INNOVATE Corp. annual report, FY2011

Business context and reporting period

Entity and period mismatch: The supplied filing is Primus Telecommunications Group, Incorporated’s Form 10-K for the fiscal year ended December 31, 2011, filed March 15, 2012—not an INNOVATE Corp. filing or a standalone 2011 fourth-quarter filing. It includes unaudited quarterly results for Q4 2011.

Primus provided communications services, including voice, broadband, data, VoIP and data-center services, primarily in Australia, Canada and the United States, alongside international wholesale carrier services. It completed its Arbinet merger in February 2011 and sold its Brazilian segment in Q4 2011. The company’s 2009 emergence from Chapter 11 and adoption of fresh-start accounting limit comparability with pre-July 2009 periods.

Financial performance and position

• Reported revenue rose 34.2%; excluding currency effects, it rose 27.0%. Arbinet contributed $204.3 million of FY 2011 revenue after acquisition.
• Cost of revenue increased to 70.3% of revenue from 63.2%, reducing gross margin to approximately 29.7% from 36.8%. Operating margin was approximately 1.3%, versus 1.6%.
• FY 2011 net loss included a $14.7 million Arbinet goodwill impairment, a $7.3 million debt-extinguishment/restructuring loss, a $2.7 million foreign-currency transaction loss, and a $4.8 million loss on sale of discontinued operations. A $13.1 million gain on Globility’s spectrum sale partly offset these items.
• Operating cash flow less capital expenditures was approximately $11.4 million, before other investing proceeds and uses. Investing cash outflow was $2.3 million; financing cash outflow was $38.8 million.
• Year-end current assets were $138.2 million and current liabilities $145.8 million, implying negative working capital of about $7.6 million and a current ratio near 0.95.
• Year-end debt principal was approximately $249.3 million; reported long-term obligations, including the current portion and discount, were $247.8 million. The debt included $235.2 million of 10% senior secured notes due 2017 and $2.4 million of 13% notes due 2016. Interest expense was $32.5 million.
• Q4 2011 unaudited revenue was $249.6 million, operating income $20.1 million, income from continuing operations $2.3 million, and net loss $3.1 million. Q4 included the $4.8 million Brazil-sale loss and the $13.1 million spectrum-sale gain.

Material changes versus the prior comparable period

• International Carrier Services revenue increased from $178.6 million to $411.4 million, mainly due to Arbinet. The segment reported an operating loss of $20.5 million, compared with operating income of $3.2 million in 2010.
• Australia revenue declined 7.8% excluding currency effects; Canada revenue increased 2.3% and U.S. revenue declined 12.9% on that basis. Data/Internet revenue increased to $185.9 million from $172.5 million; retail voice represented a smaller share of total revenue.
• Revenue growth did not translate into improved bottom-line results: the attributable net loss more than doubled, while operating income increased modestly. Cost of revenue as a share of sales rose materially.
• Primus exchanged most of its 13% and 14.25% notes for $240.2 million of 10% notes, extending maturity to 2017 and reducing the stated coupon versus the exchanged debt. It reported approximately $9 million in annual interest savings from the broader debt exchange/refinancing strategy. It repurchased $5.0 million principal of 10% notes in December.
• Brazil was sold for $4.3 million, with a $4.8 million recorded loss. Primus also held a 45.6% interest in Globility, which sold spectrum assets for CAD$15 million.

Outlook, commentary, risks and unusual items

• No specific numerical revenue, earnings or cash-flow guidance is provided. Management’s stated strategy was to grow broadband, SME VoIP, data and data-center services, manage traditional voice services for cash generation, and pursue operating efficiencies.
• In October 2011, Primus announced that a board special committee was evaluating strategic alternatives, potentially including a sale, merger, recapitalization, joint venture or asset disposition. There was no set timetable or assurance of a transaction.
• Management said existing cash was expected to meet debt service, fixed obligations and operating needs for at least the next 12 months. This outlook should be weighed against $41.1 million of unrestricted cash, substantial scheduled obligations, negative working capital and ongoing debt-service needs.
• Key risks include intense pricing competition and declining traditional voice usage; Arbinet integration and wholesale-trading volume, margin and credit risks; exposure to foreign exchange movements (about 82% of revenue came from outside the U.S., and Primus historically did not hedge); and substantial indebtedness and restrictive note covenants.
• Regulatory and contingency risks include U.S. VoIP emergency-calling compliance (about 99% of Lingo customers had required E911 service at year-end), potential VoIP taxes and fees, and changing intercarrier-compensation rules. The company disclosed $86.2 million of unrecognized tax benefits, though only $5.2 million would affect the effective tax rate if recognized.
• Management and the auditor concluded internal control over financial reporting was effective at year-end; Arbinet, representing 21% of consolidated revenue, was excluded from the control assessment because it was acquired during 2011. The prior-year income-tax control material weakness was reported as remediated. The auditor issued an unqualified opinion on the 2011 financial statements.

Important facts for investors to verify

• Confirm the filing is for Primus Telecommunications Group, not INNOVATE Corp., and distinguish annual results from the unaudited Q4 figures.
• Assess how much of the reported revenue increase and future performance depends on Arbinet, and whether its operating losses and integration costs improve.
• Reconcile cash generation with capital spending, debt payments, interest, leases and purchase commitments; review the assumptions behind management’s 12-month liquidity statement.
• Review the 10% notes’ collateral, covenants, maturity schedule and change-of-control provisions, particularly in light of the strategic-alternatives review.
• Evaluate the sustainability of operating margins given higher network costs, shrinking traditional services, and the low margins of international carrier services.
• Track Brazil disposition accounting, the Globility spectrum-sale proceeds and gain, and the potential impacts of foreign currency, tax exposures and VoIP regulatory compliance.