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Cbeyond (NASDAQ:CBEY)

Q1 2013 Earnings Call

May 01, 2013 5:00 pm ET

Executives

J. Robert Fugate - Co-Founder, Chief Financial Officer, Executive Vice President and Secretary

James F. Geiger - Co-Founder, Chairman, Chief Executive Officer and President

Robert Morrice

Analysts

Barry McCarver - Stephens Inc., Research Division

Barry M. Sine - Drexel Hamilton, LLC, Research Division

Brett Feldman - Deutsche Bank AG, Research Division

Frank G. Louthan - Raymond James & Associates, Inc., Research Division

George F. Sutton - Craig-Hallum Capital Group LLC, Research Division

Donna Jaegers - D.A. Davidson & Co., Research Division

Jennifer M. Fritzsche - Wells Fargo Securities, LLC, Research Division

Operator

Good day, ladies and gentlemen, and welcome to the Cbeyond First Quarter 2013 Conference Call and Webcast. [Operator Instructions] As a reminder, today's program is being recorded.

I would now like to introduce your host for today's program, Mr. Bob Fugate, Executive Vice President and CFO. Please go ahead.

J. Robert Fugate

Thank you, operator. And thank you, call participants, for joining us today. I would like to begin today's call by reminding you that this call contains forward-looking statements that include words such as believe, expect, anticipate, intend, project and similar expressions. Actual results may differ from our forward-looking statements. For specific factors that might cause future results to differ, we refer you to the forward-looking statements discussion in our most recent press release and the risk factors and other disclosures in our periodic reports that we file with the SEC.

On the call today, we have Jim Geiger, Chairman, President and CEO; and myself, Bob Fugate, Executive Vice President and CFO. In addition, I'm pleased to announce a new executive who will be helping us on the investor front going forward, Rob Clancy, who many of you already know.

With that said, I'll turn it over to Jim Geiger.

James F. Geiger

Thank you, Bob, and thanks for joining us on the call today. Today, we're discussing the financial and operating results for the first quarter of 2013. On our call last quarter, I spent some time putting our 2012 accomplishments in perspective as we continue to push aggressively through our transformation into a company that provides a full suite of IT infrastructure and services at the intersection of cloud, network and security. I'd like to start today by touching on a couple of financial notes that Bob will go into in more detail later.

First, I'm happy to say we are reiterating our guidance for the year and are on track versus our plan. However, I think it's important to clarify some of the numbers in our Q1 results. You'll notice that our ARPU increased this quarter. While we are pleased that our ARPU went up, it was driven by an increase in prices via a fee that allows us to recover the cost of complying with our industry's regulations. We began charging these fees in 2011 and have been gradually increasing the fees over time. We believe this new increase brought our federal cost recovery practices in line with our competitors'. As a result of the regulatory fee, we achieved an increase in ARPU in Q1. But real inflection in ARPU that we've been anticipating is still due to occur probably later this year when the higher ARPU arising from our 2.0 customers outweighs the sales of legacy products in our traditional business. When this ARPU inflection occurs, we will highlight the event.

Revenue was up 0.9% over Q4 due to the increased regulatory recovery fee. The more exciting fact is that we are building momentum in our 2.0 business, and that's where I want to focus us today.

Simply, we believe that our 2.0 platform, which is fully available in all 14 of our markets, is unmatched by our competitors. We have enterprise-class cloud products. Our TotalCloud Data Center is built on Cisco routers and servers, EMC storage and uses F5 server load balancing. Our TotalCloud Phone System is built on Cisco routers and servers, coupled with software from Broadsoft. We believe we have one of the largest Metro Ethernet footprints in our 14 markets outside of the ILEC as our total network offering provides 10 megs or more of symmetric bandwidth to over 190,000 buildings.

Finally, we have a new professional servicing -- services offering called TotalAssist that allows us to migrate our customers seamlessly to our TotalCloud family of services as well as address the lion's share of our ongoing technology needs.

Why we focused on dramatically expanding our product offering? We believe that the convergence to cloud, network and security is the next enterprise wave making its way downstream to the small and midsized business markets. We are solidly positioned to benefit from this trend over the next several years. In fact, we are the only provider with an integrated offering that can deliver this convergence to small and midsized businesses, combined with cloud enablement services that they need to take advantage of the cloud. These services are anything but commoditized. We believe that this market position will result in significant differentiation.

In support of our strategy, we have invested heavily in our new products, platforms and processes to realize our 2.0 strategy. The current state of our new capabilities are where we expected them to be at this point in our transformation. Let's review some of the highlights and then discuss the remaining area of improvement.

The revenue coming from our Cbeyond 2.0 customers was 11.4% of our total revenue in Q1, up from 9.5% in Q4, a 20% increase in the last quarter alone. The percentage of our customers who are 2.0 climbed from 4.5% in Q4 to 5.7% in Q1, a 27% increase. Based on these increases, I'd like to elaborate on our ARPU trends. Since we are getting 11.4% of our revenue from just 5.7% of our customers who are 2.0, we are clearly securing a higher ARPU from this segment.

In fact, the ARPU of our average 2.0 customer in the last quarter was more than 70% higher than our average 1.0 customer. The gap between 2.0 and 1.0 ARPU has widened each quarter since we introduced 2.0 services, and we expect this general trend to continue. The ARPU trends demonstrate that 2.0 customer is becoming increasingly valuable to us, and they are growing as a percentage of our total. In March, 2.0 revenues sold in the month represented well over 30% of total revenues sold.

The news is also good as we look at our fiber-lit buildings. Today, we have over 250 buildings lit, allowing us to reach 900 current customers and an estimated 1,600 prospective customers. Of the 900 current customers, we have already converted over 600 of them to our fiber, and that effort continues.

As I mentioned earlier, we do have an area of improvement. Rep productivity is below expectations. From a pure numbers perspective, rep productivity across all channels was down slightly in Q1 as compared to Q4. There are a variety of factors at work here. First, our core philosophy for 11 years was to drive market share growth. Consequently, moving from a transaction-focused sale for communications services to a relationship-based interaction for cloud services is a cultural change, and that mindset shift has taken longer than we have expected. To support the change, we had moved all previous incentives, reporting and prospecting metrics to revenue from units.

Second, a very substantial percentage of the prospects we talk to about 2.0 services don't fully understand the comprehensive benefits of the cloud. Those advantages range from ROI to business continuity, to security or resource flexibility. While compelling, selling the cloud to our target audience requires education. The education and ROI discussion leads to a longer sales cycle for 2.0 customers. However, we expect these customers to come onboard with higher ARPUs and lower churn than our traditional customers, and educating our sales channels regarding the breadth of our current product capability and creating the ability for these individuals to effectively construct solutions for prospects and customers have taken time. Finally, the 2.0 installation process is also longer and more complex. In many cases, we are transitioning several products simultaneously, including their servers, PBXs, broadband and digital voice services at the same time. When we put all those factors together, it's easy to understand why overall productivity has been slower to develop.

To address these issues, we've been taking aggressive steps since January to focus on the most important task we have in the near term, and that is increasing the productivity of our sales force. An important piece of our plan to drive increasing productivity is management. We have a strong group at Cbeyond that lead our efforts in the field and strengthened by some additions in the sales and marketing area with extensive cloud experience.

As an example, Bob Morrice has returned as interim head of our sales organization during this period of transition. Bob is one of the original architects of our sales model. I look forward to him reengaging his insights and leadership skills in this critical area of Cbeyond.

Moreover, we asked Cbeyond's top 100 performers from across multiple disciplines to spend the first quarter relentlessly focusing on 5 areas we are confident will have a significant impact on productivity. The first of these is the development of a new version of what we have always called the Cbeyond compass or, as many of you have heard us refer to in the past, a day in the life of a Cbeyond salesperson.

The other task focused on increasing rep productivity that we completed or made substantial progress on during the quarter were: designing and implementing a new compensation system, designing and implementing a system to create knowledge transfer within our sales organization so that the best practices get disseminated quickly, overhauling our ordering systems to make them easier to use, reduce paperwork and speed sales effectiveness and creating a targeted marketing organization to drive sales leads into the field by leveraging new technology tools.

I'm happy to say that we've come a long way in all of these focus areas. I'm confident we are going to see rep productivity ticking up as all of these initiatives take hold and the decision cycles of our prospects come due.

So to summarize, we remain on track toward this year's financial goals as well as toward our broader strategic transformation, we have a lead in offering converged network cloud and security to the SMB space, our growing 2.0 revenue and ARPU gives strong evidence of our progress and we have a host of activities under way to bring sales productivity to levels we expect.

And at this time, I'll turn the call over to Bob to provide more detail on the quarter. Bob?

J. Robert Fugate

Thanks, Jim. First of all, I'm pleased to note that Cbeyond's financial results for the first quarter of 2013 were on target versus our plan in all major areas, including revenue, ARPU, gross margin, adjusted EBITDA and free cash flow. Today, I'll provide some commentary on trends in these principal financial measures for the first quarter and also provide some updates regarding 2013 guidance.

I'll begin by providing some commentary on Q1 revenue and ARPU. We posted quarterly revenue of approximately $119.9 million in Q1, a 3.1% decrease year-over-year and a 0.9% increase from Q4, consistent with our expectations and reflecting the ongoing transformation in the business.

ARPU in Q1 was $656, an increase of $18 from Q4 levels. As Jim noted, although this increase to ARPU represents a positive event for our business, it is not the inflection point that we've been anticipating, since this increase is primarily driven by an increase to the regulatory cost recovery fees we charge our customers. This increase amounted to approximately $3.5 million over Q4 revenue or a 3% increase. We believe this puts us generally in line with what competitors charge their customers. Absent the impact of cost recovery fees, we still expect the 2.0-driven inflection in ARPU to happen in the second half of the year.

And that takes me to a discussion of our revenue categories as well as 2.0 revenue. During the quarter, our Network, Voice and Data revenue declined 4% year-over-year, as anticipated, and was due to the fact that we have a much smaller sales force addressing our traditional customer prospects than in prior years. However, our Managed Hosting and Cloud revenue increased 14.6% year-over-year.

I'm pleased to report progress on our 2.0 business that we believe confirms we are on track to deliver results in line with our strategy. We added over 600 2.0 customers during the quarter, a steady increase over prior quarters, and our 2.0 ARPU in Q1 was over 60% higher than the ARPU of our total base and over 70% higher than our 1.0 customers. Total 2.0 revenue in the quarter was $13.7 million or 11.4% of total revenue. Our 2.0 revenue in Q1 showed a 99.8% increase over 2.0 revenue in Q1 of 2012.

In addition, 2.0 revenue is up 190 basis points from last quarter. We saw progression each month through the quarter with 2.0 revenue representing 12% of March's monthly revenue. At this point, we project that our 2.0 revenue will be in the range of 20% of total revenue by the end of this year.

Now I'd like to make a few comments about customer churn. Our monthly customer churn for Q1 was 1.6%, which is consistent with recent quarters and in line with our comments from last quarter's call. One item to consider when looking at our churn is that the majority of our customers who have been churning over the past few quarters are lower-ARPU customers. So the customers we've been losing are lower-margin, declining-revenue customers that were not ideal candidates for an up-sell to our 2.0 services. Also, although our experience is recent, we believe that 2.0 customer churn will be lower than that of traditional customers. In addition, I'll note that our Q1 churn rate was unchanged despite the price increase that occurred early in the quarter.

As we've mentioned on prior calls, over the last year we have shifted our focus from a customer unit orientation to revenue and revenue quality. This shift meant that we would be posting fewer customer additions while targeting higher spending accounts. In addition, changes to the composition of our sales team contributed to several quarters of revenue decline, while our new sales channels became fully staffed and productive. So the revenue transition is happening according to our plan, and we look forward to reaccelerating year-over-year growth by the end of the year.

Next, I'll cover our gross margin and adjusted EBITDA. Gross margin in the quarter increased by 70 basis points quarter-over-quarter primarily due to the regulatory price increases we implemented in Q1. Selling, general and administrative expenses, including -- excluding noncash, share-based compensation expense were approximately $300,000 lower in Q1 than Q4.

Our adjusted EBITDA for the quarter was $20.8 million, an increase of approximately $2 million from the fourth quarter, and a decrease of approximately $2 million from the first quarter of 2012. Our adjusted EBITDA margin was 17.4%, which compares to 15.8% last quarter and 18.6% a year ago.

Moving to CapEx. Total capital expenditures in the first quarter were $15.4 million, of which $12.5 million were cash capital expenditures.

Our cash CapEx during the quarter declined roughly $2 million from last quarter's level. Noncash CapEx during Q1 was $3 million, which consisted entirely of capital lease obligations related to our fiber assets.

Next, I'll discuss our cash position and borrowings. Turning to our cash position, our cash balance at March 31 was approximately $23.8 million, a decrease from $30.6 million last quarter. The decrease in cash was primarily due to the payment of 2012 annual incentives that were previously accrued.

We currently have $2 million outstanding on our term loan, which is our loan we are currently using to pay one of our fiber partners. This is unchanged from last quarter. We expect to begin payments on this loan over a 3.5-year period beginning in late 2014. We have no borrowings outstanding under our $75 million revolving credit facility. We also have $9 million in outstanding capital lease obligations.

Next, I'd like to discuss free cash flow. Free cash flow, defined as adjusted EBITDA less our cash capital expenditures, was $8.4 million in Q1, which compares with $4.3 million last quarter. The sequential increase of $4 million was the result of growth in adjusted EBITDA by $2 million and $2 million less spent on CapEx.

To summarize, we believe that the company continues to maintain a healthy cash position with a strong balance sheet that gives us a solid platform from which to pursue our strategic evolution.

Lastly, I'd like to comment on our guidance. Based on our current assumptions for churn, sales rep productivity, the current macro environment and other key drivers of our business, and barring any material changes to these key drivers, we reiterate the following guidance for 2013. We expect revenue to be $475 million to $485 million; adjusted EBITDA is expected to be between $75 million and $82 million; cash CapEx is expected to be $60 million to $65 million, which includes $5 million to $8 million related to our dark fiber project; and free cash flow is expected to be $15 million to $20 million.

I would also like to add some comments regarding quarterly trends in some of these categories. At this point in time, based on our current assumptions for 2.0 revenue trends, churn, pricing dynamics relative to our traditional communications offerings, including mobile, and the increase in regulatory cost recovery fees, we expect the next 2 quarters of revenue to be near the Q1 level, and we expect to return to revenue growth by the fourth quarter of this year. We expect that ARPU will continue to strengthen primarily due to the increasing percentage of higher 2.0 ARPU customers. Regarding quarterly trends and adjusted EBITDA, I would expect slight declines from Q1 levels throughout this year as we make investments to continue our transformation.

Capital expenditures in Q1 were a bit lower than planned due to timing, but we expect to catch up in subsequent quarters as we invest in growing our capabilities and presence and the kinds of products our technology-dependent customers require.

Because some of our planned first quarter capital expenditures were deferred to subsequent quarters, we expect that free cash flow will decline from first quarter levels but continue positive throughout the year in line with our guidance.

In summary, at this point, we remain confident of our path toward our strategic and financial goals for the year.

And with that, I'd like to turn the call back to Jim for his closing thoughts.

James F. Geiger

Thank you, Bob. We continue to make significant promise -- progress transforming our business to become the technology ally for technology-dependent SMBs. Our broad financial metrics are on target versus our guidance this year. And importantly, our 2.0-related metrics show positive evidence of a growing business opportunity. We are focused on improving critical areas of the business, namely sales productivity, and are confident of our future growth. I want to thank you for your investment in Cbeyond. And at this time, we're ready to take questions. Operator, back to you.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from the line of Barry McCarver from Stephens Incorporated.

Barry McCarver - Stephens Inc., Research Division

.

I guess a couple of questions. First off, Bob, on the guidance when you referred to the revenue remaining flat for next couple of quarters but adjusted EBITDA coming down a little bit. Help me understand what the -- what are the drivers behind the declining EBITDA for the rest of the year.

J. Robert Fugate

Sure. The EBITDA expectations include on our part a -- just a continuing investment in the 2.0 capabilities that we're rolling out. We've mentioned our TotalAssist professional services. That's something we're investing in. That's an example. Also product capabilities. We're doing a lot across-the-board. We also expect that the productivity will pick up, and we'll likely be paying more commissions on sales in the future.

Barry McCarver - Stephens Inc., Research Division

And would those commissions be paid in front of any revenue ramp, I guess, is what you're indicating?

James F. Geiger

Correct. Yes.

Barry McCarver - Stephens Inc., Research Division

Okay. My second question really goes to the product offering and some of the new offering bundles you've talked about. I think you mentioned then on the 4Q call a new CloudAdvantage [ph] offering. I'm wondering if you could give us any color, Jim, on how the sales force took that? And any headway you made in rolling those types of bundles out?

James F. Geiger

Thanks, Barry. They've been out for about 60 days, so it's still early. The -- I think the take rate last month was somewhere in the high single digits out of all sales made, and they're pretty significant ARPU. So it's getting our people to have the right conversation about cloud and bundled cloud with the right kind of prospects. So we think of it as an early success and one that we can continue to build on.

Barry McCarver - Stephens Inc., Research Division

Okay. And then, if I look at -- last question and I'll let somebody else get on. On 2.0 revenue, if I -- it looks like it grew sequentially about 21%, I guess within your guidance for total revenue. Do you continue to expect it's going to tick along this year? Or do you get to that percentage of total revenue really because of a nice pop in 4Q? Think of -- well, help me understand how that's going to roll out in 2Q and 3Q.

J. Robert Fugate

Yes. Well, I think that it's our range [ph] that it'll steadily roll out over the next couple of quarters. And then by the end of the year, we'll be close to 20% of total revenue in the 2.0 category. Obviously, that assumes that we're going to see some pickup in productivity, and I think that's something that we expect at this point, and that would be an assumption in there.

James F. Geiger

I would remind you that the total new sales last month that were 2.0 were approaching 40% of total sales.

Operator

Our next question comes from the line of Barry Sine from Drexel Hamilton.

Barry M. Sine - Drexel Hamilton, LLC, Research Division

I wanted to zero in on something you said in your remarks, which is the longer install time for 2.0 customers, and I understand the reasons why you explain that. Could you give us a sense of what is that install time? How long from order to install? And then I guess that also implies that you end the quarter with somewhat of a backlog of sold but uninstalled customers. Could you give us any visibility on what that backlog looks like?

James F. Geiger

No to the latter. But let me help you to understand the -- you're right about that, that we are a collecting a backlog, of course. We had spent a lot of time being -- becoming extremely efficient at installing T-1-based communications bundles, and our goal was to have fewer than the 30 days, calendar days, installation, and we'll almost all the time achieve that. Very exceptional not to achieve that. A 2.0 installation is taking us a multiple of that in the 2 to 3x range to have all of the components of the solution installed. So there are some things that we can bring up in days and -- if not hours. And if building -- it's a fiber-lit building, we can bring up a connection within literally hours if not 1 day or 2. But there are -- the coordination of this total solution is taking a multiple. So in the 60- to 90-day range on average.

Barry M. Sine - Drexel Hamilton, LLC, Research Division

Okay. And then the other thing I wanted to ask about is can you describe the competitive environment and how that has changed? And maybe we could break that down. On the one side, at the low end, the 1.0 customers, are cable companies more aggressive, less aggressive, the same? And then what are you seeing now that you're getting into the market a little bit more for a few quarters on the 2.0 product line?

James F. Geiger

I'd say there's no change in there, in the low end of the marketplace. I guess the big change is that we're not focused there as we used to be. Certainly, we are running into those types of sales. And I would say there's no change in the cable companies' effectiveness there. Other than -- it's probably consistent. We don't have a lot of competition for the new bundled services that we have and the new capabilities that we're focused on. I would tell you that inertia and maybe apathy are our biggest competitors there, that somebody who hasn't yet taken the time to understand or be educated in the cloud, we're taking the time to educate them about the benefits of doing so. More and more, we're finding customers -- we've always been focused in the 5- to 250-employee base business. As we get more in the hundred-employee range, we're finding that they have a technical person on staff, if you will, a CTO or a CIO-type person. That sale generally goes a little bit more quickly because we're able to talk in a way that they understand the opportunity for them, the flexibility, the security, the avoiding CapEx, the cycles of CapEx for servers and other appliances on their premise. But mostly in that category, we have sort of a coopetition amongst the local MSPs that are in each of these markets. More and more, those folks, we're using them as a channel now for our cloud-based products. So I would say that good news on the competitive profile in the 2.0 arena but still a longer sales cycle. And on the 1.0, nothing has changed.

Operator

Our next question comes from the line of Brett Feldman from Deutsche Bank.

Brett Feldman - Deutsche Bank AG, Research Division

You mentioned during your prepared remarks that you're sort of shifting the compensation model, so that it's more focused on revenue as opposed to just units. But you also mentioned that sales productivity isn't what it needs to be yet. So as we look at your results over the next few quarters, where are we looking other than just total revenue to measure the improvement in productivity? For example, to what extent would you expect that to be reflected in the improvement in your gross adds? And then to what extent is it merely an uplift in your ARPU because you're just selling more product into existing customers?

James F. Geiger

Yes, I think that the gross adds would not be the place necessarily to look. I think revenue and the ARPU would likely be where I would direct you, Brett. We're focused on the productivity and increasing it, and I think we'll have more to say about that in future quarters.

J. Robert Fugate

Obviously, we've been very transparent about productivity, and we'll continue to be so. We'll tell you as it starts to -- as we see it turning and improving, and we'll describe that to you as we have so far.

James F. Geiger

What I can tell you is this, that folks who are tenured and sell cloud sell at levels that we expect. Folks that are untenured and sell cloud sell at levels that exceed their untenured peers. So our focus is on participation of our sales organization in selling cloud and why -- Barry asked about the CloudAdvantage [ph], or on-ramp product. Why we're very focused on educating that and getting our channels comfortable with selling cloud is because it's both a competitive advantage, it's an area that our competitors aren't. And generally speaking, the ARPU of those customers and the productivity of our salespeople are significantly higher than the average.

Brett Feldman - Deutsche Bank AG, Research Division

Okay. But just so you know, for our model exercises, so we're sort of thinking about things the correct way. I mean, it sounds like you are expecting that the lower level of gross adds is probably what persists. You've had reasonably good stability in churn. And so, that kind of says the rate at which you have been losing customers probably doesn't change a whole lot, but you -- we may in fact see a meaningful improvement in the reported ARPU, and that's kind of how we get to the guidance that you've provided. Is that correct? Or is there some visibility that no, we don't expect to be losing this rate of customers by x quarters out?

James F. Geiger

I would say that our intentions on productivity would delay some of those customer losses so that there wouldn't be simply an ARPU uplift, there would also be more accounts sold.

Brett Feldman - Deutsche Bank AG, Research Division

So churn may be an area that you could get some improvement as opposed to gross adds? I know I'm sort of nitpicking but it does help us on our end.

James F. Geiger

Churn -- certainly, churn is relevant to our top line, as -- you know better than I do. You build more models than I do. But I would say that I think of churn differently than I do productivity, yes.

Brett Feldman - Deutsche Bank AG, Research Division

Okay. So just another question, a different topic, just so I don't harp on that for too long. You've done a great job articulating all of the steps you've had to take throughout the implementation and the developing the 2.0 strategy. Can you just kind of give us a final update? Like what are the last remaining key milestones in terms of putting in place what you need in order to fully be a 2.0 operator? Or have we actually achieved all of them and it's purely an execution game at this point in time?

James F. Geiger

I would say the latter, Brett. They -- we have -- certainly, our products continue to evolve and develop. But broadly speaking, we have the products that we believe we need. And now, it's really just getting the productivity of our sales organization up to our expectation. Now it -- there's a ton of green shoots. We don't want to get out in front of ourselves, but we have some model markets where the channels are working to expectation, and we're trying to make sure that we can get more uniform performance across all of our markets. And that's really, as I view it, the singular challenge that we have today.

Operator

Our next question comes from the line of Frank Louthan from Raymond James.

Frank G. Louthan - Raymond James & Associates, Inc., Research Division

Can you talk a little bit more about the sales force and hiring trends? Are you able to find the folks that have the skill set? And how is that going to look as you continue to transition? And then in the future, will you be able to subdivide a little bit your customer base? And clearly, there's a base of your sort of 1.0 customers that probably are going to stick around for a pretty long time, and there's others that are you're either going to transition over or are possibly targets for churn. And then increasing you're building up the case -- the base of the newer customers, which would probably be better to focus for growth. I mean, is that something you can break out? And then at what point do you think you can offer that sort of information?

James F. Geiger

Let me take rep hiring first. As you might suspect after a year of doing this, a year of change, we're coming to different opinions about the kinds of people we need and the activities that they need to engage in. And so, we have a full complement of people. And now we're thinking about things like the mix, Frank. You've talked about the different levels of account management and we call the SAEs. And then we have a direct sales organization. We're working on now, I would say, some finer points of what level of resource do we invest in on the SAEs versus the direct -- the same with the direct in total versus indirect resources and trying to continue to feed some of our winners that we're seeing. So I would tell you that we have a much better idea of the type of talent and the type of talent within channel that we need than we did 6 months ago. And we're starting to see a little traction there. So we're finding that people do want to come work here. We have very capable people that have a lot of experience that do want to come here because they believe in the vision of what we're espousing, this intersection of cloud, network and security. They come from cloud companies that don't have network capability, they come from network companies that don't have cloud capability and they liked the idea of being able to sell both. So that's a positive. As to the segmentation of the base, we've done that already. We have a pretty good understanding of who has the type of markers that would make them a 2.0 prospect versus a 1.0 or tech dependent, if you will. And we have been doing a lot of selling into that base. And some of our most successful representatives are people who are focused on existing customers. When we sell to existing customers, of course we only recognize the uplift in revenue, in our productivity. But we are, of course, also signing them -- those customers up to a new contract, a multiyear contract, in most cases. So we -- I'm not sure on this phone call, Frank, that I could help you with discrete numbers about cutting up that base between 1.0 and 2.0. We've talked about in the past that the 2.0 prospective customers, the tech dependent, are somewhere in the 46% or 47% of our existing base. I haven't learned anything to suggest that, that's different. The customers that we are targeting are -- we have a good track record of changing them, converting them, up-selling them with our cloud products and network products. And 1.0, I think you're right. Things generally attrit at rates that don't quite equal what the worst-case scenario is. There's a lot of people that are just apathetic and will stay in a relationship as long as it works and, generally speaking, our service has worked well and we have good customer grades. So I would tell you that in that regard, the -- we -- the expectations that we had going into this are proving to be true.

Frank G. Louthan - Raymond James & Associates, Inc., Research Division

Yes, so apathy can work for you just as the Aurebach [ph].

James F. Geiger

Yes.

Frank G. Louthan - Raymond James & Associates, Inc., Research Division

That's helpful. And Rob, I don't know if you're on the call but congratulations and I look forward to working with you.

Robert Morrice

Thank you, Frank.

Operator

Our next question comes from the line of George Sutton from Craig-Hallum.

George F. Sutton - Craig-Hallum Capital Group LLC, Research Division

Jim, sorry to harp more on the sales productivity side. But you had mentioned a number of things that you're trying to do to really focus the efforts there, the new compensation system and knowledge transfer and ordering system, et cetera. Can you help us understand on a relative -- relevant basis what's the most important aspect that you're putting into place that you think will have the impact?

James F. Geiger

I think knowledge transfer. Really the biggest challenge we have is some -- the people that we're hiring that have experience generally come at the industry from one perspective. They've come from a network company or they've come from a data services company or web hosting company, or they've come from a managed services provider. And so they have an orientation. Our goal is to round out that orientation and teach them how to sell all of our products into a sort of a managed base of customers. So I would tell you that getting people comfortable -- knowledgeable and comfortable with the benefits of selling our solutions into these tech-dependent small businesses is greatest challenge we have. And as I said earlier, it -- we have model markets and it's working well across multiple channels, and we're just trying to understand how do we get that uniform across all 14 of our markets. So I would have to say if you put a gun to my head just getting people getting comfortable and confident in how to find the solutions that solve the pain points of these tech-dependent customers.

George F. Sutton - Craig-Hallum Capital Group LLC, Research Division

Got you. And just to make sure my hearing and memory are good, relevant to the 2.0 revenues, was the expectation a quarter ago to end this year at 25% and now it is 20%? Did I hear that correctly?

James F. Geiger

It was always 20%.

George F. Sutton - Craig-Hallum Capital Group LLC, Research Division

It was always 20%? Okay? So it's just my memory that's bad.

J. Robert Fugate

[Indiscernible]...

James F. Geiger

No, it was -- okay, sorry.

J. Robert Fugate

Originally, we did speak about a 25% number, you're right, George. But I would say that, that was a milestone or a gold that we had set really a couple of years in advance of getting into it. And as we moved along, it -- we're going at a pace that's aims us probably at a lower number as by the end of this year. But we're still growing and expect the business to be very much larger and more valuable over time. So I don't think that's significant, but it is true that it was 25% was an original number we spoke to.

James F. Geiger

Yes.

George F. Sutton - Craig-Hallum Capital Group LLC, Research Division

Okay. And Jim, you mentioned some green shoots that you're seeing. And in the past, you provided some metrics related to bids greater than $5,000, for example. Is there a -- are there some green shoot examples that you can provide that might give us some clarity as to what you're seeing that may not be obvious to us from the surface?

James F. Geiger

And the clarifier is would I be comfortable giving, I guess, we've had a number of large, complex customer wins. A fitness center that has -- uses our TotalCloud Data Center that -- across the country with an MPLS network that connects all of their locations. And there are fairly significant number of those locations, and a customer like that would bill in the $50,000 a month range, which is a significantly different customer for us. I could tell you that there is a pretty significant, as I mentioned earlier, uplift when our representatives sell cloud services as a part of their solutions. They have, we believe, therefore, have a competitive advantage and are generally well more productive than the average and certainly multiples more productive than the representative that doesn't sell cloud. So all of our direction is in that regard. And the combination of network, cloud and security, we're as strong on that thesis as we have been. The size of our funnel continues to grow. We didn't give that because I'm not sure that we have the tools, George, that can track the losses adequately enough to give you accurate information, I mean, when we -- when a decision has been made and we didn't win it. But all of those funnels that we had quoted before are all continuing to grow. So we have a significant amount of opportunity that we've uncovered and yet to put under contract and install.

Operator

Our next question comes from the line of Donna Jaegers from D.A. Davidson.

Donna Jaegers - D.A. Davidson & Co., Research Division

One sort of operational question. Jim, on -- as far as the 2.0 sales, can you give some sort of color as far as what's the percentage of up-sell to existing customers versus new logos?

James F. Geiger

Yes, just give me just a second.

J. Robert Fugate

I can jump in on that. That trend is that there over time, we're moving toward more of our new sales going to new customers. But for the most part, we've got about 2/3 of our 2.0 accounts are existing accounts that we've upgraded to 2.0. And increasingly, we're starting to sell more new accounts, 2.0 services.

Donna Jaegers - D.A. Davidson & Co., Research Division

Okay, great. And then, Bob, just a few numbers questions. In the K, you guys mentioned you had settled a patent with IP PBX. Was there an amount in SG&A that we can -- that you can break out?

James F. Geiger

It was not a material number. That's the best thing I can tell you on that.

Donna Jaegers - D.A. Davidson & Co., Research Division

Okay. And then it was also mentioned in the press release on some regulatory settlements. Was that material?

James F. Geiger

No. No, there wasn't.

Donna Jaegers - D.A. Davidson & Co., Research Division

Okay. All right. And then the change in depreciation, I take it you just -- that some of the economic lives lapsed basically on that. Or is there anything else going on?

J. Robert Fugate

Well, a year ago, we had some higher depreciation because of some -- when we made some changes in the business, we took some accelerated depreciation on some items, and that was really not the case in current quarter.

Donna Jaegers - D.A. Davidson & Co., Research Division

Okay. So this is a pretty good run rate level then to build off of?

J. Robert Fugate

Yes.

Operator

Our next question comes from the line of Jennifer Fritzsche from Wells Fargo.

Jennifer M. Fritzsche - Wells Fargo Securities, LLC, Research Division

I just had a quick question on the building demographics, and I'm sorry if you had told me this before. There is about 250 buildings you said you had dark fiber lit to. Can you just talk about how many other fiber players beyond the incumbents are in those buildings?

James F. Geiger

Yes, we -- that's tricky information to get a correct bead on. But generally speaking, Jennifer, our buildings are not inside the downtown metropolitan area. They're generally speaking out more in office parks, where you would find fewer competitors like a Coach [ph] and/or a TWTC. I would say the incumbent in many cases also doesn't have fiber in those buildings. But increasingly, I would say that the players that you will find in those areas would be the incumbent and possibly the cable company.

Jennifer M. Fritzsche - Wells Fargo Securities, LLC, Research Division

Got it, Jim. And then just a follow-up to that. Is there a way to talk about how many of your existing Cbeyond 1.0 customers are in these buildings where, to Donna's point earlier, there is an up-sell opportunity?

James F. Geiger

Yes, we have approximately 3 customers per building already in the target buildings that we -- that we're lighting. And that's -- so 3 existing, and I think the potential was another...

J. Robert Fugate

Several more per building potential who are technology dependent, and then additional customers that might be more like 1.0 accounts who are sometimes present in that -- those buildings as well. So it could be as many as 10 per building, including the 3 that we have.

Operator

Our final question comes from the line of Tunam Odukar [ph] from Jefferies.

Unknown Analyst

A couple of questions actually. One is on the difference between the commission dollars between what you pay for a cloud revenue or an IT 2.0 revenue, versus a 1.0. And the second one is when you pay the sales force in advance on the 2.0 revenue, is that for the existing year or the existing fiscal year? Or is that an NPV of the entire term of the contract?

James F. Geiger

Yes, it might be disappointingly simple. We pay now a dollar of revenue on a dollar of revenue. And we pay a portion of that up front, which I think is equal to about 50% of the monthly recurring. And then there's a net -- I'm sorry, 50% of the monthly recurring. And there -- and the -- in round numbers, the total compensation or commission on that would be 100% of the monthly recurring charge, onetime. And there are certainly some kickers that we throw in there that may make it marginally higher than 100% of that 1x monthly recurring revenue. But basically, the same for every dollar of revenue that we sell. And we do try and create incentives for promotions for cloud versus 1.0 revenues and et cetera. But it's fairly simple.

Unknown Analyst

So about 12% to 15% depending on the promotion at that point in time?

J. Robert Fugate

12% to 15%, is that what you said?

Unknown Analyst

Of the unbilled revenues. You said 100% of the monthly revenues, onetime, monthly revenue.

James F. Geiger

Yes. Yes, that would be correct, except that generally speaking, we have 3-year contracts. So that would be a fraction of the 3-year contract.

Unknown Analyst

Okay. Okay, got it.

James F. Geiger

Yes. Yes. And thank you all. And I want to thank our investors for their continued support in our company. And we look forward to providing you with an update on our second quarter later in the year. And thank you for joining the call, and have a great night.

Operator

Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.

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