Switch, Inc. - Quarter Report: 2020 June (Form 10-Q)
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
| ☑ | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 | ||||
For the quarterly period ended June 30, 2020
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: 001-38231
Switch, Inc. | ||
| (Exact name of registrant as specified in its charter) | ||
Nevada | 82-1883953 | ||||||||||
(State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) | ||||||||||
7135 S. Decatur Boulevard | |||||||||||
Las Vegas, | NV | 89118 | |||||||||
(Address of principal executive offices) | (Zip Code) | ||||||||||
(702) 444-4111
(Registrant’s telephone number, including area code)
N/A
(Former name, former address and former fiscal year, if changed since last report)
Securities registered pursuant to Section 12(b) of the Act:
| Title of each class | Trading Symbol | Name of each exchange on which registered | ||||||
| Class A common stock, par value $0.001 | SWCH | New York Stock Exchange | ||||||
Securities registered pursuant to Section 12(g) of the Act: None
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 ☑ No ☐
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☑ No ☐
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer | ☑ | Accelerated filer | ☐ | ||||||||
| Non-accelerated filer | ☐ | Smaller reporting company | ☐ | ||||||||
| Emerging growth company | ☐ | ||||||||||
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☑
As of August 6, 2020, the registrant had 108,934,512 shares of Class A common stock, 131,667,035 shares of Class B common stock, and no shares of Class C common stock outstanding.
Switch, Inc.
Table of Contents
Part I. | Financial Information | |||||||
Item 1. | ||||||||
Item 2. | ||||||||
Item 3. | ||||||||
Item 4. | ||||||||
Part II. | Other Information | |||||||
Item 1. | ||||||||
Item 1A. | ||||||||
Item 6. | ||||||||
Part I.Financial Information
Item 1.Financial Statements (Unaudited).
Switch, Inc. | Q2 2020 Form 10-Q | 3
Switch, Inc.
Consolidated Balance Sheets
(in thousands, except per share data)
| June 30, | December 31, | ||||||||||
| 2020 | 2019 | ||||||||||
| (unaudited) | |||||||||||
| ASSETS | |||||||||||
| CURRENT ASSETS: | |||||||||||
| Cash and cash equivalents | $ | 31,730 | $ | 24,721 | |||||||
Accounts receivable, net of allowance for credit losses of $676 and $309, respectively | 16,573 | 23,365 | |||||||||
| Prepaid expenses | 4,082 | 7,137 | |||||||||
Other current assets, net of allowance for credit losses of $5 and $0, respectively | 3,190 | 3,817 | |||||||||
| Total current assets | 55,575 | 59,040 | |||||||||
| Property and equipment, net | 1,630,119 | 1,551,117 | |||||||||
| Long-term deposit | 3,217 | 3,429 | |||||||||
| Deferred income taxes | 174,269 | 114,372 | |||||||||
Other assets, net of allowance for credit losses of $77 and $0, respectively | 44,270 | 45,785 | |||||||||
| TOTAL ASSETS | $ | 1,907,450 | $ | 1,773,743 | |||||||
| LIABILITIES AND STOCKHOLDERS’ EQUITY | |||||||||||
| CURRENT LIABILITIES: | |||||||||||
| Long-term debt, current portion | $ | 6,000 | $ | 6,000 | |||||||
| Accounts payable | 18,696 | 19,477 | |||||||||
| Accrued salaries and benefits | 9,202 | 5,828 | |||||||||
| Accrued expenses | 9,951 | 11,254 | |||||||||
| Accrued construction payables | 21,621 | 37,269 | |||||||||
| Deferred revenue, current portion | 12,868 | 14,991 | |||||||||
| Customer deposits | 11,655 | 10,830 | |||||||||
| Interest rate swap liability, current portion | 9,225 | 3,464 | |||||||||
| Operating lease liability, current portion | 4,011 | 4,805 | |||||||||
| Finance lease liability, current portion | 4 | 12 | |||||||||
| Total current liabilities | 103,233 | 113,930 | |||||||||
| Long-term debt, net | 832,775 | 745,372 | |||||||||
| Operating lease liability | 24,355 | 26,142 | |||||||||
| Finance lease liability | 57,570 | 57,614 | |||||||||
| Deferred revenue | 23,576 | 27,852 | |||||||||
| Liabilities under tax receivable agreement | 234,085 | 162,076 | |||||||||
| Other long-term liabilities | 26,014 | 13,112 | |||||||||
| TOTAL LIABILITIES | 1,301,608 | 1,146,098 | |||||||||
| STOCKHOLDERS’ EQUITY: | |||||||||||
Preferred stock, $0.001 par value per share, 10,000 shares authorized, none issued and outstanding | — | — | |||||||||
Class A common stock, $0.001 par value per share, 750,000 shares authorized, 106,767 and 89,768 shares issued and outstanding, respectively | 107 | 90 | |||||||||
Class B common stock, $0.001 par value per share, 300,000 shares authorized, 133,796 and 151,047 shares issued and outstanding, respectively | 134 | 151 | |||||||||
Class C common stock, $0.001 par value per share, 75,000 shares authorized, none issued and outstanding | — | — | |||||||||
| Additional paid in capital | 238,471 | 204,711 | |||||||||
| Retained earnings | 98 | 2,420 | |||||||||
| Accumulated other comprehensive income | 79 | 79 | |||||||||
| Total Switch, Inc. stockholders’ equity | 238,889 | 207,451 | |||||||||
| Noncontrolling interest | 366,953 | 420,194 | |||||||||
| TOTAL STOCKHOLDERS’ EQUITY | 605,842 | 627,645 | |||||||||
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY | $ | 1,907,450 | $ | 1,773,743 | |||||||
The accompanying condensed notes are an integral part of these consolidated financial statements.
Switch, Inc. | Q2 2020 Form 10-Q | 4
Switch, Inc.
Consolidated Statements of Comprehensive Income
(in thousands, except per share data)
(unaudited)
| Three Months Ended June 30, | Six Months Ended June 30, | ||||||||||||||||||||||
| 2020 | 2019 | 2020 | 2019 | ||||||||||||||||||||
| Revenue | $ | 126,917 | $ | 111,970 | $ | 255,013 | $ | 219,412 | |||||||||||||||
| Cost of revenue | 68,198 | 58,117 | 135,227 | 115,642 | |||||||||||||||||||
| Gross profit | 58,719 | 53,853 | 119,786 | 103,770 | |||||||||||||||||||
| Selling, general and administrative expense | 33,438 | 32,919 | 73,554 | 67,170 | |||||||||||||||||||
| Income from operations | 25,281 | 20,934 | 46,232 | 36,600 | |||||||||||||||||||
| Other income (expense): | |||||||||||||||||||||||
Interest expense, including $409, $409, $818, and $818, respectively, in amortization of debt issuance costs | (6,693) | (7,541) | (14,128) | (14,672) | |||||||||||||||||||
| Loss on interest rate swaps | (4,143) | (8,781) | (21,698) | (13,766) | |||||||||||||||||||
| Other | 271 | 518 | 548 | 1,020 | |||||||||||||||||||
| Total other expense | (10,565) | (15,804) | (35,278) | (27,418) | |||||||||||||||||||
| Income before income taxes | 14,716 | 5,130 | 10,954 | 9,182 | |||||||||||||||||||
| Income tax expense | (1,380) | (458) | (1,107) | (664) | |||||||||||||||||||
| Net income | 13,336 | 4,672 | 9,847 | 8,518 | |||||||||||||||||||
| Less: net income attributable to noncontrolling interest | 8,239 | 3,483 | 5,966 | 6,596 | |||||||||||||||||||
| Net income attributable to Switch, Inc. | $ | 5,097 | $ | 1,189 | $ | 3,881 | $ | 1,922 | |||||||||||||||
| Basic | $ | 0.05 | $ | 0.02 | $ | 0.04 | $ | 0.03 | |||||||||||||||
| Diluted | $ | 0.05 | $ | 0.02 | $ | 0.03 | $ | 0.03 | |||||||||||||||
| Basic | 104,987 | 77,714 | 99,676 | 66,686 | |||||||||||||||||||
| Diluted | 243,916 | 79,021 | 243,622 | 247,227 | |||||||||||||||||||
| Other comprehensive income: | |||||||||||||||||||||||
Foreign currency translation adjustment, net of tax of $0 | — | — | — | — | |||||||||||||||||||
| Comprehensive income | 13,336 | 4,672 | 9,847 | 8,518 | |||||||||||||||||||
| Less: comprehensive income attributable to noncontrolling interest | 8,239 | 3,483 | 5,966 | 6,596 | |||||||||||||||||||
| Comprehensive income attributable to Switch, Inc. | $ | 5,097 | $ | 1,189 | $ | 3,881 | $ | 1,922 | |||||||||||||||
The accompanying condensed notes are an integral part of these consolidated financial statements.
Switch, Inc. | Q2 2020 Form 10-Q | 5
Switch, Inc.
Consolidated Statements of Stockholders’ Equity
(in thousands)
(unaudited)
| Switch, Inc. Stockholders’ Equity | |||||||||||||||||||||||||||||||||||||||||||||||||||||
| Class A Common Stock | Class B Common Stock | ||||||||||||||||||||||||||||||||||||||||||||||||||||
| Shares | Amount | Shares | Amount | Additional Paid in Capital | (Accumulated Deficit) Retained Earnings | Accumulated Other Comprehensive Income | Noncontrolling Interest | Total Stockholders’ Equity | |||||||||||||||||||||||||||||||||||||||||||||
| Balance—December 31, 2019 | 89,768 | $ | 90 | 151,047 | $ | 151 | $ | 204,711 | $ | 2,420 | $ | 79 | $ | 420,194 | $ | 627,645 | |||||||||||||||||||||||||||||||||||||
| Cumulative adjustment due to adoption of new credit loss standard | — | — | — | — | — | (67) | — | (82) | (149) | ||||||||||||||||||||||||||||||||||||||||||||
| Net loss | — | — | — | — | — | (1,216) | — | (2,273) | (3,489) | ||||||||||||||||||||||||||||||||||||||||||||
| Equity-based compensation expense | — | — | — | — | 4,973 | — | — | 2,551 | 7,524 | ||||||||||||||||||||||||||||||||||||||||||||
| Issuance of Class A common stock upon settlement of restricted stock units, net of shares withheld for tax | 630 | — | — | — | (3,375) | — | — | (536) | (3,911) | ||||||||||||||||||||||||||||||||||||||||||||
Dividends declared ($0.0294 per share) | — | — | — | — | — | (2,891) | — | — | (2,891) | ||||||||||||||||||||||||||||||||||||||||||||
| Distributions to noncontrolling interest | — | — | — | — | — | — | — | (4,304) | (4,304) | ||||||||||||||||||||||||||||||||||||||||||||
| Exchanges of noncontrolling interest for Class A common stock | 4,637 | 5 | (4,637) | (5) | 13,403 | — | — | (13,403) | — | ||||||||||||||||||||||||||||||||||||||||||||
| Recognition of tax receivable agreement liability resulting from exchanges of noncontrolling interest for Class A common stock | — | — | — | — | (19,198) | — | — | — | (19,198) | ||||||||||||||||||||||||||||||||||||||||||||
| Net deferred tax asset resulting from changes in outside basis difference on investment in Switch, Ltd. | — | — | — | — | 16,610 | — | — | — | 16,610 | ||||||||||||||||||||||||||||||||||||||||||||
| Balance—March 31, 2020 | 95,035 | 95 | 146,410 | 146 | 217,124 | (1,754) | 79 | 402,147 | 617,837 | ||||||||||||||||||||||||||||||||||||||||||||
| Net income | — | — | — | — | — | 5,097 | — | 8,239 | 13,336 | ||||||||||||||||||||||||||||||||||||||||||||
| Equity-based compensation expense | — | — | — | — | 5,416 | — | — | 2,094 | 7,510 | ||||||||||||||||||||||||||||||||||||||||||||
| Issuance of Class A common stock upon settlement of restricted stock units, net of shares withheld for tax | 16 | — | — | — | (330) | — | — | 209 | (121) | ||||||||||||||||||||||||||||||||||||||||||||
| Issuance of Class A common stock upon exercise of stock options | 169 | — | — | — | 596 | — | — | 2,280 | 2,876 | ||||||||||||||||||||||||||||||||||||||||||||
| Issuance of restricted stock awards | 59 | — | — | — | — | — | — | — | — | ||||||||||||||||||||||||||||||||||||||||||||
Dividends declared ($0.0294 per share) | — | — | — | — | — | (3,245) | — | — | (3,245) | ||||||||||||||||||||||||||||||||||||||||||||
| Distributions to noncontrolling interest | — | — | — | — | — | — | — | (3,934) | (3,934) | ||||||||||||||||||||||||||||||||||||||||||||
| Exchanges of noncontrolling interest for Class A common stock | 11,488 | 12 | (11,488) | (12) | 31,840 | — | — | (31,840) | — | ||||||||||||||||||||||||||||||||||||||||||||
| Repurchase of common units and cancellation of Class B common stock | — | — | (1,126) | — | (7,758) | — | — | (12,242) | (20,000) | ||||||||||||||||||||||||||||||||||||||||||||
| Recognition of tax receivable agreement liability resulting from exchanges of noncontrolling interest for Class A common stock | — | — | — | — | (52,811) | — | — | — | (52,811) | ||||||||||||||||||||||||||||||||||||||||||||
| Net deferred tax asset resulting from changes in outside basis difference on investment in Switch, Ltd. | — | — | — | — | 44,394 | — | — | — | 44,394 | ||||||||||||||||||||||||||||||||||||||||||||
| Balance—June 30, 2020 | 106,767 | $ | 107 | 133,796 | $ | 134 | $ | 238,471 | $ | 98 | $ | 79 | $ | 366,953 | $ | 605,842 | |||||||||||||||||||||||||||||||||||||
Switch, Inc. | Q2 2020 Form 10-Q | 6
Switch, Inc.
Consolidated Statements of Stockholders’ Equity (Continued)
(in thousands)
(unaudited)
| Switch, Inc. Stockholders’ Equity | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Class A Common Stock | Class B Common Stock | Class C Common Stock | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Shares | Amount | Shares | Amount | Shares | Amount | Additional Paid in Capital | (Accumulated Deficit) Retained Earnings | Accumulated Other Comprehensive Income | Noncontrolling Interest | Total Stockholders’ Equity | |||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Balance—December 31, 2018 | 55,218 | $ | 55 | 148,481 | $ | 149 | 42,945 | $ | 43 | $ | 140,191 | $ | 2,693 | $ | 79 | $ | 565,142 | $ | 708,352 | ||||||||||||||||||||||||||||||||||||||||||||||
| Cumulative adjustment due to adoption of new revenue recognition standard | — | — | — | — | — | — | — | 224 | — | 940 | 1,164 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Net income | — | — | — | — | — | — | — | 733 | — | 3,113 | 3,846 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Equity-based compensation expense | — | — | — | — | — | — | 4,160 | — | — | 3,985 | 8,145 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Issuance of Class A common stock upon settlement of restricted stock units, net of shares withheld for tax | 463 | 1 | — | — | — | — | (2,016) | — | — | 705 | (1,310) | ||||||||||||||||||||||||||||||||||||||||||||||||||||||
Dividends declared ($0.0294 per share) | — | — | — | — | — | — | — | (1,728) | — | — | (1,728) | ||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Distributions to noncontrolling interest | — | — | — | — | — | — | — | — | — | (6,006) | (6,006) | ||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Net deferred tax asset resulting from changes in outside basis difference on investment in Switch, Ltd. | — | — | — | — | — | — | (728) | — | — | — | (728) | ||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Balance—March 31, 2019 | 55,681 | 56 | 148,481 | 149 | 42,945 | 43 | 141,607 | 1,922 | 79 | 567,879 | 711,735 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Net income | — | — | — | — | — | — | — | 1,189 | — | 3,483 | 4,672 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Equity-based compensation expense | — | — | — | — | — | — | 3,800 | — | — | 3,643 | 7,443 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Issuance of Class A common stock upon settlement of restricted stock units, net of shares withheld for tax | 1 | — | — | — | — | — | (195) | — | — | 190 | (5) | ||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Issuance of restricted stock awards | 80 | — | — | — | — | — | — | — | — | — | — | ||||||||||||||||||||||||||||||||||||||||||||||||||||||
Dividends declared ($0.0294 per share) | — | — | — | — | — | — | — | (2,389) | — | — | (2,389) | ||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Distributions to noncontrolling interest | — | — | — | — | — | — | — | — | — | (4,934) | (4,934) | ||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Exchanges of noncontrolling interest for Class A common stock | 22,323 | 22 | (22,323) | (22) | — | — | 67,362 | — | — | (67,362) | — | ||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Repurchase of common units and cancellation of Class B common stock | — | — | (1,288) | (2) | — | — | (2,738) | — | — | (10,857) | (13,597) | ||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Recognition of tax receivable agreement liability resulting from exchanges of noncontrolling interest for Class A common stock | — | — | — | — | — | — | (59,476) | — | — | — | (59,476) | ||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Net deferred tax asset resulting from changes in outside basis difference on investment in Switch, Ltd. | — | — | — | — | — | — | 47,871 | — | — | — | 47,871 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Balance—June 30, 2019 | 78,085 | $ | 78 | 124,870 | $ | 125 | 42,945 | $ | 43 | $ | 198,231 | $ | 722 | $ | 79 | $ | 492,042 | $ | 691,320 | ||||||||||||||||||||||||||||||||||||||||||||||
The accompanying condensed notes are an integral part of these consolidated financial statements.
Switch, Inc. | Q2 2020 Form 10-Q | 7
Switch, Inc.
Consolidated Statements of Cash Flows
(in thousands)
(unaudited)
| Six Months Ended June 30, | |||||||||||
| 2020 | 2019 | ||||||||||
| CASH FLOWS FROM OPERATING ACTIVITIES: | |||||||||||
| Net income | $ | 9,847 | $ | 8,518 | |||||||
| Adjustments to reconcile net income to net cash provided by operating activities: | |||||||||||
| Depreciation and amortization of property and equipment | 68,531 | 58,415 | |||||||||
| Loss on disposal of property and equipment | 98 | 107 | |||||||||
| Deferred income taxes | 1,107 | 664 | |||||||||
| Amortization of debt issuance costs | 818 | 818 | |||||||||
| Credit loss expense (benefit) | 313 | (72) | |||||||||
| Unrealized loss on interest rate swaps | 18,896 | 13,765 | |||||||||
| Equity-based compensation | 15,034 | 15,588 | |||||||||
| Amortization of portfolio energy credits | 765 | 685 | |||||||||
| Cost of revenue for sales-type leases | 3,436 | — | |||||||||
| Changes in operating assets and liabilities: | |||||||||||
| Accounts receivable | 4,034 | 970 | |||||||||
| Prepaid expenses | 3,055 | 2,290 | |||||||||
| Other current assets | 622 | (127) | |||||||||
| Other assets | 1,159 | 1,348 | |||||||||
| Accounts payable | 64 | (493) | |||||||||
| Accrued salaries and benefits | 3,374 | 4,639 | |||||||||
| Accrued expenses | (1,303) | 452 | |||||||||
| Deferred revenue | (6,399) | 3,614 | |||||||||
| Customer deposits | 825 | 100 | |||||||||
| Operating lease liabilities | (2,581) | (2,407) | |||||||||
| Other long-term liabilities | (204) | 81 | |||||||||
| Net cash provided by operating activities | 121,491 | 108,955 | |||||||||
| CASH FLOWS FROM INVESTING ACTIVITIES: | |||||||||||
| Acquisition of property and equipment | (166,452) | (100,131) | |||||||||
| Proceeds from sale of property and equipment | 2 | 18 | |||||||||
| Purchase of portfolio energy credits | (901) | (544) | |||||||||
| Net cash used in investing activities | (167,351) | (100,657) | |||||||||
| CASH FLOWS FROM FINANCING ACTIVITIES: | |||||||||||
| Proceeds from borrowings | 90,000 | — | |||||||||
| Repayment of borrowings, including finance lease liabilities | (3,193) | (3,000) | |||||||||
| Change in long-term deposit | 1,618 | 2,537 | |||||||||
| Payment of tax withholdings upon settlement of restricted stock unit awards | (4,166) | (1,343) | |||||||||
| Proceeds from exercise of stock options | 2,876 | — | |||||||||
| Repurchase of common units | (20,000) | (13,597) | |||||||||
| Dividends paid to Class A common stockholders | (5,930) | (3,932) | |||||||||
| Distributions paid to noncontrolling interest | (8,336) | (10,354) | |||||||||
| Net cash provided by (used in) financing activities | 52,869 | (29,689) | |||||||||
| NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS | 7,009 | (21,391) | |||||||||
CASH AND CASH EQUIVALENTS—Beginning of period | 24,721 | 81,560 | |||||||||
CASH AND CASH EQUIVALENTS—End of period | $ | 31,730 | $ | 60,169 | |||||||
Switch, Inc. | Q2 2020 Form 10-Q | 8
Switch, Inc.
Consolidated Statements of Cash Flows (Continued)
(in thousands)
(unaudited)
| Six Months Ended June 30, | |||||||||||
| 2020 | 2019 | ||||||||||
| SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: | |||||||||||
| Cash paid for interest, net of amounts capitalized | $ | 13,432 | $ | 13,555 | |||||||
| SUPPLEMENTAL DISCLOSURES OF NON-CASH INVESTING AND FINANCING INFORMATION: | |||||||||||
| (Decrease) increase in liabilities incurred to acquire property and equipment | $ | (15,765) | $ | 2,679 | |||||||
| (Decrease) increase in accrued construction payables incurred related to long-term deposit | $ | (869) | $ | 746 | |||||||
| Increase in property and equipment related to transfer of long-term deposit | $ | 244 | $ | — | |||||||
| Increase in dividends payable on unvested restricted stock units | $ | 206 | $ | 185 | |||||||
| Decrease in noncontrolling interest as a result of exchanges for Class A common stock | $ | (45,243) | $ | (67,362) | |||||||
| Recognition of liabilities under tax receivable agreement | $ | 72,009 | $ | 59,476 | |||||||
| Increase in deferred tax asset resulting from changes in outside basis difference on investment in Switch, Ltd. | $ | 61,004 | $ | 47,143 | |||||||
| Property and equipment obtained in exchange for new finance leases | $ | 138 | $ | 37,923 | |||||||
| (Decrease) increase in distributions payable on unvested common units | $ | (98) | $ | 586 | |||||||
| Dividends payable settled with shares of Class A common stock | $ | 134 | $ | 28 | |||||||
The accompanying condensed notes are an integral part of these consolidated financial statements.
Switch, Inc. | Q2 2020 Form 10-Q | 9
Switch, Inc.
Condensed Notes to Consolidated Financial Statements
(unaudited)
Note 1 | ||||||||
Note 2 | ||||||||
Note 3 | ||||||||
Note 4 | ||||||||
Note 5 | ||||||||
Note 6 | ||||||||
Note 7 | ||||||||
Note 8 | ||||||||
Note 9 | ||||||||
Note 10 | ||||||||
Switch, Inc. | Q2 2020 Form 10-Q | 10
1. Organization
Switch, Inc. was formed as a Nevada corporation in June 2017 for the purpose of completing an initial public offering (“IPO”) and related organizational transactions in order to carry on the business of Switch, Ltd. and its subsidiaries (collectively, “Switch,” and together with Switch, Inc., the “Company”). Switch is comprised of limited liability companies that provide colocation space and related services to global enterprises, financial companies, government agencies, and others that conduct critical business on the internet. Switch develops and operates data centers in Nevada, which are Tier IV Gold certified, Michigan, and Georgia (which opened in the first quarter of 2020), delivering redundant services with low latency and super capacity transport environments. As the manager of Switch, Ltd., Switch, Inc. operates and controls all of the business and affairs of Switch.
2. Summary of Significant Accounting Policies
Basis of Presentation
The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the rules and regulations of the Securities and Exchange Commission (the “SEC”) for quarterly reports on Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain footnote disclosures normally included in annual financial statements prepared in accordance with GAAP have been condensed or omitted. These consolidated financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2019.
Management believes that the accompanying consolidated financial statements reflect all adjustments, which include only normal recurring adjustments, necessary for the fair statement of these consolidated financial statements. The consolidated results of operations for the three and six months ended June 30, 2020 are not necessarily indicative of the results to be expected for the year ending December 31, 2020, or for any other future annual or interim period.
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of the Company and all significant intercompany transactions and balances have been eliminated.
As the sole manager of Switch, Ltd., Switch, Inc. operates and controls all of the business and affairs of Switch, has the sole voting interest in, and controls the management of, Switch, and has the obligation to absorb the losses of, and receive benefits from, Switch. Accordingly, Switch, Inc. identifies itself as the primary beneficiary of Switch and began consolidating Switch in its consolidated financial statements as of October 11, 2017, the closing date of the IPO, resulting in a noncontrolling interest related to the common units of Switch, Ltd. (“Common Units”) held by members, including Rob Roy, the Founder, Chief Executive Officer and Chairman of Switch, Ltd., and an affiliated entity of Mr. Roy (collectively, the “Founder Members”), other than Switch, Inc. on its consolidated financial statements.
The Company periodically evaluates entities for consolidation either through ownership of a majority voting interest, or through means other than voting interest, in accordance with the Variable Interest Entity (“VIE”) accounting model. A VIE is an entity in which either (i) the equity investors as a group, if any, lack the power through voting or similar rights to direct the activities of such entity that most significantly impact such entity’s economic performance or (ii) the equity investment at risk is insufficient to finance that entity’s activities without additional subordinated financial support.
Use of Estimates
The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. On an ongoing basis, the Company evaluates its estimates, including, but not limited to, those related to the allowance for credit losses, useful lives of property and equipment, deferred income taxes, liabilities under the tax receivable agreement, equity-based compensation, deferred revenue, incremental borrowing rate, fair value of performance obligations, and probability assessments of exercising renewal options on leases. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable. Actual results could differ from these estimates.
Switch, Inc. | Q2 2020 Form 10-Q | 11
Significant Accounting Policies
A description of the Company’s significant accounting policies is included in the audited financial statements within its Annual Report on Form 10-K for the year ended December 31, 2019. No other changes to significant accounting policies have occurred since the year ended December 31, 2019, with the exception of those detailed below.
Concentration of Credit and Other Risks
Although the Company operates primarily in Nevada, realization of its receivables and its future operations and cash flows could be affected by adverse economic conditions, both regionally and elsewhere in the United States. During the three months ended June 30, 2020 and 2019, the Company’s largest customer and its affiliates comprised 13% and 12%, respectively, of the Company’s revenue. During the six months ended June 30, 2020 and 2019, the Company’s largest customer and its affiliates comprised 14% and 12%, respectively, of the Company’s revenue. One customer accounted for 10% or more of total receivables as of June 30, 2020 and two customers, one of which was the Company’s largest customer and its affiliate, accounted for 10% or more of total receivables as of December 31, 2019.
Revenue Recognition
Contract Balances
The opening and closing balances of the Company’s contract assets, net of allowance for credit losses, and deferred revenue are as follows:
Contract Assets, Current Portion(1) | Contract Assets(2) | Deferred Revenue, Current Portion(3) | Deferred Revenue(4) | ||||||||||||||||||||
| (in thousands) | |||||||||||||||||||||||
| December 31, 2019 | 496 | 3,216 | 14,991 | 27,852 | |||||||||||||||||||
| June 30, 2020 | 272 | 3,610 | 12,868 | 23,576 | |||||||||||||||||||
| Change | $ | (224) | $ | 394 | $ | (2,123) | $ | (4,276) | |||||||||||||||
________________________________________
(1) Amounts are included within other current assets on the Company’s consolidated balance sheets.
(2) Amounts are included within other assets on the Company’s consolidated balance sheets.
(3) Amounts include $3.8 million and $2.9 million of deferred revenue related to leases as of December 31, 2019 and June 30, 2020, respectively.
(4) Amounts include $7.9 million and $2.6 million of deferred revenue related to leases as of December 31, 2019 and June 30, 2020, respectively.
The differences between the opening and closing balances of the Company’s deferred revenue primarily result from timing differences between the Company’s satisfaction of performance obligations and the associated customer payments. Revenue recognized from the balance of deferred revenue as of December 31, 2019 was $3.7 million during the three months ended June 30, 2020 and $10.3 million during the six months ended June 30, 2020. For the three and six months ended June 30, 2020 and 2019, no impairment losses related to contract assets were recognized on the consolidated statements of comprehensive income.
Remaining Performance Obligations
Remaining performance obligations represent contracted revenue that has not yet been recognized, which includes deferred revenue and amounts that will be invoiced and recognized in future periods. These amounts as of June 30, 2020 were $700.7 million, 38%, 46%, and 12% of which is expected to be recognized over the next year, to three years, and to five years, respectively, with the remainder recognized thereafter. The remaining performance obligations do not include estimates of variable consideration related to unsatisfied performance obligations, such as the usage of metered power, or any contracts that could be terminated without significant penalties.
Switch, Inc. | Q2 2020 Form 10-Q | 12
Fair Value Measurements
Information about the Company’s financial assets and liabilities measured at fair value on a recurring basis is presented below:
| June 30, 2020 | |||||||||||||||||||||||||||||
| Balance Sheet Classification | Carrying Value | Level 1 | Level 2 | Level 3 | |||||||||||||||||||||||||
| (in thousands) | |||||||||||||||||||||||||||||
| Liabilities: | |||||||||||||||||||||||||||||
| Interest rate swaps | Interest rate swap liability, current portion | $ | 9,225 | $ | — | $ | 9,225 | $ | — | ||||||||||||||||||||
| Interest rate swaps | Other long-term liabilities | $ | 23,685 | $ | — | $ | 23,685 | $ | — | ||||||||||||||||||||
| December 31, 2019 | |||||||||||||||||||||||||||||
| Balance Sheet Classification | Carrying Value | Level 1 | Level 2 | Level 3 | |||||||||||||||||||||||||
| (in thousands) | |||||||||||||||||||||||||||||
| Liabilities: | |||||||||||||||||||||||||||||
| Interest rate swaps | Interest rate swap liability, current portion | $ | 3,464 | $ | — | $ | 3,464 | $ | — | ||||||||||||||||||||
| Interest rate swaps | Other long-term liabilities | $ | 10,550 | $ | — | $ | 10,550 | $ | — | ||||||||||||||||||||
Transfers between levels of fair value hierarchy are recorded at the end of the reporting period during which the events or changes in circumstances that caused the transfers to occur. There were no transfers between levels of fair value hierarchy during the periods presented.
The fair value of interest rate swaps was measured using a present value of cash flow valuation technique based on forward yield curves for the same or similar financial instruments.
The estimated fair value of the Company’s long-term debt as of June 30, 2020 and December 31, 2019 was approximately $831.8 million and $755.0 million, respectively, compared to its carrying value, excluding debt issuance costs, of $842.0 million and $755.0 million, respectively. The estimated fair value of the Company’s long-term debt was based on Level 2 inputs using quoted market prices on or about June 30, 2020 and December 31, 2019, respectively.
Recent Accounting Pronouncements
ASU 2014-09–Revenue from Contracts with Customers and ASU 2016-02–Leases
In the fourth quarter of 2019, the Company adopted Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers (Topic 606) and ASU 2016-02, Leases (Topic 842) effective January 1, 2019, each using the modified retrospective approach. Results for the three and six months ended June 30, 2019 have been modified to reflect the adoption of this guidance each on January 1, 2019.
ASU 2016-13–Financial Instruments–Credit Losses
In June 2016, the Financial Accounting Standards Board (“FASB”) issued ASU 2016-13, Financial Instruments–Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”). Under this guidance, a company will be required to use a new forward-looking “expected loss” model for trade and other receivables that generally will result in the earlier recognition of allowances for losses. The amendments in ASU 2016-13 are effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years, and requires a modified retrospective approach to adoption. In April 2019, the FASB issued ASU 2019-04, which, among other amendments, allows for certain policy elections and practical expedients related to accrued interest on financial instruments. In May 2019, the FASB issued ASU 2019-05, which granted targeted transition relief by allowing entities to irrevocably elect the fair value option for certain financial assets previously measured at amortized cost. In November 2019, the FASB issued ASU 2019-10 and ASU 2019-11, which addressed certain aspects of the guidance related to effective dates, expected recoveries, troubled debt restructurings, accrued interest receivables, and financial assets secured by collateral. In February and March 2020, the FASB also issued ASU 2020-02 and ASU 2020-03, respectively, which provide certain amendments and improvements to sections of ASU 2016-13.
The Company adopted this guidance effective January 1, 2020 using the modified retrospective method. As a result of this adoption, the Company measured an allowance for current expected credit losses for its accounts receivable
Switch, Inc. | Q2 2020 Form 10-Q | 13
and contract assets through a loss rate method; whereby, based on past events, such as prior write-offs, it determined expected losses as of the adoption date, while adjusting for current and forward-looking conditions, such as economic news and trends, customer concentrations, changes in customer payment terms, and customer credit-worthiness. Customer credit-worthiness is determined through indicators such as third-party credit ratings, collection experience, and other internal metrics. If a customer‘s credit-worthiness resulted in an impairment of their ability to make payments, greater allowances for credit losses may be required. The Company pooled its assets based on these conditions such that each asset pool reflected a homogenous set of asset risks, including characteristics such as credit ratings, customer industry, contract term, and historical credit loss patterns. For any period beyond a reasonable and supportable forecast for current and forward-looking conditions, the Company reverted to a loss rate based only on historical information. The adoption of this guidance did not materially impact the Company’s consolidated financial statements.
ASU 2018-13–Fair Value Measurement
In August 2018, the FASB issued ASU 2018-13, Disclosure Framework–Changes to the Disclosure Requirements for Fair Value Measurement (“ASU 2018-13”). The amendments in this update modify the disclosure requirements for fair value measurements by removing, modifying, or adding certain disclosures. The amendments in ASU 2018-13 are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. In addition, in November 2018, the FASB issued ASU 2018-19, which provides clarifications and improvements on sections of ASU 2018-13. The Company has adopted this guidance as of March 31, 2020. The adoption of this guidance did not materially impact the Company’s consolidated financial statements.
ASU 2019-12–Income Taxes
In December 2019, the FASB issued ASU 2019-12, Income Taxes (Topic 740)–Simplifying the Accounting for Income Taxes (“ASU 2019-12”). The amendments in ASU 2019-12 provide certain clarifications and simplify accounting for income taxes by removing certain exceptions to the general principles in the current guidance. The amendments in ASU 2019-12 are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020. Early adoption is permitted in periods for which financial statements have not yet been issued. The Company is evaluating the impact the adoption of this guidance will have on its consolidated financial statements. The Company has not decided if early adoption will be considered.
ASU 2020-04–Reference Rate Reform
In March 2020, the FASB issued ASU 2020-04, Reference Rate Reform (Topic 848)–Facilitation of the Effects of Reference Rate Reform on Financial Reporting (“ASU 2020-04”). The amendments in ASU 2020-04 provide optional expedients and exceptions to contracts, hedging relationships, and other transactions that reference LIBOR or another reference rate expected to be discontinued due to reference rate reform if certain criteria are met. The expedients and exceptions provided by the amendments do not apply to contract modifications made and hedging relationships entered into or evaluated after December 31, 2022. The amendments in this update are elective and are effective upon issuance for all entities. The Company elected to adopt this guidance as it has LIBOR-based contracts extending beyond the expected discontinuation of LIBOR, including its term loan facility, revolving credit facility, and interest rate swap agreements. The Company has adopted this guidance as of March 31, 2020. The adoption of this guidance did not materially impact the Company’s consolidated financial statements.
Reclassification
The Company reclassified the current portion of its interest rate swap liability to present it separately from accrued expenses on the consolidated balance sheet as of December 31, 2019 to be consistent with the current period presentation. The reclassification had no impact on the Company’s financial condition, results of operations, or net cash flows.
Switch, Inc. | Q2 2020 Form 10-Q | 14
3. Property and Equipment, Net
Property and equipment, net consists of the following:
| June 30, | December 31, | ||||||||||
| 2020 | 2019 | ||||||||||
| (in thousands) | |||||||||||
| Land and land improvements | $ | 282,162 | $ | 223,877 | |||||||
| Buildings, building improvements, and leasehold improvements | 514,050 | 435,214 | |||||||||
| Substation equipment | 19,780 | 19,780 | |||||||||
| Data center equipment | 1,156,184 | 1,021,056 | |||||||||
| Vehicles | 1,933 | 1,732 | |||||||||
| Core network equipment | 39,114 | 36,572 | |||||||||
| Fiber facilities | 14,111 | 13,180 | |||||||||
| Computer equipment, furniture and fixtures | 44,683 | 39,057 | |||||||||
| Finance lease right-of-use assets | 72,951 | 72,569 | |||||||||
| Construction in progress | 120,265 | 254,750 | |||||||||
| Property and equipment, gross | 2,265,233 | 2,117,787 | |||||||||
| Less: accumulated depreciation and amortization | (635,114) | (566,670) | |||||||||
| Property and equipment, net | $ | 1,630,119 | $ | 1,551,117 | |||||||
Accumulated amortization for finance lease right-of-use assets totaled $13.0 million and $11.7 million as of June 30, 2020 and December 31, 2019, respectively.
During the six months ended June 30, 2020 and 2019, capitalized interest was $2.4 million and $2.3 million, respectively.
The Company capitalized internal use software costs of $0.4 million and $0.5 million during the three months ended June 30, 2020 and 2019, respectively, and $0.5 million and $1.0 million during the six months ended June 30, 2020 and 2019, respectively.
In May 2020, the Company closed on an agreement with an entity in which a member of its Board of Directors has a beneficial ownership interest for the purchase of approximately two acres of land in Las Vegas, Nevada for $2.5 million.
Total depreciation and amortization of property and equipment recognized on the consolidated statements of comprehensive income was as follows:
| Three Months Ended June 30, | Six Months Ended June 30, | ||||||||||||||||||||||
| 2020 | 2019 | 2020 | 2019 | ||||||||||||||||||||
| (in thousands) | |||||||||||||||||||||||
| Cost of revenue | $ | 34,883 | $ | 29,014 | $ | 66,111 | $ | 56,824 | |||||||||||||||
| Selling, general and administrative expense | 1,130 | 843 | 2,420 | 1,591 | |||||||||||||||||||
| Total depreciation and amortization of property and equipment | $ | 36,013 | $ | 29,857 | $ | 68,531 | $ | 58,415 | |||||||||||||||
4. Commitments and Contingencies
Operating Leases
During the three months ended June 30, 2020 and 2019, lease costs related to operating leases were $2.1 million and $2.0 million, respectively. During each of the six months ended June 30, 2020 and 2019, lease costs related to operating leases were $3.9 million. Related party lease costs included in these amounts were $1.2 million and $1.3 million for the three months ended June 30, 2020 and 2019, respectively, and $2.4 million and $2.5 million for the six months ended June 30, 2020 and 2019, respectively.
Switch, Inc. | Q2 2020 Form 10-Q | 15
Legal Proceedings
On September 7, 2017, Switch, Ltd. and Switch, Inc. were named in a lawsuit filed in the U.S. District Court for the District of Nevada by V5 Technologies formerly d/b/a Cobalt Data Centers. The lawsuit alleges, among other things, that Switch, Ltd. and Switch, Inc. monopolized the Las Vegas Metropolitan area of Southern Nevada’s data center colocation market and engaged in unfair business practices leading to the failure of Cobalt Data Centers in 2015 and seeks monetary damages in an amount yet to be disclosed. Discovery closed in February 2020. In March 2020, both parties filed motions for summary judgment and are waiting for the court to rule on the motions. Switch, Ltd. and Switch, Inc. are vigorously defending the case.
On September 12, 2017, Switch, Ltd. filed a complaint in the Eighth Judicial District of Nevada against the consultant, Stephen Fairfax, and his business, MTechnology Inc. Among other claims, Switch raised allegations of breach of contract and misappropriation of trade secrets. The complaint also alleged that Aligned Data Centers LLC (“Aligned”) hired Mr. Fairfax and MTechnology Inc. to design their data centers; that this consultant had toured Switch under a non-disclosure agreement; and that this consultant breached his confidentiality agreements with Switch by using Switch’s designs to design the Aligned data centers. Switch, Ltd. is seeking an injunction to prevent the defendants in the lawsuit from infringing Switch, Ltd.’s patents, as well as other remedies. The parties are currently engaged in discovery.
Four substantially similar putative class action complaints, captioned Martz v. Switch, Inc. et al. (filed April 20, 2018); Palkon v. Switch, Inc. et al. (filed April 30, 2018); Chun v. Switch, Inc. et al. (filed May 11, 2018); and Silverberg v. Switch, Inc. et al. (filed June 6, 2018), were filed in the Eighth Judicial District of Nevada, and subsequently consolidated into a single case (the “State Court Securities Action”). Additionally, on June 11, 2018, one putative class action complaint captioned Cai v. Switch, Inc. et al. was filed in the United States District Court for the District of New Jersey (the “Federal Court Securities Action,” and collectively with the State Court Securities Action, the “Securities Actions”) and subsequently transferred to the Eighth Judicial District of Nevada in August 2018 and the federal court appointed Oscar Farach lead plaintiff. These lawsuits were filed against Switch, Inc., certain current and former officers and directors and certain underwriters of Switch, Inc.’s IPO alleging federal securities law violations in connection with the IPO. These lawsuits were brought by purported stockholders of Switch, Inc. seeking to represent a class of stockholders who purchased Class A common stock in or traceable to the IPO, and seek unspecified damages and other relief. With respect to the Federal Court Securities Action, in July 2019, the federal court granted Switch, Inc.’s motion to dismiss in part, which narrowed the scope of the plaintiff’s case. In December 2019, Switch, Inc. filed a motion for judgment on the pleadings, and in July 2020, the federal court entered a judgment in favor of Switch, Inc. With respect to the State Court Securities Action, in October 2018, the state court granted the defendants’ motion to stay the State Court Securities Action in favor of the Federal Court Securities Action, which stay was affirmed by the Nevada Supreme Court in September 2019. The State Court Securities Action remains stayed until further order by the state court. Switch, Inc. believes that these lawsuits are without merit and intends to continue to vigorously defend against them.
On September 10, 2018, two purported stockholders of Switch, Inc. filed substantially similar shareholder derivative complaints, respectively captioned Liu v. Roy et al., and Zhao v. Roy et al., in the Eighth Judicial District of Nevada, which were subsequently consolidated into a single case (the “Derivative Shareholder Action”). These lawsuits allege breaches of fiduciary duty, unjust enrichment, waste of corporate assets, abuse of control, and gross mismanagement against certain current and former officers and directors of Switch, Inc. The plaintiffs also named Switch, Inc. as a nominal defendant. The complaints arise generally from the same allegations described in the State Court Securities Action and Federal Court Securities Action. The plaintiffs seek unspecified damages on Switch, Inc.’s behalf from the officer and director defendants, certain corporate governance actions, compensatory awards, and other relief. In December 2019, the court granted the parties’ stipulation to stay the Derivative Shareholder Action until the earlier of any of the following events: the Securities Actions are resolved with prejudice as to each defendant or a motion for summary judgment is resolved in the Federal Court Securities Action.
The outcomes of the legal proceedings are inherently unpredictable, subject to significant uncertainties, and could be material to the Company’s financial condition, results of operations, and cash flows for a particular period. Where the Company is a defendant, it will vigorously defend against the claims pleaded against it. These actions are each in preliminary stages and management has determined that based on proceedings to date, it is currently unable to determine the probability of the outcome of these actions or the range of reasonably possible loss, if any.
5. Income Taxes
The Company recorded a net increase in deferred tax assets of $44.4 million and $61.0 million during the three and six months ended June 30, 2020, respectively, and $47.9 million and $47.1 million during the three and six months ended June 30, 2019, respectively, with a corresponding increase to additional paid in capital, resulting from
Switch, Inc. | Q2 2020 Form 10-Q | 16
changes in the outside basis difference on Switch, Inc.’s investment in Switch, Ltd. The Company has determined it is more-likely-than-not that it will be able to realize this deferred tax asset in the future.
The Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) was enacted in March 2020. The Company does not expect the provisions of the CARES Act to have a significant impact on the effective tax rate or the deferred income tax positions of the Company.
Tax Receivable Agreement
The Company has recorded a liability under the tax receivable agreement of $234.1 million and $162.1 million as of June 30, 2020 and December 31, 2019, respectively, which provides for the payment of 85% of the amount of the tax benefits, if any, that Switch, Inc. is deemed to realize as a result of increases in the tax basis of its ownership in Switch, Ltd. related to exchanges of noncontrolling interest for Class A common stock. No amounts are expected to be paid within the next 12 months.
6. Equity-Based Compensation
Total equity-based compensation recognized on the consolidated statements of comprehensive income was as follows:
| Three Months Ended June 30, | Six Months Ended June 30, | ||||||||||||||||||||||
| 2020 | 2019 | 2020 | 2019 | ||||||||||||||||||||
| (in thousands) | |||||||||||||||||||||||
| Cost of revenue | $ | 470 | $ | 381 | $ | 940 | $ | 754 | |||||||||||||||
| Selling, general and administrative expense | 7,040 | 7,062 | 14,094 | 14,834 | |||||||||||||||||||
| Total equity-based compensation | $ | 7,510 | $ | 7,443 | $ | 15,034 | $ | 15,588 | |||||||||||||||
7. Noncontrolling Interest
Ownership
Switch, Inc. owns a minority economic interest in Switch, Ltd., where “economic interests” means the right to receive any distributions, whether cash, property or securities of Switch, Ltd., in connection with Common Units. Switch, Inc. presents interest held by noncontrolling interest holders within noncontrolling interest in the consolidated financial statements. During the six months ended June 30, 2020, Switch, Inc. issued an aggregate of 16.1 million shares of Class A common stock to members of Switch, Ltd. in connection with such members’ redemptions of an equivalent number of Common Units and corresponding cancellation and retirement of an equivalent number of Switch, Inc.’s Class B common stock. Such retired shares of Class B common stock may not be reissued. The redemptions occurred pursuant to the terms of the Switch operating agreement entered into in connection with the Company’s IPO.
In February 2020, Switch, Inc.’s Board of Directors authorized the repurchase by Switch, Ltd. of up to $20.0 million of its outstanding Common Units, which authorization expired unused on March 17, 2020. In addition, in May 2020, Switch, Inc.’s Board of Directors authorized the repurchase by Switch, Ltd. of up to $20.0 million of its outstanding Common Units held by Founder Members, with any unused amount from this authorization expiring on June 16, 2020. Repurchases under the Common Unit repurchase program were funded from Switch’s existing cash and cash equivalents. In May 2020, Switch, Ltd. elected to repurchase 1.1 million of its outstanding Common Units for $20.0 million from Founder Members. Pursuant to this repurchase, Switch, Inc. canceled and retired an equivalent amount of its shares of Class B common stock, and such shares may not be reissued. As of June 30, 2020, the Company had no repurchase authority remaining.
Switch, Inc. | Q2 2020 Form 10-Q | 17
The ownership of the Common Units is summarized as follows:
| June 30, 2020 | December 31, 2019 | |||||||||||||||||||||||||
| Units | Ownership % | Units | Ownership % | |||||||||||||||||||||||
| (units in thousands) | ||||||||||||||||||||||||||
Switch, Inc.’s ownership of Common Units(1) | 106,708 | 44.8 | % | 89,688 | 37.8 | % | ||||||||||||||||||||
Noncontrolling interest holders’ ownership of Common Units(2) | 131,404 | 55.2 | % | 147,859 | 62.2 | % | ||||||||||||||||||||
| Total Common Units | 238,112 | 100.0 | % | 237,547 | 100.0 | % | ||||||||||||||||||||
________________________________________
(1) Common Units held by Switch, Inc. exclude 59,000 and 80,000 Common Units underlying unvested restricted stock awards as of June 30, 2020 and December 31, 2019, respectively.
(2) Common Units held by noncontrolling interest holders exclude 2.4 million and 3.2 million unvested Common Unit awards as of June 30, 2020 and December 31, 2019, respectively.
The Company uses the weighted average ownership percentages during the period to calculate the income before income taxes attributable to Switch, Inc. and the noncontrolling interest holders of Switch, Ltd.
8. Net Income Per Share
The following table sets forth the calculation of basic and diluted net income per share:
| Three Months Ended June 30, | Six Months Ended June 30, | ||||||||||||||||||||||
| 2020 | 2019 | 2020 | 2019 | ||||||||||||||||||||
| (in thousands, except per share data) | |||||||||||||||||||||||
| Net income per share: | |||||||||||||||||||||||
| Numerator—basic: | |||||||||||||||||||||||
| Net income attributable to Switch, Inc.—basic | $ | 5,097 | $ | 1,189 | $ | 3,881 | $ | 1,922 | |||||||||||||||
| Numerator—diluted: | |||||||||||||||||||||||
| Net income attributable to Switch, Inc.—basic | $ | 5,097 | $ | 1,189 | $ | 3,881 | $ | 1,922 | |||||||||||||||
| Effect of dilutive securities: | |||||||||||||||||||||||
| Shares of Class B and Class C common stock | 6,253 | — | 4,598 | 5,098 | |||||||||||||||||||
| Net income attributable to Switch, Inc.—diluted | $ | 11,350 | $ | 1,189 | $ | 8,479 | $ | 7,020 | |||||||||||||||
| Denominator—basic: | |||||||||||||||||||||||
| Weighted average shares outstanding—basic | 104,987 | 77,714 | 99,676 | 66,686 | |||||||||||||||||||
| Net income per share—basic | $ | 0.05 | $ | 0.02 | $ | 0.04 | $ | 0.03 | |||||||||||||||
| Denominator—diluted: | |||||||||||||||||||||||
| Weighted average shares outstanding—basic | 104,987 | 77,714 | 99,676 | 66,686 | |||||||||||||||||||
| Weighted average effect of dilutive securities: | |||||||||||||||||||||||
| Stock options | 1,615 | 627 | 1,392 | 334 | |||||||||||||||||||
| Restricted stock units | 1,224 | 618 | 1,030 | 464 | |||||||||||||||||||
| Dividend equivalent units | 30 | 22 | 30 | 20 | |||||||||||||||||||
| Restricted stock awards | 55 | 40 | 57 | 37 | |||||||||||||||||||
| Shares of Class B and Class C common stock | 136,005 | — | 141,437 | 179,686 | |||||||||||||||||||
| Weighted average shares outstanding—diluted | 243,916 | 79,021 | 243,622 | 247,227 | |||||||||||||||||||
| Net income per share—diluted | $ | 0.05 | $ | 0.02 | $ | 0.03 | $ | 0.03 | |||||||||||||||
Shares of Class B and Class C common stock do not share in the earnings or losses of Switch, Inc. and are therefore not participating securities. As such, separate calculations of basic and diluted net income per share for each of Class B and Class C common stock under the two-class method have not been presented.
Switch, Inc. | Q2 2020 Form 10-Q | 18
The following table presents potentially dilutive securities excluded from the computation of diluted net income per share for the periods presented because their effect would have been anti-dilutive.
| Three Months Ended June 30, | Six Months Ended June 30, | ||||||||||||||||||||||
| 2020 | 2019 | 2020 | 2019 | ||||||||||||||||||||
| (in thousands) | |||||||||||||||||||||||
Stock options(1) | 1,117 | 6,288 | 1,117 | 6,288 | |||||||||||||||||||
Restricted stock units(1) | — | 1,518 | — | 1,518 | |||||||||||||||||||
Restricted stock awards(1) | — | 80 | — | 80 | |||||||||||||||||||
Shares of Class B and Class C common stock(2) | — | 167,815 | — | — | |||||||||||||||||||
________________________________________
(1) Represents the number of instruments outstanding at the end of the period. Application of the treasury stock method would reduce this amount if they had a dilutive effect and were included in the computation of diluted net income per share.
(2) Shares of Class B and Class C common stock at the end of the period are considered potentially dilutive shares of Class A common stock under application of the if-converted method.
9. Segment Reporting
The Company’s chief operating decision maker is its Chief Executive Officer. The Company manages its operations as a single operating segment for the purposes of assessing performance and making operating decisions. All of the Company’s assets are maintained in the United States, although the Company holds an equity method investment in SUPERNAP International, S.A., which has deployed facilities in Italy and Thailand. The Company derives almost all of its revenue from sales to customers in the United States, based upon the billing address of the customer. Revenue derived from customers outside the United States, based upon the billing address of the customer, was less than 2% of revenue for each of the three and six months ended June 30, 2020 and 2019.
The Company’s revenue is comprised of the following:
| Three Months Ended June 30, | Six Months Ended June 30, | ||||||||||||||||||||||
| 2020 | 2019 | 2020 | 2019 | ||||||||||||||||||||
| (in thousands) | |||||||||||||||||||||||
| Colocation | $ | 102,621 | $ | 90,963 | $ | 203,835 | $ | 177,448 | |||||||||||||||
| Connectivity | 22,753 | 19,589 | 47,944 | 38,584 | |||||||||||||||||||
| Other | 1,543 | 1,418 | 3,234 | 3,380 | |||||||||||||||||||
| Total revenue | $ | 126,917 | $ | 111,970 | $ | 255,013 | $ | 219,412 | |||||||||||||||
10. Subsequent Events
In July and August 2020, Switch, Inc. issued an aggregate of 1.7 million and 0.4 million shares, respectively, of Class A common stock to members of Switch, Ltd. in connection with such members’ redemptions of an equivalent number of Common Units and corresponding cancellation and retirement of an equivalent number of shares of Class B common stock. Such retired shares of Class B common stock may not be reissued. The redemptions occurred pursuant to the terms of the Switch operating agreement entered into in connection with the Company’s IPO.
In August 2020, Switch, Inc.’s Board of Directors declared a dividend of $0.05 per share of Class A common stock, for a total estimated to be $5.4 million, to be paid on August 31, 2020 to holders of record as of August 18, 2020. Prior to the payment of this dividend, Switch, Ltd. will make a cash distribution to all holders of record of Common Units, including Switch, Inc., of $0.05 per Common Unit, for a total estimated to be $12.0 million.
In August 2020, the Company borrowed $20.0 million under its revolving credit facility.
Switch, Inc. | Q2 2020 Form 10-Q | 19
Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the consolidated financial statements and related condensed notes included in Part I, Item 1 of this Quarterly Report on Form 10-Q (this “Form 10-Q”), and with the audited consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2019. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed below. Factors that could cause or contribute to such differences include, but are not limited to, those identified below and those discussed in “Risk Factors” in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2019. Unless the context otherwise requires, references to “we,” “us,” “our,” the “Company,” “Switch” and similar references refer to Switch, Inc., and, unless otherwise stated, all of its subsidiaries, including Switch, Ltd., and, unless otherwise stated, all of its subsidiaries.
Overview
We are a technology infrastructure company powering the sustainable growth of the connected world and the Internet of Everything. Using our technology platform, we provide solutions to help enable that growth. Our advanced data centers are the center of our platform and provide power densities that exceed industry averages with efficient cooling, while being powered by 100% renewable energy. These hyperscale data centers address the growing challenges facing the data center industry. Our critical infrastructure components in our data centers are purpose-built to satisfy customers’ needs, drive efficiency and enable the deployment of highly advanced computing technologies.
We presently own and operate four primary campus locations, called Primes, which encompass 12 colocation facilities with an aggregate of up to 4.7 million gross square feet (“GSF”) of space. Our Primes consist of The Core Campus in Las Vegas, Nevada; The Citadel Campus near Reno, Nevada; The Pyramid Campus in Grand Rapids, Michigan; and The Keep Campus in Atlanta, Georgia, which opened during the first quarter of 2020. In addition to our Primes, we hold a 50% ownership interest in SUPERNAP International, S.A. (“SUPERNAP International”), which has deployed facilities in Italy and Thailand. Until March 31, 2018, we accounted for this ownership interest under the equity method of accounting.
We currently have more than 950 customers, including some of the world’s largest technology and digital media companies, cloud, IT and software providers, financial institutions and network and telecommunications providers. Our ecosystem connects over 250 cloud, IT and software providers and more than 90 network and telecommunications providers. Our business is based on a recurring revenue model comprised of (1) colocation, which includes the licensing and leasing of cabinet space and power and (2) connectivity services, which include cross-connects, broadband services and external connectivity. We consider these services recurring because our customers are generally billed on a fixed and recurring basis each month for the duration of their contract. We generally derive more than 95% of our revenue from recurring revenue and we expect to continue to do so for the foreseeable future.
Our non-recurring revenue is primarily comprised of installation services related to a customer’s initial deployment. These services are non-recurring because they are typically billed once, upon completion of the installation.
Factors that May Influence Future Results of Operations
Impact of COVID-19. In March 2020, the World Health Organization declared the outbreak of the novel coronavirus (“COVID-19”) as a pandemic, which continues to be spread throughout the U.S. and the world. The impact from the rapidly changing market and economic conditions due to the COVID-19 outbreak is uncertain, disrupting the business of our customers, and may impact our business, consolidated results of operations, and financial condition in the future. While we have not incurred significant disruptions thus far from the COVID-19 outbreak, we are unable to accurately predict the full impact that COVID-19 will have due to numerous uncertainties, including the severity of the disease, the duration of the outbreak, actions that may be taken by governmental authorities, the impact to the business of our customers, partners and vendors, the impact and functioning of the global financial markets and other factors identified in Part II, Item 1A “Risk Factors” in this Form 10-Q. We will continue to evaluate the nature and extent of the impact to our business, consolidated results of operations, and financial condition.
Switch, Inc. | Q2 2020 Form 10-Q | 20
Market and Economic Conditions. We are affected by general business and economic conditions in the United States and globally. These conditions include short-term and long-term interest rates, inflation, money supply, political issues, legislative and regulatory changes, fluctuations in both debt and equity capital markets and broad trends in industry and finance, all of which are beyond our control. Macroeconomic conditions that affect the economy and the economic outlook of the United States and the rest of the world, including as a result of the COVID-19 pandemic, could adversely affect our customers and vendors, which could adversely affect our results of operations and financial condition.
Growth and Expansion Activities. Our future revenue growth will depend on our ability to maintain our existing revenue base while expanding and increasing utilization at our existing and developing Prime Campus locations. Our existing Prime Campus locations currently encompass 12 colocation facilities with an aggregate of up to 4.7 million GSF of space and up to 490 megawatts (“MW”) of power. As of June 30, 2020, the utilization rates at these Prime Campuses, based on currently available cabinets, were approximately 93%, 86%, 72%, and 23% at The Core Campus, The Citadel Campus, The Pyramid Campus, and The Keep Campus, respectively. Additionally, each of our existing Primes has room for further expansion. We may be unable to attract customers to our data centers or retain them for a number of reasons, including if we fail to provide competitive pricing terms, provide space that is deemed to be inferior to that of our competitors or are unable to provide services that our existing and potential customers desire.
Cost of Power. We are a large consumer of power, and the cost of energy accounts for a significant portion of our cost of revenue. We require power supply to provide many services we offer, such as powering and cooling our customers’ IT equipment and operating critical data center plant and equipment infrastructure. Pursuant to our service agreements, we provide our customers with a committed level of power supply availability and we have committed to operating our data centers with 100% clean and renewable energy. Most of our customer agreements provide the ability to increase our cost of service in response to an increase in the cost of energy; however, our gross profit can be adversely affected by increases in our cost of energy if we choose not to pass along the increases to our customers. For instance, the seasonal increase in energy costs during the summer months has not historically resulted in an adjustment to our customer pricing, and therefore has resulted in a decrease in our gross profit in those periods. Nonetheless, as an unbundled purchaser of energy in Nevada, we are able to purchase power in the open market through long-term power contracts, which we believe reduces variability of energy costs. Additionally, our existing customers may not renew their contracts with us or may reduce the services purchased from us, or we may be unable to attract new customers, if we experience increased energy costs or limited availability of power resources, including clean and renewable energy. Our brand or reputation could be adversely affected if we are unable to operate our data centers with 100% clean and renewable energy.
Capital Expenditures. Our growth and expansion initiatives require significant capital. The costs of constructing, developing, operating and maintaining data centers, and growing our operations are substantial. While we strive to match the growth of our facilities to the demand for services, we still must spend significant amounts before we receive any revenue. If we are unable to generate sufficient capital to meet our anticipated capital requirements, our growth could slow and operations could be adversely affected. Our maintenance capital expenditures were $3.2 million and $3.5 million for the six months ended June 30, 2020 and 2019, respectively.
Growth in Customers. Our results of operations could be significantly affected by the growth or reduction of our customer base. We have over 950 customers, including some of the world’s largest technology and digital media companies, cloud, IT and software providers, financial institutions, and network and telecommunications providers. We believe we have significant opportunities to both grow penetration of our existing customers as well as attract new customers. Our ability to attract new customers depends on a number of factors, including our ability to offer high quality services at competitive prices and the capability of our marketing and sales team to attract new customers. Additionally, a significant portion of our revenue is highly dependent on our top 10 customers and the loss of these customers or any significant decrease in their business could adversely affect our results of operations.
Switch, Inc. | Q2 2020 Form 10-Q | 21
Key Metrics and Non-GAAP Financial Measures
We monitor the following unaudited key metrics and financial measures, some of which are not calculated in accordance with accounting principles generally accepted in the United States of America (“GAAP”) to help us evaluate our business, identify trends affecting our business, formulate business plans and make strategic decisions.
| Three Months Ended June 30, | Six Months Ended June 30, | ||||||||||||||||||||||
| 2020 | 2019 | 2020 | 2019 | ||||||||||||||||||||
| (dollars in thousands) | |||||||||||||||||||||||
| Recurring revenue | $ | 122,729 | $ | 109,582 | $ | 243,215 | $ | 214,073 | |||||||||||||||
| Capital expenditures | $ | 85,554 | $ | 54,185 | $ | 166,452 | $ | 100,131 | |||||||||||||||
| Adjusted EBITDA | $ | 69,116 | $ | 58,841 | $ | 130,605 | $ | 112,679 | |||||||||||||||
| Adjusted EBITDA margin | 54.5 | % | 52.6 | % | 51.2 | % | 51.4 | % | |||||||||||||||
Recurring Revenue
We calculate recurring revenue as contractual revenue under signed contracts calculated in accordance with GAAP for the applicable period. Recurring revenue does not include any installation or other one-time revenue, which would be classified as non-recurring revenue. Management uses recurring revenue as a supplemental performance measure because it provides a useful measure of increases or decreases in contractual revenue from our customers and provides a baseline revenue measure on which to plan expenses.
The following table sets forth a reconciliation of recurring revenue to total revenue:
| Three Months Ended June 30, | Six Months Ended June 30, | ||||||||||||||||||||||
| 2020 | 2019 | 2020 | 2019 | ||||||||||||||||||||
| (in thousands) | |||||||||||||||||||||||
| Recurring revenue | $ | 122,729 | $ | 109,582 | $ | 243,215 | $ | 214,073 | |||||||||||||||
| Non-recurring revenue | 4,188 | 2,388 | 11,798 | 5,339 | |||||||||||||||||||
| Revenue | $ | 126,917 | $ | 111,970 | $ | 255,013 | $ | 219,412 | |||||||||||||||
Capital Expenditures
We define capital expenditures as cash purchases of property and equipment during a particular period. We believe that capital expenditures is a useful metric because it provides information regarding the growth of our technology infrastructure platform and the potential to expand our services and add new customers.
Adjusted EBITDA and Adjusted EBITDA Margin
We define Adjusted EBITDA as net income adjusted for interest expense, interest income, income taxes, depreciation and amortization of property and equipment and for specific and defined supplemental adjustments to exclude (i) non-cash equity-based compensation expense; (ii) equity in net losses of investments; and (iii) certain other items that we believe are not indicative of our core operating performance. We define Adjusted EBITDA margin as Adjusted EBITDA divided by revenue.
Our Adjusted EBITDA and Adjusted EBITDA margin are not prepared in accordance with GAAP, and should not be considered in isolation of, or as an alternative to measures prepared in accordance with GAAP. We present Adjusted EBITDA and Adjusted EBITDA margin because we believe certain investors use them as measures of a company’s historical operating performance and its ability to service and incur debt and make capital expenditures. We believe that the inclusion of certain adjustments in presenting Adjusted EBITDA and Adjusted EBITDA margin is appropriate to provide additional information to investors because Adjusted EBITDA and Adjusted EBITDA margin exclude certain items that we believe are not indicative of our core operating performance and that are not excluded in the calculation of EBITDA. Adjusted EBITDA is also similar to the measures used under the debt covenants included in our credit facilities, except that the definition used in our credit facilities does not exclude certain cash gains or shareholder-related litigation expense. Accordingly, we believe that Adjusted EBITDA and Adjusted EBITDA margin provide useful information to investors and others in understanding and evaluating our operating results, enhancing the overall understanding of our past performance and future prospects, and allowing for greater transparency with respect to key financial metrics used by our management in its financial and operational decision-making.
Switch, Inc. | Q2 2020 Form 10-Q | 22
Our non-GAAP financial measures have limitations as analytical tools and you should not consider them in isolation or as a substitute for an analysis of our results under GAAP. There are a number of limitations related to the use of these non-GAAP financial measures versus their nearest GAAP equivalents. Non-GAAP financial measures may not provide information directly comparable to measures provided by other companies in our industry, as those other companies may calculate their non-GAAP financial measures differently. In addition, the non-GAAP financial measures exclude certain recurring expenses that have been and will continue to be significant expenses of our business.
The following table sets forth a reconciliation of our net income to Adjusted EBITDA:
| Three Months Ended June 30, | Six Months Ended June 30, | ||||||||||||||||||||||
| 2020 | 2019 | 2020 | 2019 | ||||||||||||||||||||
| (in thousands) | |||||||||||||||||||||||
| Net income | $ | 13,336 | $ | 4,672 | $ | 9,847 | $ | 8,518 | |||||||||||||||
| Interest expense | 6,693 | 7,541 | 14,128 | 14,672 | |||||||||||||||||||
Interest income(1) | (44) | (257) | (77) | (565) | |||||||||||||||||||
| Income tax expense | 1,380 | 458 | 1,107 | 664 | |||||||||||||||||||
| Depreciation and amortization of property and equipment | 36,013 | 29,857 | 68,531 | 58,415 | |||||||||||||||||||
| Loss on disposal of property and equipment | 38 | 64 | 98 | 107 | |||||||||||||||||||
| Equity-based compensation | 7,510 | 7,443 | 15,034 | 15,588 | |||||||||||||||||||
| Shareholder-related litigation expense | 47 | 282 | 239 | 1,514 | |||||||||||||||||||
| Loss on interest rate swaps | 4,143 | 8,781 | 21,698 | 13,766 | |||||||||||||||||||
| Adjusted EBITDA | $ | 69,116 | $ | 58,841 | $ | 130,605 | $ | 112,679 | |||||||||||||||
________________________________________
(1) Interest income is included in the “Other” line of other income (expense) in our consolidated statements of comprehensive income.
Components of Results of Operations
Revenue
During the three and six months ended June 30, 2020 and 2019, we derived more than 95% of our revenue from recurring revenue streams, consisting primarily of (1) colocation, which includes the licensing and leasing of cabinet space and power and (2) connectivity services, which include cross-connects, broadband services and external connectivity. The remainder of our revenue is from non-recurring revenue, which primarily includes installation services related to a customer’s initial deployment. The majority of our revenue contracts are classified as licenses, with the exception of certain contracts that contain lease components. Based on the current growth stage of our business, we expect increases in revenue to be driven primarily by increases in volume, rather than changes in the prices we charge to our customers.
We recognize revenue when control of these goods and services is transferred to our customers in an amount that reflects the consideration we expect to be entitled to in exchange for those goods and services. Revenue from recurring revenue streams is generally billed monthly and recognized using a time-based measurement of progress as customers receive service benefits evenly throughout the term of the contract. Contracts with our customers generally have terms of three to five years. Non-recurring installation fees, although generally paid in a lump sum upon installation, are deferred and recognized ratably over the contract term, determined using a portfolio approach. Revenue is generally recognized on a gross basis as a principal versus on a net basis as an agent, largely because we are primarily responsible for fulfilling the contract, take title to services, and bear credit risk.
Cost of Revenue
Cost of revenue consists primarily of depreciation and amortization expense, expenses associated with the operations of our facilities, including electricity and other utility costs and repairs and maintenance, data center employees’ salaries and benefits, including equity-based compensation, connectivity costs, and rental payments related to our leased buildings and land used in data center operations. A substantial portion of our cost of revenue is fixed in nature and may not vary significantly from period to period, unless we expand our existing data centers or open new data centers. However, there are certain costs that are considered more variable in nature, including utilities and supplies that are directly related to growth in our existing and new customer base. The largest portion of our utility costs is fixed and a smaller portion is variable with market conditions.
Switch, Inc. | Q2 2020 Form 10-Q | 23
Gross Profit and Gross Margin
Gross profit, or revenue less cost of revenue, and gross margin, or gross profit as a percentage of revenue, has been and will continue to be affected by various factors, including customer growth, the expansion of our existing data centers or opening of new data centers, and the cost of our utilities, specifically electricity. Our gross margin may fluctuate from period to period depending on the interplay of these factors.
Operating Expenses
Selling, General and Administrative Expense
Selling, general and administrative expense consists primarily of salaries and related expenses, including equity-based compensation, accounting, legal and other professional service fees, real estate and personal property taxes, rental payments related to our corporate office lease, marketing and selling expenses, including sponsorships, commissions paid to partners, travel, depreciation and amortization expense, insurance, and other facility and employee related costs. This expense classification may not be comparable to those of other companies. We expect to incur additional selling, general and administrative expenses as we continue to scale our operations to invest in sales and marketing initiatives to further increase our revenue and support our growth. We also expect to continue to incur general and administrative expenses as a result of operating as a public company, including expenses related to compliance with the rules and regulations of the Securities and Exchange Commission (“SEC”) and those of the New York Stock Exchange, additional expenses related to the loss of our emerging growth company status as of December 31, 2019, additional insurance expenses, investor relations activities, and other administrative and professional services. Further, we expect to continue to incur general and administrative expenses in the form of equity-based compensation as a result of the continued vesting of awards of common membership interests in Switch, Ltd. (“Common Units”) granted to certain of our executives in 2017 and other equity awards. As a result, we expect that our selling, general and administrative expense will continue to increase in absolute dollars, but may fluctuate as a percentage of our revenue from period to period.
Other Income (Expense)
Interest Expense
Interest expense consists primarily of interest on our credit facilities and amortization of debt issuance costs, net of amounts capitalized.
Loss on Interest Rate Swaps
Loss on interest rate swaps consists of changes in the fair value of interest rate swaps used to mitigate our exposure to interest rate risk, inclusive of periodic net settlement amounts.
Other
Other income (expense) primarily consists of other items that have impacted our results of operations such as interest income and gains and losses resulting from other transactions.
Income Taxes
We are the sole manager of Switch, Ltd., which is treated as a partnership for U.S. federal and most applicable state and local income tax purposes. As a partnership, Switch, Ltd. is not subject to U.S. federal and certain state and local income taxes. Any taxable income or loss generated by Switch, Ltd. is passed through to, and included in the taxable income or loss of, its members, including us, on a pro rata basis. We are subject to U.S. federal income taxes, in addition to state and local income taxes with respect to our allocable share of any taxable income or loss generated by Switch, Ltd.
Noncontrolling Interest
As the sole manager of Switch, Ltd., we operate and control all of the business and affairs of Switch, Ltd. and its subsidiaries. Although we have a minority economic interest in Switch, Ltd., we have the sole voting interest in, and control the management of, Switch, Ltd. Accordingly, we consolidate the financial results of Switch, Ltd. and report a noncontrolling interest on our consolidated statements comprehensive income, representing the portion of net income or loss and comprehensive income or loss attributable to the noncontrolling interest. The weighted average ownership percentages during the period are used to calculate the net income or loss and other comprehensive income or loss attributable to Switch, Inc. and the noncontrolling interest.
Switch, Inc. | Q2 2020 Form 10-Q | 24
Results of Operations
The following table sets forth our results of operations:
| Three Months Ended June 30, | Six Months Ended June 30, | ||||||||||||||||||||||
| 2020 | 2019 | 2020 | 2019 | ||||||||||||||||||||
| (in thousands) | |||||||||||||||||||||||
| Consolidated Statements of Operations Data: | |||||||||||||||||||||||
| Revenue | $ | 126,917 | $ | 111,970 | $ | 255,013 | $ | 219,412 | |||||||||||||||
| Cost of revenue | 68,198 | 58,117 | 135,227 | 115,642 | |||||||||||||||||||
| Gross profit | 58,719 | 53,853 | 119,786 | 103,770 | |||||||||||||||||||
| Selling, general and administrative expense | 33,438 | 32,919 | 73,554 | 67,170 | |||||||||||||||||||
| Income from operations | 25,281 | 20,934 | 46,232 | 36,600 | |||||||||||||||||||
| Other income (expense): | |||||||||||||||||||||||
| Interest expense, including amortization of debt issuance costs | (6,693) | (7,541) | (14,128) | (14,672) | |||||||||||||||||||
| Loss on interest rate swaps | (4,143) | (8,781) | (21,698) | (13,766) | |||||||||||||||||||
| Other | 271 | 518 | 548 | 1,020 | |||||||||||||||||||
| Total other expense | (10,565) | (15,804) | (35,278) | (27,418) | |||||||||||||||||||
| Income before income taxes | 14,716 | 5,130 | 10,954 | 9,182 | |||||||||||||||||||
| Income tax expense | (1,380) | (458) | (1,107) | (664) | |||||||||||||||||||
| Net income | 13,336 | 4,672 | 9,847 | 8,518 | |||||||||||||||||||
| Less: net income attributable to noncontrolling interest | 8,239 | 3,483 | 5,966 | 6,596 | |||||||||||||||||||
| Net income attributable to Switch, Inc. | $ | 5,097 | $ | 1,189 | $ | 3,881 | $ | 1,922 | |||||||||||||||
The following table sets forth the consolidated statements of operations data presented as a percentage of revenue. Amounts may not sum due to rounding.
| Three Months Ended June 30, | Six Months Ended June 30, | ||||||||||||||||||||||
| 2020 | 2019 | 2020 | 2019 | ||||||||||||||||||||
| Consolidated Statements of Operations Data: | |||||||||||||||||||||||
| Revenue | 100 | % | 100 | % | 100 | % | 100 | % | |||||||||||||||
| Cost of revenue | 54 | 52 | 53 | 53 | |||||||||||||||||||
| Gross profit | 46 | 48 | 47 | 47 | |||||||||||||||||||
| Selling, general and administrative expense | 26 | 29 | 29 | 31 | |||||||||||||||||||
| Income from operations | 20 | 19 | 18 | 17 | |||||||||||||||||||
| Other income (expense): | |||||||||||||||||||||||
| Interest expense, including amortization of debt issuance costs | (5) | (7) | (6) | (7) | |||||||||||||||||||
| Loss on interest rate swaps | (3) | (8) | (9) | (6) | |||||||||||||||||||
| Other | — | — | — | — | |||||||||||||||||||
| Total other expense | (8) | (14) | (14) | (12) | |||||||||||||||||||
| Income before income taxes | 12 | 5 | 4 | 4 | |||||||||||||||||||
| Income tax expense | (1) | — | — | — | |||||||||||||||||||
| Net income | 11 | 4 | 4 | 4 | |||||||||||||||||||
| Less: net income attributable to noncontrolling interest | 6 | 3 | 2 | 3 | |||||||||||||||||||
| Net income attributable to Switch, Inc. | 4 | % | 1 | % | 2 | % | 1 | % | |||||||||||||||
Switch, Inc. | Q2 2020 Form 10-Q | 25
Comparison of the Three Months Ended June 30, 2020 and 2019
Revenue
| Three Months Ended June 30, | Change | ||||||||||||||||||||||
| 2020 | 2019 | Amount | % | ||||||||||||||||||||
| (dollars in thousands) | |||||||||||||||||||||||
| Colocation | $ | 102,621 | $ | 90,963 | $ | 11,658 | 13 | % | |||||||||||||||
| Connectivity | 22,753 | 19,589 | 3,164 | 16 | % | ||||||||||||||||||
| Other | 1,543 | 1,418 | 125 | 9 | % | ||||||||||||||||||
| Revenue | $ | 126,917 | $ | 111,970 | $ | 14,947 | 13 | % | |||||||||||||||
Revenue increased by $14.9 million, or 13%, for the three months ended June 30, 2020, compared to the three months ended June 30, 2019. The increase was primarily attributable to an increase of $11.7 million in colocation revenue. Of the overall increase, 19% was attributable to revenue from new customers initiating service after June 30, 2019, and the remaining 81% was attributable to increased revenue from existing customers. Additionally, during the three months ended June 30, 2020, connectivity revenue included $0.6 million in non-recurring sales-type lease revenue. There was no sales-type lease revenue during the three months ended June 30, 2019.
Cost of Revenue and Gross Margin
| Three Months Ended June 30, | Change | ||||||||||||||||||||||
| 2020 | 2019 | Amount | % | ||||||||||||||||||||
| (dollars in thousands) | |||||||||||||||||||||||
| Cost of revenue | $ | 68,198 | $ | 58,117 | $ | 10,081 | 17 | % | |||||||||||||||
| Gross margin | 46.3 | % | 48.1 | % | |||||||||||||||||||
Cost of revenue increased by $10.1 million, or 17%, for the three months ended June 30, 2020, compared to the three months ended June 30, 2019. The increase was primarily attributable to increases of $5.9 million in depreciation and amortization expense due to additional property and equipment being placed into service, $2.3 million in connectivity costs and facilities costs associated with increased occupancy as a result of expansion activities, $1.1 million in salaries and related employee expenses largely due to a decrease in capitalized labor during the three months ended June 30, 2020, and $0.6 million in costs related to sales-type lease transactions. There were no sales-type lease transactions during the three months ended June 30, 2019. Gross margin decreased by 180 basis points for the three months ended June 30, 2020, compared to the three months ended June 30, 2019.
Selling, General and Administrative Expense
| Three Months Ended June 30, | Change | ||||||||||||||||||||||
| 2020 | 2019 | Amount | % | ||||||||||||||||||||
| (dollars in thousands) | |||||||||||||||||||||||
| Selling, general and administrative expense | $ | 33,438 | $ | 32,919 | $ | 519 | 2 | % | |||||||||||||||
Selling, general and administrative expense increased by $0.5 million, or 2%, for the three months ended June 30, 2020, compared to the three months ended June 30, 2019. The increase was primarily attributable to increases of $1.7 million in salaries and related employee expenses due to an increase in headcount and $0.6 million in property taxes, partially offset by a decrease of $1.8 million in accounting, legal, and other professional service fees.
Switch, Inc. | Q2 2020 Form 10-Q | 26
Other Income (Expense)
| Three Months Ended June 30, | Change | ||||||||||||||||||||||
| 2020 | 2019 | Amount | % | ||||||||||||||||||||
| (dollars in thousands) | |||||||||||||||||||||||
| Other income (expense): | |||||||||||||||||||||||
| Interest expense | $ | (6,693) | $ | (7,541) | $ | 848 | (11) | % | |||||||||||||||
| Loss on interest rate swaps | (4,143) | (8,781) | 4,638 | (53) | % | ||||||||||||||||||
| Other | 271 | 518 | (247) | (48) | % | ||||||||||||||||||
| Total other expense | $ | (10,565) | $ | (15,804) | $ | 5,239 | (33) | % | |||||||||||||||
Interest Expense
Interest expense decreased by $0.8 million, or 11%, for the three months ended June 30, 2020, compared to the three months ended June 30, 2019. The decrease was primarily due to a decrease in our weighted average interest rate from 4.74% during the three months ended June 30, 2019 to 2.59% during the three months ended June 30, 2020, partially offset by an increase in our weighted average debt outstanding during the three months ended June 30, 2020 from borrowings on our revolving credit facility.
Loss on Interest Rate Swaps
Loss on interest rate swaps decreased by $4.6 million, or 53%, for the three months ended June 30, 2020, compared to the three months ended June 30, 2019. The decrease was driven by changes in the fair value of interest rate swaps largely from fluctuation in market interest rates.
Other
Other income decreased by $0.2 million, or 48%, for the three months ended June 30, 2020, compared to the three months ended June 30, 2019. The decrease was primarily due to a decrease in interest income earned on our cash equivalents.
Income Tax Expense
| Three Months Ended June 30, | Change | ||||||||||||||||||||||
| 2020 | 2019 | Amount | % | ||||||||||||||||||||
| (dollars in thousands) | |||||||||||||||||||||||
| Income tax expense | $ | (1,380) | $ | (458) | $ | (922) | 201 | % | |||||||||||||||
Income tax expense was $1.4 million for the three months ended June 30, 2020, compared to $0.5 million for the three months ended June 30, 2019. Income tax expense is driven by our allocable share of Switch, Ltd.’s income before income taxes.
Net Income Attributable to Noncontrolling Interest
| Three Months Ended June 30, | Change | ||||||||||||||||||||||
| 2020 | 2019 | Amount | % | ||||||||||||||||||||
| (dollars in thousands) | |||||||||||||||||||||||
| Net income attributable to noncontrolling interest | $ | 8,239 | $ | 3,483 | $ | 4,756 | 137 | % | |||||||||||||||
Net income attributable to noncontrolling interest was $8.2 million for the three months ended June 30, 2020, compared to $3.5 million for the three months ended June 30, 2019. The change was the result of an increase in net income during the three months ended June 30, 2020.
Switch, Inc. | Q2 2020 Form 10-Q | 27
Comparison of the Six Months Ended June 30, 2020 and 2019
Revenue
| Six Months Ended June 30, | Change | ||||||||||||||||||||||
| 2020 | 2019 | Amount | % | ||||||||||||||||||||
| (dollars in thousands) | |||||||||||||||||||||||
| Colocation | $ | 203,835 | $ | 177,448 | $ | 26,387 | 15 | % | |||||||||||||||
| Connectivity | 47,944 | 38,584 | 9,360 | 24 | % | ||||||||||||||||||
| Other | 3,234 | 3,380 | (146) | (4) | % | ||||||||||||||||||
| Revenue | $ | 255,013 | $ | 219,412 | $ | 35,601 | 16 | % | |||||||||||||||
Revenue increased by $35.6 million, or 16%, for the six months ended June 30, 2020, compared to the six months ended June 30, 2019. The increase was primarily attributable to an increase of $26.4 million in colocation revenue. Of the overall increase, 12% was attributable to revenue from new customers initiating service after June 30, 2019, and the remaining 88% was attributable to increased revenue from existing customers. Additionally, during the six months ended June 30, 2020, connectivity revenue included $4.8 million in non-recurring sales-type lease revenue. There was no sales-type lease revenue during the six months ended June 30, 2019.
Cost of Revenue and Gross Margin
| Six Months Ended June 30, | Change | ||||||||||||||||||||||
| 2020 | 2019 | Amount | % | ||||||||||||||||||||
| (dollars in thousands) | |||||||||||||||||||||||
| Cost of revenue | $ | 135,227 | $ | 115,642 | $ | 19,585 | 17 | % | |||||||||||||||
| Gross margin | 47.0 | % | 47.3 | % | |||||||||||||||||||
Cost of revenue increased by $19.6 million, or 17%, for the six months ended June 30, 2020, compared to the six months ended June 30, 2019. The increase was primarily attributable to increases of $9.3 million in depreciation and amortization expense due to additional property and equipment being placed into service, $4.2 million in connectivity costs and facilities costs associated with increased occupancy as a result of expansion activities, $3.4 million in costs related to sales-type lease transactions, and $2.4 million in salaries and related employee expenses largely due to a decrease in capitalized labor during the six months ended June 30, 2020. There were no sales-type lease transactions during the six months ended June 30, 2019. Gross margin decreased by 30 basis points for the six months ended June 30, 2020, compared to the six months ended June 30, 2019.
Selling, General and Administrative Expense
| Six Months Ended June 30, | Change | ||||||||||||||||||||||
| 2020 | 2019 | Amount | % | ||||||||||||||||||||
| (dollars in thousands) | |||||||||||||||||||||||
| Selling, general and administrative expense | $ | 73,554 | $ | 67,170 | $ | 6,384 | 10 | % | |||||||||||||||
Selling, general and administrative expense increased by $6.4 million, or 10%, for the six months ended June 30, 2020, compared to the six months ended June 30, 2019. The increase was primarily attributable to an increase of $3.2 million in salaries and related employee expenses, $3.9 million of which is largely due to an increase in headcount, partially offset by a decrease of $0.7 million in non-cash compensation expense primarily related to certain equity awards granted in 2017. Additionally, there were increases of $0.9 million in professional fees for accounting, consulting, and legal services, $0.8 million in depreciation and amortization expense, $0.8 million in property taxes, and $0.5 million in commission expense paid to partners.
Switch, Inc. | Q2 2020 Form 10-Q | 28
Other Income (Expense)
| Six Months Ended June 30, | Change | ||||||||||||||||||||||
| 2020 | 2019 | Amount | % | ||||||||||||||||||||
| (dollars in thousands) | |||||||||||||||||||||||
| Other income (expense): | |||||||||||||||||||||||
| Interest expense | (14,128) | (14,672) | $ | 544 | (4) | % | |||||||||||||||||
| Loss on interest rate swaps | (21,698) | (13,766) | (7,932) | 58 | % | ||||||||||||||||||
| Other | 548 | 1,020 | (472) | (46) | % | ||||||||||||||||||
| Total other expense | $ | (35,278) | $ | (27,418) | $ | (7,860) | 29 | % | |||||||||||||||
Interest Expense
Interest expense decreased by $0.5 million, or 4%, for the six months ended June 30, 2020, compared to the six months ended June 30, 2019. The decrease was primarily due to a decrease in our weighted average interest rate from 4.74% during the six months ended June 30, 2019 to 3.13% during the six months ended June 30, 2020, partially offset by an increase in our weighted average debt outstanding during the six months ended June 30, 2020 from borrowings on our revolving credit facility.
Loss on Interest Rate Swaps
Loss on interest rate swaps increased by $7.9 million, or 58%, for the six months ended June 30, 2020, compared to the six months ended June 30, 2019. The increase was driven by changes in the fair value of interest rate swaps largely from fluctuation in market interest rates.
Other
Other income decreased by $0.5 million, or 46%, for the six months ended June 30, 2020, compared to the six months ended June 30, 2019. The decrease was primarily due to a decrease in interest income earned on our cash equivalents.
Income Tax Expense
| Six Months Ended June 30, | Change | ||||||||||||||||||||||
| 2020 | 2019 | Amount | % | ||||||||||||||||||||
| (dollars in thousands) | |||||||||||||||||||||||
| Income tax expense | $ | (1,107) | $ | (664) | $ | (443) | 67 | % | |||||||||||||||
Income tax expense was $1.1 million for the six months ended June 30, 2020 compared to $0.7 million for the six months ended June 30, 2019. Income tax expense is driven by our allocable share of Switch, Ltd.’s income before income taxes.
Net Income Attributable to Noncontrolling Interest
| Six Months Ended June 30, | Change | ||||||||||||||||||||||
| 2020 | 2019 | Amount | % | ||||||||||||||||||||
| (dollars in thousands) | |||||||||||||||||||||||
| Net income attributable to noncontrolling interest | $ | 5,966 | $ | 6,596 | $ | (630) | (10) | % | |||||||||||||||
Net income attributable to noncontrolling interest was $6.0 million for the six months ended June 30, 2020, compared to $6.6 million for the six months ended June 30, 2019. The change was primarily due to a decrease in ownership by noncontrolling interest holders.
Switch, Inc. | Q2 2020 Form 10-Q | 29
Liquidity and Capital Resources
Switch, Inc. is a holding company and has no material assets other than its ownership of Common Units. As such, we have no independent means of generating revenue or cash flow, and our ability to pay our taxes and operating expenses or declare and pay dividends in the future, if any, will be dependent upon the financial results and cash flows of Switch, Ltd. and its subsidiaries and any distributions we receive from Switch, Ltd. The terms of the amended and restated credit agreement limit the ability of Switch, Ltd., among other things, to incur additional debt, incur additional liens, encumbrances or contingent liabilities, and pay distributions or make certain other restricted payments.
As of June 30, 2020, we had $31.7 million in cash and cash equivalents. As of June 30, 2020, our total indebtedness was $896.3 million consisting of (i) $578.8 million principal from our term loan facility (net of debt issuance costs), (ii) $260.0 million from our revolving credit facility, and (iii) $57.5 million from our finance lease liabilities. As of June 30, 2020, we had access to $240.0 million in additional liquidity from our revolving credit facility. For the year ending December 31, 2020, we expect to incur $290 million to $340 million in capital expenditures for development and construction projects related to our expansion (excluding acquisitions of land); however, the exact amount will depend on a number of factors. We believe we have sufficient cash and access to liquidity, coupled with anticipated cash generated from operating activities, to satisfy our anticipated cash needs for working capital and capital expenditures for at least the next 12 months, including repayment of the current portion of our debt as it becomes due and completion of our development projects. We also believe that our financial resources will allow us to manage the anticipated impact of COVID-19 on our business operations for the foreseeable future, which could include reductions in revenue and delays in payments from customers and partners. The challenges posed by COVID-19 on our business are expected to evolve. Consequently, we will continue to evaluate our financial position in light of future developments, particularly those relating to COVID-19.
In addition, we are obligated to make payments under the Tax Receivable Agreement (“TRA”). Although the actual timing and amount of any payments we make under the TRA will vary, we expect those payments will be significant. Any payments we make under the TRA will generally reduce the amount of overall cash flow that might have otherwise been available to us or to Switch, Ltd. and, to the extent we are unable to make payments under the TRA for any reason, the unpaid amounts generally will be deferred and will accrue interest until paid by us.
Cash Flows
The following table summarizes our cash flows:
| Six Months Ended June 30, | |||||||||||
| 2020 | 2019 | ||||||||||
| (in thousands) | |||||||||||
| Net cash provided by operating activities | $ | 121,491 | $ | 108,955 | |||||||
| Net cash used in investing activities | (167,351) | (100,657) | |||||||||
| Net cash provided by (used in) financing activities | 52,869 | (29,689) | |||||||||
| Net increase (decrease) in cash and cash equivalents | $ | 7,009 | $ | (21,391) | |||||||
Cash Flows from Operating Activities
Cash from operating activities is primarily generated from operating income from our colocation and connectivity services.
Net cash provided by operating activities for the six months ended June 30, 2020 was $121.5 million, compared to $109.0 million for the six months ended June 30, 2019. The increase of $12.5 million was primarily due to increased operations in our expanded data center facilities and changes in our working capital accounts.
Cash Flows from Investing Activities
During the six months ended June 30, 2020, net cash used in investing activities was $167.4 million, primarily consisting of capital expenditures of $166.5 million related to the expansion of our data center facilities.
During the six months ended June 30, 2019, net cash used in investing activities was $100.7 million, primarily consisting of capital expenditures of $100.1 million related to the expansion of our data center facilities.
Switch, Inc. | Q2 2020 Form 10-Q | 30
Cash Flows from Financing Activities
During the six months ended June 30, 2020, net cash provided by financing activities was $52.9 million, primarily consisting of $90.0 million in proceeds from borrowings on our revolving credit facility, partially offset by $20.0 million for the repurchase of common units, $8.3 million in distributions paid to noncontrolling interest, $5.9 million in dividends paid, and $4.2 million for payments of tax withholdings upon settlement of restricted stock unit awards.
During the six months ended June 30, 2019, net cash used in financing activities was $29.7 million, primarily consisting of $13.6 million for the repurchase of common units, $10.4 million in distributions paid to noncontrolling interest, and $3.9 million in dividends paid.
Outstanding Indebtedness
On June 27, 2017, we entered into an amended and restated credit agreement with Wells Fargo Bank, National Association, as administrative agent, and certain other lenders, consisting of a $600.0 million term loan facility, maturing on June 27, 2024, and a $500.0 million revolving credit facility, maturing on June 27, 2022, which replaced our prior credit facility. We refer to the term loan facility and the revolving credit facility as the credit facilities. We are required to repay the aggregate outstanding principal amount of the initial term loan in consecutive quarterly installments of $1.5 million, beginning on September 30, 2017, until the final payment of $559.5 million is made on the maturity date.
The amended and restated credit agreement permits the issuance of letters of credit upon our request of up to $30.0 million. As of June 30, 2020, we had $260.0 million outstanding under the revolving credit facility accruing interest at an underlying variable rate of 1.93% and $240.0 million of availability. As of June 30, 2020, we had $578.8 million outstanding under the term loan (net of deferred debt issuance costs) with $400.0 million effectively fixed at 4.73% pursuant to interest rate swap agreements entered into in January and February 2019 and the remaining borrowings outstanding accruing interest at an underlying variable rate of 2.43%. Upon satisfying certain conditions, the amended and restated credit agreement provides that we can increase the amount available for borrowing under the credit facilities no more than five times (up to an additional $75.0 million in total, plus an additional amount subject to certain leverage restrictions) during the term of the amended and restated credit agreement.
The credit facilities are secured by a first priority security interest in substantially all of Switch, Ltd.’s tangible and intangible personal property and guaranteed by certain of its wholly-owned subsidiaries. Interest on the credit facilities is calculated based on the base rate plus the applicable margin or a LIBOR rate plus the applicable margin (each as defined in the amended and restated credit agreement), at our election. Interest calculations are based on 365/366 days for a base rate loan and 360 days for a LIBOR loan. Base rate interest payments are due and payable in arrears on the last day of each calendar quarter. LIBOR rate interest payments are due and payable on the last day of each selected interest period (not to extend beyond three-month intervals). In addition, under the revolving credit facility we incur a fee on unused lender commitments based on the applicable margin and payment is due and payable in arrears on the last day of each calendar quarter.
The credit agreement contains affirmative and negative covenants customary for such financings, including, but not limited to, limitations, subject to specified exceptions and baskets, on incurring additional debt, incurring additional liens, encumbrances or contingent liabilities, making investments in other persons or property, selling or disposing of our assets, merging with or acquiring other companies, liquidating or dissolving ourselves or any of the subsidiary guarantors, engaging in any business that is not otherwise a related line of business, engaging in certain transactions with affiliates, paying dividends or making certain other restricted payments, and making loans, advances or guarantees. The terms of the credit agreement also require compliance with the consolidated total leverage ratio (as defined in the amended and restated credit agreement) starting with the fiscal quarter ended June 30, 2017. As of June 30, 2020, the maximum consolidated total leverage ratio was 4.25 to 1.00. The maximum consolidated total leverage ratio decreases over time to, and remains at, 4.00 to 1.00 for the quarters ending September 30, 2020 and thereafter through maturity. We were in compliance with this and our other covenants under the credit agreement as of June 30, 2020.
Events of default under the credit facilities, subject to specified thresholds, include but are not limited to: nonpayment of principal, interest, fees or any other payment obligations thereunder; failure to perform or observe covenants, conditions or agreements; material violation of any representation, warranty or certification; cross-defaults to certain material indebtedness; bankruptcy or insolvency of Switch Ltd.’s subsidiary guarantors; certain monetary judgments against the subsidiary guarantors; and any change of control occurrence.
Switch, Inc. | Q2 2020 Form 10-Q | 31
Off-Balance Sheet Arrangements
We do not have any off-balance sheet arrangements for any of the periods presented.
Contractual Obligations
In January and March 2020, we entered into two power purchase and sale agreements for electricity to purchase an aggregate firm commitment of 75 MW per energy hour for a term of one year starting on July 1, 2020. In June 2020, we entered into an additional power purchase and sale agreement for electricity to purchase an incremental firm commitment of five MW per energy hour for a term of one month starting on July 1, 2020, or a total purchase commitment of $24.0 million, inclusive of scheduling services. Additional franchise tax amounts may be due based on the data center location where the purchased power is used.
During the six months ended June 30, 2020, we borrowed an aggregate of $90.0 million under our revolving credit facility. In August 2020, we borrowed an additional $20.0 million under our revolving credit facility.
Outside of the aforementioned, and any routine transactions made in the ordinary course of business, there have been no material changes to the contractual obligations as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2019.
Critical Accounting Policies and Estimates
Our consolidated financial statements are prepared in accordance with GAAP. The preparation of these consolidated financial statements requires our management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, costs and expenses and related disclosures. Our estimates are based on our historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these judgments and estimates under different assumptions or conditions and any such differences may be material. On an ongoing basis, we evaluate the continued appropriateness of our accounting policies and resulting estimates to make adjustments we consider appropriate under the facts and circumstances. There have been no significant changes to our critical accounting policies as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2019.
Cautionary Note Regarding Forward-Looking Statements
This Form 10-Q contains forward-looking statements within the meaning of the federal securities laws, which statements involve substantial risks and uncertainties. Forward-looking statements generally relate to future events or our future financial or operating performance. In some cases, you can identify forward-looking statements because they contain word such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “could,” “intends,” “target,” “projects,” “contemplates,” “believes,” “estimates,” “predicts,” “potential” or “continue” or the negative of these words or other similar terms or expressions that concern our expectations, strategy, plans or intentions. Forward-looking statements contained in this Form 10-Q include, but are not limited to, statements about:
•our goals and strategies;
•our expansion plans, including timing for such plans;
•our future business development, financial condition and results of operations;
•the expected growth of the data center market;
•our belief regarding the anticipated impact of COVID-19 on our business operations;
•our beliefs regarding our design technology and its advantages to our business and financial results;
•our beliefs regarding opportunities that exist in the data center market due to current industry limitations;
•our expectations regarding opportunities to grow penetration of existing customers and attract new customers;
•our beliefs regarding our competitive strengths and the value of our brand;
•our expectations regarding our revenue streams and drivers of future revenue;
•our expectations regarding our future expenses, including anticipated increases;
•our expectations regarding demand for, and market acceptance of, our services, including any new services;
•our expectations regarding our customer growth rate;
•our estimated capital expenditures for 2020;
•our beliefs regarding the sufficiency of our cash and access to liquidity, and cash generated from operating activities, to satisfy our working capital and capital expenditures for at least the next 12 months;
•our intentions regarding sources of financing for our operations and capital expenditures;
Switch, Inc. | Q2 2020 Form 10-Q | 32
•the network effects associated with our business;
•our plans to further invest in and grow our business, and our ability to effectively manage our growth and associated investments;
•our ability to timely and effectively scale and adapt our existing technology;
•our ability to successfully enter new markets;
•our expectations to enter into joint ventures, strategic collaborations and other similar arrangements;
•our beliefs regarding our ability to achieve reduced variability of power costs as an unbundled purchaser of energy;
•our beliefs that we have the necessary permits and approvals to operate our business and that our properties are in substantial compliance with applicable laws;
•our ability to maintain, protect and enhance our intellectual property and not infringe upon others’ intellectual property;
•our beliefs regarding the adequacy of our insurance coverage;
•our beliefs regarding the merits of pending litigation;
•our beliefs regarding the effectiveness of efforts to improve our internal control over financial reporting;
•our plans regarding our Common Unit repurchase program;
•our expectations regarding payment of dividends; and
•our expectations regarding payments under the TRA, contingent upon our taxable income and the applicable tax rate.
We qualify all of our forward-looking statements by these cautionary statements. The forward-looking statements in this Form 10-Q are only predictions. We have based these forward-looking statements largely on our current expectations and projections about future events and financial trends that we believe may affect our business, financial condition and results of operations. Because forward-looking statements are inherently subject to risks and uncertainties, some of which cannot be predicted or quantified, you should not rely on these forward-looking statements as predictions of future events. The events and circumstances reflected in our forward-looking statements may not be achieved or occur and actual results could differ materially from those projected in the forward-looking statements. The most important factors that could prevent us from achieving our goals and cause the assumptions underlying forward-looking statements and the actual results to differ materially from those expressed in or implied by the forward-looking statements include, but are not limited to, the following:
•our ability to successfully implement our business strategies;
•our ability to effectively manage our growth and expansion plans;
•delays or unexpected costs in development and opening of data center facilities;
•any slowdown in demand for our existing data center resources;
•our ability to attract new customers and achieve sufficient customer demand to realize future expected returns on our investments;
•our ability to license space in our existing data centers, including in our new Keep Campus;
•the impact of epidemics, pandemics or outbreaks, including COVID-19, on our business and those of our customers and suppliers;
•the geographic concentration of our data centers in certain markets;
•local economic, credit and market conditions that impact our customers in these markets;
•the impact of delays or disruptions in third-party network connectivity;
•developments in the technology and data center industries in general that negatively impact us, including development of new technologies, adoption of new industry standards, declines in the technology industry or slowdown in the growth of the Internet;
•our ability to adapt to evolving technologies and customer demands in a timely and cost-effective manner;
•financial market fluctuations;
•our ability to obtain necessary capital to fund our capital requirements and our ability to continue to comply with covenants and terms in our credit instruments;
•our ability to generate sufficient cash flow to meet our debt service and working capital requirements;
•our ability to collect revenue on a timely basis;
•fluctuations in interest rates, including the impact of any discontinuance, modification or other reform of LIBOR, or the establishment of alternative reference rates;
•increased operating costs, including power costs;
•significant disruptions, security breaches, including cyber security breaches, or system failures at any of our data center facilities;
•our ability to effectively compete in the data center market;
•the success of our strategic partnerships;
•our ability to protect our intellectual property rights and not infringe upon others’ intellectual property rights;
Switch, Inc. | Q2 2020 Form 10-Q | 33
•loss of significant customers or key personnel;
•losses in excess of our insurance coverage, including due to natural disasters and other unforeseen damage;
•impact of the outcome of pending or future litigation;
•the impact of future changes in legislation and regulations, including changes in real estate and zoning laws, ABA, environmental and other laws that impact our business and industry;
•the success of our solar project;
•future increases in real estate taxes;
•early termination of data center leases or inability to renew on commercially acceptable terms;
•our ability to successfully identity and consummate future joint ventures, acquisitions or other strategic transactions;
•our realization of any benefit from the TRA, our Common Unit repurchase plan and our organizational structure;
•our ability to sufficiently remediate the material weakness identified in our internal control over financial reporting;
•volatility of our stock price, including due to future issuances of our Class A common stock upon redemption or exchange of Common Units; and
•our ability to successfully estimate the impact of certain accounting and tax matters, including the effect on our company of adopting certain accounting pronouncements.
The foregoing list of important factors does not include all such factors, nor necessarily present them in order of importance. In addition, you should consult other disclosures made by us (such as in our other filings with the SEC or in company press releases) for other factors that may cause actual results to differ materially from those projected by us. You should read this Form 10-Q, and the documents that we reference in this Form 10-Q and have filed with the SEC, and our Annual Report on Form 10-K for the year ended December 31, 2019, with the understanding that our actual future results, levels of activity, performance, and events and circumstances may be materially different from what we expect.
Except as required by applicable law, we do not plan to publicly update or revise any forward-looking statements contained herein, whether as a result of any new information, future events, changed circumstances or otherwise.
Item 3.Quantitative and Qualitative Disclosures About Market Risk.
We are exposed to financial market risks, primarily in interest rates related to our debt obligations.
Interest Rate Risk
Our primary exposure to market risk is interest rate risk associated with our long-term debt. We evaluate our exposure to market risk by monitoring interest rates in the marketplace. As of June 30, 2020, borrowings under our amended and restated credit agreement bear interest at a margin above LIBOR or base rate (each as defined in the amended and restated credit agreement) as selected by us. In January and February 2019, we entered into four interest rate swap agreements; whereby, we pay a weighted average fixed interest rate (excluding the applicable interest margin) of 2.48% on notional amounts corresponding to borrowings of $400.0 million in exchange for receipts on the same notional amount at a variable interest rate based on the applicable LIBOR at the time of payment. The interest rate swap agreements mature in June 2024. As of June 30, 2020, we had $442.0 million outstanding under our credit facilities with an underlying variable interest rate of 2.14%. As of June 30, 2020, a hypothetical increase or decrease of 100 basis points in LIBOR would cause our annual interest cost to change by $4.4 million.
Switch, Inc. | Q2 2020 Form 10-Q | 34
Item 4.Controls and Procedures.
Evaluation of Disclosure Controls and Procedures
Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated, as of June 30, 2020, the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, as amended, or the “Exchange Act”). Based on their evaluation, as of June 30, 2020, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were not effective because of the material weakness in our internal control over financial reporting described below.
In designing and evaluating our disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable, not absolute, assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply judgment in evaluating the benefits of possible controls and procedures relative to their costs. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote.
Material Weakness
As of December 31, 2019, we had a material weakness in our internal control over financial reporting. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis.
The material weakness, which was identified in connection with the audit of our 2017 consolidated financial statements, related to an insufficient complement of resources with an appropriate level of accounting expertise, knowledge, and training commensurate with the complexity of our financial reporting matters. This material weakness led to pervasive immaterial adjustments to our annual and interim consolidated financial statements, inadequate review over account reconciliations and the inability to maintain segregation of duties over journal entries resulting in the lack of an effective control environment. We concluded this material weakness continued to exist as of June 30, 2020.
Additionally, this material weakness could result in a misstatement of our account balances or disclosures that would result in a material misstatement of the annual or interim consolidated financial statements that would not be prevented or detected.
Material Weakness Remediation Efforts
We have implemented and continue to implement measures designed to improve our internal control over financial reporting to remediate this material weakness, including hiring additional personnel with appropriate education, experience and certifications for key positions in the financial reporting and accounting function, as well as designing and implementing improved processes and internal controls, including transaction-level controls, controls over the maintenance of appropriate segregation of duties over journal entries, account reconciliations, and strengthening supervisory reviews by our management.
While we believe that these efforts will improve our internal control over financial reporting, the implementation of these measures is ongoing and will require validation and testing of the design and operating effectiveness of internal controls over a sustained period of financial reporting cycles. Due to this ongoing testing, we cannot provide assurance that the measures we have taken to date, and are continuing to implement, will be sufficient to remediate the material weakness we have identified or avoid potential future material weaknesses. If the steps we take do not correct the material weakness in a timely manner, we will be unable to conclude that we maintain effective internal control over financial reporting. Accordingly, there could continue to be a reasonable possibility that a material misstatement of our financial statements would not be prevented or detected on a timely basis.
Changes in Internal Control over Financial Reporting
There were no changes in our internal control over financial reporting during the quarter ended June 30, 2020 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Switch, Inc. | Q2 2020 Form 10-Q | 35
Part II.Other Information
Item 1.Legal Proceedings.
On September 7, 2017, Switch, Ltd. and Switch, Inc. were named in a lawsuit filed in the U.S. District Court for the District of Nevada by V5 Technologies formerly d/b/a Cobalt Data Centers. The lawsuit alleges, among other things, that Switch, Ltd. and Switch, Inc. monopolized the Las Vegas Metropolitan area of Southern Nevada’s data center colocation market and engaged in unfair business practices leading to the failure of Cobalt Data Centers in 2015 and seeks monetary damages in an amount yet to be disclosed. Discovery closed in February 2020. In March 2020, both parties filed motions for summary judgment and are waiting for the court to rule on the motions. Switch, Ltd. and Switch, Inc. are vigorously defending the case.
On September 12, 2017, Switch, Ltd. filed a complaint in the Eighth Judicial District of Nevada against the consultant, Stephen Fairfax, and his business, MTechnology Inc. Among other claims, Switch raised allegations of breach of contract and misappropriation of trade secrets. The complaint also alleged that Aligned Data Centers LLC (“Aligned”) hired Mr. Fairfax and MTechnology Inc. to design their data centers; that this consultant had toured Switch under a non-disclosure agreement; and that this consultant breached his confidentiality agreements with Switch by using Switch’s designs to design the Aligned data centers. Switch, Ltd. is seeking an injunction to prevent the defendants in the lawsuit from infringing Switch, Ltd.’s patents, as well as other remedies. The parties are currently engaged in discovery.
Four substantially similar putative class action complaints, captioned Martz v. Switch, Inc. et al. (filed April 20, 2018); Palkon v. Switch, Inc. et al. (filed April 30, 2018); Chun v. Switch, Inc. et al. (filed May 11, 2018); and Silverberg v. Switch, Inc. et al. (filed June 6, 2018), were filed in the Eighth Judicial District of Nevada, and subsequently consolidated into a single case (the “State Court Securities Action”). Additionally, on June 11, 2018, one putative class action complaint captioned Cai v. Switch, Inc. et al. was filed in the United States District Court for the District of New Jersey (the “Federal Court Securities Action,” and collectively with the State Court Securities Action, the “Securities Actions”) and subsequently transferred to the Eighth Judicial District of Nevada in August 2018 and the federal court appointed Oscar Farach lead plaintiff. These lawsuits were filed against Switch, Inc., certain current and former officers and directors and certain underwriters of Switch, Inc.’s IPO alleging federal securities law violations in connection with the IPO. These lawsuits were brought by purported stockholders of Switch, Inc. seeking to represent a class of stockholders who purchased Class A common stock in or traceable to the IPO, and seek unspecified damages and other relief. With respect to the Federal Court Securities Action, in July 2019, the federal court granted Switch, Inc.’s motion to dismiss in part, which narrowed the scope of the plaintiff’s case. In December 2019, Switch, Inc. filed a motion for judgment on the pleadings, and in July 2020, the federal court entered a judgment in favor of Switch, Inc. With respect to the State Court Securities Action, in October 2018, the state court granted the defendants’ motion to stay the State Court Securities Action in favor of the Federal Court Securities Action, which stay was affirmed by the Nevada Supreme Court in September 2019. The State Court Securities Action remains stayed until further order by the state court. Switch, Inc. believes that these lawsuits are without merit and intends to continue to vigorously defend against them.
On September 10, 2018, two purported stockholders of Switch, Inc. filed substantially similar shareholder derivative complaints, respectively captioned Liu v. Roy et al., and Zhao v. Roy et al., in the Eighth Judicial District of Nevada, which were subsequently consolidated into a single case (the “Derivative Shareholder Action”). These lawsuits allege breaches of fiduciary duty, unjust enrichment, waste of corporate assets, abuse of control, and gross mismanagement against certain current and former officers and directors of Switch, Inc. The plaintiffs also named Switch, Inc. as a nominal defendant. The complaints arise generally from the same allegations described in the State Court Securities Action and Federal Court Securities Action. The plaintiffs seek unspecified damages on Switch, Inc.’s behalf from the officer and director defendants, certain corporate governance actions, compensatory awards, and other relief. In December 2019, the court granted the parties’ stipulation to stay the Derivative Shareholder Action until the earlier of any of the following events: the Securities Actions are resolved with prejudice as to each defendant or a motion for summary judgment is resolved in the Federal Court Securities Action.
The outcomes of the legal proceedings are inherently unpredictable, subject to significant uncertainties, and could be material to the Company’s financial condition, results of operations, and cash flows for a particular period. Where the Company is a defendant, it will vigorously defend against the claims pleaded against it. These actions are each in preliminary stages and management has determined that based on proceedings to date, it is currently unable to determine the probability of the outcome of these actions or the range of reasonably possible loss, if any.
Switch, Inc. | Q2 2020 Form 10-Q | 36
Item 1A.Risk Factors.
Except as provided below, there have been no material changes with respect to the risk factors disclosed in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2019.
Our business and those of our customers and suppliers may be adversely affected by epidemics, pandemics or other outbreaks.
The effects of epidemics, pandemics or other outbreaks of an illness, disease or virus are uncertain and difficult to predict. The COVID-19 pandemic is causing significant disruptions to the United States and global economies and has contributed to significant volatility and negative pressure in financial markets. The global impact of the outbreak is rapidly evolving, and any preventative or protective actions that we may take in response to COVID-19 or any other global health threat or pandemic may result in business and/or operational disruption.
Our customers’ businesses could be disrupted, which would affect their ability to make payments to us, and our revenues could be negatively affected. Additionally, global economic disruptors like COVID-19 could negatively impact our supply chain and cause delays in the construction or development of our data centers due to disruptions in the supply of materials or products or the inability of our contractors to perform on a timely basis or at all. It may not be possible to find replacement products or supplies and ongoing delays could affect our business and growth.
The extent to which COVID-19 impacts our and our customers’ operations will depend on future developments, which are highly uncertain and cannot be predicted, including, among others, the duration and severity of the outbreak, new information that might emerge, governmental measures, and the actions taken to contain COVID-19 or treat its impact. These and other potential impacts of epidemics, pandemics or other outbreaks of an illness, disease or virus could have a material adverse effect on our business, financial condition and results of operations.
Item 6.Exhibits.
| Incorporated by Reference | |||||||||||||||||
| Exhibit No. | Exhibit Description | Form | Exhibit | Filing Date | |||||||||||||
| 3.1 | 8-K | 3.1 | 10/11/2017 | ||||||||||||||
| 3.2 | 8-K | 3.2 | 10/11/2017 | ||||||||||||||
| 31.1 | * | ||||||||||||||||
| 31.2 | * | ||||||||||||||||
| 32.1 | # | ||||||||||||||||
| 101 | * | The following financial statements from the Company’s Quarterly Report on Form 10-Q, formatted in Inline XBRL: (i) Consolidated Balance Sheets as of June 30, 2020 and December 31, 2019, (ii) Consolidated Statements of Comprehensive Income for the three and six months ended June 30, 2020 and 2019, (iii) Consolidated Statements of Stockholders’ Equity for the three and six months ended June 30, 2020 and 2019, (iv) Consolidated Statements of Cash Flows for the six months ended June 30, 2020 and 2019, and (v) Condensed Notes to Consolidated Financial Statements | |||||||||||||||
| 104 | * | Cover Page Interactive Data File (formatted in Inline XBRL and contained in Exhibit 101) | |||||||||||||||
___________________________________________________________________
* Filed herewith.
# Furnished herewith.
Switch, Inc. | Q2 2020 Form 10-Q | 37
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.
Switch, Inc. (Registrant) | ||||||||
| Date: | August 10, 2020 | /s/ Gabe Nacht | ||||||
Gabe Nacht Chief Financial Officer (Principal Financial and Accounting Officer and Duly Authorized Officer) | ||||||||