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SPOK HOLDINGS, INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations
[October 30, 2014]

SPOK HOLDINGS, INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations


(Edgar Glimpses Via Acquire Media NewsEdge) Forward-Looking Statements This Quarterly Report contains forward-looking statements and information relating to Sp?k Holdings, Inc. and its subsidiaries ("SP?K" or the "Company") (formerly USA Mobility, Inc.) that set forth anticipated results based on management's current plans, known trends and assumptions. These statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Statements that are predictive in nature, that depend upon or refer to future events or conditions, or that include words such as "anticipate," "believe," "estimate," "expect," "intend," "will," "target," "forecast" and similar expressions, as they relate to SP?K are forward-looking statements.



Although these statements are based upon current plans, known trends and assumptions that management considers reasonable, they are subject to certain risks, uncertainties and assumptions, including but not limited to those discussed below and under the captions "Business," "Management's Discussion and Analysis of Financial Condition and Statements of Income ("MD&A")," and "Part I - Item 1A - Risk Factors" in our Annual Report on Form 10-K for the year ended December 31, 2013, filed with the United States Securities and Exchange Commission (the "SEC") on March 11, 2014 (the "2013 Annual Report"). Should known or unknown risks or uncertainties materialize, known trends change, or underlying assumptions prove inaccurate, actual results or outcomes may differ materially from past results and those described herein as anticipated, believed, estimated, expected, intended, targeted or forecasted. Investors are cautioned not to place undue reliance on these forward-looking statements.

The Company undertakes no obligation to update forward-looking statements.


Investors are advised to consult all further disclosures the Company makes in its subsequent reports on Form 10-Q and Form 8-K that it will file with the SEC.

Also note that, in the risk factors disclosed in the Company's 2013 Annual Report, the Company provides a cautionary discussion of risks, uncertainties and possibly inaccurate assumptions relevant to its business. These are factors that, individually or in the aggregate, could cause the Company's actual results to differ materially from past results as well as those results that may be anticipated, believed, estimated, expected, intended, targeted or forecasted. It is not possible to predict or identify all such risk factors. Consequently, investors should not consider the risk factor discussion to be a complete discussion of all of the potential risks or uncertainties that could affect SP?K's business, statement of income or financial condition, subsequent to the filing of this Quarterly Report.

Overview The following MD&A is intended to help the reader understand the statements of income and financial position of SP?K. The MD&A is provided as a supplement to, and should be read in conjunction with, our 2013 Annual Report and our condensed consolidated financial statements and accompanying notes. A reference to a "Note" in this section refers to the accompanying Unaudited Notes to the Condensed Consolidated Financial Statements.

Effective January 1, 2014, the Company is structured as one operating (and reportable) segment, a unified communication business as more fully described in Note 20. The Chief Executive Officer (who is also the chief operating decision maker as defined by ASC 280) views the business as one operation and assesses performance and allocates resources on the basis of our consolidated operations.

SP?K, acting through its indirect wholly-owned operating subsidiary, Sp?k, Inc., is a comprehensive provider of critical communication solutions for enterprises.

As a single source provider, the Company operates the largest one-way paging and advanced two-way paging networks in the United States and provides mission critical unified communication software solutions nationally and internationally (in Europe, Australia, Asia and the Middle East) to such key market segments as healthcare, government and large enterprises. Software solutions include critical smartphone communication solutions, secure texting, contact center optimization, emergency management and clinical workflow improvement. For both the three and nine months ended 13 --------------------------------------------------------------------------------September 30, 2014 and 2013, wireless and software revenue represent approximately 70% and 30%, respectively of our consolidated revenue.

The following tables indicate the wireless and software revenue by key market segments for the periods stated and illustrate the relative significance of these market segments to our operations.

For the Three Months Ended For the Three Months Ended September 30, 2014 September 30, 2013 Market Segment Wireless Software Total % of Total Wireless Software Total % of Total (Dollars in thousands) Healthcare $ 22,130 $ 10,871 $ 33,001 66.4 % $ 24,545 $ 8,502 $ 33,047 66.6 % Government 2,298 2,609 4,907 9.9 % 2,873 1,163 4,036 8.1 % Large Enterprise 3,314 533 3,847 7.7 % 4,157 490 4,647 9.4 % Other (1) 4,060 1,026 5,086 10.2 % 4,205 1,031 5,236 10.5 % Total Direct 31,802 15,039 46,841 94.1 % 35,780 11,186 46,966 94.6 % Total Indirect 1,053 1,897 2,950 5.9 % 1,287 1,416 2,703 5.4 % Total $ 32,855 $ 16,936 $ 49,791 100.0 % $ 37,067 $ 12,602 $ 49,669 100.0 % (1) Other includes hospitality, resort and billable travel revenue.

For the Nine Months Ended For the Nine Months Ended September 30, 2014 September 30, 2013 Market Segment Wireless Software Total % of Total Wireless Software Total % of Total (Dollars in thousands) Healthcare $ 68,152 $ 31,427 $ 99,579 66.8 % $ 73,540 $ 27,872 $ 101,412 65.3 % Government 7,248 6,087 13,335 8.9 % 9,234 4,212 13,446 8.7 % Large Enterprise 10,649 1,550 12,199 8.2 % 13,045 2,171 15,216 9.8 % Other (1) 11,380 2,191 13,571 9.1 % 13,530 2,379 15,909 10.3 % Total Direct 97,429 41,255 138,684 93.1 % 109,349 36,634 145,983 94.1 % Total Indirect 3,295 7,025 10,320 6.9 % 4,268 4,816 9,084 5.9 % Total $ 100,724 $ 48,280 $ 149,004 100.0 % $ 113,617 $ 41,450 $ 155,067 100.0 % (1) Other includes hospitality, resort and billable travel revenue.

The following table indicates the percentage of our paging units in service by key market segments as of the dates stated and illustrates the relative significance of these market segments to our wireless revenue: As of September 30, As of September 30, Market Segment 2014 As of June 30, 2014 2013 Healthcare 73.6 % 73.0 % 71.4 % Government 7.9 % 8.3 % 8.8 % Large Enterprise 7.8 % 7.8 % 8.2 % Other 6.4 % 6.6 % 7.1 % Total Direct 95.7 % 95.7 % 95.5 % Total Indirect 4.3 % 4.3 % 4.5 % Total 100.0 % 100.0 % 100.0 % Revenue We offer a focused suite of unified critical communication solutions that include call center operations, clinical alerting and notifications, one-way and advanced two-way wireless messaging services, mobile communications and public safety solutions.

We develop, sell, and support enterprise-wide systems for hospitals and other organizations needing to automate, centralize, and standardize mission critical communication solutions. Given the focused nature of our software products, our primary market has been the healthcare industry, particularly hospitals. We have identified hospitals with 200 or more beds as the primary targets for our software solutions.

14 --------------------------------------------------------------------------------We have established solutions for: • Hospital Call Centers - These solutions encompass operator and answering services along with call recording, scheduling and selective additional support modules.

• Clinical Workflow Communication - These solutions address hospital code processing as well as physician support tools.

• Communication Applications - These solutions support hospital notification and appointment support.

• Communications Infrastructure - These solutions support the wireless messaging infrastructure and offer a software product that can link disparate communications software ("middleware").

• Public Safety - These solutions implement and support emergency communication systems.

Revenue generated by wireless messaging services (including voice mail, personalized greeting, message storage and retrieval) and equipment loss and/or maintenance protection to both one-way and two-way messaging subscribers are presented as wireless revenue in our statements of income. In addition, we sell software solutions, professional services (installation and training), equipment (to be used in conjunction with the software) and post-contract support (on-going maintenance). Revenue generated by these communication solutions are reflected as software revenue in our statements of income. Our software is licensed to end users under an industry standard software license agreement.

We market and distribute our communication services and solutions through a direct sales force and an indirect sales channel.

Direct. The direct sales force rents or sells products, solutions, messaging services and other services directly to customers ranging from small and medium-sized businesses to companies in the Fortune 1000, healthcare and related businesses, and Federal, state and local government agencies. We will continue to market to commercial enterprises, especially healthcare organizations, that are interested in our communication solutions. We maintain a sales presence in key markets throughout the United States in an effort to gain new customers and to retain and increase sales to existing customers. We also maintain several corporate groups, such as our Key Account Management team, focused on retaining and selling additional products and services to our key healthcare accounts as well as a team selling to government and national accounts. The direct sales force targets unified communications leadership such as chief information officers, information technology directors, telecommunications directors and contact center managers. Additionally, for certain of our software solutions, we target clinical leadership including chief medical officers and chief nursing officers. The timing for a direct sale varies by the type of service or solution that is being offered, but a software solution sale may take from 6 to 18 months depending on the type of software solution.

Indirect. The direct sales force is complimented by an indirect sales channel.

This channel coordinates relationships with alliance partners or third-party service providers that are ultimately responsible for the delivery of our services or solutions to the customer.

The following details additional information on our revenue.

Wireless Revenue Our core offering includes subscriptions to one-way or two-way messaging services for a periodic (monthly, quarterly, semi-annual, or annual) service fee. This is generally based upon the type of service provided, the geographic area covered, the number of devices provided to the customer and the period of commitment. A subscriber to one-way messaging services may select coverage on a local, regional or nationwide basis to best meet their messaging needs. Two-way messaging is generally offered on a nationwide basis. In addition, subscribers either lease a messaging device from us for an additional fixed monthly fee or they own a device, having purchased it either from us or from another vendor. We also sell devices to resellers who lease or resell devices to their subscribers and then sell messaging services utilizing our networks. We offer ancillary services, such as voicemail and equipment loss or maintenance protection, which help increase the monthly recurring revenue we receive along with these traditional messaging services.

Wireless revenue consists of two primary components: paging revenue and product and other revenue. The breakout of wireless revenue by component was as follows for the periods stated: For the Three Months For the Nine Months Ended September 30, Ended September 30, Revenue 2014 2013 2014 2013 (Dollars in thousands) Paging revenue $ 30,776 $ 35,141 $ 95,130 $ 108,256 Product and other revenue 2,079 1,926 5,594 5,361 Total wireless revenue $ 32,855 $ 37,067 $ 100,724 $ 113,617 The following table summarizes the breakdown of our direct and indirect units in service at specified dates: 15 -------------------------------------------------------------------------------- As of September 30, 2014 As of June 30, 2014 As of September 30, 2013 Distribution Channel Units % of Total Units % of Total Units % of Total (Units in thousands) Direct 1,220 95.8 % 1,243 95.7 % 1,345 95.5 % Indirect 54 4.2 % 56 4.3 % 63 4.5 % Total 1,274 100.0 % 1,299 100.0 % 1,408 100.0 % The following table summarizes the breakdown of our one-way and two-way units in service at specified dates: As of September 30, 2014 As of June 30, 2014 As of September 30, 2013 Service Type Units % of Total Units % of Total Units % of Total (Units in thousands) One-way messaging 1,185 93.0 % 1,208 93.0 % 1,310 93.0 % Two-way messaging 89 7.0 % 91 7.0 % 98 7.0 % Total 1,274 100.0 % 1,299 100.0 % 1,408 100.0 % The demand for one-way and two-way messaging declined at each specified date and we believe demand will continue to decline for the foreseeable future. Demand for our services has also been impacted by the shift from narrow band wireless service offerings to broad band technology services.

As demand for one-way and two-way messaging has declined, we have developed or added service offerings such as Mobile Connect with a pager number in order to increase our revenue potential and mitigate the decline in our wireless revenue.

We will continue to explore ways to innovate and provide customers the highest value possible.

Wireless revenue is generally based upon the number of units in service and the monthly charge per unit. The number of units in service changes based on subscribers added, referred to as gross placements, less subscriber cancellations, or disconnects. The net of gross placements and disconnects is commonly referred to as net gains or losses of units in service or net disconnect rate. The absolute number of gross placements as well as the number of gross placements relative to average units in service in a period, referred to as the gross placement rate, is monitored on a monthly basis. Disconnects are also monitored on a monthly basis. The ratio of units disconnected in a period to average units in service for the same period, called the disconnect rate, is an indicator of our success at retaining subscribers, which is important in order to maintain recurring revenue and to control operating expenses.

The following table sets forth our gross placements and disconnects for the periods stated: For the Three Months Ended September 30, 2014 June 30, 2014 September 30, 2013 Gross Gross Gross Distribution Channel Placements Disconnects Placements Disconnects Placements Disconnects (Units in thousands) Direct 44 67 50 76 43 78 Indirect 1 3 1 3 1 3 Total 45 70 51 79 44 81 The following table sets forth information on our direct units in service by account size for the periods stated: As of September 30, 2014 As of June 30, 2014 As of September 30, 2013 Account Size Units % of Total Units % of Total Units % of Total (Units in thousands) 1 to 3 Units 37 3.0 % 39 3.1 % 45 3.3 % 4 to 10 Units 22 1.8 % 23 1.8 % 26 2.0 % 11 to 50 Units 53 4.3 % 56 4.5 % 64 4.8 % 51 to 100 Units 36 3.0 % 38 3.1 % 43 3.2 % 101 to 1000 Units 267 21.9 % 275 22.1 % 293 21.8 % > 1000 Units 805 66.0 % 812 65.4 % 874 64.9 % Total direct units in service 1,220 100.0 % 1,243 100.0 % 1,345 100.0 % 16--------------------------------------------------------------------------------The following table sets forth information on the direct net disconnect rate by account size for our direct customers for the periods stated: For the Three Months Ended Account Size September 30, 2014 June 30, 2014 September 30, 2013 1 to 3 Units (4.8 )% (4.1 )% (4.6 )% 4 to 10 Units (4.0 )% (5.4 )% (5.3 )% 11 to 50 Units (5.2 )% (3.2 )% (3.9 )% 51 to 100 Units (5.2 )% (8.7 )% (2.8 )% 101 to 1000 Units (2.9 )% (2.5 )% (4.0 )% > 1000 Units (1.0 )% (1.2 )% (1.7 )% Total direct net unit loss % (1.9 )% (2.0 )% (2.5 )% The other factor that contributes to revenue, in addition to the number of units in service, is the monthly charge per unit. As previously discussed, the monthly charge per unit is dependent on the subscriber's service, extent of geographic coverage, whether the subscriber leases or owns the messaging device, and the number of units the customer has in the account. The ratio of revenue for a period to the average units in service, for the same period, commonly referred to as ARPU, is a key revenue measurement as it indicates whether charges for similar services and distribution channels are increasing or decreasing. ARPU by distribution channel and messaging service are monitored regularly.

The following table sets forth ARPU by distribution channel for the periods stated: ARPU For the Three Months Ended Distribution Channel September 30, 2014 June 30, 2014 September 30, 2013 Direct $ 8.05 $ 8.06 $ 8.29 Indirect 6.32 6.39 6.57 Total 7.97 7.98 8.22 While ARPU for similar services and distribution channels is indicative of changes in monthly charges and the revenue rate applicable to new subscribers, this measurement on a consolidated basis is affected by several factors, including the mix of units in service and the pricing of the various components of our services. We expect future sequential annual revenue to decline in line with recent trends. The change in ARPU in the direct distribution channel is the most significant indicator of rate related changes in our revenue. The decrease in consolidated ARPU for the quarter ended September 30, 2014 from the quarter ended September 30, 2013 was due to the change in composition of our customer base as the percentage of units in service attributable to larger customers continues to increase. These larger customers benefit from lower pricing associated with their larger number of units-in-service. We believe that without further price adjustments, ARPU would trend lower for both the direct and indirect distribution channels in the remainder of 2014. Price increases could mitigate, but not completely offset, the expected declines in both ARPU and revenue.

The following table sets forth information on direct ARPU by account size for the periods stated: For the Three Months Ended September 30, Account Size September 30, 2014 June 30, 2014 September 30, 2013 1 to 3 Units $ 14.65 $ 14.86 $ 15.13 4 to 10 Units 14.04 14.12 14.38 11 to 50 Units 11.95 12.00 12.06 51 to 100 Units 10.16 10.18 10.66 101 to 1000 Units 8.69 8.58 8.85 > 1000 Units 6.99 7.00 7.17 Total direct ARPU $ 8.05 $ 8.06 $ 8.29 Software Revenue Software revenue consists of two primary components: operations revenue and maintenance revenue.

Operations revenue consists of license revenue, professional services revenue, and equipment sales. Maintenance revenue is for ongoing support of a software application or equipment (typically for one year). We recognize equipment revenue when it 17 -------------------------------------------------------------------------------- is shipped or delivered to the customer depending on delivery method of Free on Board ("FOB") shipping or FOB destination, respectively. As of January 1, 2014, license, professional services and maintenance revenue is recognized ratably over the longer of the period of professional services delivery to the customer or the contractual term of the maintenance agreement. If the period of delivery to the customer is not known, license and professional services revenue will be recognized when software and professional services are fully delivered to the customer and the maintenance revenue will be recognized ratably over the remaining contractual term of the agreement. Prior to January 1, 2014, license and professional services revenue was recognized when the services were fully delivered to the customer and maintenance revenue was recognized ratably over the term of the maintenance agreement.

The breakout of software revenue by component was as follows for the periods stated: For the Three Months For the Nine Months Ended September 30, Ended September 30, Revenue 2014 2013 2014 2013 (Dollars in thousands) Operations revenue $ 9,067 $ 5,551 $ 25,505 $ 20,693 Maintenance revenue 7,869 7,051 22,775 20,757 Total software revenue $ 16,936 $ 12,602 $ 48,280 $ 41,450 On a regular basis, we enter into contractual arrangements with our customers to provide software licenses, professional services, and equipment sales. In addition, we enter into contractual arrangements for maintenance with our customers on new solutions or renewals on existing solutions. These contractual arrangements are reported as bookings and represent future revenue. Bookings increased by 17.7% and 19.2% for the three and nine months ended September 30, 2014 compared to the same periods in 2013. The increase reflects the continuing success of our software sales force in closing business and expanding market penetration with new customers, as well as selling additional solutions to our installed customer base.

The following table summarizes total bookings for the periods stated: For the Three Months Ended For the Nine Months September 30, Ended September 30, Bookings 2014 2013 2014 2013 (Dollars in thousands) Operations and new maintenance orders $ 12,474 $ 9,086 $ 32,180 $ 26,466 Maintenance and subscription renewals 7,888 8,216 24,062 20,715 Total bookings $ 20,362 $ 17,302 $ 56,242 $ 47,181 We reported a software backlog of $42.1 million at September 30, 2014, which represented all purchase orders received from customers not yet recognized as revenue.

Backlog (Dollars in thousands) Beginning balance at January 1, 2014 $ 40,211 Operations bookings 32,180 Maintenance and subscription renewals 24,062 Available backlog $ 96,453 Operations revenue (25,505 ) Maintenance revenue (22,775 ) Other(1) (6,056 ) Total backlog at September 30, 2014 $ 42,117 (1) Other reflects cancellations and adjustments to backlog.

Operations - Consolidated Our operating expenses are presented in functional categories. Certain of our functional categories are especially important to overall expense control and management; these operating expenses are categorized as follows: •Cost of revenue. These are expenses primarily for hardware, third-party software, outside service expenses and payroll and related expenses for our professional services, logistics, customer support and maintenance staff.

18 -------------------------------------------------------------------------------- •Service, rental, and maintenance. These are expenses associated with the operation of our paging networks and development of our software. Expenses consist largely of site rent expenses for transmitter locations, telecommunication expenses to deliver messages over our paging networks, and payroll and related expenses for our engineering, pager repair functions and development and maintenance of our software products.

•Selling and marketing. These are expenses associated with our direct sales force and indirect sales channel and marketing expenses in support of those sales groups. This classification consists primarily of payroll and related expenses and commission expenses.

•General and administrative. These are expenses associated with information technology and administrative functions. This classification consists primarily of payroll and related expenses, outside service expenses, taxes, licenses and permit expenses, and facility rent expenses.

We review the percentages of these operating expenses to revenue on a regular basis. Even though the operating expenses are classified as described above, expense control and management are also performed by expense category.

Approximately 70% of the operating expenses referred to above were incurred in payroll and related expenses, site and facility rent expenses and telecommunication expenses for the three and nine months ended September 30, 2014 and 2013, respectively.

Our largest expense, payroll and related expenses, includes wages, commissions, incentives, employee benefits and related taxes. On a monthly basis, we review the number of employees in major functional categories and the design and physical locations of functional groups to continuously improve efficiency, to simplify organizational structures, and to minimize the number of physical locations for the Company. We have 606 full-time equivalent employees ("FTEs") at September 30, 2014, a decrease of 7.1% from 652 FTEs at September 30, 2013.

The change in the number of FTEs reflects adjustments to our workforce resulting from the changing nature of our revenues. Software revenue is anticipated to increase, while the wireless revenue is expected to continue to decrease reflecting the changing technology expectations of our customer base.

Site rent expenses for transmitter locations are largely dependent on our paging networks. We operate local, regional, and nationwide one-way and two-way paging networks. These networks each require locations on which to place transmitters, receivers, and antennae. Site rent expenses for transmitter locations are highly dependent on the number of transmitters, which in turn is dependent on the number of networks. In addition, these expenses generally do not vary directly with the number of subscribers or units in service, which is detrimental to our operating margins as wireless revenue declines. In order to reduce these expenses, we have an active program to consolidate the number of paging networks, and thus transmitter locations, which we refer to as network rationalization. We have reduced the number of active transmitters by 4.7% to 4,355 active transmitters at September 30, 2014 from 4,572 active transmitters at September 30, 2013.

Telecommunication expenses are incurred to interconnect our paging networks and to provide telephone numbers for customer use, points of contact for customer service, and connectivity among our offices. These expenses are dependent on the number of units in service, the number of customers we support and the number of office and network locations that we maintain. The number or duration of telephone calls to call centers may vary from period to period based on factors other than the number of units in service or customers, which could cause telecommunication expenses to vary.

Due to the integration of the management structure and consolidation of certain sales support functions effective January 1, 2014, certain prior year's interim revenue and operating expenses were reclassified to conform to the current year's presentation. In 2014, we will report wireless and software revenue, and have reclassified the revenue previously reported in the Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2013 (the "Third Quarter 2013 Form 10-Q") to conform with the current year's presentation. In the third quarter of 2013, wireless revenue of $37.07 million was reported as $35.54 million in service, rental and maintenance, net of service credits and $1.53 million of software revenue and other, net. Also, in the third quarter of 2013, software revenue of $12.60 million was reported in software revenue and other, net. We reclassified payroll and related expenses among functional departments and eliminated general and administrative overhead expenses previously allocated to cost of revenue, service, rental and maintenance and selling and marketing.

The reclassifications resulted in the following increases and (decreases) to the Third Quarter 2013 Form 10-Q reported operating expenses: Cost of revenue of $1.43 million; service, rental and maintenance of ($0.73) million; selling and marketing of $0.15 million and general and administrative of ($0.85) million.

The changes had no impact to previously reported total operating expenses and operating income.

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