advice of counsel and based on applicable laws, we determined that the Company no longer had any liability pertaining to a trade payable in the amount of $2,908,882. As a result, we derecognized this payable from our balance sheet and recorded a corresponding one-time gain on the extinguishment of accounts payable. Provision for Income Taxes During the three months ended June 30, 2014, we recorded income tax expense of $0.2 million, which is mainly due to the recognition of a deferred tax liability related to the goodwill acquired in the NBS and Broadvox transactions. Net (Loss) Income Net loss was $2.5 million for the three months ended June 30, 2014, compared to net income of $1.7 million in the same period of a year ago, mainly due to the absence of the $2.9 million gain on the extinguishment of the trade payable in 2014, the difference in mark-to-market impact of the derivative liabilities and the increase in interest expense in 2014, partially offset by the decrease in operating loss in 2014. 26-------------------------------------------------------------------------------- FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES Six Months Ended June 30, 2014 Compared with Six Months Ended June 30, 2013 Revenues Consolidated revenues were $46.0 million for the six months ended June 30, 2014, compared to $30.4 million for the six months ended June 30, 2013, an increase of $15.6 million, or 51.5%. Revenues for the Business Services segment increased by $16.4 million in 2014 compared to 2013, substantially all of which was due to the Broadvox Transaction. Carrier services revenue of $14.7 million represents a decrease of $0.8 million, or 4.9%, from a year ago, as a 14% increase in the volume of traffic terminated over our network was more than offset by a 17% decrease in the blended rate realized per minute of traffic terminated. Cost of Revenues and Gross Margin Consolidated cost of revenues was $25.0 million for the six months ended June 30, 2014, compared to $21.4 million for the six months ended June 30, 2013. The increase is due to $4.8 million of costs attributable to the Broadvox Assets not present in 2013, partially offset by improved margins in both of our business segments. Consolidated gross margin was 45.8% in the six months ended June 30, 2014, compared to 29.7% in 2013. The increase is due to the higher mix of Business Services revenue in 2014 resulting from the Broadvox Transaction. Gross Margin for the Business Services segment was 61.4% in 2014, compared to 51.1%, in 2013, as the Broadvox Assets have historically generated higher margins than our previously existing Business Services business, due to a higher concentration of hosted VoIP and SIP Trunking services. Gross margin for the Carrier Services business segment was 11.2% for the six months ended June 30, 2014, compared to 9.8% in the six months ended June 30, 2013, due to a 20% decrease in the cost of revenues blended rate. Depreciation and Amortization Depreciation and amortization increased by $3.4 million to $5.2 million for the six months ended June 30, 2014 from $1.7 million during the same period of a year ago, mainly due to $2.2 million of amortization expense related to intangible assets and $1.2 million of depreciation expense related to property and equipment acquired in the Broadvox Transaction. Selling, General and Administrative Expenses Selling, general, and administrative expenses increased by $6.9 million for the six months ended June 30, 2014 compared to the six months ended June 30, 2013. The increase is mainly due to $6.1 million of expenses attributable to the Broadvox Assets and, to a lesser extent, post-acquisition integration expenses associated with the Broadvox Transaction, increased third party agent commissions and higher employee compensation and related expenses. Operating Loss Our operating income was $0.3 million for the six months ending June 30, 2014, as compared to an operating loss of $1.4 million for the same period of a year ago. The Broadvox Assets generated approximately $2.0 million of operating income in 2014, which was partially offset by increases in selling general and administrative expenses. Interest Expense Interest expense increased by $1.7 million in the six months ended June 30, 2014 as compared to the six months ended June 30, 2013, mainly due to an additional $25.5 million of senior debt incurred in December of 2013 to finance the Broadvox Transaction. Loss on Extinguishment of Debt During the six months ended June 30, 2013, we recorded a loss on the extinguishment of debt of 0.2 million for the fair value of warrants to purchase shares of our common stock in connection with the conversion of debt into equity, with no comparable amount in the six months ended June 30, 2014. Change in Fair Value of Derivative Liability The change in fair value of the derivative was a gain of $1.9 million in the six months ended June 30, 2014 compared to a gain of $0.1 million the six months ended June 30, 2013. The change is due to the decrease in the Company's stock price since December 31, 2013, which decreases value of the derivatives, and to the increase in warrants not qualifying for equity treatment due to the issuance of the new senior debt and the issuance of the Series B-2 Preferred Stock on December 31, 2013 and January 24, 2014. 27 -------------------------------------------------------------------------------- FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES Other Expenses Other expenses, net for the six months ended June 30, 2014 and 2013 reflects a net loss on the sale of accounts receivable of $0.1 million, partially offset by late fees charged to customers. Gain on Extinguishment of Accounts Payable In June of 2013, pursuant to the advice of counsel and based on applicable laws, we determined that the Company no longer had any liability pertaining to a trade payable in the amount of $2,908,882. As a result, we derecognized this payable from our balance sheet and recorded a corresponding one-time gain on the extinguishment of accounts payable. Provision for Income Taxes The provision for income taxes for the six months ended June 30, 2014, consists primarily of deferred tax expense related to the goodwill acquired in the NBS and Broadvox transactions. Net (Loss) Income Our net loss was $1.0 million for the six months ended June 30, 2014, compared to net income of $0.1 million in the same period of a year ago, mainly due to the absence of the $2.9 million gain on the extinguishment of the trade payable in 2014 and the increase in interest expense in 2014, partially offset by the improvement in operating income and the $1.9 million gain on the change in fair value of derivatives in 2014. LIQUIDITY AND CAPITAL RESOURCES Since our inception, we have incurred significant operating and net losses. In addition, we have only recently begun to generate positive cash flow from operations. At June 30, 2014, we had working capital of $5.6 million and stockholders' equity of $12.0 million. At December 31, 2013, we had working capital of $1.8 million and stockholders' equity of approximately $7.0 million. Our consolidated cash balance at June 30, 2014 was $9.8 million, as compared to $6.2 million at December 31, 2013. While we believe that we have sufficient cash to fund our operations and meet our obligations for the next twelve months, we may be required to raise additional capital to support our business plan. There are no current commitments for such funds and there can be no assurances that such funds will be available to the Company as needed. During fiscal 2012, we relied primarily on the sale of our accounts receivable, including unbilled receivables, under our agreement with Prestige Capital Corporation ("Prestige"), as well as the sale of our equity securities, to fund our operations. During fiscal 2013 and the first six months of 2014, we relied primarily on the sale of our equity securities and the cash generated from the operations of our Business Services business segment to fund our operations. On December 31, 2013, we issued to a total of 82 accredited investors (the "Investors"), an aggregate of 18,480 shares of our newly designated Series B-2 Cumulative Convertible Preferred Stock, par value $0.01 per share (the "Series B-2 Preferred Stock") and (b) warrants (the "Investor Warrants") to purchase 1,182,720 shares of our common stock (the "Warrant Shares" and together with the Series B-2 Preferred Stock, the "Series B-2 Offering"). The Series B-2 Offering included the issuance of 2,052 shares of Series B-2 Preferred Stock and Investor Warrants to purchase 131,328 Warrant Shares upon the conversion of $2.052 million in indebtedness of the Company, including the conversion of $2.0 million of notes payable to Marvin Rosen and $52,000 of other Company indebtedness payable to Matthew Rosen, our Chief Executive Officer, and another Director of the Company. Gross cash proceeds received in 2013 from the Series B-2 Offering were $16.4 million, approximately $8.1 million of which was used to partially finance the Broadvox Transaction with the remainder, net of offering expenses, available for general corporate purposes. On January 24, 2014 we held a second and final closing of the Series B-2 Offering and issued to a total of 40 accredited investors an aggregate of 4,358 shares of Series B-2 Preferred Stock and warrants to purchase 278,912 Warrant Shares, and we received net proceeds of approximately $4.0 million, which is being used for general corporate purposes. Each share of Series B-2 Preferred Stock has a Stated Value of $1,000, and is convertible into shares of our common stock at a conversion price of $5.00 per share (the "Preferred Conversion Price"), subject to adjustment. Subject to the other terms of the Series B-2 Preferred Stock, the Series B-2 Preferred Stock sold to the Investors is convertible into an aggregate of 4,567,600 shares of our common stock (the "Conversion Shares"). The Investor Warrants may be exercised at any time following March 28, 2014 for a five-year term commencing on the date issuance for a number of Warrant Shares that is equal to 40% of the Stated Value divided by 125% of the Preferred Conversion Price, as adjusted for stock splits, combinations and reclassifications. 28 -------------------------------------------------------------------------------- FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES We also agreed to register the resale of the Conversion Shares and the Investor Warrant Shares, and to use its reasonable commercial efforts to cause the registration statement to remain effective until the date that all of the Conversion Shares and Warrant Shares have been sold or may be sold pursuant to Rule 144 under the Securities Act of 1933, as determined by the Company. The Company may be required to pay the Investors liquidated damages for periods during which the registration statement is not available to permit re-sales by the Investors. We filed the registration statement on May 2, 2014 and it became effective on July 21, 2014. Commencing January 1, 2016, we have the right to force the conversion of the Series B-2 Preferred Stock into common stock at the Preferred Conversion Price; provided that the volume weighted average price for our common stock is at least $12.50 for ten consecutive trading days. In addition, shares of Series B-2 Preferred Stock bear a cumulative 6% annual dividend payable quarterly in arrears commencing March 31, 2014, in cash or shares of common stock, at the option of the Company. We elected to pay the dividends in the form of our common stock for the quarters ended March 31, and June 30, 2014. Also during the year ended December 31, 2013, we entered into subscription agreements with 60 accredited investors, under which we issued an aggregate of 1,005,144 shares of common stock and five-year warrants to purchase 502,572 shares of the our common stock for aggregate consideration of $4.1 million. The warrants are exercisable at 125% of the volume weighted-average price of the Company's common stock for the 10 trading days prior to the date of closing. To finance the acquisitions of NBS and the Broadvox Assets, we entered into a Securities Purchase Agreement and Security Agreement (the "SPA") with several private funds (the "Senior Lenders"). The SPA was originally entered into on October 29, 2012 and amended on December 31, 2013. Under the SPA, as amended, we have sold to the Senior Lenders senior secured notes in the aggregate principal amount of $42 million (the "Senior Notes"). The Senior Notes pay interest monthly at a rate of 11.15% per annum and mature on December 31, 2018. Monthly principal payments aggregating $52,083 are required from January 2014 through December 2014, and monthly principal payments aggregating $102,083 are required from January 2015 through December 2018. As of June 30, 2014, the unpaid principal balance on the Senior Notes was $41.5 million. The SPA contains a number of affirmative and negative covenants, including but not limited to, restrictions on paying indebtedness subordinate to the Senior Notes, incurring additional indebtedness, making capital expenditures, dividend payments and cash distributions by subsidiaries. In addition, at all times while the Senior Notes are outstanding, we are required to maintain a minimum cash bank balance of no less than $1.0 million in excess of any amounts outstanding under a permitted working capital line of credit and in excess of any and all cash balances held by the entities that comprise our Business Services business segment. The SPA also requires on-going compliance with various financial covenants, including leverage ratio, fixed charge coverage ratio and minimum levels of earnings before interest, taxes, depreciation and amortization. Failure to comply with any of the restrictive or financial covenants could result in an event of default and accelerated demand for repayment of the Senior Notes. We do not have the financial resources to repay the Senior Notes in the event they are accelerated. As of and for the six months ended June 30, 2014, we were in compliance with all of the financial covenants under the SPA. Under the terms of the SPA, as amended, we were required to deposit $3.0 million into an account controlled by the Senior Lenders, pending receipt of certain regulatory approvals for the pledging of assets as collateral for the Senior Notes. The funds were to remain in escrow until such time as the necessary regulatory approvals are obtained. We received all of the required regulatory approvals in May of 2014, and the funds were released to us at that time. For 2014, monthly principal and interest obligations under the Senior Notes are approximately $0.4 million. In 2015 and beyond, monthly principal and interest obligations are approximately $0.5 million. While our Business Services business segment continues to generate positive cash flow from operations, the terms of the SPA prohibit any cash distributions from NBS, FBVX or FNAC to us prior to repayment of the Senior Notes. On September 12, 2011, we entered into a purchase and sale agreement with Prestige, whereby we may sell certain of our accounts receivable to Prestige at a discount in order to improve our liquidity and cash flow. Under the terms of the purchase and sale agreement, Prestige pays a percentage of the face amount of the receivables at the time of sale, and the remainder, net of the discount, is paid to us within two business days after Prestige receives payment on the receivables, which generally have 15 to 30 day terms. From the fourth quarter of fiscal 2011 through the first quarter of 2013, this arrangement was our primary source of liquidity. We may continue to utilize the agreement with Prestige to supplement our working capital needs until such time as we can consummate a traditional working capital line of credit. In connection with the issuance of the Senior Notes, Prestige and the Lenders entered into an agreement establishing priorities among them and reached certain agreements as to enforcing their respective rights against the Company. 29 -------------------------------------------------------------------------------- FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES From time to time we have also received short term advances from Prestige which are secured by a priority lien on certain of our accounts receivable; however such advances are not attributable to a transfer of specific accounts receivable and are therefore reflected as notes payable to non-related parties in the accompanying consolidated balance sheets. During the year ended December 31, 2013, the Company received advances from Prestige totaling $0.2 million, all of which were repaid during the year, along with advance fees of approximately $12,000. The Prestige agreement is currently due to expire on March 15, 2015, but automatically renews for additional nine month periods unless either party receives written notice of cancellation within 60 days prior to the scheduled expiration date. For as long as the agreement is in effect, Prestige will continue to have a first priority lien on the accounts receivable of our Carrier Services business segment and a second priority lien on the other assets of the Company. A summary of the Company's cash flows for the periods indicated is as follows: Six Months Ended June 30, 2014 2013 Net cash provided by (used in) operating activities $ 91,339 $ (397,084 ) Net cash used in investing activities (8,865 ) (788,164 ) Net cash provided by financing activities 3,527,280 1,428,937 Net increase in cash and cash equivalents 3,609,754 243,689 Cash and cash equivalents, beginning of period 6,176,575 543,214 Cash and cash equivalents, end of period $ 9,786,329 $ 786,903 Net cash used provided by operating activities was $0.1 million during the six months ended June 30, 2014, as compared to cash used in operating activities of $0.4 million in the during the six months ended June 30, 2013. The following table illustrates the primary components of our cash flows from operations: 2014 2013 Net (loss) income $ (1,027,156 ) $ 89,493 Non-cash expenses, (gains) and losses 4,554,230 (662,545 ) Accounts receivable (1,004,835 ) (992,929 ) Accounts payable and accrued expenses (1,446,993 ) 1,430,459 Other (983,907 ) (261,562 ) Net cash used in operating activities $ 91,339 $ (397,084 ) Net cash used in investing activities was $9,000 for the six months ended June 30, 2014, compared to $0.8 million for the six months ended June 30, 2013. During 2014, the $3 million of escrowed funds held by our Senior Lenders ($1 million of which is restricted under the terms of our financial covenants) was released to us. This amount was offset by capital expenditures of $1.8 million and the payment of obligations related to the acquisition of NBS of $0.2 million. Capital expenditures for the six months ending June 30, 2013 were $0.6 million. Capital expenditures for the remainder of 2014 are expected to be approximately $3.0 million, primarily for the purchase of network and related equipment and operational support systems for our Business Services segment. We anticipate that a portion of our capital expenditure requirements will be financed through capital leases or other equipment financing arrangements. Net cash provided by financing activities was $3.5 million for the six months ended June 30, 2014, as compared to $1.4 million for the six months ended June 30, 2013. During 2014 we raised approximately $4.0 million, net of offering expenses, from the sale of our equity securities and made debt service payments of approximately $0.7 million. During 2013 we raised approximately $1.6 million from the sale of our equity securities. 30 -------------------------------------------------------------------------------- FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES OTHER MATTERS Inflation We do not believe inflation has a significant effect on the Company's operations at this time. Off Balance Sheet Arrangements Under SEC regulations, we are required to disclose the Company's off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors. An off-balance sheet arrangement means a transaction, agreement or contractual arrangement to which any entity that is not consolidated with us is a party, under which we have: ? Any obligation under certain guarantee contracts ? Any retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement that serves as credit, liquidity or market risk support to that entity for such assets ? Any obligation under a contract that would be accounted for as a derivative instrument, except that it is both indexed to the Company's stock and classified in stockholder's equity in the Company's statement of financial position ? Any obligation arising out of a material variable interest held by us in an unconsolidated entity that provides financing, liquidity, market risk or credit risk support to us, or engages in leasing, hedging or research and development services with us As of June 30, 2014, we have no off-balance sheet arrangements that have, or are reasonably likely to have, a current or future effect on the Company's financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors. Forward Looking Statements Certain statements and the discussion contained herein regarding the Company's business and operations may include "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1996. Such statements consist of any statement other than a recitation of historical fact and can be identified by the use of forward-looking terminology such as "may", "expect", "anticipate", "intend", "estimate" or "continue" or the negative thereof or other variations thereof or comparable terminology. The reader is cautioned that all forward-looking statements are speculative, and there are certain risks and uncertainties that could cause actual events or results to differ from those referred to in such forward-looking statements. This disclosure highlights some of the important risks regarding the Company's business. The primary risk of the Company is its ability to attract new capital to execute its comprehensive business strategy. There may be additional risks associated with the integration of businesses following an acquisition, the Company's ability to comply with its senior debt agreements, concentration of revenue from one source, competitors with broader product lines and greater resources, emergence into new markets, natural disasters, acts of war, terrorism or other events beyond the Company's control and the other factors identified by us from time to time in the Company's filings with the SEC. However, the risks included should not be assumed to be the only things that could affect future performance. All forward-looking statements included in this document are made as of the date hereof, based on information available to us as of the date thereof, and we assume no obligation to update any forward-looking statements. |