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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

(Mark One)

þ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2011

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

Commission file number: 000-52486

 

 

PAETEC HOLDING CORP.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   20-5339741

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

One PAETEC Plaza

600 Willowbrook Office Park

Fairport, New York

  14450
(Address of principal executive offices)   (Zip Code)

Registrant’s telephone number, including area code:

(585) 340-2500

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  þ    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer   ¨    Accelerated filer   þ
Non-accelerated filer   ¨  (Do not check if a smaller reporting company)    Smaller reporting company   ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  þ

The number of shares of the registrant’s common stock outstanding on May 2, 2011 was 145,075,559.

 

 

 


Table of Contents

TABLE OF CONTENTS

 

         Page  
Part I.  

Financial Information

  
Item 1.   Financial Statements (unaudited)      1   
  Condensed Consolidated Balance Sheets as of March 31, 2011 and December 31, 2010      1   
  Condensed Consolidated Statements of Operations for the three months ended March 31, 2011 and 2010      2   
  Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2011 and 2010      3   
  Notes to Condensed Consolidated Financial Statements      4   
Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations      14   
Item 3.   Quantitative and Qualitative Disclosures About Market Risk      21   
Item 4.   Controls and Procedures      21   
Part II.  

Other Information

  
Item 1.   Legal Proceedings      22   
Item 1A.   Risk Factors      22   
Item 6.   Exhibits      22   


Table of Contents

PART I

FINANCIAL INFORMATION

 

Item 1. Financial Statements

PAETEC Holding Corp. and Subsidiaries

Condensed Consolidated Balance Sheets

March 31, 2011 and December 31, 2010

(Amounts in thousands, except share and per share amounts)

(Unaudited)

 

     March 31,
2011
    December 31,
2010
 

ASSETS

    

Current assets:

    

Cash and cash equivalents

   $ 103,853      $ 95,533   

Accounts receivable, net of allowance for doubtful accounts of $12,727 and $11,044, respectively

     250,120        253,175   

Deferred income taxes

     10,801        10,801   

Prepaid expenses and other current assets

     27,949        27,584   
                

Total current assets

     392,723        387,093   

Property and equipment, net

     863,748        860,782   

Goodwill

     443,793        439,556   

Intangible assets, net

     265,394        279,691   

Other assets, net

     42,684        40,816   
                

Total assets

   $ 2,008,342      $ 2,007,938   
                

LIABILITIES AND STOCKHOLDERS’ EQUITY

    

Current liabilities:

    

Accounts payable

   $ 85,600      $ 102,169   

Accrued expenses

     38,880        36,954   

Accrued payroll and related liabilities

     25,823        20,373   

Accrued taxes

     48,626        48,897   

Accrued commissions

     23,179        22,532   

Accrued capital expenditures

     17,286        13,707   

Accrued interest

     35,363        17,278   

Deferred revenue

     81,100        82,232   

Current portion of long-term debt and capital lease obligations

     38,684        10,733   
                

Total current liabilities

     394,541        354,875   

Long-term debt and capital lease obligations

     1,408,453        1,437,356   

Other long-term liabilities

     78,715        78,822   
                

Total liabilities

     1,881,709        1,871,053   
                

Commitments and contingencies (Note 9)

    

Stockholders’ Equity:

    

Common stock, $.01 par value; 300,000,000 authorized shares at March 31, 2011 and December 31, 2010, 145,062,716 shares issued and outstanding at March 31, 2011, 144,026,358 shares issued and outstanding at December 31, 2010

     1,451        1,440   

Additional paid-in capital

     768,615        766,948   

Accumulated deficit

     (643,433     (631,503
                

Total stockholders’ equity

     126,633        136,885   
                

Total liabilities and stockholders’ equity

   $ 2,008,342      $ 2,007,938   
                

See notes to condensed consolidated financial statements.

 

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Table of Contents

PAETEC Holding Corp. and Subsidiaries

Condensed Consolidated Statements of Operations

Three Months Ended March 31, 2011 and 2010

(Amounts in thousands, except share and per share amounts)

(Unaudited)

 

     Three Months Ended March 31,  
     2011     2010  

Revenue:

    

Network services revenue

   $ 377,032      $ 310,474   

Carrier services revenue

     82,212        63,043   

Integrated solutions revenue

     36,269        16,534   
                

Total revenue

     495,513        390,051   

Cost of sales (exclusive of operating items shown separately below)

     233,912        192,749   

Selling, general and administrative expenses (exclusive of operating items shown separately below and inclusive of stock-based compensation)

     172,692        134,260   

Acquisition, integration and separation costs

     2,493        —     

Depreciation and amortization

     63,313        47,173   
                

Income from operations

     23,103        15,869   

Debt extinguishment and related costs

     —          4,423   

Other income, net

     (81     (112

Interest expense

     34,464        22,037   
                

Loss before income taxes

     (11,280     (10,479

Provision for (benefit from) income taxes

     650        (941
                

Net loss

   $ (11,930   $ (9,538
                

Basic and diluted net loss per common share

   $ (0.08   $ (0.07
                

Basic and diluted weighted average common shares outstanding

     144,338,459        145,490,947   
                

See notes to condensed consolidated financial statements.

 

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Table of Contents

PAETEC Holding Corp. and Subsidiaries

Condensed Consolidated Statements of Cash Flows

Three Months Ended March 31, 2011 and 2010

(Amounts in thousands)

(Unaudited)

 

     Three Months Ended March 31,  
     2011     2010  

OPERATING ACTIVITIES:

    

Net loss

   $ (11,930   $ (9,538

Adjustments to reconcile net loss to net cash provided by operating activities:

    

Depreciation and amortization

     63,313        47,173   

Amortization of debt issuance costs

     1,064        659   

Amortization of debt discount, net

     792        328   

Bad debt expense

     3,547        4,141   

Stock-based compensation expense

     2,416        2,462   

Gain on disposal of property and equipment

     (45     (23

Deferred income taxes

     —          (1,342

Debt extinguishment and related costs

     —          3,667   

Change in assets and liabilities which provided (used) cash, excluding effects of acquisitions:

    

Accounts receivable

     (433     (4,604

Prepaid expenses and other current assets

     (351     (5,806

Other assets

     (2,182     729   

Accounts payable

     (16,169     (1,807

Accrued expenses

     (2,360     (9,395

Accrued payroll and related liabilities

     5,327        (17,472

Accrued taxes

     (351     (7,944

Accrued commissions

     647        (302

Accrued interest

     18,085        7,153   

Deferred revenue

     (685     (251
                

Net cash provided by operating activities

     60,685        7,828   
                

INVESTING ACTIVITIES:

    

Purchases of property and equipment

     (46,847     (29,474

Acquisitions, net of cash received

     (1,343     (5,035

Increase in restricted cash

     —          (314

Purchase of long-term investment

     (750     —     

Proceeds from disposal of property and equipment

     89        208   

Software development costs

     (480     (382
                

Net cash used in investing activities

     (49,331     (34,997
                

FINANCING ACTIVITIES:

    

Repayments of long-term debt

     (2,419     (275,652

Payment for debt issuance costs

     —          (7,328

Proceeds from long-term borrowings

     —          301,584   

Proceeds from exercise of stock options, warrants, and purchase plans

     811        1,050   

Payment of tax withholding on vested stock units

     (1,426     (1,093
                

Net cash (used in) provided by financing activities

     (3,034     18,561   
                

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS

     8,320        (8,608

CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD

     95,533        152,888   
                

CASH AND CASH EQUIVALENTS, END OF PERIOD

   $ 103,853      $ 144,280   
                

SUPPLEMENTAL CASH FLOW INFORMATION:

    

Cash paid for interest

   $ 15,225      $ 14,027   
                

Cash paid for (refund from) income taxes

   $ 21      $ (15
                

SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING TRANSACTIONS:

    

Accrued property and equipment expenditures

   $ 28,853      $ 8,493   
                

Equipment purchased under capital leases

   $ 675      $ 7,401   
                

Tenant incentive leasehold improvements

   $ 748      $ 58   
                

Contingent consideration / accrued business acquisition costs

   $ 10,199      $ 2,182   
                

See notes to condensed consolidated financial statements.

 

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Table of Contents

PAETEC Holding Corp. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

 

1. NATURE OF BUSINESS AND BASIS OF PRESENTATION

Nature of Business

PAETEC Holding Corp. (“PAETEC Holding”) is a Delaware corporation that, through its subsidiaries, provides broadband communications services, including data and Internet access services, local telephone services and domestic and international long distance services, primarily to business end-user customers.

The accompanying historical condensed consolidated financial statements and notes reflect the financial results of PAETEC Holding and PAETEC Holding’s wholly-owned subsidiaries. References to the “Company” and “PAETEC” in these Notes to Condensed Consolidated Financial Statements are to PAETEC Holding and PAETEC Holding’s wholly-owned subsidiaries.

Segment Disclosure

The Company operates in one segment.

Basis of Presentation

The accompanying condensed consolidated financial statements are unaudited and have been prepared by the Company’s management in accordance with accounting principles generally accepted in the United States of America for interim financial information and the rules and regulations of the Securities and Exchange Commission (the “SEC”) for interim financial statements and accounting policies consistent, in all material respects, with those applied in preparing the Company’s audited consolidated financial statements included in its Annual Report on Form 10-K for the year ended December 31, 2010 (the “2010 Form 10-K”), as filed with the SEC. In the opinion of management, these interim financial statements reflect all adjustments, including normal recurring adjustments, management considers necessary for the fair presentation of the Company’s financial position, operating results and cash flows for the interim periods presented. The condensed consolidated balance sheet as of December 31, 2010 has been derived from the audited consolidated balance sheet as of that date. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes included in the 2010 Form 10-K.

The accompanying condensed consolidated financial statements present results for the three months ended March 31, 2011. These results are not necessarily indicative of the results that may be achieved for the year ending December 31, 2011 or any other period.

Basis of Consolidation

The accompanying condensed consolidated financial statements include the accounts of PAETEC Holding and PAETEC Holding’s wholly-owned subsidiaries. All intercompany transactions and balances have been eliminated.

 

2. ACQUISITIONS

Definitive Agreement to Acquire XETA Technologies

On February 8, 2011, PAETEC Holding entered into an agreement and plan of merger by and among PAETEC Holding, XETA Technologies, Inc. (“XETA”), and an indirect wholly-owned subsidiary of PAETEC. Under the terms and subject to the conditions of the merger agreement, the PAETEC subsidiary will merge with and into XETA, with XETA surviving the merger as a wholly-owned subsidiary of PAETEC Holding. The merger agreement has been approved unanimously by the board of directors of each of PAETEC Holding and XETA.

Upon the completion of the merger, each share of XETA common stock (other than shares held in the treasury of XETA or any subsidiary of XETA and any shares owned by PAETEC) will be automatically converted into the right to receive $5.50 in cash (the “merger consideration”). In addition, immediately prior to the effective time of the merger, all remaining forfeiture restrictions applicable to restricted shares of XETA common stock will expire and the holders thereof will be entitled to receive the merger consideration with respect to each such share. Certain options to purchase shares of XETA common stock outstanding immediately prior to the effective time will become fully vested immediately prior to the effective time, and holders of warrants and vested options will be entitled to receive specified consideration. The merger consideration will be approximately $61 million in the aggregate.

 

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Table of Contents

Completion of the merger is subject to customary conditions, including approval by the holders of a majority of the outstanding shares of XETA’s common stock entitled to vote on the merger, receipt of any required regulatory approvals and the absence of any law or order prohibiting the merger. Moreover, each party’s obligation to consummate the merger is subject to certain other conditions, including the accuracy of the other party’s representations and warranties (subject to qualifications), the other party’s compliance with its covenants and agreements contained in the merger agreement, there not being holders of more than 15% of the outstanding shares of XETA common stock properly exercising appraisal rights and there not having been a material adverse effect on the business, financial condition or results of operations of XETA and its subsidiaries (subject to certain limitations) or the ability of XETA to consummate the transactions under the merger agreement that has not been cured. Neither the merger agreement nor the merger is subject to the approval of PAETEC Holding’s stockholders.

The merger agreement contains certain termination rights for XETA and PAETEC. Upon any termination of the merger agreement under specified circumstances, XETA is required to pay PAETEC a termination fee of $1.92 million.

Acquisition of Assets and Certain Liabilities of Iperia Mobility Solutions, LLC

On February 11, 2011, the Company completed the acquisition of assets and certain liabilities of Iperia Mobility Solutions, LLC (“Iperia”), a limited liability company providing IP-based communications solutions delivering communications-enabled applications. The purchase price for the acquisition was $4.0 million in cash, including an estimated $2.7 million of contingent consideration to be paid 24 months following the acquisition closing date. The merger was accounted for as an acquisition of Iperia by PAETEC using the acquisition method in accordance with Accounting Standards Codification (“ASC”) Topic 805, Business Combinations.

Supplemental Pro Forma Information (Unaudited)—Cavalier Telephone Corporation Acquisition

On December 6, 2010, the Company completed the acquisition of Cavalier Telephone Corporation (“Cavalier”). The revenue and net loss from continuing operations of the combined entity had the acquisition date been January 1, 2010, are as follows (in thousands):

 

     Revenue      Net loss  from
continuing
operations
 

Supplemental pro forma from January 1, 2010 through March 31, 2010

   $ 483,244       $ (11,911

The pro forma information presents the combined operating results of the Company and Cavalier, with the results prior to the merger closing date adjusted to include the pro forma effect of the elimination of transactions between the Company and Cavalier, the adjustment to depreciation and amortization expense associated with the estimated acquired fair value of property and equipment and intangible assets, the elimination of historical interest expense on Cavalier’s pre-merger indebtedness, the inclusion of interest expense related to Company borrowings used to fund the acquisition, and the amortization of debt issuance costs related to such borrowings.

The pro forma results are presented for illustrative purposes only and do not reflect either the realization of potential cost savings or any related integration costs. Certain cost savings may result from the Cavalier merger, although there can be no assurance that cost savings will be achieved. These pro forma results do not purport to be indicative of the results that would have actually been obtained if the merger had occurred as of the date indicated, nor do the pro forma results intend to be a projection of results that may be obtained in the future.

 

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Table of Contents
3. PROPERTY AND EQUIPMENT, NET

Property and equipment as of March 31, 2011 and December 31, 2010 consisted of the following:

 

     March 31,
2011
    December 31,
2010
 
     (in thousands)  

Communications networks

   $ 1,149,668      $ 1,112,615   

Computer hardware and purchased software

     179,129        167,101   

Equipment

     55,675        55,316   

Office equipment, furniture and fixtures

     93,982        91,621   

Construction-in-progress

     40,078        41,264   

Land and buildings

     46,478        46,436   
                
     1,565,010        1,514,353   

Accumulated depreciation

     (701,262     (653,571
                

Property and equipment, net

   $ 863,748      $ 860,782   
                

Construction-in-progress as of March 31, 2011 and December 31, 2010 consisted primarily of costs associated with the build-out of the Company’s communications network. Depreciation expense totaled $48.4 million and $39.5 million for the three months ended March 31, 2011 and 2010, respectively.

 

4. GOODWILL AND OTHER INTANGIBLE ASSETS

Goodwill

The changes in the carrying value of goodwill from January 1, 2011 to March 31, 2011 were as follows (in thousands):

 

Balance as of January 1, 2011

   $ 439,556   

Goodwill related to Iperia acquisition

     4,237   
        

Balance as of March 31, 2011

   $ 443,793   
        

The amount of goodwill recognized as of March 31, 2011 for the Company’s acquisition of Cavalier in December 2010 and its other recent acquisitions are based on the Company’s preliminary allocation of purchase price and may change significantly based on various valuations that will be finalized within 12 months after the applicable acquisition’s closing date (Note 2).

Other Intangible Assets

The gross carrying amount and accumulated amortization by major intangible asset category as of March 31, 2011 and December 31, 2010 were as follows:

 

     March 31, 2011         
     Gross
Carrying
Amount
     Accumulated
Amortization
    Net      Weighted
Average
Amortization
Period
 
     (in thousands)         

Amortized intangible assets:

          

Customer-related

   $ 376,343       $ (124,324   $ 252,019         11 years   

Technology-based

     1,953         (1,586     367         5 years   

Capitalized software development costs

     9,721         (4,082     5,639         4 years   

Technology license

     5,164         (1,979     3,185         5 years   

Trade name

     2,800         (1,016     1,784         6 years   
                            

Total

     395,981         (132,987     262,994         10 years   

Unamortized intangible assets:

          

Trade name

     2,400         —          2,400      
                            

Total

   $ 398,381       $ (132,987   $ 265,394      
                            

 

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Table of Contents
     December 31, 2010         
     Gross
Carrying
Amount
     Accumulated
Amortization
    Net      Weighted
Average
Amortization
Period
 
     (in thousands)         

Amortized intangible assets:

          

Customer-related

   $ 376,343       $ (111,029   $ 265,314         11 years   

Technology-based

     1,953         (1,520     433         5 years   

Capitalized software development costs

     9,242         (3,477     5,765         4 years   

Technology license

     5,164         (1,721     3,443         5 years   

Trade name

     2,800         (464     2,336         6 years   
                            

Total

     395,502         (118,211     277,291         10 years   

Unamortized intangible assets:

          

Trade name

     2,400         —          2,400      
                            

Total

   $ 397,902       $ (118,211   $ 279,691      
                            

Intangible asset amortization expense for the three months ended March 31, 2011 and 2010 was $14.8 million and $7.6 million, respectively.

Gross intangible assets as of March 31, 2011 included $159.4 million for customer relationship intangible assets (12 year weighted average useful life), $0.7 million for trade names, and $0.1 million for software acquired from Cavalier. The Company also recorded $4.6 million for a customer relationship intangible asset, $2.2 million for acquired software, and $0.5 million for the trade name acquired through the acquisition of Formula Telecom Solutions, Inc. These amounts are based on the Company’s preliminary allocations of the purchase price and may change significantly based on various valuations that will be finalized within 12 months after the applicable closing dates. The Company estimates that future aggregate amortization expense related to intangible assets as of March 31, 2011 will be as follows for the periods presented (in thousands):

 

Year Ending December 31,

      

2011 (remaining nine months)

   $ 42,990   

2012

     47,830   

2013

     38,106   

2014

     30,639   

2015

     23,361   

Thereafter

     80,068   
        

Total

   $ 262,994   
        

 

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5. LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS

Long-term debt and capital lease obligations as of March 31, 2011 and December 31, 2010 consisted of the following:

 

     March 31,
2011
    December 31,
2010
 
     (in thousands)  

8 7/8% Senior Secured Notes due 2017

   $ 650,000      $ 650,000   

Unamortized discount on 8 7/8% Senior Secured Notes due 2017, net

     (8,110     (8,435

9 7/8% Senior Notes due 2018

     450,000        450,000   

Unamortized discount on 9 7/8% Senior Notes due 2018

     (14,343     (14,811

9.5% Senior Notes due 2015

     300,000        300,000   

Senior secured credit facilities

     25,000        25,000   

Capital lease obligations

     44,067        45,805   

Other

     523        530   
                

Total debt

     1,447,137        1,448,089   

Less: current portion

     (38,684     (10,733
                

Long-term debt and capital lease obligations

   $ 1,408,453      $ 1,437,356   
                

Senior Credit Facilities

As of March 31, 2011, the Company had $25.0 million principal amount of borrowings under its revolving credit facility. There are no scheduled principal payments under the revolving loans. Any outstanding revolving loans will be payable in full on the revolving loan maturity date of February 28, 2012.

Under the terms of the total leverage ratio covenant contained in the Company’s credit agreement for its senior credit facilities, the Company’s ratio of consolidated debt to consolidated adjusted EBITDA (as defined for purposes of the credit agreement) as of any measurement date will not be permitted to be greater than 5.00:1.00. The Company was in compliance with this financial covenant as of March 31, 2011.

Fair Value of Financial Instruments

The carrying value of the Company’s financial instruments, other than debt, does not materially differ from the estimated fair values as of March 31, 2011 and December 31, 2010. As of March 31, 2011, the $450.0 million principal amount of the Company’s 9 7/8% senior notes due 2018 had an estimated fair market value of approximately $473.6 million, the $650.0 million principal amount of the Company’s 8 7/8% senior secured notes due 2017 had an estimated fair market value of approximately $697.1 million, the $300.0 million principal amount of the Company’s 9.5% senior notes due 2015 had an estimated fair market value of approximately $314.3 million, and the $25.0 million principal amount of the Company’s senior secured credit facility had an estimated fair market value of approximately $25.0 million. As of December 31, 2010, the $450.0 million principal amount of the Company’s 9 7/8% senior notes due 2018 had an estimated fair market value of approximately $463.5 million, the $650.0 million principal amount of the Company’s 8 7/8% senior secured notes due 2017 had an estimated fair market value of approximately $695.5 million, the $300.0 million principal amount of the Company’s 9.5% senior notes due 2015 had an estimated fair market value of approximately $311.3 million, and the $25.0 million principal amount of the Company’s senior secured credit facility had an estimated fair market value of approximately $25.0 million. The estimated market values as of March 31, 2011 and December 31, 2010 are based on quarter-end closing market prices published by securities firms. While the Company believes these approximations to be reasonably accurate at the time published, quarter-end closing market prices can vary widely depending on the volume traded by any given securities firm and on other factors.

 

6. INCOME TAXES

The provision for income taxes for the three months ended March 31, 2011 was $0.7 million and represents current state taxes consisting primarily of taxes based on gross margin or modified gross receipts, and income taxes in jurisdictions where net operating losses are not available. The difference between the statutory rate and the effective tax rate for the three months ended March 31, 2011 was primarily attributable to the existence of a valuation allowance on PAETEC’s net deferred tax assets.

ASC 740, Income Taxes, requires the recognition of a financial statement benefit of a tax position only after a determination that the relevant tax authority would more likely than not sustain the position following an audit. For tax positions meeting the more-likely-than-not threshold, the amount recognized in the financial statements is the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement with the relevant tax authority. The amount of unrecognized tax benefits from uncertain tax positions as of March 31, 2011 was $0.5 million, net of federal benefit, the majority of which, if recognized, would affect the effective tax rate.

 

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The Company recognizes interest and penalties accrued on unrecognized tax benefits as a component of the provision for income taxes. As of March 31, 2011, the Company had less than $0.1 million of accrued interest related to unrecognized tax benefits.

The Company files U.S. federal income tax returns and income tax returns in various state jurisdictions. The Company’s U.S. federal tax years ended December 31, 2007 through December 31, 2010 and various state tax years remain subject to income tax examinations by tax authorities.

 

7. SHARE-BASED TRANSACTIONS

Employee Stock Purchase Plan

As of March 31, 2011, purchase rights for 2,201,525 shares had been granted under PAETEC Holding’s Employee Stock Purchase Plan (the “ESPP”) and 1,898,475 shares of common stock remained available for issuance.

During the three months ended March 31, 2011, PAETEC Holding issued 174,927 shares at a purchase price of approximately $3.01 per share, which represented 90% of the closing price of the common stock as reported on the NASDAQ Global Select Market on March 31, 2011. Compensation expense attributable to the ESPP for the three months ended March 31, 2011 totaled less than $0.1 million.

Stock Option Activity

The following table summarizes stock option activity for the three months ended March 31, 2011:

 

     Shares of
Common  Stock
Underlying
Options
    Weighted
Average
Exercise
Price
     Weighted
Average
Remaining
Contractual Life
(years)
     Aggregate
Intrinsic  Value
(in thousands)
 

Outstanding at January 1, 2011

     10,457,311      $ 4.35         

Granted

     567,378      $ 3.80         

Exercised

     (97,473   $ 2.34         

Canceled

     (519,973   $ 5.38         

Forfeited

     (77,327   $ 4.33         
                

Outstanding at March 31, 2011

     10,329,916      $ 4.29         5.1       $ 5,484   
                

Exercisable at March 31, 2011

     8,304,451      $ 4.38         4.2       $ 4,787   
                

The aggregate intrinsic value in the table above represents the total pretax intrinsic value (the difference between the closing sale price of PAETEC Holding’s common stock as reported on the NASDAQ Global Select Market on March 31, 2011 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders if all option holders had exercised their options on March 31, 2011. This amount changes based on the fair market value of PAETEC Holding’s common stock. The aggregate intrinsic value of options exercised during the three months ended March 31, 2011 was approximately $0.2 million.

For options granted during the three months ended March 31, 2011 and 2010, the weighted average fair values of the stock options granted, estimated on the dates of grant using the Black-Scholes option-pricing model, were $2.58 and $2.91, respectively, using the following assumptions:

 

     Three Months Ended March 31,
     2011    2010

Expected option life (in years)

   6.2    6.2

Risk free interest rate

   3.1% – 3.2%    2.7% – 3.0%

Expected volatility

   74.3%    75.5% – 75.6%

Expected dividend yield

     

Total compensation expense related to stock options granted was approximately $0.5 million and $0.7 million for the three months ended March 31, 2011 and 2010, respectively. These amounts are recorded as part of selling, general and administrative expenses in the accompanying condensed consolidated statements of operations.

 

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The following table summarizes stock option information as of March 31, 2011:

 

     Options Outstanding      Options Exercisable  

Range of Exercise Prices

   Number of
Options
     Weighted
Average
Exercise
Price
     Number of
Options
     Weighted
Average
Exercise
Price
 

$0.00 - $2.10

     2,507,714       $ 1.66         2,165,791       $ 1.71   

$2.11 - $3.15

     1,256,515       $ 2.33         1,226,375       $ 2.32   

$3.16 - $7.35

     4,707,204       $ 4.10         3,217,387       $ 4.16   

$7.36 - $13.46

     1,858,483       $ 9.63         1,694,898       $ 9.69   
                       
     10,329,916       $ 4.29         8,304,451       $ 4.38   
                       

As of March 31, 2011, there was approximately $4.1 million of total unrecognized stock-based compensation expense related to unvested stock options. The Company expects to recognize the expense over a weighted average period of approximately 1.9 years.

Stock Unit Activity

The following table summarizes stock unit activity for the three months ended March 31, 2011:

 

     Shares of
Common Stock
Underlying
Stock Units
    Weighted
Average
Grant Date
Fair Value
 

Outstanding at January 1, 2011

     3,987,767      $ 5.29   

Granted

     268,578      $ 3.81   

Vested

     (1,153,380   $ 6.61   

Canceled

     (686,350   $ 3.43   

Forfeited

     (100,691   $ 4.70   
          

Outstanding at March 31, 2011

     2,315,924      $ 4.95   
          

For stock units granted during the three months ended March 31, 2011 and 2010, the weighted average fair values of the stock units granted, determined by the closing sale price of PAETEC Holding’s common stock as reported on the NASDAQ Global Select Market on the dates of grant, were $3.81 and $3.68, respectively.

The aggregate intrinsic value of stock units that vested during the three months ended March 31, 2011 was approximately $4.4 million.

To satisfy income tax withholding requirements in connection with the vesting of stock units during the three months ended March 31, 2011, the Company withheld shares of PAETEC Holding common stock totaling 409,422 shares.

For the three months ended March 31, 2011 and 2010, total compensation expense related to stock units granted was approximately $1.8 million and $1.7 million, respectively. These amounts are recorded as part of selling, general and administrative expenses in the accompanying condensed consolidated statements of operations.

As of March 31, 2011, there was unrecognized stock-based compensation expense related to unvested stock unit awards of approximately $9.7 million. The Company expects to recognize the expense over a weighted-average period of approximately 1.2 years.

 

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Warrant Activity

The following table summarizes warrant activity for the three months ended March 31, 2011:

 

     Shares of
Common  Stock
Underlying
Warrants
    Weighted
Average
Exercise
Price
     Weighted
Average
Remaining
Contractual Life
(years)
     Aggregate
Intrinsic  Value
(in thousands)
 

Outstanding at January 1, 2011

     2,521,935      $ 2.41         

Exercised

     (20,000     2.89         

Forfeited

     (109,546     4.93         
                

Outstanding at March 31, 2011

     2,392,389      $ 2.29         3.4       $ 2,541   
                

Exercisable at March 31, 2011

     1,952,389      $ 2.16         2.3       $ 2,343   
                

The aggregate intrinsic value in the table above represents the total pretax intrinsic value (the difference between the closing sale price of PAETEC Holding’s common stock as reported on the NASDAQ Global Select Market on March 31, 2011 and the warrant exercise price, multiplied by the number of in-the-money warrants) that would have been received by the warrant holders if all warrant holders had exercised their warrants on March 31, 2011. This amount changes based on the fair market value of PAETEC Holding’s common stock. The aggregate intrinsic value of warrants exercised during the three months ended March 31, 2011 was less than $0.1 million.

For the three months ended March 31, 2011, total stock-based compensation expense related to warrants was less than $0.1 million. No stock-based compensation expense related to warrants was recognized during the three months ended March 31, 2010. These amounts are recorded as part of selling, general and administrative expenses in the accompanying condensed consolidated statements of operations.

The following table summarizes information relating to outstanding warrants as of March 31, 2011:

 

     Warrants Outstanding      Warrants Exercisable  

Range of Exercise Prices

   Number of
Warrants
     Weighted
Average
Exercise
Price
     Number of
Warrants
     Weighted
Average
Exercise
Price
 

$0.00 - $2.06

     1,660,093       $ 1.97         1,660,093       $ 1.97   

$2.07 - $2.89

     599,214       $ 2.88         159,214       $ 2.87   

$2.90 - $4.01

     133,082       $ 3.60         133,082       $ 3.60   
                       
     2,392,389       $ 2.29         1,952,389       $ 2.16   
                       

 

8. LOSS PER COMMON SHARE

The computation of basic and diluted net loss per common share for the three months ended March 31, 2011 and 2010 was as follows:

 

     Three Months Ended March 31,  
     2011     2010  
     (in thousands, except share and per share data)  

Net loss

   $ (11,930   $ (9,538
                

Weighted average common shares outstanding – basic and diluted

     144,338,459        145,490,947   
                

Net loss per common share – basic and diluted

   $ (0.08   $ (0.07
                

 

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For the three months ended March 31, 2011 and 2010, the Company had outstanding options, warrants and restricted stock units for 15,038,229 and 19,042,769 shares, respectively, that were not included in the calculation of diluted net loss per common share because the effect would have been anti-dilutive.

 

9. COMMITMENTS AND CONTINGENCIES

Purchase Commitments

As of March 31, 2011, the Company had entered into agreements with vendors to purchase approximately $31.1 million of equipment and services, of which the Company expects $25.9 million to be delivered and payable in the year ending December 31, 2011, $2.6 million to be delivered and payable in the year ending December 31, 2012, and $2.6 million to be delivered and payable in the year ending December 31, 2013.

Data and Voice Services

The Company has various agreements with certain carriers for data and voice services. As of March 31, 2011, the Company’s minimum commitments under these agreements totaled $138.5 million, of which $110.8 million expires in the year ending December 31, 2011, $12.5 million expires in the year ending December 31, 2012, $12.5 million expires in the year ending December 31, 2013, and the remaining $2.7 million expires in the year ending December 31, 2014. Related expenses, when incurred, are included in cost of sales in the accompanying condensed consolidated statements of operations.

Regulation

The Company’s services are subject to varying degrees of federal, state and local regulation. These regulations are subject to ongoing proceedings at federal and state administrative agencies or within state and federal judicial systems. Results of these proceedings could change, in varying degrees, the manner in which the Company operates. The Company cannot predict the outcome of these proceedings or their effect on the Company’s industry generally or on the Company specifically.

Interconnection and Network Access Agreements

The Company is dependent on the use of incumbent local exchange carriers’ local and transport networks and access services to provide telecommunications services to its customers. Charges for leasing local and transport network components and purchasing special access services historically have made up a significant percentage of the Company’s overall cost of providing the services. These network components and services are purchased in each PAETEC market through interconnection agreements, special access contracts, commercial agreements or a combination of such agreements from the incumbent local exchange carrier, or, where available, from other wholesale network service providers. These costs are recognized in the period in which the services are delivered and are included as a component of the Company’s cost of sales in the accompanying condensed consolidated statements of operations.

Letters of Credit

The Company is party to letters of credit totaling $8.0 million as of March 31, 2011. The Company does not expect any material losses from these financial instruments since performance under these letters of credit is not likely to be required.

Litigation

The Company is party to various legal proceedings, most of which relate to routine matters incidental to the Company’s business. The result of any current or future litigation or other legal proceedings is inherently unpredictable. The Company’s management, however, believes that there is no litigation or other legal proceedings asserted or pending against the Company that could have, individually or in the aggregate, a material adverse effect on its financial position, results of operations or cash flows except as indicated below.

In October 2008, PaeTec Communications, Inc. filed a claim in the Supreme Court for the State of New York, County of Monroe, against Lucent Technologies, Inc., Alcatel USA Marketing, Inc. and Alcatel-Lucent (collectively “Alcatel-Lucent”) for reimbursement of costs and fees in connection with a patent infringement case brought against the Company by Sprint Communications Company L.P. (“Sprint”) and settled in May 2009. The Company’s claim against Alcatel-Lucent alleges that because the Sprint claims arose from the use by the Company of Alcatel-Lucent equipment, Alcatel-Lucent has an obligation to defend and indemnify the Company pursuant to the contract terms under which it sold the equipment to the Company. Alcatel-Lucent has denied the claim and counter-claimed against the Company for allegedly unpaid switch software licensing charges, and associated late fees. The Company believes that it has meritorious defenses against these counter-claims. At this time, the Company is unable to estimate a potential loss or range of loss, if any.

 

10. FAIR VALUE MEASUREMENTS

The provisions of ASC 820, Fair Value Measurements and Disclosures, establishes a framework for measuring the fair value of financial assets and financial liabilities by establishing a hierarchy that categorizes and prioritizes the sources to be used to estimate fair value as follows:

Level 1 —defined as observable inputs such as quoted prices in active markets;

Level 2 —inputs include quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (interest rates, yield curves, etc.), and inputs that are derived principally from or corroborated by observable market data by correlation or other means (market corroborated inputs); and

 

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Level 3 —unobservable inputs that reflect the Company’s determination of assumptions that market participants would use in pricing the asset or liability. These inputs are developed based on the best information available, including the Company’s own data.

The following table summarizes the valuation of the Company’s financial instruments by the foregoing fair value hierarchy levels as of March 31, 2011 and December 31, 2010, respectively (in thousands):

 

MM(Level03)MM MM(Level03)MM MM(Level03)MM
     Fair Value Measurements as of March 31, 2011 Using:  
             (Level 1)                       (Level 2)                       (Level 3)           

Assets

        

Cash and cash equivalents

   $ 9,394         —           —     

Other assets, net

   $ 2,909         —           —     
     Fair Value Measurements as of December 31, 2010 Using:  
     (Level 1)      (Level 2)      (Level 3)  

Assets

        

Cash and cash equivalents

   $ 11,186         —           —     

Other assets, net

   $ 2,859         —           —     

At March 31, 2011, the fair value of cash and cash equivalents presented in the table above was primarily composed of the Company’s investments in publicly traded money market instruments. The Company’s cash and cash equivalent balances excluded from the table above are composed of cash, certificates of deposits with original maturities of one month or less and overnight investments. The fair value of the Company’s other assets, net consists of restricted investments in registered money market instruments.

 

11. RECENT ACCOUNTING PRONOUNCEMENTS

In October 2009, the FASB issued Accounting Standard Update, or “ASU,” 2009-13, Revenue Recognition (Topic 605). This ASU provides amendments to the criteria in ASC 605-25 for separating consideration in multiple-deliverable revenue arrangements. It establishes a hierarchy of selling prices to determine the selling price of each specific deliverable, which includes vendor-specific objective evidence (if available), third-party evidence (if vendor-specific evidence is not available), or estimated selling price if neither of the first two is available. This ASU also eliminates the residual method for allocating revenue between the elements of an arrangement and requires that arrangement consideration be allocated at the inception of the arrangement. Finally, this ASU expands the disclosure requirements regarding a vendor’s multiple-deliverable revenue arrangements. The adoption of this accounting standard on January 1, 2011 did not have a material impact on the Company’s financial statements.

In October 2009, the FASB issued ASU 2009-14, Certain Revenue Arrangements that include Software Elements. This ASU amends accounting and reporting guidance under ASC 605-985 to exclude from its scope all tangible products containing both software and non-software components that function together to deliver the product’s essential functionality. The adoption of this accounting standard on January 1, 2011 did not have a material impact on the Company’s financial statements.

 

12. SUBSEQUENT EVENTS

In accordance with the provisions of ASC 855, Subsequent Events, the Company has evaluated all subsequent events to ensure that this Quarterly Report on Form 10-Q includes appropriate disclosure of events both recognized in the financial statements as of March 31, 2011, and events which occurred subsequent to March 31, 2011 but were not recognized in the financial statements. No subsequent events which required recognition or disclosure were identified.

 

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

Except for statements that present historical facts, this management’s discussion and analysis contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. In some cases, you can identify these statements by such forward-looking words as “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “potential,” “should,” “will” and “would,” or similar expressions. These statements involve known and unknown risks, uncertainties and other factors that may cause our actual operating results, financial position, levels of activity or performance to be materially different from those expressed or implied by such forward-looking statements. Some of these risks, uncertainties and factors are discussed under the caption “Item 1A. Risk Factors” in our Annual Report on Form 10-K for our 2010 fiscal year and in our subsequently filed SEC reports.

You should read the following management’s discussion and analysis in conjunction with our Annual Report on Form 10-K for our 2010 fiscal year and together with the condensed consolidated financial statements and related notes and the other financial information that appear elsewhere in this report.

Unless the context indicates otherwise, references in this management’s discussion and analysis to “we,” “us,” “our,” and “PAETEC” mean PAETEC Holding Corp. and its subsidiaries and “PAETEC Holding” means PAETEC Holding Corp.

Overview

PAETEC is a competitive broadband communications services and solutions provider guided by the principle that delivering superior customer service is the key to competing successfully with other communications services providers. PAETEC’s primary business is providing business end-user customers in metropolitan areas with a package of integrated broadband services that encompasses data services, including Internet access services and virtual private network services, and voice services, including local telephone services and domestic and international long distance services. As of March 31, 2011, PAETEC provided services for over 54,000 business customers in a service area encompassing 86 of the top 100 metropolitan statistical areas.

Business Acquisition. On February 8, 2011, PAETEC Holding entered into a merger agreement by and among PAETEC Holding, XETA Technologies, Inc., which we refer to as “XETA,” and an indirect, wholly-owned subsidiary of PAETEC Holding, pursuant to which XETA will become a wholly-owned subsidiary of PAETEC Holding at the effective time of the merger. Under the merger agreement, XETA’s security holders have the right to receive total merger consideration of approximately $61 million. The merger agreement has been approved unanimously by the board of directors of each of PAETEC Holding and XETA. The consummation of the merger is subject to customary conditions, including approval by the holders of a majority of the outstanding shares of XETA’s common stock entitled to vote on the merger and receipt of any required regulatory approvals.

Revenue. PAETEC derives revenue from sales of its network services, carrier services and integrated solutions services. PAETEC derives most of its revenue from monthly recurring fees and usage-based fees that are generated principally by sales of its network services.

Monthly recurring fees include the fees paid by PAETEC’s customers for lines in service and additional features on those lines. PAETEC primarily bills monthly recurring fees in advance.

Usage-based fees consist of fees paid by PAETEC’s network services customers for each call made, fees paid by the incumbent carriers in PAETEC’s markets as “reciprocal compensation” when PAETEC terminates local calls made by their customers, and access fees paid by other carriers for long distance calls PAETEC originates or terminates for those carriers.

The monthly recurring fees and usage-based fees generated by sales of PAETEC’s network services to end users and carrier services to any customer tend to be relatively consistent from month to month, subject to changes in the calling patterns of the customer’s business.

Network Services. PAETEC delivers integrated communications services, including data and Internet services, local services and long distance services, to end users on a retail basis, which the company refers to as its “network services.”

PAETEC’s network services revenue consists primarily of monthly recurring fees and usage-based fees. In addition to usage-based fees invoiced directly to the end-user customers, usage-based fees for PAETEC’s network services include the interstate and intrastate access fees the company receives from other communications providers when it originates or terminates long-distance calls for those other providers to or from PAETEC’s network services customers, and the reciprocal compensation fees PAETEC receives from some other local carriers when it terminates non-toll calls originated by customers of other carriers. PAETEC recognizes revenue during the period in which the revenue is earned. PAETEC’s network services also generate non-recurring service activation and installation fee revenues, which it receives upon initiation of service. PAETEC defers recognition of these revenues and amortizes them over the average customer life.

 

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PAETEC’s core network services are those that generate revenue from retail enterprise customers to which PAETEC delivers such integrated communications services on primarily T1 or larger access lines, which excludes access fee and reciprocal compensation fee revenue related to network services and revenue from the company’s non-core POTS operations. POTS operations involve the provision of basic telephone services supplying standard single line telephones, telephone lines and access to the public switched network.

Carrier Services. PAETEC generates revenue from wholesale sales of communications services to other communications businesses, which the company refers to as its “carrier services.”

PAETEC’s carrier services revenue consists primarily of monthly recurring fees and usage-based fees. Usage-based fees for PAETEC’s carrier services consist primarily of the interstate and intrastate access fees the company receives from other communications providers when it originates or terminates long distance calls for those other providers to or from PAETEC’s carrier services customers, and the reciprocal compensation fees PAETEC receives from some other local carriers when it terminates to its carrier services customers local calls made by customers of other local carriers.

PAETEC’s core carrier services are those that generate revenue from other communications providers, which excludes access fee and reciprocal compensation fee revenue related to carrier services and revenue from the company’s non-core POTS operations.

Integrated Solutions. PAETEC derives revenue from sales to retail end-user customers of telecommunications equipment and software and related services and energy supply services, which the company refers to collectively as its “integrated solutions.”

A portion of PAETEC’s integrated solutions revenue consists of fees its customers pay for equipment and for PAETEC’s system design and installation services. PAETEC recognizes revenue for equipment sales and system design and installation services upon delivery and acceptance of the underlying installed equipment.

PAETEC derives an additional component of its integrated solutions revenue by selling and supporting its proprietary telecommunications software. PAETEC recognizes revenue related to software sales upon delivery of the software. Support fees include fees for maintenance of PAETEC’s telecommunications software and fees for training the end user in the proper use of that software. PAETEC recognizes maintenance fees on a pro rata basis over the length of the underlying maintenance contract and training fees after it fulfills the training obligation.

Energy supply services revenue consists primarily of usage-based fees its customers pay for unregulated electricity. Revenues are subject to variability based upon market factors. PAETEC recognizes revenue related to energy sales when the service is provided.

Cost of Sales. PAETEC provides its network services and carrier services by using electronic network components that it owns and telephone and data transmission lines that it leases from other telecommunications carriers. PAETEC’s cost of sales for these services consists primarily of leased transport charges and usage costs for local and long distance calls. PAETEC’s leased transport charges are the payments it makes to lease the telephone and data transmission lines, which the company uses to connect its customers to its network and to connect its network to the networks of other carriers. Usage costs for local and long distance are the costs that PAETEC incurs for calls made by its customers. Cost of sales for PAETEC’s integrated solutions includes the costs it incurs in designing systems and purchasing and installing equipment and the costs incurred in procuring electricity from the market operators on a wholesale basis.

Selling, General and Administrative Expenses. PAETEC’s selling, general and administrative expenses include selling and marketing, customer service, billing, corporate administration, engineering personnel and other personnel costs.

Depreciation and Amortization. Depreciation and amortization include depreciation of PAETEC’s telecommunications network and equipment, computer hardware and purchased software, office equipment, furniture and fixtures, and buildings, as well as amortization of intangible assets.

Acquisition, Integration and Separation Costs. Acquisition, integration and separation costs include external costs directly related to PAETEC’s acquisition activities, such as advisory, legal, accounting, valuation and other professional fees. In addition, such costs include employee severance and benefit costs associated with PAETEC’s acquisition activities.

Debt Extinguishment and Related Costs. PAETEC’s debt extinguishment and related costs include expenses related to the repayment of outstanding term loans under PAETEC’s senior secured credit facilities and costs incurred related to PAETEC’s former interest rate swap agreement.

Interest Expense. Interest expense includes interest due on PAETEC’s long-term debt and capital leases, amortization of debt issuance costs, debt premiums, and debt discounts.

Other Income, Net. Other income, net includes investment income and other financing income.

 

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Accounting for Income Taxes. PAETEC recognizes deferred income tax assets and liabilities for the expected future tax consequences of transactions and events. Under this method, PAETEC determines deferred income tax assets and liabilities based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which it expects the differences to reverse. If necessary, PAETEC reduces deferred income tax assets by a valuation allowance to an amount that it determines is more likely than not to be recoverable.

Stock-Based Compensation

PAETEC’s employees participate in a variety of equity incentive plans. Stock-based compensation expense for all stock-based compensation awards is based on the grant date fair value estimated in accordance with the Financial Accounting Standards Board, or “FASB,” Accounting Standards Codification, or “ASC,” Topic 718, CompensationStock Compensation. PAETEC recognizes these compensation costs, net of an estimated forfeiture rate, ratably over the requisite service period of the award.

Results of Operations

The following table presents selected operating data for the three months ended March 31, 2011 and 2010. The comparison of PAETEC’s operating results for the three months ended March 31, 2011, which we refer to as our “2011 quarter,” to PAETEC’s operating results for the three months ended March 31, 2010, which we refer to as our “2010 quarter,” is materially affected by PAETEC’s acquisition by merger of Cavalier Telephone Corporation, or “Cavalier,” on December 6, 2010. Cavalier’s operating results are included in PAETEC’s operating results beginning on December 6, 2010. Because of the significance of this transaction, PAETEC’s operating results for the 2011 quarter and the 2010 quarter are not directly comparable. PAETEC’s operating results for the 2011 and 2010 quarters were as follows (dollars in thousands):

 

     Three Months Ended
March 31, 2011 (1)
    Three Months Ended
March 31, 2010
 
     $     % of
Revenue
    $     % of
Revenue
 

Revenue:

        

Network services revenue

   $ 377,032        76   $ 310,474        80

Carrier services revenue

     82,212        17     63,043        16

Integrated solutions revenue

     36,269        7     16,534        4
                    

Total revenue

     495,513        100     390,051        100

Cost of sales (2)

     233,912        47     192,749        49

Selling, general and administrative expenses (3)

     172,692        35     134,260        34

Acquisition, integration and separation costs

     2,493        *        —          *   

Depreciation and amortization

     63,313        13     47,173        12
                    

Income from operations

     23,103        5     15,869        4

Debt extinguishment and related costs

     —          *        4,423        1

Other income, net

     (81     *        (112     *   

Interest expense

     34,464        7     22,037        6
                    

Loss before income taxes

     (11,280     (2 )%      (10,479     (3 )% 

Provision for (benefit from) income taxes

     650        *        (941     *   
                    

Net loss

   $ (11,930     (2 )%    $ (9,538     (2 )% 
                    

Adjusted EBITDA (4)

   $ 91,355        $ 65,543     
                    

 

* Less than one percent
(1) Includes the results of Cavalier as of the Cavalier merger closing date of December 6, 2010.
(2) Exclusive of operating items shown separately below.
(3) Exclusive of operating items shown separately below and inclusive of stock-based compensation.

 

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(4) Adjusted EBITDA, as defined by PAETEC for the periods presented, represents net loss before depreciation and amortization, interest expense, provision for (benefit from) income taxes, stock-based compensation, acquisition, integration and separation costs, and debt extinguishment and related costs. Adjusted EBITDA is not a financial measurement prepared in accordance with accounting principles generally accepted in the United States of America, or “GAAP.” See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Overview—Adjusted EBITDA Presentation” in PAETEC’s Annual Report on Form 10-K for PAETEC’s 2010 fiscal year for PAETEC’s reasons for including adjusted EBITDA data in this report and for material limitations with respect to the usefulness of this measurement. The following table sets forth, for the periods indicated, a reconciliation of adjusted EBITDA to net loss, as net loss is calculated in accordance with GAAP (in thousands):

 

     Three Months Ended
March 31, 2011
    Three Months Ended
March 31, 2010
 

Net loss

   $ (11,930   $ (9,538

Add back non-EBITDA items included in net loss:

    

Depreciation and amortization

     63,313        47,173   

Interest expense, net of interest income

     34,413        21,964   

Provision for (benefit from) income taxes

     650        (941
                

EBITDA

     86,446        58,658   

Stock-based compensation

     2,416        2,462   

Acquisition, integration and separation costs

     2,493        —     

Debt extinguishment and related costs

     —          4,423   
                

Adjusted EBITDA

   $ 91,355      $ 65,543   
                

Three Months Ended March 31, 2011 Compared With Three Months Ended March 31, 2010

Revenue. Total revenue increased $105.5 million, or 27.0%, to $495.5 million for the 2011 quarter from $390.1 million for the 2010 quarter primarily from the inclusion of operating results from Cavalier and other recently acquired businesses for the full 2011 quarter. Of total revenue for the 2011 quarter, revenue from network services, carrier services and integrated solutions accounted for 76.1%, 16.6% and 7.3%, respectively, compared to 79.6%, 16.2% and 4.2%, respectively, for the 2010 quarter.

Revenue from network services increased $66.6 million, or 21.4%, to $377.0 million for the 2011 quarter from $310.5 million for the 2010 quarter. Of total network services revenue for the 2011 quarter, revenue from core network services, access fee and reciprocal compensation revenue related to network services, and non-core POTS revenue related to network services accounted for 89.3%, 4.0% and 6.7%, respectively, compared to 91.2%, 5.7% and 3.1%, respectively, for the 2010 quarter.

Revenue from core network services increased $53.7 million, or 19.0%, to $336.8 million for the 2011 quarter from $283.1 million for the 2010 quarter. For the 2011 quarter, revenue from monthly recurring fees and usage-based fees accounted for 80.2% and 19.9%, respectively, of revenue from core network services, compared to 77.6% and 21.8%, respectively, of such revenue for the 2010 quarter. The increase in core network services revenue primarily resulted from the inclusion of Cavalier’s operating results for the full 2011 quarter.

Access fee revenue and reciprocal compensation included in network services revenue decreased $2.9 million, or 16.2%, to $14.9 million for the 2011 quarter from $17.8 million for the 2010 quarter. Of total access fee revenue and reciprocal compensation included in network services for the 2011 quarter, revenue from access fees accounted for 92.1% compared to 91.8% for the 2010 quarter.

Non-core POTS revenue included in network services revenue increased $15.8 million, or 165%, to $25.3 million for the 2011 quarter from $9.5 million for the 2010 quarter. The increase in non-core POTS revenue primarily resulted from the inclusion of Cavalier’s operating results for the full 2011 quarter, the effect of which was partially offset by customer attrition during the quarter.

Revenue from carrier services increased $19.2 million, or 30.4%, to $82.2 million for the 2011 quarter from $63.0 million for the 2010 quarter. Of total carrier services revenue for the 2011 quarter, revenue from core carrier services, access fee and reciprocal compensation revenue related to carrier services, and non-core POTS revenue related to carrier services accounted for 72.0%, 24.5% and 3.5%, respectively, compared to 70.8%, 23.4% and 5.8%, respectively, for the 2010 quarter.

Revenue from core carrier services increased $14.6 million, or 32.6%, to $59.2 million for the 2011 quarter from $44.7 million for the 2010 quarter. The increase in core carrier services revenue primarily resulted from the inclusion of Cavalier’s operating results for the full 2011 quarter. For the 2011 quarter, revenue from monthly recurring fees and usage-based fees accounted for 67.6% and 20.0%, respectively, of revenue from core carrier services, compared to 59.9% and 27.1%, respectively, of such revenue for the 2010 quarter.

Access fee revenue and reciprocal compensation included in carrier services revenue increased $5.4 million, or 36.4%, to $20.1 million for the 2011 quarter from $14.7 million for the 2010 quarter. Of total access fee revenue and reciprocal compensation included in carrier services revenue for the 2011 quarter, revenue from access fees accounted for 88.8% compared to 83.0% for the 2010 quarter.

Non-core POTS revenue included in carrier services revenue decreased $0.8 million, or 21.3%, to $2.9 million for the 2011 quarter from $3.6 million for the 2010 quarter. The decrease in non-core POTS revenue primarily resulted from customer attrition.

 

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Revenue from integrated solutions services increased $19.8 million, or 119.4%, to $36.3 million for the 2011 quarter from $16.5 million for the 2010 quarter. The increase in integrated solution services revenue primarily resulted from growth in both equipment sales and energy supply services due to the inclusion of operating results from U.S. Energy Partners LLC and Quagga Corporation for the full 2011 quarter.

Cost of Sales. Cost of sales increased to $233.9 million for the 2011 quarter from $192.7 million for the 2010 quarter, in part because of increased costs associated with the acquisition of Cavalier, increased costs associated with equipment sales due to the June 2010 acquisition of Quagga Corporation, and costs incurred to procure electricity from market operators on a wholesale basis.

Leased transport charges increased to $177.2 million, or 75.8% of cost of sales, for the 2011 quarter from $153.0 million, or 79.3% of cost of sales, for the 2010 quarter.

Usage costs for local and long distance calls increased to $33.4 million, or 14.3% of cost of sales, for the 2011 quarter from $29.5 million, or 15.3% of cost of sales, for the 2010 quarter.

Cost of sales as a percentage of total revenue decreased to 47.2% for the 2011 quarter from 49.4% for the 2010 quarter. The improvement was driven by a broad array of operational enhancements, including the contribution of higher margin Cavalier revenues, improved local network cost resulting from earlier initiatives to transition special access circuits to unbundled network elements, and an increase in integrated equipment and network sales driven by our IP Simple Product, which leverages PAETEC’s proprietary Allworx platform.

Selling, General and Administrative Expenses. Selling, general and administrative expenses increased to $172.7 million for the 2011 quarter from $134.3 million for the 2010 quarter primarily due to costs associated with higher staffing levels in PAETEC’s sales force and additional growth in headcount from acquisitions completed during 2010. Selling, general and administrative expenses as a percentage of total revenue increased to 34.9% for the 2011 quarter from 34.4 % for the 2010 quarter.

Acquisition, Integration and Separation Costs. During the 2011 quarter, PAETEC recognized approximately $2.5 million of acquisition, integration and separation costs. These costs were primarily related to employee separations.

Depreciation and Amortization. Depreciation and amortization expense increased to $63.3 million for the 2011 quarter from $47.2 million for the 2010 quarter. The increase was primarily attributable to the inclusion of Cavalier’s operating results for the full 2011 quarter and PAETEC’s network deployment and maintenance activities.

Debt Extinguishment and Related Costs. During the 2010 quarter, PAETEC recognized a total of $4.4 million of debt extinguishment and related costs, which represented the elimination of $3.6 million of debt issuance costs and unamortized debt discount associated with the repayment of $240.2 million in aggregate principal amount of term loans and $30.0 million in aggregate principal amount of revolving loans outstanding under its senior secured credit facilities with the proceeds from the January 2010 issuance of $300.0 million aggregate principal amount of its 8 7/8% senior secured notes due 2017 and $0.8 million of costs related to the termination of its interest rate swap agreement.

Interest Expense. PAETEC’s average outstanding debt balances increased to $1,470.2 million for the 2011 quarter from $946.0 million for the 2010 quarter, as a result of the December 2010 issuance of $450.0 million aggregate principal amount of its 9 7/8% senior notes due 2018. Interest expense increased to $34.5 million for the 2011 quarter from $22.0 million for the 2010 quarter due primarily to an increase in the average outstanding debt balances and an increase in the average annual borrowing rate. The weighted average annual borrowing rate, including the amortization of the debt discount and the debt premium but excluding the amortization of deferred financing costs, for the 2011 quarter was 9.4%, compared to 9.1% for the 2010 quarter.

Income Taxes. The provision for income taxes for the 2011 quarter was $0.7 million. The difference between the statutory rate and the effective tax rate for the 2011 quarter was primarily attributable to the existence of a valuation allowance on PAETEC’s net deferred tax assets.

Liquidity and Capital Resources

PAETEC finances its operations and growth primarily with cash flow from operations, issuances of debt securities and other loans, operating leases and normal trade credit terms.

 

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Sources and Uses of Cash. PAETEC’s cash flows for the three months ended March 31, 2011 and 2010, respectively, were as follows (in thousands):

 

     Three Months Ended March 31,  
     2011     2010  

Net cash provided by operating activities

   $ 60,685      $ 7,828   

Net cash used in investing activities

   $ (49,331   $ (34,997

Net cash (used in) provided by financing activities

   $ (3,034   $ 18,561   

The $52.9 million increase in cash flows from operating activities for the 2011 quarter over the 2010 quarter was primarily attributable to a $11.6 million increase in net loss adjusted for non-cash items and a $41.2 million increase in working capital.

PAETEC’s investing activities during the 2011 and 2010 quarters consisted primarily of activities related to the purchase of property and equipment. Investing activities during the 2010 quarter also included the acquisition of U.S. Energy Partners LLC.

Net cash used in financing activities of $3.0 million for the 2011 quarter was primarily related to repayments of long-term debt. Net cash provided by financing activities of $18.6 million for the 2010 quarter was primarily related to the January 2010 issuance and sale of $300.0 million in aggregate principal amount of PAETEC Holding’s 8 7/8% senior secured notes due 2017, partially offset by the payment of debt issuance costs incurred in connection with such sale. PAETEC applied a portion of the proceeds from the January 2010 sale of the 8 7/8% senior secured notes to repay $240.2 million in aggregate principal amount of term loans and $30.0 million in aggregate principal of revolving loans outstanding under its senior secured credit facilities.

Contractual Obligations. PAETEC has various contractual obligations and commercial commitments. PAETEC does not have off-balance sheet financing arrangements other than its letters of credit and operating leases. There were no material changes in PAETEC’s contractual obligations as set forth in PAETEC’s Annual Report on Form 10-K for its 2010 fiscal year.

Indebtedness. At March 31, 2011, PAETEC had approximately $1,447.1 million of total indebtedness, net of an unamortized discount of $22.5 million. The overall weighted average annual interest rate, including the amortization of the debt discount and debt premium but excluding deferred financing costs, was 9.4%. Of this total indebtedness, an aggregate principal amount of $300.0 million was outstanding under PAETEC Holding’s 9.5% senior notes due 2015, an aggregate principal amount of $650.0 million was outstanding under PAETEC Holding’s 8 7/8% senior secured notes due 2017, an aggregate principal amount of $450.0 million was outstanding under PAETEC Holding’s 9 7/8% senior notes due 2018, an aggregate principal amount of $25.0 million was outstanding under the company’s revolving credit facility, and an aggregate of $44.6 million consisted of capital leases and other indebtedness.

As of March 31, 2011, PAETEC’s senior secured credit facilities available pursuant to its credit agreement consisted of the following:

 

   

a term loan credit facility under which no term loans were outstanding and under which PAETEC could obtain incremental term loans, subject to conditions, in an aggregate principal amount of up to approximately $65.0 million under one or more incremental facilities; and

 

   

a revolving credit facility under which PAETEC could obtain from time to time revolving loans of up to an aggregate principal amount of $50.0 million outstanding at any time, of which $25.0 million principal amount of revolving loans were outstanding.

Under the terms of the total leverage ratio covenant contained in PAETEC’s credit agreement for its senior credit facilities, PAETEC’s ratio of consolidated debt to consolidated adjusted EBITDA (as defined for purposes of the credit agreement) as of any measurement date will not be permitted to be greater than 5.00:1.00. PAETEC was in compliance with this financial covenant as of March 31, 2011.

On April 12, 2011, PAETEC announced that it will seek $225 million principal amount of new senior secured credit facilities to replace its existing credit facilities. The new credit facilities will consist of a five-year senior secured revolving credit facility in an aggregate principal amount of $125 million and a seven-year senior secured term loan facility in an aggregate principal amount of $100 million. The proceeds from borrowings under the new credit facilities will be used for general corporate purposes, including repayment of the $25 million principal amount of borrowings outstanding under PAETEC’s existing senior secured revolving credit facility and to complete the recently announced acquisition of XETA Technologies, Inc., the closing of which is subject to customary closing conditions. PAETEC’s ability to obtain the new credit facilities on terms that are acceptable to it will be subject to market conditions and customary closing conditions.

 

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See Note 5 to PAETEC’s condensed consolidated financial statements appearing elsewhere in this report for additional information regarding the company’s indebtedness.

Capital and Cash Requirements. PAETEC expects that it will continue to require significant capital expenditures to maintain and enhance its network and services and to generate planned revenue growth. PAETEC made capital expenditures, principally for the purchase of communications equipment, of approximately $46.8 million in the 2011 quarter. PAETEC expects to fund all of its 2011 capital expenditures from cash on hand and cash flow from operations. PAETEC plans to make such capital expenditures primarily for the following purposes:

 

   

to continue to acquire and install equipment to enhance and maintain its network;

 

   

to increase penetration of its existing markets;

 

   

to expand its operations into additional geographic markets; and

 

   

to make infrastructure enhancements, principally for its back office systems.

The actual amount and timing of PAETEC’s capital requirements may differ materially from its estimates as a result of regulatory, technological and competitive developments in the company’s industry. As of March 31, 2011, PAETEC had entered into agreements with vendors to purchase approximately $169.6 million of equipment and services, of which the Company expects $136.7 million to be delivered and payable in the year ending December 31, 2011, $15.1 million to be delivered and payable in the year ending December 31, 2012, $15.1 million to be delivered and payable in the year ending December 31, 2013, and the remaining $2.7 million to be delivered and payable in the year ending December 31, 2014.

PAETEC may seek to purchase from time to time some of its outstanding senior notes and/or some of its outstanding senior secured notes for cash in open market transactions, privately negotiated transactions or otherwise. Such repurchases, if any, will depend on prevailing market conditions and the discount, if any, at which the notes may be purchased, PAETEC’s liquidity requirements, contractual restrictions and other factors. The amounts involved in any such purchases may be material.

PAETEC believes that cash on hand and cash flow from operations, and amounts expected to be available under its revolving credit facility will provide sufficient cash to enable the company to fund its planned capital expenditures, make scheduled principal and interest payments on its debt, meet its other cash requirements, and maintain compliance with the terms of its financing agreements for at least the next 12 months. After the foregoing period, PAETEC may require additional capital for network enhancements to provide increased capacity to meet expected increased demand for its services. The amount and timing of these additional network enhancements, if any, will depend on the anticipated demand for services, the availability of funds and other factors. The actual amount and timing of PAETEC’s future capital requirements may differ materially from the company’s estimates depending on the demand for its services and new market developments and opportunities, and on other factors, including those described in Part I, “Item 1A. Risk Factors” in its Annual Report on Form 10-K for its 2010 fiscal year. If PAETEC’s plans or assumptions change or prove to be inaccurate, the foregoing sources of funds may prove to be insufficient. In addition, if PAETEC seeks to acquire other businesses or to accelerate the expansion of its business, it may be required to seek material amounts of additional capital. Additional sources may include equity and debt financing and other financing arrangements, such as vendor financing. Further, if PAETEC believes it can obtain additional debt financing on advantageous terms, PAETEC may seek such financing at any time, to the extent that market conditions and other factors permit it to do so. The debt financing PAETEC may seek could be in the form of additional term loans under its existing or new senior secured credit facilities or additional debt securities having substantially the same terms as, or different terms from, PAETEC’s outstanding senior notes and senior secured notes. Any inability of PAETEC to generate the sufficient funds that it may require or to obtain such funds under reasonable terms could limit its ability to increase its revenue or to operate profitably. PAETEC’s ability to raise any required funds is subject to restrictions imposed by covenants contained in its existing debt agreements and could be negatively affected by a continuation of adverse conditions in the credit and capital markets.

Critical Accounting Policies

PAETEC’s condensed consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the rules and regulations of the Securities and Exchange Commission. Preparing consolidated financial statements requires PAETEC to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses. These estimates and assumptions are affected by the application of PAETEC’s accounting policies. PAETEC’s significant accounting policies are described in the note captioned “Summary of Significant Accounting Policies” in Note 2 to the consolidated financial statements included in PAETEC’s Form 10-K for its 2010 fiscal year, and a discussion of PAETEC’s critical accounting estimates is provided in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in that report.

Recent Accounting Pronouncements

In October 2009, the FASB issued Accounting Standard Update, or “ASU,” 2009-13, Revenue Recognition (Topic 605). This

ASU provides amendments to the criteria in ASC 605-25 for separating consideration in multiple-deliverable revenue arrangements.

It establishes a hierarchy of selling prices to determine the selling price of each specific deliverable, which includes vendor-specific objective evidence (if available), third-party evidence (if vendor-specific evidence is not available), or estimated selling price if neither of the first two is available. This ASU also eliminates the residual method for allocating revenue between the elements of an arrangement and requires that arrangement consideration be allocated at the inception of the arrangement. Finally, this ASU expands the disclosure requirements regarding a vendor’s multiple-deliverable revenue arrangements. The adoption of this accounting standard on January 1, 2011 did not have a material impact on PAETEC’s financial statements.

In October 2009, the FASB issued ASU 2009-14, Certain Revenue Arrangements that include Software Elements. This ASU amends accounting and reporting guidance under ASC 605-985 to exclude from its scope all tangible products containing both software and non-software components that function together to deliver the product’s essential functionality. The adoption of this accounting standard on January 1, 2011 did not have a material impact on PAETEC’s financial statements.

 

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Item 3. Quantitative and Qualitative Disclosures about Market Risk

PAETEC is exposed to market risks in the normal course of business. PAETEC manages the sensitivity of its results of operations to these risks by maintaining an investment portfolio consisting primarily of short-term, interest-bearing securities and by entering into long-term debt obligations with appropriate pricing and terms. PAETEC does not hold or issue derivative, derivative commodity or other financial instruments for trading purposes. PAETEC does not have any material foreign currency exposure. PAETEC’s major market risk exposure is to changing interest rates associated with borrowings the company uses to fund the expansion of its business and to support its acquisition activities. The interest rates that PAETEC is able to obtain on this debt financing depend on market conditions. PAETEC’s policy is to manage interest rates through a combination of fixed-rate debt and, from time to time, the use of interest rate swap contracts to manage the company’s exposure to fluctuations in interest rates on variable-rate debt. As of March 31, 2011, the $25.0 million aggregate principal amount outstanding under PAETEC’s revolving credit facility accrued interest at floating rates. A change of one percentage point in the interest rates applicable to the balance of PAETEC’s variable rate debt would result in a fluctuation of approximately $0.3 million in the company’s annual interest expense.

 

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Our management, with the participation of our Chairman, President and Chief Executive Officer, who is our principal executive officer, and our Executive Vice President and Chief Financial Officer, who is our principal financial officer, has evaluated the effectiveness of our disclosure controls and procedures, as defined in Rule 13a-15 under the Securities Exchange Act of 1934, as of March 31, 2011. Based upon that evaluation, our Chairman, President and Chief Executive Officer and our Executive Vice President and Chief Financial Officer have concluded that our disclosure controls and procedures were effective as of March 31, 2011.

Changes in Internal Control Over Financial Reporting

During the fiscal period covered by this report, there were no changes in our internal control over financial reporting that materially affected, or that are reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II

OTHER INFORMATION

 

Item 1. Legal Proceedings

PAETEC is a party or otherwise subject to various legal proceedings. A description of these proceedings is set forth in the company’s Annual Report on Form 10-K for the year ended December 31, 2010 under the caption “Legal Proceedings” in Part I and under the caption “Litigation” in Note 12 to the consolidated financial statements included in that report.

 

Item 1A. Risk Factors

In addition to the other information set forth in this report, the factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for our 2010 fiscal year could materially affect PAETEC’s business, financial condition or operating results. The risks described in our Annual Report on Form 10-K and in our subsequently filed SEC reports are not the only risks facing us. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition or operating results.

 

Item 6. Exhibits

The following exhibits are either filed with this Quarterly Report on Form 10-Q or are incorporated herein by reference. Our Securities Exchange Act file number is 000-52486.

 

Exhibit

Number

  

Description

    2.1    Agreement and Plan of Merger, dated February 8, 2011, among PAETEC Holding Corp. (“PAETEC Holding”), Hera Corporation and XETA Technologies, Inc. (including form of Voting Agreement). Filed as Exhibit 2.1 to the Current Report on Form 8-K of PAETEC Holding filed on February 10, 2011 and incorporated herein by reference.
*31.1    Certification of Chief Executive Officer of PAETEC Holding pursuant to Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934.
*31.2    Certification of Executive Vice President and Chief Financial Officer of PAETEC Holding pursuant to Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934.
*32    Certifications pursuant to Rule 13a-14(b) or Rule 15d-14(b) under the Securities Exchange Act of 1934 and 18 U.S.C. 1350.

 

* Filed herewith.

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

PAETEC Holding Corp.

(Registrant)

Dated: May 5, 2011   By:  

/S/    KEITH M. WILSON

    Keith M. Wilson
    Executive Vice President and Chief Financial Officer
    (Duly Authorized Officer and Principal Financial Officer)

 

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Exhibit Index

 

Exhibit

Number

  

Description

    2.1    Agreement and Plan of Merger, dated February 8, 2011, among PAETEC Holding Corp. (“PAETEC Holding”), Hera Corporation and XETA Technologies, Inc. (including form of Voting Agreement). Filed as Exhibit 2.1 to the Current Report on Form 8-K of PAETEC Holding filed on February 10, 2011 and incorporated herein by reference.
*31.1    Certification of Chief Executive Officer of PAETEC Holding pursuant to Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934.
*31.2    Certification of Executive Vice President and Chief Financial Officer of PAETEC Holding pursuant to Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934.
*32    Certifications pursuant to Rule 13a-14(b) or Rule 15d-14(b) under the Securities Exchange Act of 1934 and 18 U.S.C. 1350.

 

* Filed herewith.

 

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